Daniel K. Zismer
Jay B. Sterns
Does business model design predict capital efficiency performance in community health systems?
At a Glance
- Community health system design plays a role in capital efficiency, including returns on invested capital.
- This role becomes important in a future healthcare world of pressured payments, increased consolidation, constrained resources, and stretched community service missions and budgets.
For many industries, capital asset efficiency is a principal focus of management and management strategy, especially industries that have intensive capital asset requirements (property, plant, and equipment). Health care in the United States is such an industry, in that it requires significant investments in capital assets. Yet community health system executives tend to focus less on capital asset management, or efficiency, than do their counterparts in other capital-intensive industries. This difference is largely due to the business model traditionally used by health systems, which is designed for the relative independence of both the community hospital and affiliated physicians.
Under this business model, physicians in independent medical practices organize themselves around independent community hospitals (typically not-for-profit, tax-exempts) and use hospital assets for their livelihoods. They are not, however, responsible for capital cost or maintenance. With this model of community healthcare delivery, capital asset ownership is typically "weighted" toward the hospitals. However, larger, well-organized physician groups (especially the larger, multispecialty group practices) may also own and control substantial capital assets, which may be deployed in competition with "affiliated" hospitals. Such assets include, for example, large ambulatory facilities that house surgical and procedural services, diagnostic imaging, rehabilitation services, diagnostic laboratories, and other physician-owned ancillary services. Consequently, this traditional business model offers community health systems limited opportunities for capital efficiency.
A "Reforming" U.S. Healthcare Marketplace Drives Consolidation
The traditional business model in health care is undergoing a transformation under the influence of healthcare reform legislation and related initiatives. Market, economic, regulatory, and legislative market forces are converging to pressure the provider side of the U.S. healthcare delivery system, with the effect that the industry will likely see increasing consolidation, especially involving physicians becoming engaged as employees of community health systems. This trend is evident in U.S. markets, according to Modern Healthcare's annual report ranking "integrated health systems" on several comparative characteristics. The health systems described in this report can be categorized into two "affinity groups":
- Health systems that employ some, but not all, physicians required to meet mission-related, clinical, strategic, and financial needs
- Health systems that employ nearly all the physicians required to meet those needs
This second group can be "fully integrated" community health systems, which are often led or co-led by physicians. Most include physicians extensively in governance, in senior leadership of the "embedded" physician enterprise, and in the co-management of key clinical service lines. Clinical programs and capital asset platforms are often sized to the medical group, and by definition, physicians are not "independent." They do not compete with the health system for patients and revenues.
Capital Efficiency of Fully Integrated Versus Less Integrated Health System Models
Given the important differences between these two groups, two questions have growing significance for U.S. community-based health systems:
- As community health systems become more "integrated" (i.e., with physicians as fully integrated, employed, and engaged members of community health systems), can capital assets be more efficiently applied?
- Do the model, method, and degree of integration offer different opportunities to improve capital asset efficiency?
The questions assume that as economic pressure on U.S. health care intensifies, the industry's leaders will need to focus more time, attention, and innovation on capital asset allocation, application, and efficiency as a principal management goal.
For this study, we based our investigation on the working hypothesis that fully integrated models are more capital efficient, and returns on capital assets of these models should be better than those of less integrated models. We defined a fully integrated community health system as one that employs most, if not all, physicians required for its mission, strategy, clinical services models, and financial performance.
The rationale for the hypothesis:
- With the fully integrated model, physicians, by definition, are not competitors with their affiliated hospitals.
- Capital assets can be more readily rationalized (sized) to a unified strategic business plan.
- Clinical care processes are more reasonably amenable to "best practices," producing more efficient utilization of capital assets.
- Because physician compensation is typically tied, in part, to the performance of the integrated model, physicians will be more mindful of the application of funds to capital asset purchases.
For the two groups of integrated health systems identified, we examined audited financial statements from 2004 and 2009. In each category,14 health systems were identified from the list of self-identified and self-reporting integrated health systems included in Modern Healthcare's "Top 100 Integrated Health Systems" report. The 28 health systems are shown in the exhibit below.
The goal was to create two groups for comparison with minimized selection bias, except as distinguished by investigators' definition of fully integrated. Group A, therefore, consisted of 14 integrated health systems that met the criteria for this definition, while Group B consisted of the top 14 ranked integrated health systems, excluding any listed in Group A.
Invested capital was defined as gross property plant and equipment (PP&E) rather than net PP&E. To measure financial returns on gross PP&E, we examined operating cash flows, defined as operating income plus depreciation/amortization and interest. We used pre-interest cash flow so we could measure the cash generated by the assets, regardless of financing methods and related costs.
Our investigation revealed that the average return on invested capital for Group A was 10.9 percent in 2004 and 11.1 percent in 2009, a 1.8 percent growth rate. The standard deviation was 1.9 percent in 2004 and 2.1 percent in 2009.
