5 Business principles for plastic surgeons
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.
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?
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.
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.
The income statement, also known as the profit/loss statement, describes financial transactions within a defined period of time, which may be quarterly or annually. Revenue refers to the gross income that a company receives from normal business activities, typically the sales of goods or services, but may also include rent, dividends, or royalties. In accrual accounting, revenue occurs at the time of the transaction, not when receipts are collected. Net income is expressed as a profit or loss, after deducting expenses, which usually include operating expenses (cost of goods sold (COGS), variable overhead expenses), depreciation of assets and amortization of leases, fixed overheads (selling and administrative expenses, research and development), interest expenses, and taxes.
The balance sheet is a snapshot of what the company owns and owes, at a single point in time. On one hand, the balance sheet summarizes the cumulative impact of all transactions, but the balance sheet does not provide much useful information on the operational performance of the firm. The net worth of the company, referred to as owners’ equity, is defined as the difference between the assets and the liabilities. Reframed another way, the following equation must always balance:
The actual worth of a company is difficult to ascertain, but one method to calculate value is market capitalization, which is (share price) × (shares outstanding); this represents the public consensus of the value of the firm’s equity.
Assets are defined as resources with probable future economic benefit, obtained or controlled by the entity, as a result of past transactions, that are expected to contribute to positive net cash flows. Examples of assets include cash and cash equivalents (prepaid expenses, bonds, stock), accounts receivable (the money that is owed but has not been collected), inventory (raw materials, work in process, and finished goods), property/plant/equipment (purchase price less depreciation), goodwill (intangible value of brand), and intellectual property.
Liabilities refer to what a company owes, or from a different perspective, how the assets were obtained. Liabilities include short-term loans (credit lines), current portion of long-term debt, accounts payable (the money a company owes its vendors), and long-term debt.
Owners’ equity – the difference between assets and liabilities – can be allocated into several categories: preferred shares (which usually receive periodic dividends), common stock, and retained earnings (accumulated earnings that have been reinvested into the business, instead of being distributed as dividends).
An assessment of a company’s cash flows is critical in determining the financial viability of the firm, because profit is not the same as cash. This disconnect is due to multiple reasons: (1) cash may be coming in from investors or loan; (2) revenue is booked at time of sale, not collection; (3) expenses are matched to revenue, not when they are actually paid; and (4) capital expenditures do not count against profit (because only the depreciation is charged against revenue) but require cash or debt to pay for the assets. As a result of this discrepancy between when a good or service is provided and when cash is exchanged, following the flow of cash can be very complicated. Fortunately, we have accountants. For mature, stable, and well-managed companies, cash flow does approximate net profit. But for younger, growing, and poorly managed companies, profit can occur without gaining cash (resulting in bankruptcy, because bills cannot be paid) or cash can accrue without being profitable (which bodes poorly for long-term success, if expenses cannot be controlled).
Overall cash flows are further subdivided into three categories – operations, investing, and financing – based upon the conduit for the flow. Cash flows from operating activities (CFO) indicate how much cash was generated from operations: selling goods and services. Cash flows from investing activities (CFI) indicate how much cash the company spent (or received) from buying and selling businesses, property, plant, and equipment (PPE). Finally, cash flows from financing activities (CFF) indicate how much cash the firm borrowed, received from selling stock, or used to pay down debt or repurchase stock.
Many financial analysts believe that total cash flow myopically focuses on earnings while ignoring “real” cash that a firm generates and retains for future investments. Therefore, another measure of the ability of a firm to create value is free cash flow (FCF), which is defined numerically as:
In other words, free cash flow represents the total cash that a company is able to generate after laying out the funds required to maintain or grow its asset base. Free cash flow is very important to investors because this allows a firm to pursue opportunities that increase shareholder value. This is the best source of capital for development of new products and services, acquiring new companies, paying stock dividends, and reducing debt. Cash really is king, and this is why.
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.
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.
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).
Money increases in value over time, and such appreciation is actually logarithmic (although it takes a while to get going!). Even Einstein conceded, “The most powerful force in the universe is compound interest.” Essentially, a dollar today is worth slightly more tomorrow and a lot more in 10 years. A dollar invested in a money market account with an annual return of 2% will yield 2 pennies next year, increasing the value of this investment to $1.02, which is future value of today’s dollar. The formula for the time value of money is:
Why does money have a time value? Economists attribute this to two factors: postponement of consumption and expectations of inflation. Interest rates are a hedge against this type of depreciation. As risk of an investment increases, then the reward to the investor needs to increase, to convince the investor to part with $1 today, in the hopes of having possibly $1.20 next year (which would be a 20% return). The actual rate that money can appreciate is determined by multiple factors, such as the risk of the specific investment, the performance of the stock market, the return on US Treasury bonds, and the monetary policy established by the Federal Reserve, which sets the overnight lending rates to commercial markets.
