Marginal cost pricing in health care

Ratan Jalan

For me, an airplane is simply marginal cost with wings”, said Alfred Kahn, economist and former chairman, Civil Aeronautics Board, USA.

Price is the marketing-mix element that produces revenue, the others produce cost. It is also one of the most flexible elements and can effectively be used as a ‘strategic tool’.

While the market environment sets a framework for the price a hospital or a diagnostic centre can charge for its services, costs set the floor. It is precisely in this context that an understanding of costs becomes extremely important. Costs, as we know, take two forms, fixed and variable. Fixed costs (also known as overhead) are costs that do not vary with the quantity or amount of services sold (or produced).

A hospital incurs certain expenses on account of rent, salaries, air-conditioning etc regardless of output.

These fixed costs can be split into two categories: Direct Fixed Cost and Indirect Fixed Cost. While estimating the cost of a particular service (Chest X-ray, for example), elements such as salary of radiographer and radiologist, depreciation of the x-ray equipment and rental for x-ray room should be categorised as ‘Direct Fixed Cost’, whereas elements like salaries for customer care executives and other administrative staff, rental for reception/administration areas and common utilities such as toilets and cafeteria get termed as ‘Indirect Fixed Cost’.

Variable costs vary directly with the level of service provided. For example, each x-ray involves cost of x-ray film, developer, fixer, and the like. These costs, to a large extent, tend to be constant per unit of service provided. While there will be some scope of variation even in case of such cost with the amount of services provided (as a result of economy of scale), the may be assumed as constant for the sake of simplicity. In this article, the more appropriate term Direct Variable Cost has been used. At times, this term gets used interchangeably with marginal cost or incremental cost also.

Marginal Cost Pricing

Service industries such as airlines and hotels have certain uniqueness associated with them. The products they sell are most perishable (an empty seat after take-off or an empty hotel room the next morning are worth zero) and the direct variable cost (or marginal or incremental cost) of servicing one more customer is extremely low in relation to the normal tariff. It is easy to understand why these organisations often resort to extremely low prices to select customers on certain occasions to fill in unutilised capacity.

During low occupancy season, a guest paying a ridiculously low amount of Rs 1000/- per night to the Taj Hotels (in response to the promotional offer with Indian Airlines) will also contribute positively to the profitability of the hotel. The same, in fact, is the case with Jet Airways (or all other airlines) offering 50 per cent or more off to certain section of passengers. Certain price-based promotional offers from hospitals or outpatient facilities such as diagnostic centres have to be viewed in this light. It is extremely important to generate volumes particularly in the initial months and for that, extend offers to select customers, who more than cover direct variable costs and contribute positively.

More importantly, like in the case of hotels, customers tend to consume other services as well (pharmacy or other tests, if and when required) and thus mean additional (non-discounted) revenue in those areas. As we also know, organisations often invest in the sampling exercise. It is critical for a new facility to get customers to walk in and experience its services. As an example, let us understand the cost of a service such as x-ray.

In the following table, I have focused largely on Direct Variable Cost (and also Direct Fixed Cost) for arriving at the cost of a particular service, such as x-ray, at different levels of production/service delivery. In the current context (and also due to immense subjectivity in allocation of indirect fixed cost), the same has not been taken into account. The following table provides a summary of direct variable cost for taking a x-ray.

As we can see (from the adjoining graph), it falls dramatically with increase in output.

It is therefore easy to understand how a facility offering this service even at a price less than Rs 100 can be profitable, if it manages to attract enough volumes.

Not surprisingly, promotional offers, particularly in diagnostics are quite common.

The adjoining advertisement is just one of the examples, where a Heart Check (comprising of services such as 2D Echo, Lipid profile, ECG, cardiologist consultation and blood sugar fasting) has been offered at just Rs 500, which will appear less incredible in relation to the direct variable cost of these services.

However,I need not emphasise the sensitivities associated with health care services. None of us would like to be made an offer, which says, “Buy one x-ray.

And get one free for your family.” Let me conclude by saying, there is a lot one can learn from other service sectors in various facets of marketing, which would be more than relevant to health care as well.

(The author is CEO, Apollo Health & Lifestyle Ltd. Email:ratan_jalan@theapolloclinic.com)