Benchmarks and Budget Targets

One of the simplest ways to develop budget projections is to use benchmarks or budget targets as the budgeted value. One example is using the national benchmark of 3% of labor expenses as the budget for overtime expenses (Beckers Hospital Review, 2018). An internally developed budget target might also be applied, such as reducing medical supplies expenses by 5% over the coming year.

Retrospective Forecasting

Budget planners often use past performance as a guide for budget projections, a method known as retrospective forecasting. Retrospective forecasting methods use past event data to predict future values. Budgets are frequently developed based on various forms of retrospective forecasting. The assumption is that the best available predictor of future performance is past performance. Retrospective forecasts are generally quantitative, relying on numerical data. Retrospective forecasts can be supplemented with qualitative data that do not rely on numerical data. Qualitative data include the history, policies, and politics of an organization, as well as the nurse’s experience.

A simple and frequently used approach to budget preparation is incremental budgeting, in which the current year’s budget is used as the base for the next year’s budget, making additions, reductions, or keeping the base the same. These incremental changes to the budget usually depend on administrative guidelines communicated during the budget preparation phase of the budget cycle. Administrative guidelines might require either a given dollar amount or a percent of an incremental change for the new budget. For example, a hospital might assume inflation and wage increases over the next fiscal year support an incremental budget increase of 5% for all nursing unit operating expense budgets.

The advantage of incremental budgeting is that it is simple to understand and implement. Incremental budget decisions are largely centralized and controlled at the top administrative levels, although in some settings department directors or other staff responsible for budgets may provide input. One problem with incremental budgeting is that there is a tendency to increase the budget year by year, without always fully analyzing the actual need for an increase. For example, a 5% increase in an operating budget might be greater than actually required, or it might be insufficient for the unit’s needs. Incremental budgeting may therefore be inefficient.

Incremental reductions (budget cuts) may also occur without a complete analysis of their need or consequences. For example, hospital administrators might require a 5% cut in the operating expense budgets of all departments and nursing units. The actual budget requirements may vary from one department to another, so an incremental budget reduction might be excessive for one department, while other departments, such as nursing, could manage with a greater than 5% budget reduction. Because incremental budgeting relies on administrative guidelines, there may be little analysis or negotiation of budget items by the managers or staff who are most familiar with the nursing unit facing the budget cuts. Incremental budgeting does not account for the resources a nursing unit may require to operate efficiently and profitably. Other approaches discussed in this chapter that involve more analysis of the budget and the impact of budgeting decisions help overcome the limitations of incremental budgeting.

Another of the more common approaches to retrospective forecasting is the annual spend down or “use it or lose it” method. Managers are expected to spend their entire budget by the end of the fiscal year, or the amount not spent is cut from the next year’s budget. For example, if a nurse manager has $100,000 budgeted for a line item over a year and only spends $90,000 that year, the next year’s budget for that line item is reduced to $90,000.

The spend-down method rewards managers who meet annual budget targets without going over or under budget. Grant funders use the spend-down method to motivate grant writers to estimate, as well as spend, their budgets as accurately as possible. However, in many settings managers are compelled to spend down the entire budget by the end of the year, whether this is the most efficient use of resources or not, so that they avoid budget cuts. If the setting uses flexible budgeting, a spend-down approach may either be inappropriate or complicated to apply, as expenses are expected to drop if volume drops. Spend-down incentives may penalize managers who find innovative ways to reduce expenses without reducing quality.

Variance analysis is another approach to retrospective forecasting. Variance analysis identifies sources of uncontrollable variance that may require adjustment of the next year’s budget. For example, if price increases result in an uncontrollable increase in the expenses for medical supplies, the next year’s budget may be adjusted to increase the amount budgeted for those supplies.

In some situations, variance analysis indicates that an unfavorable variance is controllable. Rather than adjusting the budget over the next year, a controllable unfavorable variance is often addressed as a performance problem. For example, if an unfavorable overtime expense variance is determined to be controllable, the next year’s budget likely will not increase the amount budgeted for overtime expenses. Instead, the manager is expected to develop strategies to improve the control of overtime expenses and to meet the overtime expense budget target over the next year. Many hospitals require nurse managers to complete variance reports monthly, explaining the variance and creating an action plan to correct negative variances.

Unexpected events during the fiscal year might result in unbudgeted expenditures. As a result, earlier time periods in the annual budget might not reflect performance later in the year. One method to adjust for unbudgeted events in budget planning is annualizing. The monthly annualized budget amount is multiplied by the remaining months of the fiscal year to estimate a revised budget. The monthly annualized budget amount is multiplied by 12 to estimate the amount required for the next year’s annual budget.

