Capital Budget Policy and Process
Vernita Davis-Knight
Susan Friguglietti
Edna Primas
Ronald Rehn
University of Phoenix-Online
February 27, 2008

Capital Budget Policy and Process Capital budgeting is the process by which capital investment decisions are made. Capital can be described as an organization’s operating assets (Diamond, Hanson &, Murphy, 1994). The capital budgeting process includes "planning, setting goals and priorities, arranging financing, and identifying criteria for making long-term investments" (Diamond et al., 1994, p. 463). Previously, capital budgets were known as plant and equipment budgets (Berman, Kukla &, Weeks, 1994). As the previous term implies, most capital expenditures are long-term investments for plant or equipment investments. Most, if not all, organizations have limited financial resources and must decide how to invest the financial resources for the best advantage of the organization. Capital investment decisions have a significant impact on the organization since large amounts of the organization’s resources are at risk for extended periods of time. This makes capital budgeting one of the most important decision making opportunities an organization can undertake (Diamond et al., 1994). There are two basic types of capital budgeting projects, independent projects and mutually exclusive projects. The independent project does not affect the cash flow of other projects. That is, regardless of whether the project is accepted or rejected it will have no effect on any other specific project. Mutually exclusive projects, on the other hand, do have effects on other projects. An organization may have to choose from several alternatives that provide the same service. By picking one of the alternatives, the other alternatives are rejected and cannot be utilized (Diamond et al., 1994). Historically, capital budget decisions were based solely on financial criteria, if criteria were used at all (Berman et al., 1994). Many hospital systems made capital acquisition decisions based on internal organizational politics and individual leadership opinions (Orme, Parsos &, Baxter, 1993). Using financial returns as a basis for choosing capital expenditures discourages investments in areas where returns may be difficult to measure. For example, investing in technology to increase patient satisfaction or quality of care may not have specific financial returns associated with the purchase (Kleinmuntz & Kleinmuntz, 1999). The process for identifying the criteria to use in the capital budget process starts at the very essence of the organization and includes the mission and vision of the organization. In addition, since the mission and vision drive the strategic plan, strategic goals must also play a major role in selection and evaluation of the budgeting criteria. Criteria generally fall into three main categories including financial impact, strategic impact, and quality of service impact (Kleinmuntz & Kleinmuntz, 1999). The decision-making process using multiple criteria can be complicated, which lends it well to computer decision-making models. An interview with Sean Douglas, the chief financial officer of Mount Carmel Hospital in Colville, Washington, (September 23, 2003) revealed there are software programs designed to help with the capital budget decision-making process. Mount Carmel Hospital and Providence Health Services use the StrataCap capital budgeting decision-making software which is a product of Strata Decision Technology, www.strata-decision.com. The program employs and analyses multiple capital decision-making criteria. This paper will describe the criteria to be used by the capital budget review team as they make capital investment decisions. This paper will also describe the policy and procedure to be used by the Surovered Medical Center in creating the capital budget. Finally, internal stakeholders often have disparate and conflicting interests in the capital budgeting process (Rogers & Rothe, 1993). This paper will explore these conflicting issues and viewpoints. Development of a list of capital budget criteria is a crucial step in the creation of a strategic capital budgeting process. First, the criteria force employees requesting capital expenditures to review their request based on what the organization has outlined as their most important issues. Second, the criteria give the capital budget decision makers a foundation for decisions based on objective measures (Orme et al., 1993). The Surovered Medical Center capital budget review committee will use the following specific criteria to determine the value of each capital budget request: 1. Impact on customer service 2. Facility quality 3. Image and reputation quality 4. Information systems integration 5. Market share 6. Patient outcomes 7. Resource efficiency (net present value and return on investment) 8. Mission and vision effectiveness 9. Relevance to strategic plan 10. Impact on employee relations 11. Cost benefit analysis 12. Physician relationships Decision-making Criteria
Impact on Customer Service Customer satisfaction has been identified as a primary goal for any service organization. Healthcare is a service organization and should see patient satisfaction as one of their primary goals (Carroll, 2004). Superior customer satisfaction is a way an organization can distinguish themselves from other healthcare organizations and gain a competitive advantage. Competitive advantage can translate into increased market share, productivity, and profitability. With this in mind, the impact on customer service or patient satisfaction is a primary capital budgeting criterion.
Facility Quality Facility quality includes a number of risk management components including patient and employee safety, accreditation, and regulatory compliance. The better a company does at managing their risk, the more competitive they can be in the market and the more profit they can generate (Carroll, 2004). In order for an organization to be competitive in the healthcare industry, there are certain accreditations that must be maintained such as the Joint Commission on Accreditation of Healthcare Organizations. Without this accreditation, insurance contracts may be unattainable. In addition, noncompliance with regulatory agencies can actually put the healthcare organization out of business. Again, facility quality is a primary capital budget criterion.
Image and Reputation Quality Healthcare organizations have developed the public’s trust in their communities. Community members trust the healthcare organization to take care of them and to do them no harm. The community trusts the organization to hire competent staff and provide top-notch medical care. In addition to the public trust, the community also has choices, many can travel to other healthcare organizations and have their healthcare needs met. A high-quality image and reputation translates into return visits, positive word-of-mouth advertising, increased market share, increased productivity and potential increased profitability.
