The Beach Street office of Getwell Clinics specializes in the treatment of three

Question

The Beach Street office of Getwell Clinics specializes in the treatment of three types of patients: DRG M, DRG J, and DRG P. The operating statistics for patient care of these three DRGs for last year are shown below. They include patient volume proportions, average charges, average variable costs, and the amount of specific fixed costs assignable to each DRG. In addition, the satellite office had joint fixed costs last year of $240,000.

Getwell Clinics Operating Statistics
DRG Proportion Charge Variable Cost Fixed Cost
M 50% $1,700 $1,000 $500,000
J 30% 2,600 1,200 280,000
P 20% 900 600 110,000

Joint Fixed Costs 830,000
100% $1,720,000

Doctor Barkley, newly appointed director of the satellite office, has requested that you determine the breakeven points for each DRG. Dr. Barkley also wants to know which DRG would be the most profitable to promote in growing the practice. A recent time study showed that procedures involved in each DRG took the following time: DRG M, 2 hours; DRG J, 5 hours; and DRG P, 1 hour.

· Prepare a formal and comprehensive response to Dr. Barkley that demonstrates understanding of the Week Three objectives.

o Explain the relevance of DRG analysis as a tool that drives costs and affects management decisions in healthcare.
o Calculate the breakeven points, in numbers of treatments, for each type of DRG, using the weighted average contribution margin approach.
o Propose your recommendations that answer the following questions:
· Which DRG must be promoted in an advertising program if the office has excess capacity? Explain why.
· Which DRG must be promoted if the office is almost at maximum capacity in terms of available hours? Explain why.
· What rationale may be used to support the use of DRGs as an approach to allocating costs?

Explanation / Answer

All figure (per unit)                DRGM                        DRGJ              DRGP

Sales                                       1700                            2600                900

(less)VC                                  (1000)                         (1200)             (600)

Contribution margin               700                              1400                300

Hours required                        2 hrs                            5 hrs                1 hr

Contribution per hour[1]          350                              280                  300

Fixed cost                               500000                        280000            110000

Contribution margin ratio[2] 41.18%                       53.85%           33.33%

Since contribution per hour from DRGM is highest maximum units should be sold to generate more profit.

Weighted average contribution margin[3]:

= 0.4118*0.5 + 0.5385*0.3 + 0.3333*0.2 = 43.41%

Breakeven volume for the company[4] = $890000 + $830000 / 0.4341 = 3962220

Now simply allocate this $3962220 in the ratio of sales mix which is 50%:30%:20%

Hence DRGM (50%) = 1981110

            DRGJ (30%) = 1188666

            DRGP (20%) = 792445

Now get the breakeven dollars and divide it by the selling price per product respectively to get break even units:

Hence DRGM = $1981110 / 1700 = 1165 units

            DRGJ = $1188666 / 2600 = 457 units

            DRGP = $792445 / 900 = 881 units

Rationale: Since all units are separate investment centres joint cost can be allocated based on a proper allocation base.

  

[1] Contribution margin per hour = Contribution margin per unit / Number of hours required

[2] Contribution margin ratio = (Contribution margin per unit / selling price per unit) *100

[3] Weighted average contribution margin = contribution margin ratio * sales mix %

[4] Breakeven dollars = Total fixed cost / Weighted average contribution margin

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