Identification and explanation of the main cost management problem using the cost management theory, a. Identification of (5) external or internal causes that originates the proposed main cost management problem, b. What should be Bay Area Health Networks mission in the context of the proposed main cost management problem and internal and external causes? c. Propose an adequate ABC analysis for Bay Area Health Networks situation to answer the questions presented in the case d. Define (5) cost management strategies oriented to solve the main cost management problem and how these strategies could be implemented in your proposed Bay Area Health Networks cost management ABC management system.

BAY AREA HEALTH NETWORK ABC ANALYSIS BAY AREA HEALTH NETWORK (the Network), which is a newly created subsidiary of Bay Area Health System (the System), consists of five medical group practices. When initially acquired, the practices were placed in a for-profit subsidiary, but concerns over both Stark Law provisions and the fact that the practices were barely profitable prompted the System to place them in the newly created not-for-profit subsidiary. The practices include both primary care and specialty physicians, with an emphasis on obstetrics/gynecology, surgery, pediatrics, and psychology. Although the physicians are administratively organized into five groups, they practice at only three different locations, each one staffed with a physician mix of primary care and specialists. In spite of the fact that its direct contribution to system profitability is negligible, the Network is considered an essential part of the System because it generates a large amount of indirect income from both inpatient refer- rals and outpatient ancillary services. In fact, it has been estimated that each dollar of revenue generated by the Network leads to eight dollars of inpatient and ancillary revenues. By limiting the amount of ancillary services provided at the Network locations, patients are forced (or at least encouraged) to utilize Bay Area Hospital (the Hospital), the founder of the System, for such services. Still, some ancillary services are best performed at the Network lo- cations for one or more of the following reasons: lower costs, increased physician efficiency, and improved patient convenience. For example, 74 Cases in Healthcare Finance one of the practice locations now has diagnostic imaging capability, When the scanner was moved from the Hospital to the Network, volume increased, costs decreased, and both physician and patient satisfaction improved The proposal now being considered by the Network is to provide ultrasound services at the Network locations. Preliminary analysis indi- cates that two approaches are most suitable. Alternative 1 involves the purchase of one ultrasound machine for each of the Network's three locations. Patients would schedule appointments, generally at the clinic that they are using, during preset times on particular days of the week. Then, the full-time ultrasound technician would travel from one loca- tion to another to administer the tests as scheduled In Alternative 2, patient scheduling would be the same, but only one ultrasound machine would be purchased. It would be mounted in a van that the technician would drive to each of the three Network loca- tions. Most of the operating costs of the two alternatives are identical, but Alternative 2 has the added cost of operating the van and setting up the machine after each move. The two alternatives differ substantially in capital costs because Al- ternative requires three ultrasound machines, at a cost of $75,000 each, while Alternative 2 requires only one. However, Alternative 2 requires a van, which with necessary modifications would cost $40,000. Thus, the capital costs for Alternative total 3 x $75,000 = $225,000, while those for Alternative 2 amount to only $75,000+ $40,000 = $115.000. Note, though, that because the two alternatives have different operat ing costs, a proper cost analysis of the two alternatives must include both capital and operating costs. The Network financial staff, which in reality is the System financial staff, considered several methods for estimating the operating costs of each alternative. After much discussion, the chief financial officer (CFO) decided that the activity based costing (ABC) method would be best. Furthermore, an ad hoc task force was assigned the task of performing the cost analysis. To begin the ABC analysis, the task force had to develop the activi- ties involved in the two alternatives. This was accomplished by con ducting "walk-throughs" of the entire process from the standpoints of the patient, the ultrasound technician, and the billing and collections department. The results are contained in Table 10.1. A review of the activities confirms that all except one-machine setup-are applicable to both alternatives. Bay Area Health Network 75 The next step in the ABC process is to detail the costs associated with each activity. This step uses mancial, operational, and volume data, along with the appropriate cost driver for each activity, to estimate resource consumption. Note that traditional casting, which often focuses on department-level costs, typically first deals with direct costs and then