Information Systems Integration “Organizations need to learn how to integrate technologies and information flows from all related infrastructures” (Lewis, 2001, p. 196). Given the increasing technological focus in many fields, it would be prudent for healthcare organizations to stay on top of the changing technology available. By using this criterion to assess appropriate capital expenditures, Surovered Medical Center will be able to maintain a high level of efficiency when dealing with information systems.
Market Share This criterion assesses if the proposed capital expenditure will increase Surovered Medical Center’s market share through increased admissions and/or increased revenue. “Strategic goals that are out of line with the marketplace cause everyone in the organization to waste resources, miss critical opportunities for growth, and allow competitors to win time after time” (Lewis, 2001, p. 11). The CBR committee must determine if the item is unique to the community and it is not offered at other local hospitals. This will allow for the hospital to attain an edge in admissions and insurance contracts.
Patient Outcomes Patient outcomes are a healthcare quality, risk management, profitability, and market share issue. Good patient outcomes, when compared to other healthcare organizations, can lead to an increased community recognition and increased market share. Poor patient outcomes can have a devastating effect on an organization's reputation. Poor patient outcomes and reputation can lead to recruitment and retention problems for hospital and medical staff. Poor patient outcomes can lead to malpractice issues and all the costs associated with increased malpractice insurance premium rates. Poor patient outcomes may also be related to a poor relationship with the best practice number of days a patient is admitted to the hospital for a particular diagnostic related group (DRG). An increased number of days admitted to the hospital translate to financial losses. In short, patient outcomes and quality of care are high priority issues for a healthcare organization’s determination of the capital budget.
Resource Efficiency The net present value (NPV) will be utilized in the capital budget process for the CBR committee to make effective decisions regarding capital budgeting selection. The following will be used to find the NPV: (1) The present value of each net cash flow, including both inflows and outflows, discounted at the project’s cost of capital (2) sum the present values, (3) if the NPV is positive, the project is profitable and the higher the NPV the more profitable the project; if the NPV is negative, the project is unprofitable (Gapenski, 1996). This will determine whether the project’s cash inflows are sufficient to return the capital invested in the project and to provide the required rate of return on that invested capital. If the project has a positive NPV, then it is generating excess cash flows, and these excess cash flows are available to reinvest in the organization. If the NPV is negative, its cash inflows are insufficient to compensate the organization for the capital invested, so the project will be unprofitable and acceptance would cause the financial condition of the hospital to deteriorate (Gapenski, 1996). The capital expenditure that has the highest NPV should be given high priority. The return on investment (ROI) is crucial to the capital budget process because the organization must produce returns on their investment that are greater than the cost of capital used to finance the investment. ROI will be based upon historical costs to determine how well the investment has done, but will not be able used to predict how well it will do in the future. The ROI will be used as part of an overall system of program evaluation and selection to ensure that the organization can generate sufficient revenue from the capital that they invest in (Cleverly, 1997, p. 199).
Mission and Vision Effectiveness “Cost and quality variables must be defined adequately to predict the outcomes that any change creates in the operation of a business unit” (Lewis, 2001, p. 40). When determining the effectiveness of a capital expenditure, the CBR committee must not only consider the cost and quality of the item, but also if the outcomes provided by the item meet the mission and vision of Surovered Medical Center. If the item is not aligned with the mission of the organization, it may not be appropriate to consider the purchase.
Relevance to Strategic Plan The capital expenditure should link back to the strategic, financial, and clinical plan because it will represent the CBR committee’s projections on what future capital expenditures will be essential to meet and maintain the hospital’s mission (Cleverly, 1997). The capital budgeting process should reflect the strategic plan, which includes providing high quality, cost-effective health care to the communities served. In addition to fiscal factors, the CBR should evaluate the internal and external stakeholders’ needs relevant to the strategic plan that will include the needs of the medical staff and the good of the community. These may outweigh the financial considerations of the project (Gapenski, 1997). The ability for the CBR committee to make effective decisions regarding the capital budgeting process for the future viability of the organization requires that it reflect the strategic plan.
Impact on Employee Relations "Healthcare, more than any other industry, depends on people to carry out its mission" (Fried & Johnson, 2002, p. 7). Human resources are key elements in the success and quality of the healthcare organization. Any strategic plan must include the impact and effects of those plans on the people that will be carrying them out. Leaders must count the cost of any decision, including capital decisions, on the people that make up the organization. Without people there is no organization.
Cost-Benefit Analysis The cost-benefit analysis will be conducted in ranking alternative projects with similar characteristics. The CBR committee will conduct cost-benefit analyses in order to see the secondary benefits accrued to the organization in terms of greater market share, overall growth, reputation, and utilization of related and non-related services and products among other factors (Dr. Richens’ lecture week 4, 2004, p. 6). This will ensure effective decisions are being made and that the organization will benefit from the capital projects.
Physician Relationships "The competitive advantage of most healthcare organizations is rooted in the competency, commitment, and quality of its physicians" (Fried & Johnson, 2002, p. 46). Physicians continue to be seen as the leader of the healthcare team and may be responsible for nearly 80% of healthcare expenditures (Fried & Johnson, 2002). With these points in mind, physicians can financially make or break a healthcare organization. It would be best to have physicians supporting a healthcare organization's capital expenditures, as the physicians are integral stakeholders in the successful organization.

