Question

Background

Dr. Eileen O’Toole bought the assets of the old “OK Care Hospital” in 2010 believing the former company had gone out of business because of poor management rather then issues relating to market demand. The new “Extra Care Hospital” was a 24/7 emergency hospital and the only one in the County. The closest direct rival was over 45 minutes in any direction. With many 80 hour weeks and the help of friends, the new Extra Care Hospital was building a strong reputation in the community helping to overcome some of the negative impact of one of the worst recessions in US history.

Dr. O’Toole immediately faced an unexpected issue of equipment maintenance/failure. While the new company had bought all the assets of the former company, this did not include the warranties, guaranties and service agreements that the former company had received when the equipment was originally purchased.

Almost all clients/patients require blood work in early diagnosis and treatment. To perform these tests the company owned a three year old “Itech” Blood Analyzer that had recently begun acting up. It had been down for two days and the less sophisticated back-up machine was showing signs of failure. If a new machine was not acquired or the current one repaired, the hospital would be unable to perform basic diagnoses.

Blood Analyzer Situation

When Dr. O’Toole called Itech to have the machine repaired, she learned that there was neither a service agreement nor a warranty. Furthermore, the software on her machines was out of date.

Before signing and paying for a new service agreement, Dr. O’Toole decided to contact other equipment distributors about their machines. Dr. O’Toole contacted a competitor, “Hester”, and inquired about what kind of deal Hester could offer on a new machine. The next day, a “sample” Hester DC-70 blood analyzer arrived for Extra Care to use while their Itech machine was down.

The hospital staff were trained the same day and were excitedly talking about the new Hester machine when Dr. O’Toole came in later that day.

Razors and Blades

In the medical / healthcare industry many procedures require special equipment and “consumables” that would only fit specific machines. For example, a Hester blood analyzer required specific cartridges that uniquely fit its machine and contained special chemical formulas that in conjunction with the analyzer actually performed the various tests on the blood sample. Itech sold a different cartridge that only fit its analyzers. Thus the inventory of “panels” or cartridges that Extra Care possessed only worked with Itech machines. Needless to say, both Itech and Hester made substantial profits on their consumable business. Once their machine was purchased, the customer had no choice on their vendor for the related consumables. Much like once you buy a particular razor you could only buy blades from the same company.

Many industries use this “Razor and blade” or “recurring revenue” business model. For example, Ink Jet printers are often practically given away so as to build the demand for the highly profitable ink cartridges.

Hester’s Blood Analyzer cartridges were less expensive then were Itech’s, as the volume of usage grows with the business, the gap in operating cost of the two machines grows as well.

Itech Estimated Costs

Cost to purchase: $ 25,999 (in year 8)

Life Expectancy: 10 years

Annual Service Agreement: $1,300

Cost of Annual Calibration (varies with use): $400 (current year)

Estimated cost of consumables (varies with volume/usage): $15,114 (Year 1)

Cost to install new linking software: $500 (waved)

One time credits/discount awarded for other Itech consumables: $2,000

Extra-Care Hospital currently earns $50,000/yr in Blood Analysis Revenue

Hester Estimated Costs

Cost to purchase: $ 16,694 (the price after the 20% discount

Life Expectancy: 10 years  Annual Service Agreement: $750

Cost of Annual Calibration (varies with use): $175 (current year)

Estimated cost of consumables (varies with volume/usage): $13,434 (current year)

Cost to install new linking software: feature not available

Extra-Care Hospital currently earns $50,000/yr in Blood Analysis Revenue

The Alternatives

Option 1 – Stay with Itech 3 year old machine: Itech will give Extra Care a one time $2000 of credits for the purchase of consumables over the next 2 years and will provide two new services: (1) integration into the company’s hospital management software to automatically link blood tests with client records and invoices thus eliminating the need for staff to enter the charges themselves, and (2) a link to Itech laboratories allowing automated software updates and Itech lab results to be downloaded to company records. Additionally, Itech will bring the current Extra Care machine up to current specs or replace it with one that is. The blood analyzer needs to be calibrated at a frequency related to usage. High use requires more frequent calibration. Itech will reduce the price of the chemicals needed for the calibration process.

Option 2 – Purchase the Hester DC-70  Hester has reduced the purchase price by over 20%.  Hester’s machine has a lower cost of calibration. Hester’s machine uses lower cost consumables.

Extra Care Hospital growth is expected to grow at about 10-15% per year with a direct 10-15% growth in blood tests.

Questions

1. Dr. O’Toole wonders if she should take this opportunity to switch from the current 3 year old Itech blood analyzer to the new Hester DC-70. What would be the financial implications over the next 10 years?

2. Also, she wonders what the operational considerations might be with regards to staff training, dependability, etc.

3. Dr. O’Toole read recently that, on average, hospital staff forgets to bill for about 15-20% of the services provided. If her staff was similar to the industry norm then would the Itech software link to the Extra Care Hospital management software lead to an increase in revenue? If so, how would that 15-20% increase affect her decision?

4. Dr. O’Toole wonders what other factors should be included in her analysis?

Financial Assumptions

10 year analysis period

Cost of capital (discount rate): Low risk investments: 10% Medium risk investments: 15% New ventures other high risk: 25%

Replace Itech in year 8 for $25,999

Hester machines last for 10 years

No impact for inflation, work in constant dollars

Cost of calibration and consumables increase with revenue increases.

