HM 416 Chapter 4

© 2018 American Health Information Management Association© 2018 American Health Information Management Association
Principles of Finance for
Health Information and
Informatics Professionals
Second Edition
Chapter 4
Budgets

© 2018 American Health Information Management Association
Learning Objectives
• Develop and implement budgets appropriate to the
organization and situation
• Explain the source of the revenue budget
• Calculate factors that influence the expense budget
• Specify the difference between expenses and costs
• Explain the allocation of overhead costs to revenue
producing areas
• Explain the relationship between the operating budget
and the cash budget
• Analyze budget variances
2

Types of Budgets
• Statistical budget
– Defines the expected revenues and expenses
for the coming year
– Framework for developing operating budgets
and capital budget
• Capital budget
– Defines the long-term financial plan for
purchasing fixed assets, such as diagnostic
equipment or new hospital beds
• Operating budget
– Plan for the coming fiscal year that describes
the estimated results of activities in a particular
department or program
3

Types of Budgets
• Traditional budget
– Target percent increases/decreases
• Flexible budget
– Flexes based on the volume of services
• Zero-based budget
– Service or department must at least break-even
during every budget cycle
4

Budget Tools
• Financial accounting system tracks revenue and
expenses during the budget period
• Historical figures offer a guideline for expectations
– If exec team did not project significant operational changes
• Statistical budget must be translated to operational
targets in departments
• May require significant data collection
– Historical results
– Changes in market
– Projected new technology purchases
5

Traditional Budget
• Department head given a percent increase/decrease for
revenues and expenses based on previous year results
• Values are “fixed” at the beginning of the year
– Budget revisions are possible, but require significant justification
• Typically a top-down approach
– Targets are pushed down to the department heads
– Department heads manage the monthly budget to drive to targets
– Does not allow flexibility due to volume fluctuations
• May be developed bottom-up
– Departments drive the overall organizational budget
6

Flexible Budget
• Varies based on volume
• Appropriate if revenue and expenses are tied directly
to the volume of services
• Example – Laboratory
– Volume of tests primary driver of revenue and expense
– Flexible budget appropriate
• Example – HIM department
– No direct revenue (indirectly driven through coding/billing)
– Expenses primarily personnel and IT – not volume driven
7

Zero-based Budget
• Each project or department evaluated during
the budget period
• Each expense must be justified based on
revenue produced
• Budget basically starts a zero and is built up
based on justifications
• In large healthcare operations, used
primarily for special projects
8

Operating Revenue Budget
Volume drivers
• Market share
• Capacity
Price or revenue per unit
drivers
• Payer mix
• Pricing
• Case mix index
(inpatient)
• Unreimbursed services
(self-pay, denials, etc.)
9
Gross revenue = Volume × Price

Operating Budget
• Defines routine
revenue and expenses
for a coming period
• Communicates
financial expectations
– Executives
– Management
– Staff
10
Example: Physician
Practice

Gross versus Net Revenue
• Gross revenue
– Charges as billed
– [Volume] × [Charge or Price]
• Net revenue
– Payment received for services
– [Volume] × [Reimbursement]
• Contractual Allowance
= Gross Revenue – Net Revenue
11

Net Revenue Drivers
• Volume
• Service mix
– Relative value units (RVU) – physician
services
– Case mix index (CMI) – inpatient
hospital services
• Payer mix
– Payers have varying contract terms that
yield different contractual allowances
12

Service Mix
13
Substitute CMI for RVU for inpatient hospital setting

Operating Expense Budget
• Matching principle
– Expenses must be recorded in the
period they are used to create revenue
• Expense examples
– Salaries
– Utilities
– Supplies
– Depreciation
14

Cost Characteristics
• Traceability
– Directly or indirectly related to product
– Direct example: surgical supplies
– Indirect example: housekeeping
• Variability
– Fixed cost: does not depend on volume
– Variable cost: volume driven
• Controllability
– Level of control: departmental vs. facility
– Is cost controlled by department head?
15

Cost vs Expense Example
16

Cost of Producing Revenue
Expense
• Financial accounting term –
found on income statement
• Quantifies the level of
resources required to
support revenue generated
during the period
• Expense on the income
statement is difficult to
allocate to a particular
product or service
Cost
• Managerial accounting
term
• Tracks the specific
resources required to
produce a product
• Assigns or allocates
expenses to particular
departments
17

Direct vs Indirect Costs
Direct costs
• Personnel
• Contrast media
• Technical staff
• Professional staff
Indirect costs
• Housekeeping
• Electricity
• IT
• Admissions
18
Example – Radiology Department

Allocation of Indirect Costs
• Overhead or indirect costs must be allocated to
departments to reflect true cost of producing the
product
• Allocation or assignment of overhead must be:
– Consistent across periods
– A reflection of the amount of the effort or value from the
overhead that is used by the department
• Examples:
– Housekeeping: allocated by square footage
– Admissions: allocated by number of patients served
19

Allocation Methods
• Direct Method
– Costs for non-patient care departments are distributed
across patient care departments
• Step-Down Method
– Departments are ordered from least to most dependent
on overhead
– Used for Medicare cost report
20

Direct Method
• Cost for non-patient care
departments are distributed across
patient care departments
• Least accurate, but most common
and easiest
• Does not account for non-patient care
areas using overhead services
– Admitting uses housekeeping services
21

