THE BUSINESS OF PRACTICE: WORDS OF WISDOM FROM EVERYDAY PRACTICE


goods. For example, physical exams and rectal pal- pations should have low cost of goods associated with them, whereas blood work and ancillary testing should carry a high cost of goods. These two sce- narios would require COGS to be applied at different rates of COGS expense against each dollar of reve- nue. To this end, different cost pools should be created for the different classes of revenue as dic- tated by the cost of goods that goes with each class. Each dollar of revenue within each pool would still act as the cost driver but each one would carry the cost of goods associated with that revenue pool (see Appendix 1 for a case example). Although the differentiation of revenues into dif-


ferent subdivisions depending on the cost pool being estimated will significantly increase the complexity of the data preparation for financial analysis, the increase in precision obtained through better sepa- ration of data will not only significantly improve the accuracy in assigning overhead costs and COGS against each dollar of revenue, but it will ultimately serve as the platform needed for a previously de- scribed method of determining the price for a proce- dure.11 And, as the example in Appendix 1 shows, a more precise analysis can better define the profit- ability of each revenue center so that service efforts and attempts at business growth can be directed and implemented more appropriately.


6. How Much Can I Pay the New Associate?


With the information previously detailed, the busi- ness owner should be able to generate a complete forecast of the expenses expected to be incurred on behalf of the new associate during the process of setting him/her up for practice and during the first year of employment. The ability to compare the expected revenue production against the more pre- cise calculation of the expected expenses will create a framework that can be used to decide on a salary compensation style and compensation amount that will make the situation work for the practice. Given that it would be fair and honest to give this


type of investment several years to demonstrate its financial worthiness, the numbers calculated for revenue and cash expenses should be forecasted for at least a 5-year period.


Present Value of Cash Flows and Net Present Value of the Hiring Project


The forecasted revenues and expenses, including compensation, will produce a net cash flow for each of the five forecasted years as detailed in our case example. Using a discount rate equivalent to the business owner’s risk-adjusted required rate of re- turn for an investment (25% required rate of return for our case example), the value of each future cash flow can be brought back into today’s dollars, a con- cept better known as discounted cash flow analysis (Appendix 2). By subtracting from this estimated present value of future cash flows the cash outflow for the original investment associated with the setup


556 2016  Vol. 62  AAEP PROCEEDINGS


and hiring expenses, one will arrive at the net pres- ent value (NPV) of the hiring project. If this value is equal to or greater than zero, the cash flows pro- duced by the hiring will equal or surpass those that would be produced by the required rate of return and the hiring project should therefore be seen as an attractive investment opportunity. Our case example provided a present value of future cash flows that exceeded the initial cash investment, thereby producing a positive NPV of the Project, making the hiring decision an attractive invest- ment opportunity. There will be cases in which the NPV of the project


will be negative. The only ways to try to mend this issue during the forecasting process are to reduce the projected outflow expenses (including salary compensation), increase the projected revenue in- flows, and/or reduce the required rate of return. If an honest manipulation of these expectations still does not provide a positive number for the NPV of the project, then hiring a new associate would not be a sound financial decision.


Internal Rate of Return


An internal rate of return (IRR) analysis uses the project’s initial cash outflow and future cash flows to calculate the discount rate that will result in a zero NPV for the hiring project. A computed IRR that exceeds the owner’s required rate of return suggests, just like a positive NPV of the project explained above, that the hiring project should be viewed fa- vorably. In our case example, as expected from the positive NPV of the Project obtained, the project’s IRR of 37.9% exceeded the required 25% rate of return. The exact amount of salary compensation that can


be offered, that meets the owner’s required rate of return, can be arrived at without the need for trial- and-error calculations by using the Solver data anal- ysis tool on Microsoft Excel. Given that the project’s NPV will be zero when the project’s IRR equals the required rate of return, one can set Solver to analyze for the salary compensation amount vari- able that will provide the desired IRR result.


7. Analysis of the New Associate Hire Case Example


Using a risk-adjusted required rate of return for an investment of 25%, the NPV and IRR of the project were around $18,500 and 38%, respectively (Table 1). By definition, the obtained results suggested the hiring of the associate to be an attractive invest- ment opportunity. A significant observation from the analysis was


that, whereas a previously published article sug- gests that a generic employee’s cost (base salary, employment taxes and benefits) is typically in the 1.25–1.4 times the base salary range,12 the new vet- erinary associate’s expense-to-salary ratio hovered between 1.88 and 2.01 for our case example (Table 5). The primary sources for this significance seem to be the ABC application of COGS and overhead


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