Over the past few months, the proposed healthcare reform has been the subject of much discussion and the healthcare industry has come under intense scrutiny as a result of the administration’s efforts to curtail the increasing cost of healthcare. As an offshoot of the increasing cost of healthcare now more than ever hospitals have been placed in a situation whereby capital budgeting has become a necessary tool; Not only for sustenance but mostly for survival. Absence of a sound capital budgeting policy might potentially spell disaster for hospitals because an increase in cost accompanied by a decrease in revenue negatively impacts the bottom line and when funds are limited, it is essential to have a game plan of how the funds are to be used otherwise the hospital might find itself in a precarious situation.
Capital budgeting refers to the analysis of investment alternatives involving cash flows received or paid over a certain period of time. More often than not, the best alternative is usually the one that yields the greatest cash flow over time. This point can be disputed because other hospitals might place much emphasis on non-monetary results. In such cases, the best alternative is usually the one that comes as close as possible to yielding results that catapults the hospital closer to its objectives. Capital budgeting is a complicated process in the sense that great care has to be taken in the selection process and competing forces makes it the more challenging. Where there is competition, the possibility of politics being a factor is heightened and politics often times has its drawbacks especially when the voice of the minority is drowned out by the majority or the louder voice.
In order to better understand how capital budgeting works in the healthcare industry, we’ll explore three different scenarios that do play out every once in a while in most hospitals throughout the country. For instance, Human Resources propose a day care facility for employees with children. Justification being: turnover rate of employees will be minimized and more nurses will potentially be attracted to the hospital because of the day care services offered. Turnover is costly to the hospital. Therefore, even though the project does not increase revenue, the project will get to benefit the hospital through reduced costs.
The second scenario is the Imaging Services Department proposes the purchase of an additional CT scanner to ease the bottleneck and the backlog of work in the department. Purchase of a scanner is quite costly and therefore, if the present one is functional is there a need for a second one? One might argue that the high demand for usage creates tension between employees, wear and tear of the machine increases maintenance costs, overtime pay for the technicians’ increases overhead costs and the hospital is left vulnerable in the event that the current scanner seizes to function. These are all valid considerations. However, one wonders; does the total benefit exceed the total cost?
The last scenario is a group of doctors working for the hospital propose the purchase of a special machine that eliminates the need for in house hospitalization of patients. With the new machine comes the benefit of reduced hospitalization. With reduced hospitalization of patients, the hospital might be better placed to reduce variable costs associated with the use of the facilities and safety might be enhanced because the possibility of the hospital exceeding capacity will be greatly reduced by having fewer patients in the facilities. The only drawback is the massive costs involved. The machine requires a large capital outlay upfront. Therefore, in as much as the purchase sounds good, the other alternatives sound equally as good if not better.
Faced with the three alternatives, a financial manager in the healthcare industry should determine the opportunity cost of capital. Opportunity cost of capital works on the fundamental law of finance that states that a dollar today is not the same as a dollar tomorrow. Therefore, when analyzing the three alternatives, the time value of money should not be ignored because one might come to a wrong conclusion if one doesn’t consider the time value of money in the analysis. Future cash flows are discounted to the present value using a stated interest rate. Once the present value of all the alternatives is established, then the alternative that yields the highest present value is considered to be the best option. This method of analysis is known as the discounted cash flow method and from a personal standpoint; this method should be used widely in the healthcare industry because it is guided by the important law of finance stated above. I acknowledge the fact that each hospital is unique and estimating the future cash flow is difficult in other instances. In this case, other methods should be considered. However, discounted cash flow method though imperfect at times should be given first priority if all else is clear and all the variables are known.