Consequently, obtaining capital costs money. If one borrows money from the bank, this loan creates risk for that institution, so the bank will need to collect more money from the borrower, when the debt is repaid, at some point in the future. But here is the catch: Banks need to charge not only for the time value of money, which is their expected rate of return (also called the discount rate), but the bank must also hedge against your riskiness as a borrower, driving up the cost of capital and increasing the interest rate that you must pay. In fact, if the bank can make a safer investment, with a possibly higher rate of return, then the bank should not pursue the loan.
When considering a new project or purchasing a piece of equipment, one should proceed if the intrinsic value of the asset equals or exceeds its cost. What one must also consider, though, is the opportunity cost of tying up precious time, money, and energy in that project or asset, when those resources could be invested elsewhere. The definition of opportunity cost is the potential benefit forgone from not following the financially optimal course of action. Rather than thinking in yes/no parameters, investors should make either/or decisions, searching for other opportunities, until they can compare the proposed course of action with the next best alternative. In the world of surgery, where most physician revenue is generated from procedures, any activity that takes the surgeon out of the operating room (OR) should be carefully compared to what the surgeon could accomplish by staying in the OR.
The decision to pursue a project, when economic considerations are important, involves determining the NPV of that opportunity. NPV is calculated by adding a time-series of cash flows, both incoming and outgoing, that the project is expected to produce, over a series of future periods. This calculation would include the initial cost of purchasing the asset, at DCF0, plus the anticipated revenue that the asset would generate, from DCF1 to DCFn. Each future cash flow must be discounted back to its present value.
If the NPV is > 0, then the investment would add value to the firm, and the project may be accepted. If the NPV is < 0, then the investment would subtract value from the firm, and the project should be rejected. The discount rate selected is often the firm’s WACC, which blends the cost of debt (borrowing money) with the cost of equity (shareholders’ expected returns on their stock). Another approach in selecting the appropriate discount rate is to determine the rate that another investment would yield, if this capital were used in a different project. This required rate of return is often referred to as the hurdle rate, which is higher for riskier projects and lower for safer ones. The hurdle rate represents the expected rate of return for risk-free projects (tied to the US Treasury bill) plus the potential rate of return for risky projects.
After one has projected future cash flows for an investment, how can one evaluate these future cash flows, in terms of the value of this investment? Several approaches are helpful in deciding the potential value of future ventures and in retrospectively examining the actual value of past ventures. These methodologies include: formal ROI or yield, the payback method, the IRR, and the NPV/DCF model. The most rigorous and powerful technique is NPV/DCF analysis, but limitations include multiple assumptions regarding future cash flows, selecting the appropriate discount rate, and complexity of the calculation. As a result, predictions using NPV tend to be conservative, but at least they incorporate the time value of money, so that the investor can make decisions based on the value of today’s dollars.
Yield, however, is expressed as a percentage, and therefore gives little information about the magnitude of the value of the investment. Furthermore, yield can be easily manipulated by using varied metrics to define “gain” and “cost.” Yield is helpful when comparing similar products or services, within a market or industry.
The payback method, which measures the time required for the cash flow from the project to pay for the original investment, is also quite popular with mid-level managers, who need to justify the purchase of capital equipment and predict time to breakeven.
What payback period does not take into account is depreciation of the equipment, useful lifespan of the asset, and residual value of the asset at the end of the period. Furthermore, cash flows for a project or asset usually change from year to year, and therefore the payback period only estimates when the project or asset reaches breakeven. If the useful life of the investment is greater than the payback time, then the investment should be pursued, at least for financial reasons.
Another technique used to assess ROI is IRR. Instead of assuming a particular discount rate for an investment and calculating the NPV, the IRR method determines the actual return projected by the cash flows. The IRR is then compared with the firm’s hurdle rate, which may vary for different projects, depending upon the risk, the time horizon for the returns, and the cost of capital for the firm or WACC. Another way of understanding this method is that IRR represents the hurdle rate necessary to make NPV = 0. Problems with using IRR include not quantifying the overall value of the project, as well as how long the company can anticipate the length of the return. Nevertheless, IRR, payback method, and yield are helpful when communicating potential ROI to stakeholders, because of their simplicity and ease of understanding.
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?
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:
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.