modelH update: Costs

by Kevin Riley

modelH update: CostsEditor’s note: This article is an update on modelH, the dynamic co-creation forum created by Kevin Riley and Associates, Innovation Excellence, and Batterii where healthcare innovators from around the world are building a foundation for new business models in healthcare. Their goal is to co-create an open source business model canvas that applies specifically to the US healthcare system.

Learnings on Costs for the Business Model Canvas for Healthcare (modelH)

We just wrapped up our 14th business building block sprint on Costs. In summary, the sprint for Project 1.14 on Costs completed 2 objectives:

  • What are the questions to ask on the canvas for the Costs?
  • What tools do you need to understand your business model costs?

modelH update: CostsWhy Do Costs Matter So Much More in Healthcare Business Models?

Before we get into the findings from this part of the modelH forum, I’d like to share a few facts that demonstrate why Costs are such an important part — perhaps the most important part — of your healthcare business model. This idea is supported by the fact that federal spending for health care programs is growing much faster than other federal spending in comparison to the economy as a whole. In 2011, the most recent year in which most of the countries reported data, the U.S. spent 17.7% of its GDP on health care, whereas none of the other countries tracked by the OECD reported more than 11.9%. The following graph shows the misalignment regarding the spending of U.S. healthcare dollars (as a percent of GDP) with the rest of the world. And there’s also a debate about just how well the American health-care system works. As the Journal reported recently, Americans are living longer but not necessarily healthier.

According to the Congressional Budget Office, total spending for healthcare in the United States in 2011 was approximately $2.5 trillion. Private financing accounted for 53 percent of that spending, and public sources made up the remaining 47 percent. It has not slowed. According to the CBO’s 2013 long-term budget outlook report, healthcare spending will increase to approximately 22 percent of the gross domestic product by 2038 under current law. The increase in overall costs is driven by various factors such as an aging population, new medical technologies, and expanding health insurance coverage.  Likewise, the CBO projects spending on federal healthcare programs including Medicare, Medicaid and the Children’s Health Insurance Program will grow much faster than the economy, increasing from their current level of 5 percent of GDP to 8 percent by 2038.

1. Questions to Ask on the Canvas for the Key Behaviors Block

We defined the Questions that should be added to our business model canvas for helping practitioners define the Costs for their healthcare business models.

  1. What are the most important fixed Costs inherent in our business model?
  2. What are the most important variable Costs inherent in our business model?
  3. What drives these Costs and which ones are controllable?
  4. What Costs can be reduced through economies of scale?
  5. What Costs can be reduced through economies of scope?
  6. Which Key Behaviors are most expensive?
  7. Which Key Resources are most expensive?
  8. Which Key Activities are most expensive?

2. What tools do you need to understand your business model costs?

What are the key Costs a business model should identify and what tools do you need to show those costs?

As discussed above, healthcare costs are out of control, and it is hard to tell the good costs from the bad. To do so, we must first agree on what defines value within the healthcare ecosystem. Our definition of value is based on Michael Porter’s work in What is Value in Health Care? Porter explains this definition as “the patient health outcome achieved per healthcare dollar spent.”  Therefore a value-based healthcare business model must result in:

  • Increased access to necessary care through an engaged delivery system;
  • Reduced aggregate cost of care, with a market-driven, balanced incentive and reward model; and
  • Improved consumer experience yielding an informed decision maker aligned to their risk and reward.

It is this second pillar that we are focused on. What are the key Costs a business model should identify and what tools do you need to show those costs? It really depends on which side of the model you are looking at … patient, provider, payer, or purveyor. They are all inter-related.

Let’s look at this question slightly differently. In general, you have all the information you need from your business model’s P&L (aka your Income Statement). For example, if your business model is around the provision of care, your items of importance might look like this:

  • Revenue (what you are paid to provide that care)
  • Cost of Goods Sold (aka your actual medical cost)
  • Gross Margin (Revenue – Cost of Goods Sold)
  • Operating Costs (anything that is not specifically part of the delivery of care)
  • Operating Income (Gross Margin – Operating Costs)
  • Other Income and Expenses (Investment Income, etc.)
  • Income Tax
  • Net Income

Which Costs Should I Be Concerned About?

Your base costs are probably from one of these “Standard Expenses.

  • Salary, Wages and Benefits
  • Professional Fees
  • Rent
  • Utilities
  • Depreciation and Amortization
  • Interest
  • Maintenance

Then you might want to layer on “Expenses Impacting Gross Margin/Profit,” which are typically industry specific.  In insurance, for example, these are categorized as medical expenses.  In Retail, this would be considered a cost of sales.

Then you will want to add in your “Expense Accruals,” which are industry specific as well.  For example, insurance companies are required to book reserves for claims incurred but not reported (called IBNR). Keep in mind that Accruals are contingent upon your method of accounting – cash versus accrual accounting.

So How Can I Track My Costs?

Though your business model is still just an idea, you can build “budgeted” expenses in Excel.  When your business model becomes a “business,” you need to start tracking “actual” expenses. Actual expenses are tracked in accounting software such as QuickBooks, PeopleSoft, etc.

This process of budgeted versus actuals will be repeated for as long as you run your business – at least we hope that you follow this method. As such, as you mature, we recommend using the same system for building your budgets that you do for tracking your actuals.  This will make tracking your variance analysis much easier.

As an additional exercise, it is interesting to compare the costs in a proposed business model versus the costs when doing nothing. For example, what are the costs of not changing the old business model – and are they more or less to the User, Buyer, and System.  If they are less, you should question the value of your business model beyond your own financial benefit.

In conclusion

We offer these closing words of advice: Accuracy and clarity on your finances will make the difference between success and failure. You cannot run a business – any business – without an accurate and timely understanding of where your money is being spent. Having started several healthcare companies, some successful and some not, my biggest learning has been two-fold:

  1. Utilize a trustful and qualified financial expert who understands the business you are in, and
  2. Involve that expert from the start.

Take time to incorporate these approaches into the Costs block in your business model canvas. Regardless if your business model is aimed at Patients, Providers, Payers, and or Purveyors, defining the Cost is a fundamental discipline you need in order to make your idea into a successful company.

What is Next?

We are finishing up our current project sprint on Platforms this week, and have just launched our final project sprint on Externalities, which will wrap up on December 30.

Interested in what we are doing?

Step up to the plate and become involved. This first major stage of modelH is coming to a close, so don’t delay.