Financial Managementof an Academic Unit

College of Human MedicineMichigan State University

November 9, 2006

Executive Director, University Physicians, Inc.Senior Associate Dean, Administration and Finance

University of Colorado School of Medicine

Lilly Marks

© Lilly Marks 2006

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Financial Management of an Academic UnitSession Outline

1. Financial Analysis• Breakeven analysis• Marginal cost• Marginal utility• Diminishing returns• Leveraging

2. Issues, Implications & Trends• Review of School of Medicine & departmental

funding patterns: issues, implications, trends

3. Trouble Traps

3

BREAKEVEN ANALYSIS

The process of determining

the volume at which a

program becomes financially

self-sufficient.

4

Breakeven Analysis

1. Fixed Costs (FC) Costs that are incurred regardless of volume or

activity (e.g., capital equipment, salaries, rent).

2. Variable Costs (VC)

Costs that fluctuate in direct proportion with

volume (e.g., materials and supplies, temporary

help).

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Breakeven Analysis

3. Price (P)

4. Contribution Margin (CM)

The difference between the price of a product or

service and the variable cost. That difference

represents the amount available to cover or defray

fixed cost (and hopefully provide a profit).

5. Capacity (C)

The maximum volume of production or service your

fixed resources can accommodate.

6

BREAKEVEN POINT

Fixed costs divided by the contribution margin per unit = volume necessary for breakeven

Fixed cost Contrib. Margin

(price - variable cost)

= B.E. volume

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Breakeven Analysis

Example: You run a lab that has the capacity (equipment and staff) to run 20,000 tests per year. You currently process 10,000 tests.

Loss/test: ($1)Total loss: $10,000 ($1 x

10,000)

Capacity:Volume:

Price/test:Fixed costs:

Variable costs:Contribution margin:

Cost/test:Price/test:

$9 ($7 fixed + $2 variable) $8

10,000$8 (maximum market will bear)$70,000 ($7/test = fc ÷ v)$20,000 ($2/test)$6/test

20,000

8

Suppose you are offered a contract to Suppose you are offered a contract to

run an additional 5,000 tests per year run an additional 5,000 tests per year

at $8 per test.at $8 per test.

Can you afford to run more tests per Can you afford to run more tests per

year given your current loss of $1 per year given your current loss of $1 per

test? test?

“If you lose a little on

every service, can you

make it up on volume?”

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If you lose a little on every test, can you make it up on volume?

Answer: Yes. (Unused capacity allows you to

increase volume without increasing fixed

cost).

How many tests would you have to run to break even?

Answer: 11,666 (Fixed cost $70,000 ÷ contribution

margin $6).

FCCM BE 70,000

$6== 11,666 TestsFormula:

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Every test over breakeven point of 11,666,

up to 20,000 test capacity, increases your

profit by $6.

• At 15,000 tests, profit = $20,000 • At 20,000 tests, profit = $50,000 • You can lose a little on every test and

make it up on volume if you have

sufficient excess capacity.

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MARGINAL COSTS

The additional costs incurred as a

result of providing one more unit of

service (e.g., one more lab test).

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Represents the incremental value of each

incremental unit of investment.

Marginal Utility

Diminishing Returns

Represents the point at which each incremental

unit of investment generates a smaller rate of

return.

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Marginal Utility & Diminishing Returns

Value of Investment

Valu

e o

f R

etu

rn

8M

6M

4M

2M

X

Example: - Fee coders cost $50K in salary & benefits but can process an average of $2M in clinical charges/year. - Your dept. currently processes $6M in charges/year.

X = pt of diminishing returns

$50K $50K $50K $50K $50K $50K

Where is the point of diminishing returns?

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“Rule of 72”

72 ÷ % interest =

# of years needed to

double investment

e.g. [ 72 ÷ 6% = 12 yrs ]

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Leverage

1. Financial Leverage: The degree to which an entity

obtains its cash resources from borrowing or from

external sources rather than from equity. (The

greater the ratio of debt to equity, the more

leveraged.)

2. Operating Leverage: The degree to which entity is

committed to high levels of fixed cost. (The greater the

percentage of fixed costs in your budget, the more

leveraged.)

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Leverage continued….

3. The more financially leveraged an organization is, the greater the potential rewards during good times, the greater the risk in downtimes.

4. The greater the fluctuation in revenue, the greater the risk for organizations with high degree of financial and operating leverage.

