Introduction

Not only is healthcare business, it is big business.

The healthcare–industrial complex incorporates multiple sectors to deliver health and depends on an expanding group of interdisciplinary teams, services, and institutions to achieve this value proposition. Business sectors involved in the delivery of healthcare include not only professionals such as doctors, nurses, and administrators, but also hospitals, nursing homes, and home healthcare groups; drug manufacturers and developers; manufacturers of medical equipment and instruments; diagnostic laboratories; biomedical research; and biotechnological entrepreneurs.

Current estimates by the Office of Economic Cooperation and Development place healthcare spending at 16.0% of US gross domestic product, with that percentage expected to increase to 19.5% by 2017.¹ For every dollar spent in the US on healthcare, 31% goes to hospital services, 21% to physicians, 10% to pharmaceuticals, 8% to nursing homes, and 30% to other categories, such as diagnostics laboratories, medical equipment, and medical devices. Of note, 7% of total spending is assigned to administrative overhead costs.

If healthcare provided by physicians is not business, then physicians are certainly surrounded by business; they must navigate a complex environment that is full of paradoxes, inefficiency, and bureaucracy. Unfortunately, physicians receive no formal education in business but must learn on the job, through mistakes and successes, often one patient and one business problem at a time. Although many critics argue that healthcare has been tainted by the intersection with big business, which places the bottom line at the top and undermines the physician–provider relationship, many other thought leaders contend that healthcare needs business, to help solve problems of inconsistent quality, sporadic access, and rising costs. Indeed, business thinking and business processes are desperately needed to transform our current system, so that healthcare can be available to all people, at fair-market prices, to improve the health of our community.

Why should plastic surgeons care about the business of healthcare? From an individual perspective, every plastic surgeon must either run a business or be part of a business, if the surgeon’s practice is to thrive, grow, change, and continue to provide high-quality care. Whether one works for oneself, for a hospital or health maintenance organization, for an academic institution, for a nonprofit or nongovernmental organization, for a free community clinic, or for an overseas volunteer mission trip, plastic surgeons are involved with organizations that utilize business principles and interface with business entities.

From a broader perspective, however, plastic surgeons are uniquely situated to serve as leaders of healthcare systems and healthcare businesses. Given our extensive training, our collaboration with multiple specialties, our diverse portfolio of services that we provide, our problem-solving skills, and our entrepreneurial spirit, plastic surgeons have the leadership skills, influence, and positioning within the healthcare system to effect real change. Just as the Greek word plastikos, which means to shape or to mold, was chosen to describe what we do as surgeons, this word could also impart upon us the ability to shape or mold our systems of healthcare delivery.

The knowledge and application of business principles are of paramount importance if plastic surgeons are to become and remain leaders in healthcare. The purpose of this chapter is to provide a broad overview of the essential principles that characterize what a business does and how a business does its work. Each section offers a very superficial view, and readers are strongly encouraged to explore in more depth the following components of this chapter:

At the very least, plastic surgeons must learn the language of business, so that we can have meaningful interactions with hospital administrators, insurance carriers, salespeople, and marketing firms. Hopefully, though, plastic surgeons can utilize the principles of business to improve the care that we provide, and in the end, to transform the industry in which we practice our science, and our art.

Strategy

Competitive advantage begins and ends with strategy. Nearly all of the components of business are affected by strategy, from finance to operations, from marketing to managing human capital, and therefore a review of business principles should commence with an understanding of how strategy guides decision-making within an organization.

Strategy can be characterized as the art of inducing your competitor to do something else, while you focus on doing what you do well. In more academic terms, strategy is the process of forming, implementing, and evaluating decisions that enable an organization to achieve its long-term goals. Strategy is dictated by (and in turn, can influence) the organization’s mission, vision, and values, which serve as a foundation to guide policy, projects, and programs. Furthermore, strategy is about competing on differentiation – creating a value proposition, in which a firm provides the consumer with a product or service of greater quality or at less cost than its competitor, deliberately choosing a different set of activities to deliver a unique mix of outputs.

Before examining specific strategic principles, one should become familiar with how the business environment affects the flow of inputs to outputs, along the supply chain. Because value is added at various points along this process, the entire axis, from supplier to consumer, is called the value chain. Primary activities of the company, which include inbound logistics, operations, outbound logistics, marketing and sales, and ultimately customer service, each create value that manifests in the final product; these processes are guided by strategic priorities and are coordinated by support activities that include technological development, human resource management, and firm infrastructure.