Direct Method Example
22
500,35$
%15%20%10%10%10
%10



Method does not allow the allocation of housekeeping to administration

Step-Down Method
• Allocation basis generated for each department
• Departments ordered from least to most dependent on
overhead departments
– Considering both number of departments and level of
dependency
– Must be consistent year-to-year
• Used for Medicare Cost Report purposes
• Allocation occurs from left to right
– No allocating “up”
• Order matters in step-down allocation!
23

Step-Down Method Example
24
500,35$%10 
Method still does not allow the allocation of housekeeping to administration
)550,3$900,20($
%15%25%10%10%10%10
%10




Comparison of Direct vs. Step-Down
25

Broad Cost Categories
• Labor Cost
• Non-Labor Cost
26

Labor Costs
• Labor is largest single expense for a healthcare
facility
• Most labor costs are fixed
• Variable labor costs include:
– Temporary employees
– Contract labor
• Compared using Full Time Equivalents (FTEs) and
not a head count
• FTE-computed based expectation of hours worked
27

Determining FTE Requirements
• Key drivers
– Volume of work (tests per hour, charts coded per day,
and the like)
– Service standards (24-hour coverage)
– Technical skills
– Productivity standards
• Labor supply issues
– Environment – Is travel required?
– Labor pool
– Labor mix – full/part/contract
28

FTE Calculations
• Typically based on 2080 worked hours per year
40 hours/week × 52 weeks/year
• Example: 24-hour ED requires two triage
nurses on duty at all times. How many FTEs
are required to meet that need?
24 hours/day × 2 nurses = 48 worked hours per day
ED is open 365 days per year
Require: 48 × 365 = 17,520 worked hours
FTEs Required= 17,520/2,080 = 6
29

Operating Expense Calculation
Generalized calculation:
Operating Expense = Volume × Variable Expenses + Fixed Expenses
• Volume – number of procedures, patients, etc.
• Variable Expenses – expense per unit of volume
• Fixed Expenses – expenses that are the same regardless of volume
30

Management Reporting: Budget
Variance
• Budget variances reported and analyzed if
they meet thresholds
• Favorable variances
– Revenue higher than budget
– Expense lower than budget
• Unfavorable variances
– Revenue lower than budget
– Expense higher than budget
31

Budget Variance Example
32

Budget Variances
Permanent
• Not expected to resolve
before year end
• Not due to timing
• Changes in vendors >
changes expense level
• Employee turnover – not
replaced until later month
• Special events (natural
disaster, unsuccessful
payer negotiations)
Temporary
– Expected to resolve
before year end
– Due to timing
– Month-to-month
volume fluctuations to
not match projections
– Special events
(system conversion,
payment delays)
33

Identifying Significant Budget
Variances
• Objective criteria
– Sensitive enough so that significant variances are
identified quickly
– Specific enough that “false alarms” are not sounded over
expected fluctuations
• Example thresholds
– Variances greater than $10,000 (positive or negative)
– Variances greater than 10%
– Variances greater than $5,000 for two consecutive
periods
34

Indentifying Source of Budget
Variance
• Determining root cause of budget variance
requires methodical investigation
• Once root cause is determined a strategy for
correction must be developed and implemented
• Cost and revenue variances may be investigated
using the same strategy
• Three most common variance causes:
– Volume
– Unit price (cost or revenue depending on context)
– Intensity
35

Volume
• Metric depends on the context
• Should represent quantity of items produced
or purchased to drive the budget line
• Examples
– Laboratory tests
– Discharges
– Clinic visits
– Surgical trays
36

Unit Price
• Cost variance analysis: Cost to produce a unit
• Revenue variance analysis: Revenue per unit
• “Unit” must be defined the same as volume metric
• Examples:
– Cost
• Cost per dose for a drug
• Cost to assemble a surgical tray
• Labor cost per hour
– Revenue
• Payment per case from a third party payer
• Fee schedule payment for per test
37

Intensity
• Required if the price per unit may vary by
“type” of unit
• Based on context
38
Context Intensity Measure
Hospital Inpatient Services Case Mix Index
Physician Clinic RBRVS
HIM Department Inpatient versus outpatient claims
Radiology Average APC weight of tests performed
Nurse Staffing RN to LPN ratio

Segment Variance Components
• Consider only volume and unit price variance (add intensity as a
component later)
• Budget amounts were based on a statistical budget that included
volume and unit price assumptions
• Goal: Determine which of these two budget assumptions are not
coming to fruition
39
Variance Component Actual Value Budget Value
Volume (V) VA VB
Unit Price (P) PA PB
Total (T) TA TB
Volume Variance Component (VVC) = (VA – VB) x PB
Price Variance Component (PVC) = (PA – PB) x VA
Total Variance (TV) = TA – TB = VVC + PVC

Investigating Budget Variances
• The basic steps to follow when investigating a
budget variance are:
– Determine if the budget variance is significant
– Identify the key drivers of the cost or payment
– Identify the data elements needed to measure volume,
unit price, and intensity
– Break the budget variance into volume and unit price
components
– If necessary, further break the unit price component into
input price and intensity
40

Summary
• Financial budgets can be developed in different ways,
depending on the needs of the organization
– Common budget types are traditional, flexible, and zero-
based
• The revenue budget inherently drives the rest of the
operating budget
– Revenue expectations are based on volume, pricing,
intensity of service, and payer mix
• Cost expresses the specific resources used to produce
a particular product or service
– Can include fixed, variable, and semi-variable
• Budget variances must be identified to determine if
they need further investigation
41

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