Capital Budgets

Los Reyes Hospital (A)
Preparing this budget requires many assumptions that I’m not the least bit qualified to make. If the hospital is to have something that’s realistic, I’m going to have to involve the physician chiefs and a few other
key managers. The real question is how best to do that.
Alex Cohn, the Chief Financial Officer of Los Reyes Hospital, was commenting on the frustration he felt as he began the process of preparing the hospital’s budget for the upcoming fiscal year.
As a first step in the process, he had requested some basic information from each of the hospital’s
clinical and service departments. He continued:
In reviewing this information, I realized that I simply couldn’t make many of the budgetary decisions in a
sensible way. So, I thought it would make sense to decentralize some decisions to the clinical and service
departments. However, I know that I’ll encounter some resistance in doing that since these people have
never been involved in budgetary decision making before. I thought it might make sense to show them
how they could become involved in a way that takes advantage of their expertise. I only hope that I’m not
creating a monster of some sort!
To demonstrate the potential role for physician chiefs and service department managers in formulating the hospital’s budget, Mr. Cohn chose four case types in the department of medicine and
four hospital service departments as the building blocks for a sample budget. He felt that if he
could demonstrate a better approach to budgeting for these four case types and four departments,
his approach then could be expanded to cover the rest of the hospital.
The four case types he chose were DRG089 (Simple pneumonia & pleurisy, age over 17),
DRG014 (Specific cerebral vascular disorders except transient ischemic attack), DRG096
(Bronchitis & asthma, age over 17), and DRG140 (Angina pectoris). The four service departments
he chose were routine care (i.e. the hospital stay itself), radiology, laboratory, and pharmacy.
Financial Information
Mr. Cohn used the information he had obtained from his meetings and conversations with the
the chief of medicine, Maria Delgado, M.D., to determine how many cases of each type she expected the physicians in her department would treat during the upcoming year, and how many units
of service she expected each case would use from each of the four service departments.
Since most of the hospital’s contracts used a diagnosis-based form of payment, he then discussed the expected revenue the hospital would receive for each case type with his manager of contracting. The results of his information gathering efforts are contained in Exhibit 1.
Mr. Cohn next met with the heads of the four service departments to discuss and agree on their
variable expenses. Since the hospital had just completed a lengthy and extensive study of the breakdown between its fixed and variable expenses, this information was readily available.
He determined that the variable expenses were as follows:
Day of routine care $250
Radiology film 25
Laboratory test 15
Pharmacy unit (e.g., a prescription) 5
HBSP Product Number TCG147
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This case was prepared by Professor David W. Young. It is intended as a basis for class discussion and not to illustrate either effective or ineffective handling of an administrative situation.
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The final step in his analysis was to determine the fixed costs of the department of medicine.
This information also was quite readily available because of the study that had been completed. He
concluded that the department would have fixed costs totaling $1,950,600 for the upcoming year.
These consisted of both the department’s direct fixed costs and costs that would be allocated to it
from the hospital’s service centers (such as housekeeping, laundry, and dietary).
Mr. Cohn then asked his staff assistant to use this information to prepare a budget for the department of medicine for these four case types and the four service departments. He realized that
this budget would not show the complete operating activities for the department of medicine, since
the department treated many more case types. Nevertheless, he felt that if he could present the information to Dr. Delgado in an easily understandable form, she would see its value, and would be
willing to use the same process for completing the budget for the remaining cases in her department.
Assignment
1. Using the information contained in the case and Exhibit 1, prepare a budget for the department of medicine
for the four case types shown. Organize your figures so that Dr. Delgado will find them understandable and
useful. In so doing, try to set up a spreadsheet to calculate the budget, and make it as formula-driven as possible. This will allow you to easily test assumptions in answering Question 2.
2. Assuming Dr. Delgado and Mr. Cohn are unhappy with the “bottom line” of this budget, what options are
available to change it? Which options seem the most feasible to implement?
3. What approach should be taken to include the department’s fixed costs in the budget? If, after attaching the
appropriate amount of fixed costs to each DRG, one DRGs is losing money, what action should Dr. Delgado take?
4. What problems do you think Mr. Cohn will encounter in attempting to expand this effort to the rest of the
department of medicine? The rest of the hospital? What should be done about those problems?
LOS REYES HOSPITAL (A)
Exhibit 1. Budget Data
Expected Expected Expected Expected
Expected Expected Days of Radiology Laboratory Pharmacy
Number Revenue Routine Care Films Tests Units
DRG of Cases per Case per Case per Case per Case per Case
089 300 $6,000 9 5 10 55
014 200 6,500 11 6 10 20
096 100 5,000 7 4 3 12
140 50 3,000 4 1 5 21
TCG147 • Los Reyes Hospital (A) 2 of 2
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