5. Medical schools typically have a high degree of both financial leverage and operating leverage. In recent years they have also experienced greater fluctuation in revenue.

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Leveraging Example

On 1/1/2005 you purchase a home for $100,000.

On 1/1/2006 you sell the home for $120,000.

Scenario 1:

You purchase a home with $100,000 cash.

Scenario 2:

You put $10,000 cash down and obtain a $90,000

mortgage at 10% interest.

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Example 1

110%

(11k ÷ 10k)

20%

(20k ÷ 100k)

$ 11,000

$ 9,000

$ 90,000

$ 20,000

--

--

$110,000 $ 20,000

$ 10,000 $100,000

$120,000 $120,000

Return on investment (ROI)

Net return

Loan interest

Loan repayment

Sale proceeds

Initial Investment

Sale price

Scenario 2Scenario 1

When leveraged, rewards are far greater on the upside.More complete & sophisticated ROI analysis must also include calculation of opportunity costs (i.e., the cost [or forgone income] of investing your funds in one option vs. another.)

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(-190%)

(19k ÷ 10k)

(-10%)

(10k ÷ 100k)

Return on investment (ROI)

($19,000)Net return

Loan interest $9,000

$90,000

($10,000)

--

--Loan repayment

$80,000Sale proceeds

$10,000 $100,000Initial Investment

$90,000 $90,000Sale price

Scenario 2Scenario 1

Example 2

($10,000)

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Understanding the risks, rewards and

nuances of leveraging is critical to

understanding the financing of academic

medicine.

Medical schools have built and financed

their missions on leveraged capital.

22

University of Colorado School of MedicineComparison of Medical School Funding

FY 2003-04

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Public Private Colorado Top 20 Research

Per

cent

age

of T

otal

Rev

enue

State and Local Appropriations Tuition and FeesGifts and Endowment Grants & Contracts (Federal & Nonfederal)

Clinical Revenue (Hospital & FPP) Other

All Schools Have Witnessed Prodigious Growth Fueled by Medical Service Income

$0 B

$10 B

$20 B

$30 B

$40 B

$50 B

$60 B

$70 B

1965 1975 1985 1995 2005

Source: LCME I-A, Annual Financial Questionnaire

Medical Service

Federal Research and Other Grants/Contracts

Other Income

State & Local Approp.

Tuition and Fees

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University of Colorado School of MedicineTrend in Sources of Revenue

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Only “hard” $ (w/endowment) in SOM budget.

Now < 10% of average SOM budget.

$ have remained flat when adjusted for general inflation.

Underpins core educational mission of School & basic administrative and infrastructure costs.

Institutional & State Appropriations – Tuition Revenue:

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Institutional & State Appropriation Issues:

1. Many states have developed budget deficits & reduced state support to SOM.2. Allocation of funds to departments and programs = often illogical, political,

historical; Usually designated as teaching $ but distribution not faithfully based on teaching.

3. Faculty under increasing pressure to cover salaries via research and clinical activities and believe they can’t afford teaching and administrative commitments, which aren’t adequately compensated.

4. Inadequate as cross-subsidy for any other missions or gaps in funding.5. Limits and implications of using tuition as a revenue strategy.6. Financial underpinning for academic entitlements (tenure, guaranteed

appointments & salaried).

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Grant Revenue: Includes federal and non-federal, basic and clinical research.

5-Fold increase nationally over two decades.

Schools have geared up for and benefited from doubling of NIH

Budget (1998-2003)

Indirect costs = major revenue source for supporting facilities

and administrative infrastructure.

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Grant Issues:

1. Although overall grant $ up, certain faculty are losing grants and salary support.

2. NIH $ = restricted (not fungible) so excess $ in one area can’t be shifted to cover deficit in another.

3. NIH 2006 salary cap at $183,500; Requires institutional cost share for faculty with higher salaries.

4. NIH growth has flattened making grant awards far more competitive.

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Bill Coming Due on NIH Budget Run-up

• NIH funds record high 34,143 grants in 2002, up 34% from 1997 and 51% higher than 1993.

• $367,000 per grant in 2002 up 36% from 1998

• Nearly 50% of $2.4 billion budget increase in 2001 was already committed to previously awarded grants, which run nearly 4 years on average.

