'Purchasing Capital Equipment,' Part 2 -- Capital budget versus operating budget

AuntMinnie.com is pleased to present the second installment of a three-part chapter titled "Purchasing Capital Equipment" from Radiology Business Practice: How to Succeed, edited by Dr. David Yousem, a professor in the department of radiology at Johns Hopkins Hospital in Baltimore, and Dr. Norman Beauchamp Jr., the chairman of the department of radiology at the University of Washington in Seattle. The book will be published in November by Elsevier. This section of the chapter, authored by Dr. Bob Gayler, addresses capital budget versus operating budget.

Many, perhaps most, organizations will separate the operating budget from the capital budget. This is logical and usually easy to understand, but there are some gray areas, into which capital and operating budgets fall and influence each other. Therefore, I will give a brief discussion and some examples of this overlap and mutual influence.

The capital budget is typically for discreet items that last for several years, typically six to 10 years, occasionally longer. The organization will include an inventory list, detailing items that will usually need maintenance. Items that involve ionizing radiation will need state or federal registration, and frequently preapproval from some regulatory agency, before purchase or installation, depending on the state.

Capital budget items can be divided into major and minor, depending on the dollar value. This distinction is usually determined by the organization. The separation may be $5,000, $10,000, or $50,000. Thus, at a $50,000 cutoff, a mobile radiographic unit would be minor capital; a mobile fluoroscopic unit costing more than $100,000 would be major capital. A small ultrasound unit would be minor capital and a traditional ultrasound unit would be major capital. The distinction may be important considering the amount of lead time for budgeting, whether competitive bids are required, and whether a separate contract is required. There will be a certain dollar level, below which items that might look like capital equipment are actually supplies and are purchased from the operating budget. An example of a gray-area item would be an x-ray cassette, costing, for example, $1,200. This lasts more than one year, but usually is not tracked as a capital asset, and does not require outside maintenance but does require regular cleaning. If a group of cassettes is purchased as part of a computed (CR) radiography contract, it would be considered capital. Replacement CR cassettes would ordinarily be purchased from operating dollars, however.

The operating budget is usually a one-year budget and includes salaries, supplies, rent, insurance, maintenance, and various contractual items, such as telephones. A merger area of overlap with the capital budget occurs with respect to maintenance. New capital items typically carry a one-year warranty. Therefore, the operating budget maintenance category would be decreased for one year each time a new piece of equipment is installed, then either go back to the previous annual maintenance cost or increase if the new equipment is more complex. Putting together the operating budget therefore requires specific knowledge about when capital equipment items are coming off warranty and how much the service will cost when that happens. If the new capital items increase volume, supply cost will increase.

With the ubiquitous distribution of computers, a special category is required. Software is usually treated as an operating expense unless it is an integral component of a capital project. For example, you wouldn't buy a CT scanner with no software from capital dollars, then buy all the software for the scanner out of operating dollars. However, subsequent purchase of software enhancements might well be considered an operating expense. This may be true, even if the software cost exceeds the traditional dollar cutoff points, such as $5,000, for distinguishing between operating expense and capital expense. It should also be noted that service contracts on computer equipment are typically more expensive as a percentage of cost than service contracts on traditional x-ray equipment.

When requesting new equipment, a cost and revenue analysis is usually required. This involves accounting input, since there are rules of financial operation to be followed.

Categories for the user to be aware of include:

  1. Equipment cost
  2. Financing cost
  3. Construction cost
  4. Rent
  5. Supplies
  6. Labor
  7. Overhead
  8. Maintenance (including nonobsolescence agreements for certain types of equipment)
  9. Additional PACS cost

These categories will be briefly discussed.

Equipment cost

There will be additional comments on the purchase price later. At this prepurchase stage, there should be an estimated equipment price. It is important that this be the maximum real price (it is typically difficult to get additional money after the budget process is completed), but not so high that the proposal is denied. Intentionally overestimating is a ploy to be discouraged. Reasons for overestimating include not doing your homework in getting price estimates (so that there is no risk of having to ask for more money) and not having a reserve contingency, in case some other capital need arises. Consistently overestimating destroys one's credibility. Good estimates require discussion with two or more prospective vendors, who should know that these are "budgetary quotes," not best and final quotes.

