All businesses require a profit and loss statement (P&L) to determine profitability. Yet, according to our research, only 41 percent of outreach programs are provided with periodic profitability reports. More than half are not. Forty-six percent do not get reports, and the remaining 14 percent are uncertain. There is an astounding lack of transparency for this business line. Seriously, how can anyone run a business without a P&L? Why would any hospital allow that in this day and age? To put this into context, we are talking about a median and average business of $11 million and $19 million, respectively. These are substantial businesses that are run like a mom-and-pop or, perhaps more appropriately, worse than a mom-and-pop. At least the local family business knows whether they are making money! This is a case of the not-for-profit mentality gone haywire, or alternatively, a view into the surprisingly unsophisticated financial management of hospital business lines.
Everyone knows how to construct a P&L, but not everyone knows what costs to include and exclude. The most common problem we encounter with P&Ls is the misallocation of costs. Misallocation inadvertently makes the outreach program look like a loser. Our philosophy is that the P&L should only contain costs that are specific to outreach: costs that would go away if you decided to exit the business. Therefore, hospital and laboratory overhead should be excluded; those costs would not go away if you got out of the business. Likewise, facility costs and laboratory equipment are required to support hospital patients. There are specific, unique outreach costs that are appropriate to include such as courier vehicles, patient service centers, physician connectivity software, interface costs, and new labor costs (outreach manager, phlebotomists, couriers, client services, sales staff, extra specimen processing FTEs, and incremental technical FTEs in labor intensive disciplines like microbiology or cytology).
This past year, a client with a $12 million outreach program contacted us because the profitability of its program was diminishing, and it was reluctant to make a required upgrade to its IT connectivity if the business was not sustainable. The client wanted to know whether to invest in the business for future growth or to exit. We looked at its P&L as a combined hospital/outreach entity shown on the table below under “Total.” The operating margin was a paltry two percent, one tenth of the expected margin.
Next, we analyzed cost allocations between the hospital and outreach and developed separate proformas for each. Not surprisingly, the outreach program was profitable at 19 percent (very close to the expected range of 20 percent for an independent laboratory billing on the commercial laboratory fee schedule). It was actually the hospital laboratory that was unprofitable at a 19 percent negative operating margin. This makes much more sense since the hospital has a required investment in laboratory facilities, equipment, and staffing for a 24/7 operation to support the acute, inpatient business. These costs should not be viewed as part of the outreach business since they would remain even if the hospital decided to exit the business.
Our analysis represented a major turnaround in thinking. Outreach was truly accretive; the new revenues helped cover fixed overhead costs and provide $2.3 million in new operating margin that would be foregone otherwise. Seeing it in this new light, the same executives who originally questioned the IT investment now want to accelerate growth. We also solved a common conundrum for the laboratory. They did not have a competitive IT offering. Growth stagnated. The laboratory asked for capital to upgrade IT which, in turn, was not approved because the laboratory wasn’t growing and was viewed as a low margin business—a veritable catch-22 for the laboratory.
I would be remiss if I did not point out another important advantage of outreach: lowering unit costs overall. The blended cost per test of $13.30 distorts the picture. The cost per test for hospital patients is actually 23 percent higher than outreach ($16.72 versus $10.75 for hospital and outreach, respectively). In a similar study conducted two years ago, we estimated that the cost of testing would increase by 30 percent if the system monetized a $42 million outreach program. There are important, unintended consequences of exiting an established business that are not always readily apparent nor appreciated. With volume decreases, the test menu would be pared down and turnaround time would suffer.
Stay tuned to this blog series for information on additional financial issues that laboratory outreach program leaders must consider. You can also learn more in my book, The Profit Machine in the Hospital Basement.
Kathleen A. Murphy, PhD
Senior Growth Advisor
Chi Solutions Inc.