In the face of ever-growing pressure on organizational resources, hospital and health system executives can benefit from having processes in place that help ensure capital allocation decisions align with strategic goals.
In today’s rapidly changing healthcare industry, U.S. hospitals and health systems are contending with tightening margins that conflict with an ever-expanding list of capital needs. Given competing demands on scarce capital resources, an organization’s long-term success and sustainability hinges on its ability to make smart strategic investment decisions today. The alignment of capital decisions and capital management with the organization’s strategic objectives is critical.1
Adopting a thoughtful capital allocation process allows hospitals and health systems to find an acceptable balance between the need for continuing strategic investment and the ability to generate capital capacity. Such an approach brings together strategy, financial and capital budgeting, and planning. The process also helps to foster an organizational culture that respects the relationships among strategic objectives, capital capacity (i.e., the capital required to fund strategic and routine capital needs), and financial risk.
With the transition to a value-based payment and care delivery model, now is the time for hospitals and health systems to reassess the capital allocation processes they have in place and make sure they are well designed with these objectives in mind.
Evolved Decision Making
Hospitals, health systems, and other providers will continue to experience mounting pressures on their operating margins due to declining payments, the increasing need under value-based payment to reduce care costs and enhance quality, and other forces of change affecting the industry. Demand for more consumer-centric health care is growing as patients and families bear a greater share of their healthcare costs and become more engaged in decisions about their own care. As a result, the capital needs of healthcare organizations are becoming more diverse, often extending beyond traditional spending areas.
Although strategic investments in areas beyond traditional operations add risk, they can be vital to protecting and/or improving an organization’s strategic and financial position. For example, many organizations are pursuing affiliations and partnerships to enhance access and extend their care continuum. These arrangements often require significant capital. Similarly, organizations must build their capital reserves and invest in actuarial expertise to pursue strategies such as capitation contracting, and health plan ownership or partnership.
Given such demands, the capital allocation process now must encompass a broader range of decisions. The following five strategies are key when designing capital allocation processes and procedures.
Redefine capital and its role in the budgeting and planning process
A new definition of capital is required that captures the changing strategic direction of healthcare organizations and reflects a greater breadth of their strategic investments. This definition should include all types of proposed investments that will be subject to the policies, structure, and transparency of the capital allocation process. Investments that should be included in this new definition of capital include:
- Facilities, property, and equipment, including IT
- New operating entities/programs
- Business acquisitions and partnerships
- Network development
- Managed care investments
- Program start-up subsidies/expansion
- Physician integration
- System initiatives
These and other capital investments should be included in the capital allocation process regardless of the accounting treatment or potential source of financing. For example, equipment acquisitions using lease financing should be considered in an organization’s capital allocation decision making, even though historically that has not been the practice.
Best-practice capital allocation and management processes define three capital allocation “pools.” The threshold capital pool is a centrally managed pool of available dollars for which threshold capital requests compete. A threshold capital request is any proposed expenditure above a dollar amount specified by the organization. Such expenditures require comprehensive business planning analysis and centralized review, as described later. The non-threshold capital pool covers capital requests that are below the threshold dollar amount and can be handled on a decentralized basis. The contingency pool supports and/or supplements unfunded or unforeseen threshold capital needs.
Both capital allocation and capital management are essential parts of the comprehensive planning cycle. Having an integrated calendar improves decision making throughout the annual management cycle. The importance of integration is depicted in the exhibit above.
Establish clear objectives and principles to frame the allocation process.
Objectives should be specific and measurable and have an established time frame for execution and completion. In setting process-related objectives, key considerations for hospital and health system executives include ensuring that investment decisions are rational and consistent, assessing how the decisions will affect capital capacity and credit rating, and establishing a formal review process that uses uniform criteria for evaluating all investment decisions.