The most established and respected model of the business environment is Michael Porter’s 5-Forces model of competition (Fig. 5.1).² Each industry contains: (1) previously established competitors; (2) the potential for new entrants; (3) the threat of substitute rivals, who often compete on price; (4) suppliers, who can have significant bargaining power; and (5) buyers, who create demand for the outputs. Understanding the environment of a specific industry, such as healthcare, can strengthen decision-making and help with strategic planning. For example, how should an academic plastic surgery practice respond to the influx of recently graduated residents into the community? How should the solo private practitioner attract new patients in a fixed market, when a group practice dominates the landscape? How should surgeons challenge scope of practice with nonsurgeon physicians and nonphysician providers? What is the optimal portfolio of services, specifically the mix of reconstructive surgery, cosmetic procedures, and skin care, to achieve the goals of the organization?

Fig. 5.1 Strategy: Porter’s 5-Forces model. HMOs, health maintenance organizations; PPOs, preferred provider organizations.

Once the dynamics and landscape of the business environment are defined, specific decisions can be made regarding change in operations, marketing, investment in new assets, alliances, or supply chain.^3–5 Most mature industries, such as the automotive industry or the personal computer industry, settle into a competitive scenario in which one firm dominates with 60% market share, while a second firm contains 30% of the market share, and the remaining competitors occupy 10%. Because of barriers to entry, new entrants may not be able to compete successfully, unless disruptive technology lowers production costs or the market shifts, due to cultural, social, economic, or political forces. In fact, significant competitive advantage is conferred to small, nimble firms that focus their product line or services and offer a unique selling proposition to a targeted segment of the market. When executed correctly, this activity, termed judo strategy, has the power to undermine dominant businesses and increase market share substantially.

A major limitation of competitive strategy is that most efforts deal with gaining a larger portion of a fixed market or attracting new customers via the “rising tide” of a slowly growing market. If companies in search of sustained, profitable growth compete with multiple rivals, then differentiation becomes difficult, price wars may ensue, and the total profit pool shrinks. Instead, companies may pursue a “blue-ocean strategy,” in which uncontested but related market space is discovered, rendering rivals obsolete and generating new demand. Previous “settlers” will “migrate” to this new market space and become “pioneers.” Apple has done this over and over with the personal computer market, introducing new devices that expand the functionality of their operating system and hardware, evidenced by the transition from desktop to laptop to iPhone to iPad.

True value innovation comes when a company jumps out of its industry and creates an entirely new market, often in a different industry.^6,7 This foray into uncharted territory, which is referred to as “white space,” typically occurs when a company develops a disruptive technology that permits the use of core competencies to produce a radically different product or service. Apple was successful in capturing the dominant position in the digital music market by designing and offering iTunes, despite being a computer company. Inherent to this success was the fact that Apple also changed the business model for purchasing music; consumers could buy singles or albums, listen to samples, and of course, use the website for free.

In summary, strategy involves the following steps:

Accounting

Business management must be based upon a common language that is used to communicate objectively information related to the quantitative metrics of an organization. That language is accounting. This section will review the tools that accountants use to assess the financial health of a business: income statement, balance sheet, summary of cash flows, and financial ratios.^8–10 The nuances of accounting are beyond the scope of this overview, but healthcare providers must have a basic comprehension of these instruments and how they represent the financial standing of their practice, their hospital, and their healthcare system. Furthermore, these instruments are used in budgeting to construct pro forma predictions of future performance.

The field of accounting is governed by generally accepted accounting principles, also known as GAAP, which are rules used to prepare, present, and report financial statements for various entities, such as nonprofit organizations, publicly traded companies, and privately held firms. Although the government does not set these standards, the US Securities and Exchange Commission does require that public firms follow these rules. Managerial accounting, which is used to allocate cost and assign overhead, does not follow GAAP and is dependent upon institutional culture and practice.

Financial ratios

Because companies even within a single industry can vary in size and maturity, such instruments as the income statement, balance sheet, and summary of cash flows may not permit a valid comparison of those companies. Instead, financial ratios – the numerical relationship between two categories – can provide powerful insight into the financial health of a company. Jonathan Swift observed that “vision is the art of seeing what is invisible to others,” and financial ratios provide that vision.

Four types of ratios help managers and stakeholders analyze a company’s performance: profitability, leverage, liquidity, and efficiency. These ratios can be used to follow the performance of a firm over time or to compare several firms across related industries.