No increases to cost of annual service contract

Answer 1

Ans 1.

Assuming the cost of purchasing the machine is expensed fully in the same year of purchase (And not depreciated over a period) we can evaluate the 2 options by comparing the NPVs (Net Present Value) of the cash flows occurring from each of them over 10 years. Following are the cash flows (Machine Cost has been assumed to have been incurred in Year 8 and Year 1 for the 2 options):

Option 1 - Stay with Itech

	Machine Cost	Service Agreement	Callibration (Growing at 12.5% annually)	Consumables (Growing at 12.5% annually)	Total	Discount	Revenue (Growing at 12.5% annually)	Profit
Year 1	$                    -	$                   1,300.00	$       400.00	$     15,114.00	$ 16,814.00	$ 2,000.00	$    50,000.00	$    35,186.00
Year 2	$                    -	$                   1,300.00	$       450.00	$     17,003.25	$ 18,753.25		$    56,250.00	$    37,496.75
Year 3	$                    -	$                   1,300.00	$       506.25	$     19,128.66	$ 20,934.91		$    63,281.25	$    42,346.34
Year 4	$                    -	$                   1,300.00	$       569.53	$     21,519.74	$ 23,389.27		$    71,191.41	$    47,802.14
Year 5	$                    -	$                   1,300.00	$       640.72	$     24,209.71	$ 26,150.43		$    80,090.33	$    53,939.90
Year 6	$                    -	$                   1,300.00	$       720.81	$     27,235.92	$ 29,256.73		$    90,101.62	$    60,844.89
Year 7	$                    -	$                   1,300.00	$       810.91	$     30,640.41	$ 32,751.32		$ 101,364.33	$    68,613.00
Year 8	$     25,999.00	$                   1,300.00	$       912.28	$     34,470.46	$ 62,681.74		$ 114,034.87	$    51,353.13
Year 9	$                    -	$                   1,300.00	$   1,026.31	$     38,779.27	$ 41,105.58		$ 128,289.23	$    87,183.64
Year 10	$                    -	$                   1,300.00	$   1,154.60	$     43,626.68	$ 46,081.28		$ 144,325.38	$    98,244.10

NPV of the 10 Income Flows at end of each Year from 1 to 10 = NPV (Rate, [Value 1...10]) = $258,895.55

Option 1 - Purchase the Hester DC

	Machine Cost	Service Agreement	Callibration (Growing at 12.5% annually)	Consumables (Growing at 12.5% annually)	Total	Discount	Revenue (Growing at 12.5% annually)	Profit
Year 1	$     16,694.00	$                       750.00	$       175.00	$     13,434.00	$ 31,053.00	$               -	$    50,000.00	$    18,947.00
Year 2		$                       750.00	$       196.88	$     15,113.25	$ 16,060.13		$    56,250.00	$    40,189.88
Year 3		$                       750.00	$       221.48	$     17,002.41	$ 17,973.89		$    63,281.25	$    45,307.36
Year 4		$                       750.00	$       249.17	$     19,127.71	$ 20,126.88		$    71,191.41	$    51,064.53
Year 5		$                       750.00	$       280.32	$     21,518.67	$ 22,548.99		$    80,090.33	$    57,541.35
Year 6		$                       750.00	$       315.36	$     24,208.50	$ 25,273.86		$    90,101.62	$    64,827.76
Year 7		$                       750.00	$       354.78	$     27,234.57	$ 28,339.34		$ 101,364.33	$    73,024.98
Year 8		$                       750.00	$       399.12	$     30,638.89	$ 31,788.01		$ 114,034.87	$    82,246.86
Year 9		$                       750.00	$       449.01	$     34,468.75	$ 35,667.76		$ 128,289.23	$    92,621.46
Year 10		$                       750.00	$       505.14	$     38,777.34	$ 40,032.48		$ 144,325.38	$ 104,292.90

NPV of the 10 Income Flows at end of each Year from 1 to 10 = NPV (Rate, [Value 1...10]) = $268,934.51

Hence Option 2 is financially more profitable to go with.

Ans 2.

The operational consideration that would need to be considered are complexity of the use of 2 machines and the cost of training the staff for the same.

Ans 3.

If usage of Itech software linkage increase the revenues by 15-20%, then that would definitely contribute to an increase in cash flows and profitability of Option 1. Assuming 17.5% increase in revenue, the projected cash flows of Option 1 would be:

Revenue	Profit
$    58,750.000	$    43,936.000
$    66,093.750	$    47,340.500
$    74,355.469	$    53,420.563
$    83,649.902	$    60,260.633
$    94,106.140	$    67,955.712
$ 105,869.408	$    76,612.676
$ 119,103.084	$    86,351.760
$ 133,990.969	$    71,309.230
$ 150,739.840	$ 109,634.259
$ 169,582.320	$ 123,501.042

The NPV of these would be $327,954.72 and would make Option 1 more profitable.

Ans 4.

Other factors that could be included in the analysis are:

- Rate of Depreciation and any associate Tax Benefits

- Stability of the Machine Vendors and their Financial Strength

- Rate of change in Technology such that the machines may become outdated sooner than 10 years

- Timeliness and Quaity of Service and Support of the 2 vendors.