HLTH5613 Module 4 strategic option financial analysis example

Pricing the Joint Venture Surgery Center: Capital, Cannibalization, Payback and the Electrophysiology Lab It Pushes Back Two Years

Student Name

American College of Education

HLTH5613: Leading and Strategy Development in Healthcare Organizations

Module 4 Assignment

Instructor Name

March 27, 2028

The Option and Its Assumptions

The previous module recommended that Cedar Plains Regional Medical Center, the invented 180-bed hospital used throughout this course, go into partnership on an outpatient surgery center with the two-surgeon independent orthopedic practice that still operates there, leaving room for further surgeon investors. This module prices that option. All figures are composite estimates prepared for the assignment and stated so that a reader can change any of them and follow the effect.

The center would have two operating rooms and two procedure rooms in a hospital-owned outpatient building. Ownership would be 60 percent hospital and 40 percent surgeons, with capital contributed in the same proportions, a structure intended to fit within federal safe harbor rules for hospital and physician investment, subject to review by compliance counsel. Steady-state volume, reached in the second year, is estimated at 1,450 cases: 220 hip and knee replacements and 1,230 other orthopedic procedures such as arthroscopy and hand and foot surgery. Ambulatory surgery centers can typically perform procedures more quickly than hospital outpatient departments; one national analysis found that procedures took about 25 percent less time in surgery centers, which supports both lower costs and higher throughput (Munnich & Parente, 2014). Every number in a financial analysis is an assumption until the center opens, which is why the assumptions come first.

Capital and Operating Estimate

Capital required is $4.8 million: $2.6 million for construction within the existing building, $1.7 million for surgical and anesthesia equipment and $0.5 million for information systems and start-up costs. The hospital's 60 percent share is about $2.9 million. At steady state, net facility revenue is estimated at $5.73 million a year: $2.53 million from joint replacements at an average of $11,500 per case, reflecting a mix of commercial and Medicare payers, and $3.20 million from other orthopedic procedures at an average of $2,600.

Operating costs are estimated at $3.79 million: $0.92 million for joint replacement implants and supplies at $4,200 per case, $0.62 million for other supplies, $1.55 million for staffing and $0.70 million for occupancy and other expenses. That leaves earnings before interest, taxes, depreciation and amortization of about $1.94 million. After depreciation of about $0.48 million a year, income is about $1.46 million, of which the hospital's 60 percent share is about $0.88 million. The hospital would also receive a management services fee of 5 percent of revenue, about $0.29 million, for operating the center. Reiter and Song (2021) describe how a project's value to an organization depends on the incremental cash flows it generates, which is why the next step, subtracting what the hospital loses, is essential.

Cannibalization and Downstream Revenue

Not all of the center's cases are new to Cedar Plains. The independent group currently performs about 520 outpatient orthopedic procedures a year in the hospital's outpatient department and about 60 joint replacements that are suitable for an ambulatory setting. When those cases move to the center, the hospital loses their contribution margin: an estimated $900 per outpatient procedure and $3,500 per joint replacement, a total of about $0.68 million a year. The remaining 870 cases represent volume recaptured from competitors or new growth.

Recaptured patients also bring downstream revenue that stays at the hospital: preoperative imaging and testing, physical therapy and occasional admissions for complications or complex follow-up care. At an estimated $600 in contribution margin per recaptured patient, that adds about $0.52 million a year. The net annual benefit to the hospital is therefore the $0.88 million share of income plus the $0.29 million management fee plus $0.52 million in downstream margin, less $0.68 million in cannibalized margin, or about $1.01 million a year. Ignoring cannibalization would have overstated the center's value to the hospital by two-thirds; ignoring downstream revenue would have understated it by half.

Payback and Risk

With a hospital investment of about $2.9 million and a net annual benefit of about $1.01 million at steady state, and a first year at roughly half of steady-state volume, the simple payback period is a little over three years. The estimate is most sensitive to volume. If the center reaches only 1,100 cases a year because additional surgeons do not invest, the hospital's net benefit falls to roughly $0.55 million and payback extends to about six years. If the payer mix of joint replacements is more heavily Medicare than assumed, revenue per case falls and payback lengthens further. The main risk identified in the previous module, surgeon participation, is therefore also the main financial risk.

What the Investment Displaces

The finance committee set a $6 million limit on strategic capital over three years. The joint venture would use about $2.9 million of it. The project that would otherwise have used that money is an expansion of the cardiac electrophysiology laboratory, estimated at $2.5 million, which the competitive analysis identified as the second strategic priority because elective cardiac procedures are migrating to the academic center. Approving the surgery center means delaying the electrophysiology expansion by about two years, until the surgery center's distributions and the hospital's operating results allow it.

That delay has a cost. The cardiology service line could lose an estimated 40 to 60 elective ablation cases a year to the academic center in the interim, representing perhaps $0.4 to $0.6 million in annual contribution margin, and some of those patients may not return. The committee should weigh that cost against the larger and faster-growing loss in orthopedics. Ginter et al. (2018) note that strategic decisions allocate scarce resources among competing priorities, and naming the priority that loses is part of making the decision honestly.

What the Estimate Leaves Out

Three factors are not in the numbers, and each could matter. The first is the effect on the hospital's relationship with the academic center's orthopedic group, which may see the joint venture as competition and move even more of its remaining cases away; the estimate assumes no further loss, which may be optimistic. The second is the potential for a direct employer contract, the complementary option from the previous module, which would add commercially insured joint replacements at a negotiated price and improve the payer mix assumed here. The third is regulatory: if Medicare changes the payment rates for ambulatory joint replacement, revenue per case could move in either direction. None of these can be priced with confidence now, and the committee should treat them as reasons to review the estimate at six-month intervals once the center opens rather than as reasons to delay the decision.

Conclusion

The joint venture surgery center requires about $2.9 million of hospital capital and, after accounting for the hospital revenue it will cannibalize and the downstream revenue it will bring back, should return about $1.0 million a year at steady state, for a payback of a little over three years. The result depends heavily on recruiting additional surgeon investors. The investment displaces the electrophysiology lab expansion for about two years, at a cost of some elective cardiac volume. On balance, the numbers support the joint venture, and they tell the committee exactly which assumption to watch and which priority it is choosing to defer.

References

Ginter, P. M., Duncan, W. J., & Swayne, L. E. (2018). Strategic management of health care organizations (8th ed.). Wiley.

Munnich, E. L., & Parente, S. T. (2014). Procedures take less time at ambulatory surgery centers, keeping costs down and ability to meet demand up. Health Affairs, 33(5), 764-769. https://doi.org/10.1377/hlthaff.2013.1281

Reiter, K. L., & Song, P. H. (2021). Gapenski's healthcare finance: An introduction to accounting and financial management (7th ed.). Health Administration Press.