Profitability ratios

Gross margin = gross profit/revenue

Operating margin = operating profit/revenue

Net margin = net profit/revenue

Return on assets = net profit/total assets

= (net income/revenue) × (revenue/assets)

Return on equity = net profit/shareholders’ equity

Contribution margin = revenue – variable direct costs

(technically not a ratio, but loved by CFOs everywhere)

Leverage ratios

Debt-to-equity ratio = total liabilities/shareholders’ equity

Interest coverage = operating profit/annual interest charges

Liquidity ratios

Current ratio = current assets/current liabilities

Quick ratio = (current assets – inventory)/current liabilities

Efficiency ratios

Days in inventory = average inventory/(COGS/day)

Inventory turns = 360/days in inventory

Days sales outstanding = accounts receivable/(revenue/day)

Days payable outstanding = accounts payable/(COGS/day)

PPE turnover = revenue/PPE

Total asset turnover = revenue/total assets

Figures 5.2–5.4 demonstrate the income statement, balance sheet, and cash flows for a proposed aesthetic and laser center that offers patient consultations, skin care, and office-based procedures. Pro formas are typically estimated for 3–5 years and include many assumptions about revenue streams, costs, and growth. Such planning is important to the success of the venture, so that real-time performance can be compared to the expected results, and changes can be implemented if necessary. Figure 5.5 demonstrates the time to breakeven, when revenue exceeds expenses, and income becomes positive.

Fig. 5.2 Accounting. Sample pro forma: profit/loss statement.

Fig. 5.3 Accounting. Sample pro forma: balance sheet.

Fig. 5.4 Accounting. Sample pro forma: summary of cash flows.

Fig. 5.5 Accounting. Sample pro forma: breakeven analysis.

Finance

The goal of finance is to maximize corporate value while minimizing the firm’s financial risks.¹¹ If accounting is the language and grammar of business, then finance is a combination of poetry and theoretical physics, with some rock‘n’roll added to keep the mix interesting. The central thesis of finance is that risk can be managed successfully, in such a way that wealth is created, by combining the variables of cash, assets, supply chain, and human capital, to produce a good or service that is more valuable than the cost of production. The consumer, however, is the final arbiter who decides if the good or service is more valuable than the cost of the inputs, and if the output is more valuable than the price the consumer is willing to pay. If so, the consumer exchanges money for the good or service.

Risk can be measured statistically and therefore, given assumptions that are known with certainty, the outcome of decision-making can be predicted with specific probability. Thus, the decision to make an investment in a new piece of equipment, a new employee, a new product line, or to purchase another company, can be made with a certain level of confidence. However, when some variables are unknown (ambiguity) or when no variables are known (true uncertainty), sound financial management may not be possible, to the point that flipping a coin may provide more insight regarding outcomes.

This section will introduce common tools used by financial managers when analyzing a financial scenario, to determine go/no-go decisions about acquiring and allocating assets. While understanding the mechanics of such calculations is not essential, understanding the logic behind the decision-making is critical, as well as understanding the significance of the results. We will review the following concepts: time value of money, opportunity cost, net present value (NPV), discounted cash flows (DCF), weighted average cost of capital (WACC) and the hurdle rate, return on investment (ROI), and internal rate of return (IRR).

Economics

The sheer enormity of the field of economics prohibits a detailed review in this setting, but nevertheless, key concepts can be outlined. The entire discipline ranges from macroeconomics to microeconomics, from normative economics to behavioral economics, from heterodox economics to game theory.

Like other branches of economics, healthcare economics deals with decision-making in the setting of uncertainty, limited resources, and variable demand.^12–14 However, healthcare economics is distinctly different from other branches of economics, because healthcare is an industry that includes extensive government intervention and regulation; asymmetry of information between provider, patient, and payer; lack of precise metrics, with regard to patient outcomes; and considerable externalities, which are the downstream effects on other entities, outside the healthcare system.

Demand for a good or service is based upon a buyer’s willingness to pay, which in turn is influenced by the buyer’s tastes or needs, the consumer’s income or wealth, and the availability of substitute and complementary goods. Demand curves can then be constructed to describe an individual’s or population’s willingness to purchase: as price increases, demand decreases. Price elasticity represents the change in quantity demanded as a function in change of price and is crucial to the way that markets adjust. Goods or services with close substitutes, such as Botox and Dysport, have a flat, elastic curve, in which small changes in price produce large changes in demand. Other goods and services may have steep, inelastic demand curves, in which large changes in price may have minimal effects on demand; this is the case for necessities with few substitutes, as well as some luxury items. Price elasticity for a given good or service may also vary, based upon the specific segment of the market targeted, and may be influenced by macroeconomic forces.

