Please, I need help with this case. Analyze and discuss whether the two systems have the same financial risk. In other words, are the cash flows being discounted equally risky?

JONES MEMORIAL HOSPITAL Case 27

COMPETING TECHNOLOGIES WITH BACKFILL

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JOHNSON MEMORIAL HOSPITAL (the Hospital) is an 8oo-bed, acute care, not-for-profit teaching hospital affiliated with one of the largest public universities in the country. In addition to serving the primary and secondary clinical care needs of the neighboring population, the Hospital serves as a tertiary and quaternary referral center for the entire region. For the most part, referred patients seek specialty care that requires unique and often costly clinical expertise and treatment that is available only at select institutions. Thus, it is not surprising that specialty care programs provide the Hospital with about 75 percent of its net operating income.

The Hospital's Center for Digestive Disorders (the Center) is one of the most successful of the specialty care programs. It consistently ranks among the best programs in the country in the diagnosis and treatment of disorders of the gastrointestinal tract. The Center's excellent reputation is further evidenced by the extent of its research funding and its ability to attract patients outside the immediate service area. The 20 gastroenterologists who staff the Center are physicians drawn from the faculty of the university's College of Medicine. Unlike private practitioners, who focus exclusively on the clinical care of patients, faculty physicians pursue a tripartite mission of clinical service, research, and teaching. It is the successful combination of these pursuits that has helped elevate the status of the Center.

The Center provides care that ranges from gastrointestinal screening to the diagnosis and therapy of common and rare disorders to the

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referral of appropriate patients to faculty surgeons for the treatment of benign and malignant diseases. The Center encompasses three separate business units: an outpatient clinic, a hospital-based endoscopy suite, and a hospital-based motility (movement) laboratory. Each business unit operates as a separate profit center, and hence each unit maintains its own budget. However, from a patient perspective the care provided is seamless because the Hospital's patient management system expedites patient flow among the Center's three units as well as to outpatient surgery or inpatient status when required.

Although the motility lab generates less than 5 percent of the Center's total net patient service revenue, it is a vital component. The lab currently performs 600 manometry tests per year. These tests measure the pressure (flow) along the gastrointestinal tract, which assists in the diagnosis of gastrointestinal disorders that cannot be diagnosed visually. The prevalence of disorders such as noncardiac chest pain, dysphasia, gastroesophageal reflux disease, and small bowel motility disorders make manometry testing beneficial to significant segments of the population.

Each test involves the insertion of catheters (probes) into a patient's gastrointestinal tract that relay data back to a computer work station for for analysis. Two technologies are used in motility testing: water perfusion and solid-state. The Center currently has three water perfusion work stations dedicated to motility testing, each of which is used to perform roughly 200 tests per year.

Both water perfusion and solid-state technologies provide relatively reliable data for diagnosis. Furthermore, net reimbursement averages $250 per test regardless of technology, and the current per-test operating costs are identical: $150 for labor, $30 for medical supplies, and $15 for administrative supplies.

However, there are distinct differences between the two technologies, the most important of which is patient venue. Water perfusion technology requires the patient to spend one day as an inpatient, while solid-state technology can be done on an outpatient basis. Thus, each test that uses solid-state rather than water perfusion technology frees up one bed-day for other purposes. In general, the space freed up by new projects or technology is called "backfill space," so any beds made available for other purposes by replacing water perfusion with solid-state technology are called "backfill beds."

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Although the Center is known for its state-of-the-art technology, its motility laboratory currently has some dated manometry equipment. The Center's medical director, Dr. Carl Forsyth, has made proposals in the past to update the equipment, but more pressing capital-investment needs within the Center have kept the proposals from being funded. However, one of the current work stations is becoming increasingly unreliable, which has inconvenienced patients and created backlogs. In addition, manometry demand has grown to the point where some patients are being referred to other providers to ensure timely testing. These factors have prompted the Center's administrative director, Edith Hargrove, to seek immediate approval for the acquisition of one new manometry system.

To begin the capital-expenditure request process, Edith is currently reviewing quotes from various manufacturers of manometry equipment. Her research on quality and cost has narrowed the field of competing manufacturers to one: Digestive Diagnostics, Inc. A water perfusion work station, which Edith favors, would cost $25,000, while the nine catheters needed to properly equip the work station would cost $500 each. The new generation of water perfusion systems, but not solid-state systems, has lower per-test supply costs: $15 for medical supplies and $10 for administrative supplies. On the other hand, Dr. Forsyth believes that the Center should purchase a solid-state technology work station. Regardless of the technology purchased, the existing unreliable water perfusion work station would be "junked," as it is no longer capable of providing satisfactory service.

