Understanding Your Costs

One of the most significant disagreements I see amongst partners is the allocation of costs. They typically fight over who pays for how much of the expenses incurred by the practice. As I begin to work with them, I discover they all are not on the same page in understanding what a cost is. A cost is not simply a cost. There are many types of costs. If you want to track and control something such as a cost, you must first understand the nature of it.

What is a Cost?

The simplest definition of a cost is the value of money which is used up in the production of a good or service. It’s how much money you spend on creating your service. Costs may also be referred to as charges, expenditures, outlays, payments, and expenses.

There are two broad classifications of costs in business, fixed costs or variable costs. There are also direct and indirect costs. Usually what people fight over is the allocation of costs, and that involves the fixed and variable costs.

Fixed vs. Variable Costs

Fixed costs are those costs that are fixed. They do not change over the course of a year and are the same from month to month. An example would be rent, insurance, and subscription services. These costs are unaffected by how busy or slow your practice is. If you see ten or one hundred patients in one month, these costs do not change. The good news is that as your productivity increases, your fixed costs per patient decreases.

Variable costs are those that change with the productivity of your business. If you pay your employees by the hour and they work more hours, then you will spend more money as they work more hours. As your business activity fluctuates, so will these costs. The variable costs per patient will remain constant over a given period.

Then there are semi-variable costs. The best example of this would be your cell phone bill if it’s not an unlimited plan. Let’s say you have 10GB of data per month for $50. If you exceed your 50GB data allotment, then you are charged $10 per 1GB extra. As long as you stay under 50GB, your cell bill behaves like a fixed cost. If you go over 50GB, it acts as a variable cost.

How to Figure Your Costs

Figuring out what your costs are is easier than you might think. There are a few methods you can use. Perhaps the easiest is to sit down with your accountant or office manager and go line by line through your expense reports and mark which ones are fixed and variable expenses. Once you’ve done this, you can begin to monitor and allocate those costs.

If you haven’t done that, then you can use a simple mathematical process to estimate your fixed and variable costs. For this, you’ll need your monthly expenses for many consecutive months, preferably a whole year. You will also need your activity levels for these months as well.

The first step is to plot your expenses as a function of time. On the x-axis, you’ll have your months, and the y-axis will be your total expenses for the month. Using a program like Excel, you can perform a linear regression to estimate the cost function of the data points. Typically, Excel will create a linear equation, y=mx+b, where b represents your fixed costs and m represents your variable costs. This can be a good starting place as you begin to budget and plan for your fiscal year.

An Example

Drs. Smith and Davis are partners in a clinic. Dr. Smith holds clinic five days a week. Dr. Davis only sees patients three days a week. The utilities, rent, and insurance are split evenly between the partners. The reasoning is that if Dr. Davis were to operate in a solo practice, those costs would remain if he saw patients one day or five days each week because they are fixed. The variable costs, which are the labor costs of the office staff, are assigned to each physician according to their productivity. Their relationship works because they agreed to their fixed and variable costs. They could also decide to divide up the fixed costs by ownership in the practice or by a number of days worked in a month. The more critical issue isn’t how you decide to allocate your costs, but rather that everyone involved knows and agrees to it. I encourage you to have a similar conversation with your partners if you have done so already.