Capital Budgeting in Healthcare Organizations

Abstract

Capital budgeting has become an increasingly important aspect of operations for the healthcare industry in recent years. Escalated competition, coupled with significant changes in third-party payer policies, have augmented the nee~ for healthcare organizations to place more emphasis on long-term financial stability. Since hospitals must continually expand services to keep up with changing technology and demand, this stability is accomplished primarily through the purchase of new equipment, renovations of old equipment, or the development of new service programs. Such asset acquisition yields future cash inflows, so they represent a substantial form of investment for hospitals. Thus, effective budgeting for capital expansion has a substantial effect on the long-term financial status of healthcare institutions. This Work Experience Senior Individualized Project (WESIP) involved work on a capital budgeting project for Borgess Medical Center (BMC). BMC is a 336 bed medical facility located in Kalamazoo, Michigan. It is a not-for-profit healthcare institution, and the core of the Borgess Health Alliance, a group of affiliated area hospitals. The finance committee of BMC wanted to develop a Return on Investment (ROI) model that it could use to consistently evaluate capital requests. The model would be implemented for those requests subject to evaluation- that is, any project not required of the hospital by a change in legislation, and any project over $150,000. Prior to this, the hospital did not have a specific model that was used for such evaluation. Departments often conducted individual assessments of their proposals, using different methods of evaluation. Additionally, each department used various sources of information to carry out their ROI computations. This system resulted in inconsistent and sometimes inaccurate evaluation of a proposed project's investment value. The WESIP project was an attempt to eliminate such inconsistency, and establish a standard capital budgeting system to be utilized for all pertinent requests. It was my specific task to design a spreadsheet on the Lotus 123 software, that was capable of performing ROI computations such as Net Present Value (NPV) and Internal Rate of Return (IRR). It was also necessary that the model be able to incorporate special modifications into its calculations due to some of the characteristics specific to the healthcare industry that will be discussed subsequently. The program was to be automated, so that a user need not fully understand Lotus to operate it. Finally, the design of a standardized data form, containing the input information necessary to run the program, was required so that the information provided by departments about their requests was consistent. This report will reflect information gathered while researching the topic of capital budgeting in healthcare, as well as knowledge gained while constructing the ROI model. Although research was initially important to the study, much of the information came through direct work on the model itself. Most of the research contained only the key principles (or slight variations) of capital budgeting. However, I found that many modifications to the traditional theories were necessary to apply capital budgeting to the specific industry of healthcare. The Research section of this study will briefly discuss the history leading up to the current situation in the industry. It will deal primarily, though, with some of the modifications involved in improving the quantitative accuracy of capital budgeting in healthcare. Those factors that will be presented include discounted cash flows techniques, the cost of capital, new revenue reimbursement, cost reduction reimbursement and additional, non-quantitative considerations. The Materials section of this study will present the model, and briefly explain how it functions. This will be followed by an example of the model applied to a past capital request.to demonstrate how it improves accuracy. Finally, the Integration section will contain my conclusions and personal reflections gained through work on this WESIP.