Academic journal article Research in Healthcare Financial Management

A Variance Analysis of the Contribution Margin: An Approach to Improving Financial Performance and Reducing Fiscal Risk

Academic journal article Research in Healthcare Financial Management

A Variance Analysis of the Contribution Margin: An Approach to Improving Financial Performance and Reducing Fiscal Risk

Article excerpt

An important objective of the typical health service organization is to improve fiscal performance as indicated by profitability, liquidity and debt structure. In addition, the dependence on prospective payment mechanisms increases the importance of reducing financial risks that are related to financial and operating leverage.

In this paper, it is assumed that the analysis is within the relevant range of operations and pertains to a given budget period. Operating costs are thus defined as the sum of total fixed and total variable costs, but exclude interest expense. The contribution margin may be defined as the difference between total revenue (TR) and total variable costs (TVC) (Lusk & Lusk, 1979; Broyles et al., 2003; Finkler et al., 2007). In the interest of simplicity, taxes are not explicitly considered in this paper.

As is well known, the contribution margin is a measure that can be used to improve decisions concerning short term operating activity. If the contribution margin is negative (i.e. TR - TVC < 0), theoretically the organization should discontinue operations and incur a net loss equal to the sum of total fixed costs (TFC), and interest expense (IE). Conversely, if the contribution margin is positive, the expression

(TR - TVC) - (TFC + IE) < 0 (1.1)

would represent the net loss for the period and the exposure of the organization to the risks accompanying operating and financial leverage. On the other hand, the expression

(TR - TVC) - (TFC + IE) > 0 (1.2)

corresponds to the net surplus of the period which acts as a financial buffer protecting the organization from the risks associated with operating and financial leverage (Boles & Glenn, 1986).

Equations 1.1 and 1.2 also suggest that, ceteris paribus, an improvement in profitability enhances the net cash flow from operations and the cash balance--an important component of the organization's liquidity. In addition, an improvement in profitability resulting from higher contribution margin also increases internally generated funds and the financial latitude to modify the debt structure of the organization. Accordingly, these observations suggest that practices designed to increase the contribution margin will likely result in improved profitability, liquidity and debt structure while increasing the buffer that protects the organization from the risks of operating and financial leverage.

PURPOSE

With a focus on a multi-payer health service organization, the purpose of this paper is twofold. The first objective is to develop a model that partitions the variance in the realizable cash value of the contribution margin into controllable portions. The second objective of this paper is to develop an interactive spreadsheet that enables the organization to perform a sensitivity analysis that generates the information needed to guide operating decisions.

A controllable variance is defined as the difference between an actual and standard outcome that is attributable to factors that are controlled, to a significant extent, by an individual or group of individuals associated with the healthcare provider. As suggested by McCue (1991) and Kane (1991), this analysis focuses on the realizable cash value of operating results. After adjusting for uncollectibles, we let CM correspond to the contribution margin. We also employ the organizational budget as the standard against which actual performance is compared and evaluated. In the following, let the subscripts a and s represent an actual and the corresponding standard value as expressed by the budget, respectively. We let C[M.sub.a] and C[M.sub.s] correspond to the actual (or realized) and standard (or expected) contribution margin, respectively. After an application of the model, the actual (or realized) contribution margin can be expressed in the form

C[M.sub.a] = C[M.sub.s] + Var(Gross Price) + Var(Payer Mix) + Var(Collection Rate) + Var(Volume) + Var(Average Variable Cost) + Var(Interactive) (2)

The model also indicates that each component of CM is attributable to factors that are controllable to a significant extent by an individual or group within the health service organization. …

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