The average return on invested capital for Group B was 11.6 percent in 2004 and 10.9 percent in 2009, a 6 percent drop in growth rate. In 2004 standard deviation was 2.9 percent and 3.5 percent in 2009 for a 20.6 percent increase in standard deviations.
We also examined capital expenditures for Group A and Group B in 2004 and 2009 and compared these results with accumulated depreciation expense between the two years. The ratio was 320 percent for Group A and 248 percent for Group B. The standard deviation for these measures was larger for Group A than for Group B- 152 percent and 91 percent, respectively.
Group A health systems invested substantially higher amounts of their depreciation expense in physical assets in 2009 than they did in 2004. This increase may have been due to greater confidence in the business model, or it may have been due to other factors.
This would be an area worthy of follow-up investigation because the weakening U.S. economy in 2008 and 2009 caused a downturn in health system investment portfolios with corresponding negative effects on balance sheets and, for some, credit ratings. Under such market conditions, a continuation of comparatively aggressive approaches to investments in physical assets would not be expected.
In response, the Group B organizations may have significantly curtailed capital expenditures while the Group A organizations, heavily governed and managed by physicians, may have been more inclined to continue investing in their core operations rather than copy Group B and much of corporate America.
We also examined the average age of plant and equipment to determine how the two groups compared on reasonable measures of deferred capital expense. Average age of plant and equipment is calculated as accumulated depreciation/ current depreciation expense. For Group A, these ratios were 9.3 in 2004 and 9.6 in 2009. For Group B, the ratios were 9.4 in 2004 and 9.9 in 2009. Based upon these calculations and comparing standard deviations of calculated means, Group A organizations' continued investment in capital assets limited their growth in average age of plant to 0.3 years. The average age for Group B organizations increased by 0.5 years.
In addition, Group A organizations had a lower average age of plant in both 2004 and 2009 and lower standard deviations, indicating that these organizations, with common business models, may have similar capital investment philosophies.
A possible explanation for the differences may be that Group A organizations are early adopters of complete and comprehensive electronic health records, such as complete system conversions. IT investments reduce the average age of physical assets due to their rapid depreciation relative to plant and property.
Interpretations and Impressions
The data indicate that returns on invested capital for Group A, the fully integrated organizations, have less variance as measured by standard deviation than for Group B. This finding is true for both 2004 and 2009, and the standard deviation was approximately 50 percent higher for Group B than for Group A in both years. In addition, the returns on invested capital for Group A were more consistent-the ratio increased by 0.2 percent between 2004 and 2009, whereas for Group B, it declined by 0.7 percent.
The ability of Group A organizations to integrate strategic and capital planning, where the hospitals and physicians are part of one economic unit, enables their assets, once placed into service, to generate a more consistent return than could be generated by the assets of Group B organizations, where physicians are independent economic actors who may or may not use capital assets at the expected level. In addition, the return on capital invested is greater than the cost of tax-exempt borrowing, the most common form of third-party capital for the hospital industry.
MultiCare Health System, a fully integrated health system in Tacoma, Wash., has seen significant improvement on its return on assets between 2004 and 2009. As part of Group A, the health system has been able to integrate strategic and capital planning. As depicted in the exhibit above, MultiCare increased property, plant, and equipment in excess of $600 million between these two years, reducing the average age of plant by 0.44 years to 9.19. Cash flows were $159 million greater in 2009 than in 2004, resulting in an increased return on PP&E from 6 percent in 2004 to 23 percent in 2009. While many healthcare providers struggled with operating difficulties during the economic downturn, by 2009, MultiCare Health System had increased cash flow 260 percent over its 2004 level, translating into the 23 percent return on PP&E.
This study, although limited in scope and by methods, lends beginning support to suggest that community health system design plays a role in capital efficiency, including returns on invested capital. Such findings become important in a future healthcare world of pressured reimbursements, increased consolidating, constrained resources, and stretched community service missions and budgets.
We shared the results of our study with a small group of integrated health system leaders, who said they were not surprised with the findings. For all, it was intuitive that the integrated model should produce a more efficient capital asset base. None of these leaders' organizations, however, routinely monitors or evaluates capital asset efficiency in any organized manner, which supports a secondary goal of this study: to encourage further development of useful and practical methods for the planning, application, and management of capital assets in community health system organizational designs.
Daniel K. Zismer, PhD, is associate professor of health policy and management and director of the MHA and Executive Studies Programs, University of Minnesota, Minneapolis (firstname.lastname@example.org).
Jay B. Sterns is a director, Barclays Capital, Chicago (email@example.com).
Bill Claus is assistant vice president, Barclays Capital, Chicago (firstname.lastname@example.org).
Publication Date: Friday, July 01, 2011