For example, assume that the East Wing medical-surgical unit experiences a surge in volume midyear 2021. Beginning in September 2021, East Wing staffs an additional five beds for a total of 25 staffed beds (Table 4.2). The nurse salaries and wages are budgeted based on 20 staffed beds. However, the increase in UOS results in actual nurse salaries and wages of $161,536 in September and $158,464 in October. The increase in UOS is expected to continue, so the performance for September and October 2021 is annualized to budget an average of $160,000 for nurse salaries and wages for November and December 2021 ($320,000 ÷ 2 months). This annualized estimate is used to estimate the annual nurse salaries and wages budget of $1,920,000 for 2021 ($160,000 × 12 months).

A trend line (discussed in more depth in Chapter 5, “Reporting and Managing Budgets”) is a line created by a mathematical equation that estimates or predicts the movement of an economic variable over time. Budget data from prior years is used to create the trend line, which predicts the budget value in the future. The trend line provides a visual representation of the trend, making the trend data easier to present and understand.

Trend lines can be created using spreadsheet programs that calculate the trend line as part of a line graph. In many institutions, financial officers create graphs of historical budget performance with trend lines. For example, Figure 4.1 presents a trend line to predict the total nursing costs for the East Wing medical-surgical nursing unit for 2021. The trend line predicts that the total nursing costs for 2022 will be similar to 2021 performance, a little over $2.5 million.

FIGURE 4.1

East Wing medical-surgical unit trend line forecast for 2021 total nursing costs.

Prospective Forecasting

Another method of forecasting is prospective forecasting, based on the assumption that current information enables the prediction of future events. Prospective forecasts are often related to knowledge of new or changed policies and regulations that will affect financial performance in the future. Some institutions have research departments that compile and analyze legislative reports, updates from health plans, and other information that helps forecast revenue and expenses for the next fiscal year. For example, the Patient Protection and Affordable Care Act of 2010 imposes financial penalties for hospitals with high readmission rates, and selected 30-day readmission rates for Medicare patients are reported to the public (Centers for Medicare & Medicaid Services [CMS], 2022a). These regulations and initiatives likely result in hospitals providing more resources to reduce preventable readmissions and to consider the impact of preventable readmissions on hospital revenue.

Related to the use of information is the application of expert opinion to prospective budget forecasting, also known as qualitative forecasting. For example, nurse managers and administrators may meet to discuss changes they anticipate over the next year that may impact operating budgets as part of a strategic planning process. The expertise and experience of these leaders may be incorporated in projections of patient volume, revenue, and expenses. The findings from an analysis of expert opinion often result in a range of predicted outcomes. Scenarios for patient volume might be rated as a specified range to allow for differences among the experts who offer their opinions. For example, a strategic planning session might result in ranges of the highest predicted level of patient volume to the lowest or the most likely level of patient volume to the least likely.

Another prospective forecasting approach is using what-if scenarios to analyze the possible impact of a change in revenue or expenses. Computer spreadsheets are well suited to making what-if calculations. Calculating various what-if estimates allows the review of potential alternative outcomes. This approach enables predictions of the impact of budget decisions for the next fiscal year.

The earlier example using Table 4.2 can be viewed as a what-if scenario. Before deciding to expand East Wing’s capacity from 20 to 25 beds, the nurse manager can see what impact the expansion will have on patient days, nurse full-time equivalents (FTEs), and nurse salaries and wages. The nurse manager also wants to be sure that the change in capacity from 20 to 25 beds maintains an occupancy rate close to 85% for most days of the year. It is clear that expanding East Wing’s capacity affects not only the 2021 budget but also will require increases in the 2022 budget. The nurse manager and the Bigtown Hospital administration are thus better informed about the future impact of decisions that affect East Wing’s operating budget.

Prospective budgeting includes budgeting for new line items. In some situations, the new line items are the result of unexpected expenses over the fiscal year. For example, the NPs at MNC may find that a number of their disease management patients require wound care management. MNC incurs expenses for medical supplies for these patients that were not anticipated in the 2021 budget. The additional time NPs need to manage these patients strains the capacity of MNC.

In many cases, special projects or new initiatives are planned that require additional line items in the next year’s budget. For example, the MNC nurse manager writes a business plan to establish an outpatient wound care clinic in 2022. This new initiative requires budget projections for anticipated reimbursement and expenses for a wound care nurse, an examination room, and the necessary equipment and supplies. Chapter 6, “Special Purpose, Capital, and Other Budgets,” and Chapter 9, “Building a Business Case,” discuss budgeting for special projects and business plans in more detail. Chapter 11, “Health Program Grant Writing,” presents details of budgeting for health program grant proposals. Sustainability of these special projects requires including these new line items in the next year’s operating budget when the plan or proposal funding ends.

