Question

As a part of proposed health care reform, the federal government is encouraging hospitals to use new health information technology as a means to reduce health care costs and increase quality of services. You are the CFO of a nonprofit hospital and need to conduct a cost-benefit analysis of the idea to present to the board. Being well trained in economic evaluation, especially cost-benefit analysis, you have happily accepted the challenge of this task.

You have collected some relevant information. You know that the new system will enable the hospital staff to make more timely diagnoses and interventions, will reduce medical errors, and will improve communication within the care team. The initial start-up cost for your hospital is estimated to be $10 million, which includes planning, purchasing of information systems (hardware and software), and staff training, among other things. You also estimate that the operating and maintenance cost of the new system will be about $1 million. After the system is implemented, the hospital is expected to benefit financially from cost savings and revenue enhancement. It is estimated that cash inflow will increase by $2.4 million. The information system will be obsolete in about ten years, and no residual value is expected. The improved quality of diagnosis and appropriate treatment will also have broader social and human consequences. Studies show that for hospitals similar in size to yours, the system has saved an average of two lives because of reduction of errors, plus a likely decrease in injuries and long-term disabilities to patients.

Based on the information collected, and following the steps outlined above, you decide to study the matter from the perspectives of both the hospital financials and the larger social impact. In consultation with the CEO and other key personnel, you specify the current hospital status quo as the basis for comparison, which dictates that all costs and benefits are incremental from that of current practice of the organization. Working with your evaluation team, you identify key impacts, such as cost savings and increased revenue, to be included in the benefit accounting when studied from the hospital perspective. From the societal perspective, the benefit includes the lives saved. You search the literature and decide to use $7 million as the statistical value for a human life.

You could borrow money, through municipal bond with the help of the local government, at the 4 percent real interest rate. You decide to use this as the discount rate in the analysis. You also decide to conduct a sensitivity analysis, in which you change the discount rate to 8 percent, in case you need to borrow from the financial markets directly. If the net present value of the analysis is positive at either discount rate, you will have more confidence of the robustness of the results.

What do you find in your base case cost-benefit analysis—that is, from the hospital perspective and using 4 percent as the discount rate?

Changing the discount rate to 8 percent, what is your conclusion in your sensitivity analysis?

What is the result if you conduct the cost-benefit analysis from the societal perspective under the 4 percent and the 8 percent discount scenarios?

What is your recommendation to the CEO with regard to the adoption of the new system?

Answer 1

Solution:

Given:

Initial investment : 10 mn
Operation & Maintenance expense per year : 1 mn (assumed per year)
Cost Savings : 2.4 mn  
Life of machine : 10   years..... therefore each year machine depreciation = 10/10 = 1 mn
Human Life Saved benefit : 7 x 2 = 14 mn

Company Perspective:

Net cash inflow per year =   Cost Savings + Depreciation - Operations & Maintenance Cost = 2.4 + 1 -1 = 2.4 mn

So the cash flows for ten years are as under:

Year	Cash Flows
0	-10
1	2.4
2	2.4
3	2.4
4	2.4
5	2.4
6	2.4
7	2.4
8	2.4
9	2.4
10	2.4

NPV @ 4% =  9.47
NPV @ 8% =  6.10

From societal perspective:

There would be additional benefit of live saved.

Net cash inflow per year = 2.4 + 14 = 16.4 mn

So the cash flows for ten years are as under:

Year	Cash Flows
0	-10
1	16.4
2	16.4
3	16.4
4	16.4
5	16.4
6	16.4
7	16.4
8	16.4
9	16.4
10	16.4

NPV @4% = 123.02 mn
NPV @8% = 100.05 mn

From both hospital perspective and societal perspective and considering the sensitvity analysis, the recommendation to the CEO is to DO the project.

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