• Preliminary studies project that some institutes would need annual budget increases of 7% to 12% after 2003 to sustain existing programs and keep pace with inflation…

• …while post-doubling era NIH budgets expected to average 2% to 3% per year

"…only a miracle will prevent stagnation and slumps after 2003 in the number of grants infrastructure spending and clinical research…the bill is rapidly coming due" -Science

"…only a miracle will prevent stagnation and slumps after 2003 in the number of grants infrastructure spending and clinical research…the bill is rapidly coming due" -Science

Source: Science, Vol. 292, Issues 5524, 1992-1995, 15 June 2001 ©2004 University Health System Consortium Sizing The Vision draft 8-31-04

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‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ’05 est. ’06 est.

NCI 32% 26% 27% 26% 27% 24% 20% 19%

NHLBI 36% 35% 36% 33% 34% 29% 27% 25%

NIDCR 24% 27% 34% 29% 27% 30% 25% 24%

NIDDK 33% 28% 29% 34% 33% 27% 24% 24%

NINDS 35% 37% 32% 29% 30% 25% 20% 17%

NIAID 34% 36% 38% 38% 35% 24% 22% 19%

NIGMS 39% 37% 37% 38% 38% 30% 25% 26%

NICHD 30% 29% 27% 28% 27% 17% 15% 17%

NEI 40% 42% 40% 34% 33% 30% 21% 22%

NIEHS 27% 29% 29% 29% 25% 19% 25% 29%

NIA 28% 26% 32% 28% 29% 21% 19% 20%

NIAMS 24% 27% 29% 23% 20% 20% 21% 21%

NIDCD 34% 40% 42% 39% 38% 35% 27% 29%

NIMH 27% 29% 31% 27% 27% 24% 21% 22%

NIDA 34% 38% 36% 31% 35% 27% 22% 23%

NIAAA 30% 31% 33% 32% 27% 29% 31% 29%

NINR 14% 32% 26% 26% 27% 21% 22% 20%

NHGRI 38% 43% 42% 34% 30% 23% 28% 37%

NIBIB N/A N/A N/A N/A 29% 17% 15% 15%

NCRR 34% 18% 29% 28% 28% 21% 23% 36%

NCCAM 57% 29% 27% 14% 14% 17% 15% 8%

FIC 39% 23% 30% 28% 19% 22% 18% 14%Source: NIH

The success rate indicates the percentage of reviewed research project grant applications that receive funding in a fiscal year. Success rates would continue a downward trend under the Bush budget, even at the biggest funders, such as the National Cancer Institute of Allergy and Infectious Diseases.

Article published in Federal Grants and Contracts Weekly, Vol. 29, No. 9, February 22, 2005.

RPG Success Rates by NIH Institute

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NIH Funding HistoryFYs 1995-2007 [in billions]

Year Current $ %change Constant $ % change BRDPI

1995 $11,300 3.1% $11,300 -- 3.5%

1996 $11,928 5.6% $11,626 2.9% 2.6%

1997 $12,741 6.8% $12,088 4.0% 2.8%

1998 $13,648 7.1% $12,521 3.6% 3.4%

1999 $15,629 14.5% $13,905 11.1% 3.2%

2000 $17,821 14.0% $15,284 9.9% 3.7%

2001 $20,458 14.8% $16,978 11.1% 3.3%

2002 $23,296 13.9% $18,712 10.2% 3.2%

2003 $27,067 16.2% $20,998 12.2% 3.5%

2004 $27,888 3.0% $20,859 -0.7%3.7%

2005 $28,415 1.9% $20,472 -1.9%3.8%

2006 $28,349 -0.2% $19,728 -3.6%3.5%

2007 $28,350 0.0% $19,078 -3.3%3.4%

Source: NIHAAMC

DATA SERVICES

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NIH Funding, FY 1995-2007[in billions]

AllSchools

AAMCDATA SERVICES

$0

$5

$10

$15

$20

$25

$30

1995 1997 1999 2001 2003 2005 2007

Current Constant (BRDPI)

[Decline in real Dollars of ~10%]

32

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Grant Issues continued:5. Will investments in faculty recruitments, program development and

facilities construction yield expected returns?

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Investment in Research Facilities atU.S. Medical Schools

AllSchools

Slide developed by NIH from AAMC data – 2002 Survey of Research Facility Investments (99 of 125 AAMC Member Schools responding) AAMC

DATA SERVICES

3.2B

5.4B

9.5B

0

2

4

6

8

10

1990-1997 1998-2002 2003-2007 Projected

Do

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s (i

n b

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on

s)

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Grant Issues continued:6. Clinical trials will become less flexible and large balances more suspect,

however, translational research will present new opportunities for programmatic growth.