Supply of a good or service depends on a firm’s short-term and long-run strategic goals. Decisions about supply are based initially on marginal costs, which vary with level of production. As production increases, so do marginal costs. However, average fixed costs decrease with increasing volume. These curves are combined to produce a U-shaped curve of average total cost, the nadir of which is the lowest price that the firm can charge and break even. A company can offer a good or service, as long as the market price remains above the average total costs. An aggregate market supply curve demonstrates that, as price increases, more firms are willing and able to produce outputs.

Market equilibrium occurs when the supply and demand forces adjust to a price and quantity that satisfy both producers and consumers. Markets will move in predictable ways, based upon changes in supply and demand. Increased supply causes the equilibrium price to fall and the equilibrium quantity to increase. Conversely, new demand for a product or service will cause the equilibrium price to rise, with a subsequent increase in the equilibrium quantity.

Real markets, however, are messy and may behave in ways that only approach these rules. For these economic models to work, markets must have perfect competition, in which products are identical, sellers and buyers do not engage in strategic manipulation of supply and demand, players make rational choices, entry and exit barriers are nonexistent, and participants are fully informed. Such a market does not exist. Predicting how economic forces shape the healthcare market is a considerable challenge, given that such competition is far from perfect.

Firms can gain strategic advantage, then, by exploiting the inefficiencies of the market. Ethical approaches include product differentiation, segmentation of the market, responding to new cultural, social, and political shifts, and using technology and innovation to create new value propositions. Unethical tactics would involve maintaining an asymmetry of information between consumer and producer, taking advantage of irrational decision-making, artificially creating demand or limiting supply, collusion with other players, and creating impassable barriers of entry for new participants. In the healthcare industry, providers must remain cognizant of these opportunities – both ethical and unethical – and maintain a level of responsibility that ensures professionalism at all times.

In summary, markets strive for equilibrium, but adjustments in supply and demand may not lead to productive efficiency, which by itself is not a guarantee of the fair distribution of wealth in society. A final quandary to ponder: not all of the costs and benefits of a transaction accrue to the buyer and the seller. These externalities – downstream effects on society – may be beneficial (new technology that extends life), but are too often detrimental (production of medical waste products). How can we incorporate these externalities into our decision-making, so that we increase the total social value of our actions?

Marketing

Business could not exist without the customer, and marketing is the process that enables business to connect with the customer.^15,16 Marketing strategy identifies, attracts, satisfies, and retains customers. Seeking to build more than a single exchange between the producer and the consumer (or in healthcare, the provider and the patient), marketing is first and foremost driven by customer needs and desires. The ideal approach in marketing is initially to understand the customers in the context of their environment, which includes not only assessment of market size but also competitive forces, barriers to entry, and market structure. Next, marketing seeks to develop a specific product or service offering, based upon anticipated customer needs that may or may not be adequately met, or may not even be appreciated. Finally, marketing strives to deliver customer value, in the form of price point, quality, and distribution.

Although marketing strategy has often oversimplified by focusing on the “4Ps” – product, price, promotion, placement – this is a good starting point for our review. Product refers to the characteristics and defining features of a good or service. Price is determined by factoring in cost of production with what additional value can be extracted by the producer, based upon value-added features and the demand for the good or service. Calculating breakeven volume is important to determine if a pricing strategy is reasonable. The formula for finding out how many units a company must sell, so that its costs are covered, is represented as follows:

To achieve a specific profit target, the formula can be modified as follows:

Promotion involves the channels that will be necessary through which the company can communicate its message and may involve advertising, use of a sales force, or incentives (bundled pricing, discounts, rewards, and frequent buyer benefits, for example). Placement is arguably the most important of these variables; marketing experts segment a general market to determine what types of people (young versus old, male versus female, high-income versus low-income) desire what types of products. Segmentation allows for better allocation of a company’s finite resources, enables the firm to target specific high-yield groups, and improves positioning of the product for higher market penetration. In fact, a company can offer related but slightly different products if marketing research demonstrates that multiple segments have slightly different needs. Instead of pursuing a one-size-fits-all philosophy and missing segments of the market, a firm can employ marketing analysis to justify, with confidence, multiple offerings of related products.

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