Policy and Procedure The executive capital review (CBR) committee consists of the Chief Financial Officer, Chief Information Officer, Chief of the Medical Staff, and Director of Patient Care Services. The CBR meets on an annual basis during the hospital's yearly budgeting process to review capital budget requests and recommend capital expenditures based on a systematic weighted analysis of each request and the overall mission, vision, and strategic direction of Surovered Medical Center (see appendix A and B). A capital expenditure is defined as the purchase of an asset that increases the value of the organization's property, has a minimum purchase value of $500 per unit, and is not used for repair or maintenance of property. Department managers individually develop their department’s capital budget requests. Each department manager is expected to include an explanation of how the requested capital item meets organizational criteria for capital expenditures with their department's capital budget request. After all departments have submitted their capital budget requests, the requests are entered onto the capital budget decision matrix (see appendix C). Each member of the CBR scores each of the department manager’s requests using the predetermined capital budget criteria. Based on the scoring, the requests are either recommended or not recommended for approval to the CEO and Board of Directors who have final approval of the capital budget. Upon final approval, the requests are included in the organization’s budget.
How the Process Considers Each Role’s Wants and Needs Surovered Medical Center’s policy and procedure for capital expenditure reviews takes each role’s wants and needs into consideration in many ways. By having each member of the CBR committee individually rank each request prior to ranking the request as a group, the CBR process allows each role to have significant input into the final decision. The CBR decision matrix also takes each role’s concerns into account in the process of weighing the criteria.
How the Process Works for Each Role to Make Capital Decisions The process works well for each role as each team member has an equal voice in the decision-making process given the capital budget review (CBR) committee members individually complete the capital budget matrix. In addition, defining and choosing criteria that are essential the strategic objectives, mission and vision of the organization before the actual budget process commences, clearly aligns the CBR committee’s goals and practices. The organization’s common vision, created by the leadership and communicated throughout the organization, creates an atmosphere where capital budget decisions are made for the good of the organization rather than for the good of individual stakeholders.
Inherent Conflicts within the Roles of the Capital Budget Review Team
Chief of the Medical Staff (CMO) The CMO is responsible for the medical requirements of the hospital which include: medical records, facility services, infection control, pharmacy, continuous improvement, all inpatient areas, all outpatient areas, business office, call centers, and information services (DMC Policy, 2001, # 3TCH ADM 006). The CMO will be informed of any medical technology and equipment capital requests that flow through the hospital. The CMO will be key to identifying the future needs of capital expenditures from the medical standpoint because of the vital role of physicians as integral stakeholders within the organization. This role will conflict with the chief financial officer (CFO) because of the financial constraints that might be given based on the hospital’s financial position.