Budget projections often include adjusting for predicted inflation. The same method may be used to estimate the impact of increases in salaries and wages over the next fiscal year. For example, based on the annualized estimates in Table 4.2, the 2021 nurse salaries and wages budget is estimated at $1,920,000. However, a salary and wage increase of 3% is planned for 2022. The 2021 salaries and wages budget is therefore adjusted for the projected increase, resulting in a budget estimate of $1,977,600 ($1,920,000 × 1.03).

Zero-Based Budgeting and Step-Fixed Budgeting

Preparing a continuing budget as if it were intended for a new program or service is known as zero-based budgeting (ZBB). ZBB is a prospective approach intended to improve the accuracy and control of the budgeting process, thus reducing waste and improving efficiency. In contrast to incremental budgeting, which automatically applies budget increases or cuts, ZBB requires detailed analysis of every line item as it is added to the budget.

Although ZBB increases efficiency and can improve financial performance, this approach also has limitations. The ZBB process is complex, requiring considerable time and effort, and is a burdensome requirement of all operating budgets each year. A better approach is to require zero-based budgets for selected programs or line items. For example, the nurse manager of MNC believes that the $6,000 annual budget for nonmedical supplies is excessive and should be reduced for 2022. A ZBB approach requires that the nurse manager start with a budget of $0 and identify and evaluate each line item as it is added to the budget. This process is time consuming but assures that the 2022 budgeting for nonmedical supplies is accurate and cost-effective. ZBB is typically not used in hospitals.

When budget projections indicate changes that require a change in capacity, step-fixed budgeting is a useful approach for budget planning. For example, the MNC NPs are able to manage about 1,300 patient encounters per year, or about 3,900 total encounters for the health center. The NPs are functioning close to their maximum capacity over 2021. If MNC assumes any additional contracts for patient encounters, the health center must hire at least one more NP. As the workload increases beyond 1,300 additional patient encounters, another NP must be hired. In other words, three NPs are sufficient to cover 3,900 patient encounters, four NPs are needed to cover up to 5,200 patient encounters, and five NPs are required to cover up to 6,500 patient encounters. Budgeting for additional examination rooms and equipment may require capital budgeting, discussed in Chapter 6, “Special Purpose, Capital, and Other Budgets.”

Forecasting Challenges

The future is always somewhat unpredictable, so the forecasting methods that have been presented must allow for error. One way to measure and understand error is to compare the forecasted to actual data at the end of the forecasted time period. For example, if in 2020 the MNC nurse manager projects 5,000 patient encounters for 2021, the predicted UOS can be compared with the actual 2021 UOS after the end of the 2022 fiscal year.

The accuracy of a forecast is expected to decrease as the time frame for a prediction increases. In other words, a forecast made in 2020 for 2021 is likely more accurate than a forecast made in 2019 for 2022. One implication is that nurses interpret forecasts using methods such as trend lines conservatively as short-term forecasts. It is also recommended that any known error or possible sources of errors be reported when providing a forecast. For example, if the amount estimated for inflation is uncertain and based on one’s best guess, this uncertainty should be reported when the budget figures that are adjusted for inflation are reported.

Another approach to address possible forecast errors is to report a range of predictions rather than a single specific number. For example, the nurse managers of several medical-surgical units might be asked to predict the percent of change in patient volume for the next fiscal year. In addition, each nurse manager could be requested to provide both a high and low estimate. The sets of high estimates and low estimates could each be averaged, resulting in an overall range. Reporting a range of estimates helps account for forecasting error, as there are many factors that influence events, such as patient volume.

A combination of retrospective and prospective methods is often advisable in forecasting. It is also advisable to apply a combination of qualitative and quantitative methods when making forecasts. For example, in forecasting UOS, it is possible to review historical data and create a trend line (a quantitative, retrospective approach). The trend line prediction can then be compared with the predictions made by experienced managers and administrators (a qualitative, prospective approach). Further refinement of the forecast is possible by analyzing anticipated changes in the coming fiscal year, such as employment rates that could affect the numbers of persons who are insured and thus more likely to access healthcare. Rapidly changing situations or forecasting errors might lead to widely differing forecasts from each of these approaches. On the other hand, similar forecasts based on various approaches help reinforce the likely accuracy and certainty of these predictions.

Combinations of forecasting approaches help in considering all possible internal and external sources of change. Internal sources of change include the various factors in the work setting or institution that might affect the forecast. For example, if a hospital is expanding its cardiovascular services and programs, it is reasonable to predict that more nurses might need to be hired to staff these services and programs.

External sources of change include new laws, regulations, and findings from medical research that might affect the forecast. For example, in 2012 the CMS changed a number of regulatory requirements for hospitals. One change is that APRNs and other nonphysician practitioners may be appointed to the hospital’s medical staff and function at their full scope of practice. These and other changes in CMS regulations should reduce costs to hospitals (CMS, 2022b). Strategic planning and hospital budgets will likely be influenced by these new regulations.