Objectives should aim to guarantee that capital allocation decisions are aligned with long-range strategic, financial, and related operating plans, and that they are directly integrated with the hospital’s annual budget and multi-year financial plan. Applying a portfolio approach is an effective way to ensure that broad allocation decisions contribute measurable financial and strategic value to the overall organization. Roles, responsibilities, and accountability should be clearly defined.
Similarly, organizations should establish solid principles that ensure the decision-making process is focused, consistent, and transparent, and that decisions are aligned with the organization’s strategic goals. The sidebar at left outlines 10 key considerations for healthcare leaders in developing such principles.
Quantify available capital comprehensively
A best-practice capital allocation process clearly defines an organization’s capital constraint, which is the net cash flow available for spending during a designated time period. To accurately assess a hospital’s or health system’s capital constraint, the finance leader must account for all of the organization’s sources and uses of cash based on its multiyear financial plan.
Institute additional planning for high-dollar, multi-year projects
In developing the capital allocation process, a finance leader should remember that large projects often require several phases of planning, review, and approval, and structure the decision-making process accordingly. Although the early stages of large projects typically require limited allocations of capital, it may be necessary to designate “way points” for making allocation decisions before major capital commitments are needed.
Creating a separate preplanning contingency fund for these early efforts ensures that a proper evaluation can be performed to prioritize project concepts and funding. During the concept phase, healthcare leaders should determine a project’s strategic fit for the organization, and broadly estimate the costs and how the project might impact facilities.
From there, an approved and broadly scoped project proposal can move into the preplanning phase. Numerous individuals and departments may contribute to planning during this phase, including outside architects or advisers and organizational finance, planning, and facilities staff. Key steps during this phase include performance of a feasibility analysis to detail and more clearly define the capital required and facilities impacts, and completion of a business plan.
Require complete business planning analysis of high-dollar projects
With an effective capital allocation process, the dollar amount of the proposed investment should trigger the appropriate level of analysis and review. Again, as part of the process, leaders must set a threshold dollar amount for projects, with the requirement that any proposed expenditure above that threshold undergo more rigorous evaluation, including comprehensive business planning, analysis, and centralized review.
Consistently applying standard analytic procedures based on tried-and-true corporate finance techniques is a key to successful capital evaluation and allocation. Analytic requirements should be universal and understood throughout the organization.
Structured analysis of both qualitative and quantitative measures enables leaders to thoroughly assess capital priorities. Qualitative measures are changing as the definition and uses of capital expand. Currently, such measures may include a proposed project’s relationship to mission, safety and quality of care, physician alignment, and workforce development. Evaluating these criteria is increasingly important in identifying an effective portfolio of investments to meet new-era demands.
A Structured, Portfolio-Based Approach
As hospital and health system leaders shape their capital allocation processes, it is important that they take a portfolio approach. Leaders should develop a comprehensive catalog of capital allocation needs, so that each can be considered relative to other priorities. A structured process for review and comparison is best practice, and is especially important in times of uncertainty, because it highlights inconsistencies, quantifies changes in portfolio value on a real-time basis, and provides a means to address continuing and developing needs.
The capital allocation process should evolve over time to meet changing requirements. Ultimately, the capital allocation discussion should focus on the trade-offs among mission, strategy, and financial return for the entire portfolio. This process will be effective only if all proposals are evaluated on an apples-to-apples basis, and the ultimate portfolio of projects selected has a positive expected net present value, creating sufficient financial returns to support the organization’s mission in its community going forward.
One final point bears emphasis: Capital decision making should be transparent, enabling management to reinforce support for all aspects of organizational strategy as reflected in the selected portfolio of capital investments.
1 Capital allocation is the planning process for deploying scarce capital resources (cash and debt capacity) for investment in mission and community-based imperatives. Capital management is the ongoing monitoring and control function that ensures appropriate application of allocated funds.
Reprinted from the May 2016 Early Edition of hfm magazine.
Copyright 2016 by Healthcare Financial Management Association, Three Westbrook Corporate Center, Suite 600, Westchester, IL 60154-5732.
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