At a recent lecture day hosted by ourselves, a lawyer specialising in federations mentioned a case where the federation were so keen to get going that they had taken on a contract that was impossible to deliver without making a loss. Not even a loss leader, it was a case of poor planning and inadequate thought that had committed the federation to delivering a service that it could not afford.
In general practice, decisions are commonly made on taking on services without some thought given to the financial merits of the service on offer.
Fixed vs variable costs
To make some sense of this, it is necessary to set out some basic principles. Perhaps the most important one is to distinguish costs between those that are fixed and those that are variable, depending on the level of activity.
For example, if the cost of providing a travel service necessitates employing a full-time nurse, once the decision is made to employ the nurse, the nurse’s salary is fixed, whether the nurse gives one injection or one thousand. The costs of the vaccines, the Band-Aids, etc are all variable – their cost depends on how many vaccines are given.
How does this help? Let’s suppose that the nurse costs £30,000 as a fixed cost and the practice expects to deliver one thousand immunisations in a year at a price of £50 each per patient, with each immunisation costing £10.
The practice will receive £50,000 (£50 x 1,000) and will have spent £40,000 (£30,000 on the nurse and £10,000 on the vaccines). All good. But we can extract much more information from this, including working out the break-even point to cover costs and to make an expected level of profits. The first step in these calculations is to establish what is called the contribution.
Contribution and break even point
The contribution is the difference between the unit selling price and the unit variable costs. In this case the unit sales price of the vaccine and the unit price of the vaccine.
Unit Selling Price – Unit Variable Costs = Contribution
The division of the fixed costs by the contribution tells us the break even point, the number of unit sales we need to make to cover all our costs.
-------------- = Break-even point
Using the example above, the contribution is the difference between the unit selling price of a vaccine and the cost of each vaccine.
Unit selling price of a vaccine (£50) – Unit cost or each vaccine (£10) = Contribution (£40)
So the breakeven point for the immunisations will be:
Fixed costs (cost of the nurse) £30,000
------------------------------------------------- = 750 vaccines
The proof of this can be seen by working this through, 750 vaccines at £50 each will generate £37,500. Each vaccine cost £10 so total vaccine cost is £7,500 – and with the nurse costing £30,000 the proof is evidential.
But no practice is going to want to do this work to make no profit - unless there is an altruistic intent. Suppose the practice decided that it wanted to make a profit of at least £5,000 to make this project worthwhile. By adding this required profit to the fixed costs facilitates the calculation of the number of vaccinations to be achieved
Using the above example:
Fixed Costs + Required Profits (£30,000 + £5,000)
----------------------------------------------------------------- = 875 vaccine
The proof of this is that 875 vaccines generate £43,750, the cost of the vaccines will be £8,750 (875 x £10 each) and the nurse cost is £30,000 so the profits will be £5,000.
There is another point that needs to be mentioned, when fixed cost are being considered, we should ignore those costs that are ‘sunk’ in other words will be incurred whether the project is undertaken or not.
Take a builder whose main line of work is in developing new homes, he may have a number of workers, plumbers and electricians who are permanent fixtures on his payroll. If he has a lean period and his staff are sitting idly by, and he gets the opportunity to refurbish a property for a client during a slack period, he will not factor in the costs of the labour, he is paying for them anyway, any income he receives which delivers a positive contribution will be welcome.
Using the example of the nurse undertaking the immunisations, patients will have to report to reception. If there are no extra hours being worked at reception, the cost of the receptionist may well be fixed in nature but it is irrelevant – it is being incurred anyway. Reception costs are therefore sunk.
Download a spreadsheet
These simple calculations can deliver decisions for practices on not only whether a proposed activity is worthwhile, and at what point the activity becomes worthwhile. The unplanned admissions service at £2.87 per patient is well paid, but potentially expensive to deliver.
Using these calculations should ensure practices make good decisions, and as always if they are unsure, they should ask their accountant.