The Budget Cycle and Calendar

Although budgeting is a continuous managerial activity, most organizations establish a budget cycle, including a schedule for budget preparation, negotiation, approval, and implementation. As with other aspects of budgeting, organizations differ in their policies for establishing the budget cycle. In many settings, a calendar for assignments such as budget reports, proposals, budget negotiations, and final budgets is distributed. Box 4.1 summarizes the elements of a typical budget cycle.

Following the development of the strategic plan, department directors (ideally assisted by staff) prepare and submit departmental and other work unit budget proposals. These proposals include budgets for new programs, substantial changes in programs, or extensive capital improvements. Department directors or nurse managers also prepare the operating and capital budgets for continuing programs and services. After submission of these budgets, there is a schedule of review, negotiation, and approval or denial of the budgets by upper-level administration. Budgets may be required to be revised and resubmitted for final approval.

Statistics Budget Planning

The statistics budget is a projection of UOS that represents utilization of health services. The statistics budget is prepared before planning the operating budget, because healthcare revenue and expenses are usually based on volume. The volume statistics are also linked to a setting’s capacity or the maximum UOS that can be managed in a healthcare setting. Performance targets must be set at some point below capacity because factors such as unexpected delays prevent healthcare settings from operating at full capacity for an extensive time period. Therefore, budget projections are often based on performance targets set at levels somewhat below capacity.

Table 4.3 presents the 2022 projected operating budget for MNC. The budget presents actual past budget performance data for 2020 and 2021. As budget indicators are discussed, examples of approaches to budget planning and projection are presented. The first items show the actual 2020 and 2021 statistics, followed by the 2022 budgeted statistics.

The number of examination rooms and NPs on staff are indicators of actual and budgeted capacity. The NP capacity is based on performance targets of four encounters per day per NP for 2020 and six encounters per day per NP for 2021 and 2022. The increase in capacity is because the MNC now has administrative support so that the NPs can focus all their time on clinical activities. The encounters per day are multiplied by the 224 days each NP is budgeted to work. Actual performance is reported as actual encounters per day and the total encounters from accountable care organization (ACO) contracts and self-pay encounters.

A line is reported for NP productivity or the proportion of actual encounters to NP capacity. The performance target is for the NPs to work at 95% of capacity overall, the level at which the NPs are believed to function most efficiently. The 2022 budget therefore projects 3,830 patient encounters, or 95% of the 4,032 capacity. The nurse manager and NPs at the MNC decide to maintain their current contracts with Welby ACO for disease management and wellness care. A contract for immunization of Bigtown school children is changed so that the MNC will provide about 300 encounters rather than the 500 encounters contracted in 2016. The NPs will focus more on immunizing preschoolers entering the school system in 2017, compared with older children. Some continued increase in self-pay encounters is anticipated for 2017.

Table 4.4 presents the 2022 projected operating budget for the East Wing medical-surgical unit. The actual performance for 2020 and 2021 is displayed, with budget projections for 2022. The statistics indicate that East Wing will increase its capacity from 20 to 25 staffed beds over the next year. Strategic planning led to the reorganization of medical-surgical units at Bigtown Hospital. The reorganization resulted in the closure of one medical-surgical nursing unit (North Wing) and the allocation of additional beds to East Wing. The 2022 budgeted patient days of 7,756 reflect a performance target of 85% occupancy, a level at which East Wing is believed to operate most efficiently. These projections are based on strategic planning decisions and expert opinion, as well as historical information and trends for patient days.

Revenue Budget Planning

Operating revenue projections are based on the statistics budget and on anticipated reimbursement for the coming fiscal year. MNC negotiates the same reimbursement for 2021 as for 2020 (Table 4.3). Although MNC will manage about 200 fewer immunization encounters over 2017, the continued reimbursement of $450,000 adjusts for inflation. Grant funding continues at $50,000, and additional revenue is anticipated from private collections from self-pay patients and from donations. Revenue is budgeted at $138 per patient encounter, reflecting a per-unit increase.

Gross revenue for the East Wing medical-surgical unit is estimated at $6,522,120 for 2022. The gross revenue reflects the charges for services on East Wing, not the actual reimbursement (net revenue) that is received by Bigtown Hospital. The hospital administrators use a combination of retrospective and prospective approaches to estimate revenue and reimbursement for 2022. Retrospective approaches include historical data and trend lines of revenue and reimbursement for prior years. Prospective approaches include a review of new Medicare, Medicaid, and commercial insurance regulations and policies for reimbursement, as well as expert opinion regarding local employment and the anticipated payer mix sources of reimbursement that are expected over the coming year.

Operating Expense Budget Planning

The operating expense budget is the budget most likely to be reported to nurses and nurse managers. Ideally, nurses and nurse managers provide input for the development of the next year’s operating expense budget. Performance targets are frequently used to budget expenses in order to motivate cost control and efficiency.