Director of Patient Care Services The Director of Patient Care Services (DPC) is responsible for the continuous quality improvement indictor data, site updates, JCAHO initiatives, recruitment/retention, and capital equipment acquisitions (DMC Policy, 2001, 2 RT 002). This role collaborates closely with the CMO to establish the capital budgeting aspect of patient care needs. This conflicts with the CFO because the financial constraints of the organization often clash with the capital acquisition goals for patient care.
Chief Information Officer (CIO) The CIO is responsible for forecasting, preparing and managing an annual budget to provide the resources needed to support the information management needs of the hospital. Budgeting includes capital, personnel, and technology needs (DMC Policy, I-IS002). The position of CIO conflicts with other team members given the financing available to fund the information technology projects may conflict with ability to meet the overall needs of the organization's internal and external stakeholders. This role also conflicts with the CFO because of the budgeting and allocation of funds to different sources. The allocation between technology and medical needs might be a potential conflict.
Chief Financial Officer (CFO) The CFO’s role in the capital budget process is to estimate the amount that is to be spent and what is financially affordable for the organization. Affordability is determined by estimates of future probability, cash flow, and debt capacity. The CFO allocates a portion of the capital budget for small item projects and routine replacement (DMC Policy, FIN 036). The inherent conflict often lies with the CMO, CIO, and DPC when determining funding for projects that might not be in the budget. The budget is based on future probability and past performance, and the CFO focus will be on the bottom line and the other roles will conflict based on their departmental needs.
How Finite Resources Affect the Capital Budget Process Health care organizations are facing problems with resource allocation and capital budgeting because of complex fund limitations due to reimbursement rates. Capital budgeting is complex in nature due to quality and quantity of services provided, and setting priorities to satisfy internal and external stakeholders. Escalating costs in medical services make decisions on the capital budget urgent and crucial to the long-range stability of the organization (Keown & Martin, 1976, p. 28). A healthcare organization’s finite resources must be used efficiently and wisely (Dr. Richins’ lecture week 4, 2004, p. 1). Because of finite resources, health care organizations may place monetary value to projects on the capital budget (Keown, Martin, Petty, & Scott, 2001, p. 307). This practice is known as capital rationing. Capital rationing enables the healthcare organization to make decisions in the complexity of reality. This method demonstrates advantage of the NPV over the internal rate of return (IRR).
Conclusion
Originally, capital budgets were decided politically and by arbitrary leadership decisions. Later on, a financial base for capital expenditure decision making was the primary criteria used. If the organizations made a good return on investment the capital was purchased. This led to a skewed decision making process where only financial considerations were weighed. Organizations found that sometimes important initiatives could not be properly evaluated using financial formulas. Organizations also found that they could not obtain their strategic goals because crucial capital investments may not have shown initial profitability. More recently, a more holistic and strategic approach to capital budgeting has been adopted. Instead of only financial criteria being used to make capital budgeting decisions the organization’s strategic plan, mission, vision and human resource impact is evaluated. The opportunity to apply different weights to the criteria gives the organization's leaders the ability to focus priorities depending on the changing marketplace. Using multiple criteria is both a balanced and strategic approach to capital budgeting.
References
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DMC Policy I-IS002 (2002, Jan. 14). Detroit Medical Center Tier 1. Provision of Information Services. Retrieved on September 27, 2004 from http://intraweb/portalapps/search/dmcsearch.asp
DMC Policy FIN 036 (2001, February). Detroit Medical Center Tier 1. Operating and Capital Budget Process. Retrieved on September 27, 2004 from http://intraweb/main_dmcinfo/hr/policies/tier1/policy-fin%20036.html
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management. Saddle River, New Jersey: Prentice Hall.

