Health Care and Fixed Costs

There are many health care plans being proposed to “fix” the growth in medical costs in the United States. Each of these plans has different elements but I haven’t really seen the particular linked issue addressed that I am going to speak of in this blog post.

I make a point of reviewing my medical bills. When you have surgery, for example, you receive an itemized bill. In that bill you can see services from each provider and also the cost for the room, medicine, etc… Frequently the costs seem far out of line from reality (outside the walls of medicine); a room could cost hundreds or thousands of dollars a night; an aspirin or readily available over-the-counter medicine could cost many dollars per pill.

The real issue is that the medical industry is primarily a “fixed cost” business, with very low “marginal costs”. For example, if you look at the Northwestern Hospital facility downtown, a vast series of interconnected buildings, and asked yourself this question:

How would costs vary on a given day if the facility was full of patients vs. having NO patients?

The answer is that the costs for that day would be virtually identical whether or not the hospital had patients. You still need to pay for the facility, the doctors, the electricity, and all the support workers and nurses. Virtually the only “variable” costs that would be avoided are the cost of medicines and food, but the medicines are inventoried and they need to hold stocks in advance and the food must be purchased based on planned demand and the spare food would just be thrown away (the costs would be pretty much the same).

Over some longer period of time if patient loads went WAY down the hospital could make some minor changes. The hospital could lay off some administrative staff (supporting paperwork) and buy less food and hold lower stock levels of medicines. The hospital really couldn’t do much on the level of doctors and nurses unless they wanted to essentially abandon certain types of services (cardiology, ER) because the level of staffing is to a great degree not dependent on the volume of patients but IS dependent on the level of services that need to be provided (hours of coverage, specialists available, etc…).

Fixed cost businesses do not receive price and volume signals the same way a “variable cost” business does, and in fact their internal processes often are not directed towards maximizing profits, because profits by customer aren’t really known. Cost accounting systems often send strange or misleading systems to fixed cost businesses.

Let’s compare the hospital to say, a car repair shop. The car repair shop has some fixed costs, such as the building and a base level of employees and administrative staff. When customers bring in their cars to be repaired, the body shop does an estimate and then purchases the parts from a supplier for the car (adding a markup) and then does the work on an hourly basis (with a markup) and bills the customer. In the very short term only the cost of parts is variable; but in the moderately short term the cost of labor becomes variable because you can easily scale up or down your level of staff, and you can even shorten your hours to limit your support staff costs. In the longer term, if you don’t have enough business to cover your fixed costs you shut down; but along the way you can pretty clearly see that the volume of business and the type of business (you probably make more per hour for your labor then you make on your parts write up) generally shows you the way to make decent decisions. In addition, the billing process is pretty clear for car repair – everyone receives a bill, and people pay by credit card, cash or check. Write offs are relatively rare (and can be avoided by requiring payment to receive the car back).

At a hospital, for example, the real costs are the revenue that you forgo when the facility isn’t full. When you build a facility, you need to UTILIZE the facility and provide the services that you are offering. The cost to provide each of the specialties are hard to determine; you have doctors and nurses and support staff; but then you need to allocate the facilities and beds back to that specialty and apportion some of the other vast overhead to that particular service. Different types of services also have different write-offs for billings; the ER might be packed with people but if they are uninsured then this is a profit-less business and your costs being allocated or assigned to that business are matched with non-revenues. On the other hand, you can’t have a full service hospital without offering these services, so even if they are loss-making (according to the internal costing models) you can’t shut them down without impairing the facility as a whole.

Overall, the best way to run a fixed cost business is to fill it up with people and run it as full as possible. This represents the “utilization factor” such as how airlines (another sad example of profitless enterprises) manage their business. Hospitals, however, also have the problem that many / most of the people aren’t paying full rate, or aren’t paying at all. This is a very difficult problem to manage.

The bill that you receive from the hospital reflects this complexity. That asprin is $10 not because it cost them $10 (you could buy that aspirin for maybe 5 cents as an example on the street, and it would cost the hospital a lot less) but because it is a UNIT upon which they load fixed costs that has nothing to do with the fact that you received this aspirin. The difference between the 1 cent that the aspirin cost the hospital (these are hypothetical examples, I don’t know the real cost of aspirin or the typical markup used) and the $10 you are charged represents the total of all the other costs that the hospital bears that are not itemized on your bill… the support staff, the electricity, the cost of all the uninsured patients in the ER, the cost of lawyers to fight the other lawyers suing the hospital, the cost of other departments that are half empty, etc… People think that if they didn’t get that aspirin their costs would be less; well maybe in the ultra-short term but then the hospital would just tack this cost onto something else like the cost of the room for the night which is why it is cheaper to stay in a five star hotel than in a lousy decrepit room in your local medical complex (with bad food, to boot).

The complexity of costing services in a hospital when a huge percentage of the costs are fixed in the short and medium term and a whole gamut of services must be offered when some are very likely losing money (the ER) because you need to offer a complete package is immense. Add to this a super-complex revenue methodology where there are uninsured patients, government-insured patients, privately insured patients and self-pay patients and the “revenue mix” of these patients varies by service, and it gets even crazier. For practical purposes you could say that there is a huge disconnect between the marginal costs of providing these services and the billings (which will be negotiated) to each user for these services.

This process in a way is kind of like the energy business when it was vertically integrated and regulated. The residents, businesses and government paid for power on a cost basis that is far above the marginal cost of producing power (for hydro power, as an example, the marginal cost of the power is zero) and they each receive different discounts (governments pay the least and businesses sometimes subsidize residents, although not always). This system can work overall if the revenue comes in above costs, but when there are problems it is very difficult to pinpoint who is not paying their fair share due to the complexity and sheer arbitrariness of the cost allocation decisions.