Edith, who is a clinically trained nurse, questions the clinical necessity of solid-state technology, especially in light of its higher cost. Although the cost of the work station is the same ($25,000), the cost of the catheters is substantially higher: $6,000 for each solid-state catheter versus $500 for each water perfusion catheter. Nine catheters are required for both technologies, so the total cost for catheters is $54,000 for solid-state technology versus only $4,500 for water perfusion technology. In addition, solid-state technology has higher operating (supply) costs than does the new water perfusion technology.

Dr. Forsyth agrees with the capital and operating cost estimates, but he argues that the higher cost of solid-state technology is justified for the following reasons:

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1. Solid-state technology enables a technician to perform two tests in the time it takes to do one using water perfusion; rather than performing 200 tests per work station per year using water perfusion, 400 tests could be performed with solid-state. This would shorten patient wait time for appointments, decrease the current four-month backlog for motility testing, and potentially increase overall volume for the Center from 600 to 800 tests.

2. The current water perfusion technology requires close observation and correct body positioning during testing to ensure accurate data collection. As a result, each patient is kept in a hospital bed as an "observation" patient. Conversely, solid-state technology enables the tests to be performed on an outpatient basis. This point is of particular interest to the Hospital because under current operations even' test using water perfusion is a bed-day that cannot be filled by a medical/surgical patient. Each bed-day by a "true" inpatient yields an average contribution margin of $520, whereas the bed-day contribution margin for a motility test patient is only $40.

3. Solid-state technology is quickly becoming the standard of care; not offering it would damage the Center's reputation.

4. Solid-state technology will enhance the teaching curriculum for residents and fellows and will provide additional opportunities for research funding.

To his credit, Dr. Forsyth is a respected physician with a reputation for providing the very best of patient care and at the same time remaining aware of his responsibilities to do so in the most cost-effective way possible. However, he has been criticized in the past for lobbying Hospital administrators for medical equipment that, in retrospect, could be labeled as being nothing more than "toys" for himself and his colleagues.

Edith listened to Dr. Forsyth's case for solid-state technology. She believes he makes some good points, especially in regard to the clinical efficiencies of solid-state technology. Still, in an environment where

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resources are limited and maintaining a positive bottom line is increasingly important, Edith continues to believe that the cost of the solid-state catheters is a financial burden the lab cannot afford, especially when reimbursement is the same regardless of the technology used.

The two technology proposals have been brought to the attention of the Hospital's chief operating officer, Belinda Brach, for resolution. Believing that a detailed financial analysis is the only rational basis for a decision, she has asked you, a recently hired financial analyst, to investigate the situation. Specifically, you have been asked to use capital budgeting techniques to evaluate the two technologies and make a recommendation on which one to choose.

In addition, Belinda provided some much needed guidance. First, assume that the life of both technologies is five years and that it is unlikely that either the work stations or the catheters will have any salvage value after five years of use. Second, no good methodology is available to estimate the additional number of tests (more than 200) that might result from pent-up demand if solid-state technology is used. Volume might increase by 100 tests (to 300), but it could increase by as few as 50 or as many as 150. Third, it is difficult to say how many of the bed-days freed by the use of solid-state technology will actually be filled by medical/surgical patients. Again, without good data, she suggests you assume that 100 additional medical/surgical bed-days will result, but this number could be as low as 80 or as high as 175. Fourth, standard practice calls for all capital-budgeting analyses to assume a 3 percent inflation rate in both costs and reimbursements. Finally, the Hospital's corporate cost of capital is 10 percent, and it adds or subtracts 3 percentage points to account for differential risk.

Just as you were about to start the analysis, the phone rang; it was Belinda. She said it was likely that she could put her hands on some additional funding to buy a second system, but the amount will only be enough to buy a water perfusion system. When you asked Edith what the lab will do with the second current system, if it too should be replaced, she said the Hospital could sell it for about $10,000 because it is only three years old. Edith added, "You might as well crunch the numbers on the potential second system while you're at it.