7. Significant institutional cost of developing and maintaining research programs. (protected time, unfunded research, bridge funding, institutional cost sharing).

8. Bridge funding.

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Other Revenue:

Affiliated hospital contracts (including VA 1/8’s and clinical administrative service contracts)

Gifts/endowments ICR income (may also be part of state appropriation at some institutions)

$0

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Other Revenue Issues:

1. Hospital margins declining, growing deficits; Future support

unclear and unstable.

2. Philanthropy subject to economy, income and estate tax

issues, all of which are currently changing.

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Clinical Revenue:

1. Fastest growing, largest, most flexible revenue source in SOM budget.

2. Professional fees increased from 6% in 1961 to ~35%. Accounts for 50% of total budget when affiliated hospital and clinical service contracts included.

3. Represents major source of cross-subsidy for other SOM missions and programs.

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Clinical Revenue Issues:

1. Reimbursement per unit of service and profit margins are declining driven

by changes in Medicare fee schedule and managed care competition.

2. 3rd Party payers are no longer willing to subsidize other missions via

reimbursement premiums.

3. Funding has become more volatile.

4. Market defines productivity differently than academics.

5. Increased malpractice costs have erased revenue gains.

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Clinical Revenue Issues continued:

6. Growing number of uninsured and underinsured in FPP payor mix.

7. Emerging workforce shortages in some specialties.

8. FPP’s must develop new revenue streams to include technical revenue.

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Faculty Practice Plan Revenues Used to Support Academic Programs

Med Student Educ $702 M

Research $816 M

GME $594 M

Other $244 M

$2.356 B

ClinicalPrograms

72%

AcademicPrograms

28%

Source: AAMC41

...But the Rate of Growth Is Now Beginning to SlowCURRENT $

All Schools

02468

101214161820

Percent Change in Annual Revenues

Source: LCME Part I-A Annual Financial Questionnaire

Copyright 2003 by the Association of American Medical Colleges. All Rights Reserved. AAMCDATA SERVICES

42

Percent Schools Reporting Negative Change in Revenue (Constant $) from FY04 to FY05

AllSchools

Source: LCME Part I-A Annual Financial Questionnaire Copyright 2003 by the Association of American Medical Colleges. All Rights Reserved.

AAMCDATA SERVICES

510

24

16

25

16

0

10

20

30

40

50

60

Total Revenues

FPP Revenues

HospitalSupport

Public

Private

Percent

43

44

Balancing the Missions

ResearchTeaching

OtherClinical

45

Balancing the Missions

PRINCIPLE PRINCIPAL

46

Balancing the Missions

PRINCIPLE PRINCIPAL

• Schools/departments have leveraged budgets, program and

faculty growth on external sources of revenue (principal).

• External sources define productivity differently than

School/University.

• External sources unwilling to subsidize some fundamental

PRINCIPLES of academics with their PRINCIPAL.

No margin . . .

. . . no mission.

48

Intersection of Funding Realities and SOM Policies

• Interconnectivity of missions requires interconnectivity of solutions. Changes may be required in:

• University/school policies• tenure• appointments and promotions• specialty tracks• compensation• assignable income• conflicts of interest and commitment

• School/Department practices:• investment and recruitment decisions• centralized/decentralized management and decision making

• Culture• entitlements• productivity• accountability

“At every crossroad on the

path that leads to the future,

tradition has placed 10,000

men & women to guard

the past.” - Author Unknown

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No margin . . .

. . . no marginalmission.

Revenue cycle is not

the only answer, and

cost of overhead is

not the only villain.

52

Survey of Common Policies regardingDeficit Departments

1. Departments must use accumulated reserves to cover deficit.

2. Deficits subsidized by Dean's tax or School of Medicine reallocations.

3. Deficit subsidies treated as loan.

4. Deficits subsidized by FPP reserves or reallocations.

5. SOM/FPP receivership in cases of extreme or chronic fiscal mismanagement.

6. Faculty salary adjustment and/or layoffs.

7. No policy - case by case basis.

8. Finance Committee oversight.

9. Replacement of Chair.

10. Negotiate hospital subsidy.

11. Departments must budget 90-180 days cash on hand.

12. Mandate to reach break-even the following year.

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Mission-Based Budgeting

Effort to align the revenues

and costs related to each

SOM mission.

