You serve 3,000 private-pay patients and 1,000 health maintenance organization (
ID: 1224318 • Letter: Y
Question
You serve 3,000 private-pay patients and 1,000 health maintenance organization (HMO) members. Your fixed costs are $50,000 and your incremental cost is $50. You currently charge private-pay patients $75 and HMO members $60.
This line of business is profitable.
Profits would increase if you stopped serving HMO members.
You should stop serving HMO members if fixed costs increased to $60,000.
All of the above
This line of business is profitable.
Profits would increase if you stopped serving HMO members.
You should stop serving HMO members if fixed costs increased to $60,000.
All of the above
Explanation / Answer
Case I - When firm serves both private-pay patients and HMO members
Total private-pay patients served = 3,000
Total HMO members served = 1,000
Charge per private-pay patient = $75
Charge per HMO member = $60
Calculate Total revenue -
Total revenue = (Total private-pay patients served*Charge per private-pay patient) + (Total HMO members served*Charge per HMO member)
Total revenue = (3,000*$75) + (1,000*$60) = $225,000 + $60,000 = $285,000
Calculate Total cost
Total cost = (Total private-pay patients served*incremental cost) + (Total HMO members served*incremental cost) + Fixed cost
Total cost = (3,000*$50) + (1,000*$50) + $50,000 = $150,000 + $50,000 + $50,000
Total cost = $250,000
Calculate Total profit -
Total profit = Total revenue - Total cost = $285,000 - $250,000 = $35,000
Thus, firm earn $35,000 as profit when it serves both private-pay patients and HMO members.
Case II - When firm serves only private-pay patients -
Total private-pay patients served = 3,000
Charge per private-pay patient = $75
Calculate Total revenue -
Total revenue = (Total private-pay patients served*Charge per private-pay patient)
Total revenue = (3,000*$75) = $225,000
Calculate Total cost
Total cost = (Total private-pay patients served*incremental cost) + Fixed cost
Total cost = (3,000*$50) + $50,000 = $150,000 + $50,000
Total cost = $200,000
Calculate Total profit -
Total profit = Total revenue - Total cost = $225,000 - $200,000 = $25,000
Thus, firm earn $25,000 as profit when it serves only private-pay patients.
As we can see that profit of firm decreases when it stop serving HMO members.
Moreover, increase in total cost is not the criteria to determine whether a particular group of customers to be served or not because firm has to pay the fixed cost even if no customer is served.
So, firm takes into account incremental cost. Until and unless incremental cost per customer is less than the revenue per customer with respect to particular group of customers, firm will serve those customers.
In given case, incremental cost per patient for HMO members is $50 while revenue per HMO member is $60. So, whatever be the increase in fixed cost, firm will serve HMO members as incremental cost per patient for HMO members is less than revenue per HMO member.
Thus, options (2), (3), and (4) are not correct.
In case I we have calculated that when firm serves both private pay patients and HMO members (as the case), it earn a profit of $35,000.
This indicates that this line of business is profitable.
Hence, the correct answer is option (1).
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