allocates indirect overhead) costs proportionally according to a predetermined allocation rate. In ABC costing, the activities required to produce some service, including both direct and indirect, are estimated simultaneously. For example, Table 10.1 contains activities that entail direct costs such as technician time) and activities that entail indirect costs (such as billing and collection). Although the ABC method is more complex and hence costlier than the traditional method, it is the only way to accurately (more or less) estimate the costs of individual procedures. Activity cost detail on a per procedure basis is contained in Table 10.2. In essence, each activity is assigned a cost driver that is most highly correlated with the actual utilization of resources. Then the number of driver units, along with the cost per unit, is estimated for each activity. The product of the number of units and the cost per unit gives the cost of each activity. Finally, the activity costs are summed to obtain the total per procedure cost. Many of the activity costs cannot be estimated without an estimate of the number of ultrasounds that will be performed. The best estimate is that so procedures would be done each week, regardless of which alternative is chosen. Assuming the technician works 48 weeks per year, the annual volume estimate is 2,400 procedures. Of course, one of the factors that complicate the analysis is that a much greater total volume TABLE 10.1 Bay Area Health Network Activities Associated with Alternatives 1 and 2 1. Appointment scheduling 2. Patient check.in 3. Ultrasound testing 4. Patient check-out 5. Film processing 6. Film reading 7. Billing and collection 8. General administration 9. Transportation and setup (Alternative 2 only! Bay Are Health Network 77 costs of operating the prin c e mal nintenance costs will mak it is estimated e Furthermore, maintenance costs on each of the t h ings under Alterative are estimated at So while the m a intenance costs for the single machine under Alterative an estimated higher S oo because of added wear and tear. Also, the manufacturer of the sound chines has indicated that a discount be available if three machines as opposed to only one, are purchased. The amount of the discount is somewhat uncertain, although percent has been mentioned Finally, to have a rough estimate of total annual costs over the life of the equipment, it is necessary to make assumptions about the use ful life of the ultrasound machines and the van. Although somewhat controversial, the decision was made to assume a five year life for both the ultrasound machines and the van. Furthermore, the assumption was made that the value of these assets would be negligible at the end of five years. Assume that you are the chairperson of the ad hoc task force. Your charge is to evaluate the two alteratives and to make a recommenda- tion on which one to accept, assuming that revenues would be identical for the two alternatives, and hence the decision can be made solely on the basis of costs. As part of the analysis, it will be necessary to estimate the costs of the two alternatives on a per procedure and annual basis. In addition, any qualitative factors that are relevant to the decision must be considered before the recommendation is made To keep the analysis manageable, the task force was instructed to assume that operating costs remain constant over the useful life of the equipment. For comparative purposes, this assumption is not too egre- gious because the activities are roughly the same for both alternatives, and hence inflation would have a somewhat neutral impact on costs. In addition to the base case analysis, the System CFO has asked the task force to perform some sensitivity (scenario) analyses. First, he is concerned about the accuracy of the cost detail inputs. Although there is some confidence in many of the estimates, others are more arbitrary. Those activity cost inputs that are considered to be most uncertain are supplies cost per unit, billing and collection cost per unit, general ad- ministration cost per unit, and transportation and setup cost per unit Thus, the task force has been asked to redo the analysis assuming that these inputs are higher than the base case values by so and a percent. Activity cost inputs less than the base case values could also be examined, 78 Cases in Healthcare Finance but the critical issue here is not to underestimate the total costs involved in the two alternatives. Along the same lines, the task force was also asked what would hap- pen to the cost estimates if the useful life of the capital equipment was as short as three years or as long as seven years. Also, there was some concem expressed that the useful life of the equipment depended on the alternative chosen; that is, there would be less wear and tear under Alternative than under Alternative 2. Finally, you were asked to assess the impact of the purchase disount--would a higher discount amount influence the ultimate decision? Although you believe that it also would be very useful to perform a sensitivity analysis on the number of procedures, this task would require recalculation of the per unit cost inputs, an effort thought to be too time consuming to undertake at this point in the analysis