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Orme, C. N., Parsos, R. J., & Baxter, T. D. (1993, February). Beating the capital budgeting blues: Developing capital request evaluation criteria. Healthcare Financial Management, 47(2), 83-86.
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DHA-713 course materials.
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Appendix A
Surovered Medical Center

Policy: Capital Expenditures

Purpose: To establish procedures on capital expenditure decision-making

Policy Statement: The executive capital budget review (CBR) committee will meet on an annual basis during the hospital’s yearly budgeting process to review capital budget requests recommend capital expenditures based on a systematic weighted analysis of each request and the overall mission, vision, and strategic direction of Surovered Medical Center.

Definition of Capital Expenditure: A capital expenditure is the purchase of an asset that meets the following criteria: 1. Increases the value of the property 2. Has a minimum purchase value of $500 per unit 3. Is not used for repair or maintenance of property 4. Meets the criteria of the weighted scale system as determined by the CBR

Basic procedure for yearly capital expenditure review: 1. Department managers develop capital requests 2. Each capital request is accompanied by an explanation of how the requested item meets the organizational criteria for capital expenditures. 3. Each capital equipment request is added to the capital budget decision matrix. 4. Each member of the CBR committee rates the request according to the matrix. 5. Based upon the scoring determined, the request is approved or denied. 6. Final approval or denial is determined by the CEO and Board of Directors based on the recommendations of the CBR committee. 7. Requests are budgeted into the plan for the next fiscal year.

CBR Committee: The CBR committee consists of the Chief Financial Officer, Chief Information Officer, Chief of the Medical Staff, and Director of Patient Care Services.

Criteria for Determining Approval of Capital Request: Criteria will be weighted on a yearly basis dependent upon the strategic goals and financial status of the hospital. 1. Impact on customer service 2. Facility quality 3. Image and reputation quality 4. Information systems integration 5. Market share 6. Patient outcomes 7. Resource efficiency (net present value and return on investment) 8. Mission and vision effectiveness 9. Relevance to strategic plan 10. Impact on employee relations 11. Cost benefit analysis 13. Physician relationships Appendix B
Flowchart of Process:

Appendix C
9/29/2004 | |Capital Budget SCALE 0-10 WITH 10 BEING HIGHEST | | | | | | | | | | | | | | | | | | | | | | | |Weight |1 |1 |2 |1 |1 |2 |1 |2 |1 |1 |1 |1 | | |Budget Requests |Impact on Customer service |Facility Quality |Image and reputation quality |Information system integration |Market Share |Patient Outcomes |Physician Relationships |NPV and ROI |Mission and Vision Effectiveness |Relevance to Strategic Plan |Impact on Employee Relations |Cost-benefit Analysis |Total | |Example 1 |10 |8 |5 |0 |5 |4 |10 |8 |10 |10 |5 |9 |101 | |Example 2 |7 |8 |9 |5 |4 |10 |2 |0 |8 |9 |9 |8 |98 | |Example 3 |3 |2 |10 |2 |2 |0 |0 |5 |5 |5 |5 |8 |62 | |Example 4 |2 |3 |3 |8 |4 |4 |5 |3 |3 |3 |0 |5 |53 | |Example 5 |10 |10 |10 |10 |10 |10 |10 |5 |10 |10 |10 |5 |135 | |Example 6 |6 |6 |5 |8 |7 |4 |3 |2 |1 |1 |8 |6 |68 | |Example 7 |4 |7 |9 |6 |3 |2 |1 |4 |8 |8 |9 |5 |81 | | | | | | | | | | | | | | | | |

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Hospital board reviews CBR and CEO recommendations and approves final capital budget for the next fiscal year

CEO makes final decisions on all capital budget requests and sends final budget to board for approval

CBR makes recommendations for final selection criteria and final budget requests to the CEO

CBR committee reviews each individual ranking and determines a final ranking for each request

CBR committee members individually rank each request according to matrix criteria

CBR committee reviews the matrix and adds weighting to the criteria based on strategic goals and current financial status

Department managers develop capital requests, including information on relevance to matrix criteria, and submit to CBR