The medical industry can work like the power industry USED to work as long as it is a “closed” system and people can’t escape. As long as the full freight insurers are in the market and the system has enough money to pay bills and salaries, they can prop up the entire system and we don’t need to really take it apart and prune out the money losers and face the consequence of those actions (i.e. poor people not receiving the same services as rich people).

In the longer term, however, there are escape routes. For example, many other countries offer “medical tourism” where you can go abroad and get a hip replacement or cosmetic surgery. The quality of these services can be as high as the general quality of service in the United States; after all, if there was some problem with doctors from the sub-continent we’d have a problem overall because they make up a huge proportion of the doctors here, as well. Medical knowledge is generally known and the equipment is standard (if expensive) – you can and investors do build high quality medical systems overseas that can be operated at a high profit, while being much less expensive on a per surgery level than the US.

How can they be cheaper? Easy. First thing you do is build a giant fence around it to keep out the locals, who are often impoverished and don’t even receive minimal medical care. They don’t have an ER to serve the locals, they just offer the services that paying customers want (the overseas or rich locals). When you go to these facilities, you pay up front or in some defined manner; they aren’t jerking around with an insurance company paying 20 cents / dollar in some semi-random and complex manner. In addition, they know that there is competition for these services, so THEY TRY TO DO A GOOD JOB. You can be an inner city hospital in the US and run like crap for years; as long as the government keeps subsidizing you (and your unionized employees) you will be in business. But these for-profit facilities have to care about their reputation because no one will travel to them unless they have a solid reputation.

On a larger scale, it goes beyond hospitals and includes local doctors and outpatient services. You could see a place like Baja California in Mexico being an area where you could build a local medical infrastructure just to serve the retiree community, at a large profit, while still being substantially cheaper than the US. The key is to be able to wall it off from the local community (or build it where there aren’t many locals, like the resorts do) and make it a tourist or retiree based community at world standards.

The problem with US medical costs is that they are difficult to prepare for. If you lose your job and you aren’t retiree age or impoverished, you will be up the creek in the US. Only the richest people could afford to take on something like cancer without insurance; and insurance is typically tied to your job and the quality of your firms’ health care. If your company goes bankrupt and you are between carriers private insurers won’t touch you if you are already sick, so you are in trouble.

The cost of being sick on a recurring basis is so expensive in the US because of the way costs are allocated. If you keep running into the health system, and you have insurance, you are going to be “allocated” a high share of those fixed costs. If you don’t have insurance then you will get some level of care but the health systems unofficial ways of discouraging you such as long lines will ultimately put you in an unhappy place. What you are actually costing on a “marginal” basis is out of sync with the overall system costs that are being allocated to you.

If you were in a closed system that was funded at market based rates you could “buy” security in advance; someone would fund it as long as they understood the overall system and it was capped to keep out poor or impoverished customers. At this point it is “true” insurance, and there is always someone around to offer insurance if the model is profitable for them.

The purpose of this post is not to recommend reforms to the US system; that is beyond my knowledge. The point of this post is to point out the following facts:

1) any fixed cost model sends poor price signals to customers and providers
2) there are market based equivalents emerging that can win on price and quality for selected services
3) the wider availability of #2 type functions will make #1 less viable over the long term, as quality patients “opt out” of the system and leave the poorer patients inside. There are significant costs to opting out (moving, leaving family) but ultimately this could prove compelling for lots of people

The integrated, fixed costs systems are overall falling apart as the rich become more mobile and can insulate them from the poor with parallel, high-quality offerings. This is true in energy and housing and is starting to prove more and more true in the health care system. And one factor that is driving a lot of this thrash is the poor price and cost signals inherent in a fixed cost, integrated service model.

Cross posted at LITGM

5 thoughts on “Health Care and Fixed Costs”

  1. Carl From Chicago,

    It seems like the post was a bit off-putting because it didn’t get much in the way of comments

    Its really dense material. It took me a couple of passes to get it all. People like me who do not deal with such concepts on a routine basis have to work to understand it. Also, like most vitally important things, its a boring subject except to a small minority of specialist. I mean. its a lazy Sunday afternoon, no one but us geeks are here reading or writing about finances.

    If you want popular post, get them relatively short, low in detail and make sure you piss someone off.

  2. I intentionally don’t want that sort of popularity, that is why I am at Chicago Boyz and not at Perez Hilton :).

    I do like coming here to see the intellectual commentary, comments are usually the best part of a solid environment.

    At LITGM Dan from Madison is on comment duty and he whacks the nutjobs before I even see them.

  3. One of the further barriers to escaping the system is that billing is done by CPT codes, a coding list owned by the AMA which has an abominable royalty policy which I cannot fathom how it stands constitutional scrutiny. It makes price comparisons very hard. I can (and some people do) go around and quote prices of gasoline stations for regular, plus, and super gasoline on the web without paying anybody for the use of the words regular, plus, and super. I cannot assemble a similar web site that covers medical prices. Not only will I have to pay the AMA to enter CPT codes and use them in my database, I will also be charged for every user who comes and price shops on my site.

    Doctors cannot find out their competitors prices for the most part and the insurance market gives a perverse incentive to charge the highest prices to those who have the least ability to pay, poor patients without insurance. It’s a travesty.

    Until the CPT codes are freed of copyright restrictions, we will never have the possibility of a proper free market in medical procedures.

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