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Understanding Production Income

By May 1, 2018Business

A very common misconception amongst health-care professionals is the method of determining profits from the operation of their practices. Their accountants take the gross income (collections) of the practice and subtract the direct expenses to determine what they call “operating profits.” This is an error when computing the true operating profits of a practice.

The operating profits of most business corporations are usually easy to determine. An investor would look at the corporation’s profit and loss statement, which would reflect the gross income of the corporation and subtract:

• The cost of materials, supplies or goods
• All advertising and administrative expenses
• Miscellaneous expenses
• Cost of labor, including:
• Management – Administrative – Production – Support Staff. The resulting would be considered “operating profits.”
Most profit and loss statements for a professional practice (corporate or non-corporate) will reflect the gross income of the practice and then subtract:
• The cost of materials, supplies or goods
• All advertising and administrative expenses
• Miscellaneous expenses
• Cost of labor, including:
• Administrative – Support Staff

What happened to Management and Production? Surely a practice cannot operate without those two important elements. Someone must be performing these functions; of course, the owner-practitioner is! But supposing the owner-practitioner could not function in either role, one would assume that the practice would have to hire a professional associate to produce the services that the owner-practitioner is now providing. The money paid to that associate-doctor would be considered an expense, not profit.

So, if the owner-practitioner is now providing the required management and production services for his practice, instead of an associate, then a similar amount should be considered a labor expense and not an operating profit. That labor expense is being paid to the owner-practitioner instead of to an associate and is therefore a production expense and should be separated out when determining the operating profits of the practice.

NOTE : Another comparable example would be if we were to take a production worker on a Ford Motor Company assembly line who happens to own ten shares of Ford stock. To include his wages in with this stock dividend (his share of operating profits for ten shares of stock) when determining his return on investment (R.O.I.) for purchasing the Ford stock would be unthinkable and invalid. The production worker is not going to consider his wages (which to him is production income) as part of his return on investment (which is his share of profits for ten shares, which is the real R.O.I.). Neither should the practice owner-practitioner.

When a practice P&L is showing an operating expense percentage of 50%, then you must add to that the cost for hiring a professional to produce the services (usually 30% to 35%). If you add an associate to your practice, or enter into a partnership arrangement, then this is the percentage each of you should be paid for your respective “true” operating expense of 80% to 85%, resulting in a 15% to 20% figure as operating profits.

Operating profits can be increased considerably by increasing the productivity of the practice. Methods of increasing productivity are adding an associate, maintaining longer office hours, practice mergers, consolidations or office sharing. Operating profits can be increased to as much as 30% of gross income if planned properly.

This is the “passive income” or “practice annuity” that each practitioner should hope and plan to someday derive from the practice they worked so hard to build and maintain. As the older practitioner slows down his production, his production income will drop, but the operating profits, which are distributed relative to each party’s stock ownership, continue at a constant level and provide that long-awaited, and well-earned passive income or practice annuity.

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Nancy McNutt

Author Nancy McNutt

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