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•Greatest single expense in School of Medicine

budget (2/3-3/4 of budget).

•A department or program facing serious financial

problems can’t solve them by trimming peripheral,

non-personnel expenses.

•Compensation plan that facilitates the mission and

strategic goals is critical

Cost of Labor

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To rob from the rich and give to the poor =

may be acceptable application of academic

principle.

To rob from the rich and give to the

unproductive = may be unwise use of

financial principal.

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How much socialism is

appropriate vs. how much

capitalism is necessary?

57

To protect our historic missions & strategic goals, we must:

1. Determine whether we have excess capacity and full productivity

of our faculty, space and equipment. (If the answer is “yes” to

capacity and “no” to productivity, need to increase productivity to

maintain revenue levels.)

2. Regularly and thoroughly examine the outcomes, value and ROI

of programs being subsidized by clinical margins.

3. Explore which traditional university principles and entitlements are sustainable in the current funding scenario and which need modification.

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To protect our historic missions & strategic goals,

we must:

4. Examine school and department policies and practices relative to compensation, appointments, promotions, incentives, assignable income, etc.

5. Become more sophisticated and disciplined in how we allocate and manage our resources.

6. Reinvest margins to stimulate new programs and capitalize on new opportunities.

“Trouble Traps”

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Trouble Traps(i.e. The following will get you into trouble!)

1. Lack of budget discipline. Programs either don’t develop budgets,

don't make realistic projections and assumptions, or don’t regularly

monitor performance against budgets and ignore variances.

2. Confuse fund balances (carry-forward funds) with recurring revenue.

3. Make base building commitments on one-time funds.

4. Commingle resources and obligations of various programs. Don’t

appropriately allocate costs.

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Trouble Trapscontinued

5. Don’t understand limitations of restricted vs. unrestricted (fungible) funds.

6. Don’t understand School’s finances and budget processes. There is no

“off the top fund”.

7. Don’t understand concept of cash flow. You may have adequate, even

substantial, revenues but they may not arrive on same schedule as

expenses.

8. Underestimate salary expense by forgetting to include fringe benefit

expense (20% - 25%).

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Trouble Trapscontinued

9. Confuse Accounts Receivables with Cash.

10. Lack appropriate reserves.

11. ● Letters of offer often too vague about

resource commitments.

● Letters of offer often too explicit or generous

about protected time & entitlements & not

explicit enough about expectations &

accountabilities.

12. Don’t methodically & clearly record commitments &

encumber funds for those commitments.

MARKS’ LAW Of FINANCIAL PHYSICS

You can only spend one dollar

one time!

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13. Failure to adhere to fiscal policy or establish

appropriate system of internal controls.

14. Failure to establish productivity metrics and

expectations for allocation of resources leads to

culture of entitlement & lack of accountability.

Trouble Trapscontinued

15. Aversion to overhead and taxes leads to

inadequate infrastructure.

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Trouble Trapscontinued

16. Balkanization of resources.

17. The power of “yes”.

18. Learning to distinguish between want and need.

19. Underutilizing a competent administrator or overvaluing an

incompetent administrator.

20. Finding appropriate balance between strategic and opportunistic

investments.

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SOM and FPP Cultural Issues

1. Ostrich Mentality

2. Faculty resistance to oversight and overhead.

3. Perfect is often the enemy of good.

4. Risk averse.

5. Intellectual rigor applied to academic missions not equally applied to business decisions.

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SOM and FPP Cultural Issuescontinued….

6. Know more about professional/specialty issues

nationally and internationally than about the

competition across the street.

7. Track team vs. football team mentality.

8. Doing God’s work: entitled to special status due to

inherent social value of the missions.

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Final Thoughts

1. There are no generic solutions. Beware of groupthink.

2. Market forces will not recognize the inherent social value of the

academic mission. Behaviors and processes will have to

change to remain competitive.

3. While academic missions complicate clinical success, they are

all that differentiate us in the market.

4. Shrinking margins will force elimination of marginal missions.

69

Final Thoughtscontinued….

5. Leadership is an art. Good management is not. It’s

process and discipline.

6. Losing money is not the 4th mission of the SOM/FPP.

7. School of Medicine and FPP leaders must act as

trustees of the institution.

8. Recognize the difference between doing things right and

doing the right thing.