Financing cost

This will vary from business to business. If the equipment is being purchased for cash, this does not apply. Vendors frequently have financing divisions and may offer lease arrangements, as well as financing the purchase price. Either borrowing the money to purchase the equipment or acquiring it through a lease involves complexities, which should be carefully reviewed by knowledgeable accounting personnel. However, the radiologist should be comfortable with all the language and conditions. Lease arrangements typically have a buyout provision at "fair market value" after five years. This buyout must be budgeted for, since most imaging equipment is kept longer than five years. Negotiating a fixed, low buyout value, such as $1, means that the buyer pays the full price in the five-year period through the lease cost. The vendors are legally prohibited from "forgiving" a significant obligation remaining after a five-year lease.

A special cautionary comment is appropriate: If a service contract is combined with a lease, be careful to separate out the purchase price before the service contract is added. The equipment should have a one-year warranty, so there should be no service cost the first year unless you are getting extended-hour coverage, or special glassware coverage, projected because of unusually heavy use (glassware coverage involves x-ray tubes and image intensifiers). After the first year and the service contract begins, payments are typically quarterly without interest for the service contract. If you want identical payments for the full term of the lease, you are in effect paying down principal early so your total interest should be reduced. In summary, compare financing options carefully and do not pay interest on the service contract.

Leases

Capital lease and operating lease are terms used by financial officers. You need to know the difference. A capital lease is paid by money designated for purchase, used for leasing instead. The reasons may have to do with capital markets. This is analogous to leasing a car when you have the resources to purchase it.

An operating lease is paid out of the operating budget as an additional category, like salaries and supplies. In the hospital setting this may be important, if radiology has a fixed operating budget with a separate capital budget. Will finance increase the operating budget to cover the lease expense? If not, you are unlikely to welcome an operating lease.

Example: Assume a $10 million operating budget annually with a $2 million average capital budget. Assume a lease of $1 million worth of this annual expenditure for $200,000 per year. If the operating budget does not increase, you will be spending $10.2 million with a negative variance, therefore, of $200,000. The capital budget, underspent by $1 million, will look good for the hospital and your imaging administrator will be in hot water for failure to meet the budget.

Construction costs

These are part of capital projects costs, so they form an important part of the "return on investment" calculation. These are far more difficult to estimate than equipment costs. Working closely with an experienced facilities coordinator is the best general approach, but there are too many variables to come closer than ballpark numbers. The good news is that mobile radiographic units and C-arm fluoroscopic devices only need electrical outlets and alcoves, and ultrasound units only need outlets, a sink, and floor space. Requirements for all other devices have significant construction features including the following:

Replacement in the same space

  1. Electrical requirements may be different
  2. HVAC (heating, ventilation, air conditioning) requirements may be different
  3. Any ceiling-mounted equipment may be different
  4. Floor conduits will likely be different
  5. Floor weight will likely be different
  6. There may be new PACS requirements
  7. Potential shielding requirement changes

New equipment in existing, nonimaging space

  1. New electrical requirements
  2. New HVAC requirements
  3. New ceiling requirements
  4. Floor conduit requirements
  5. Floor weight issues
  6. Plumbing issues for sinks
  7. Lead lining when appropriate
  8. Wall construction
  9. Space for electrical cabinets
  10. PACS connections
  11. MRI (including magnetic shielding, acoustical shielding, radiofrequency shielding, delivery route)
  12. Plumbing (including restrooms and sinks)
  13. Patient prep and holding areas

New equipment in new space

New equipment in a new space is the same as all of the items above under new equipment in existing, nonimaging space, but involves more complex planning.

You should be aware of infectious disease requirements concerning hand washing, so sinks should be conveniently located in all exam rooms and technologist work areas. You should also be aware that the Joint Commission (formerly the Joint Commission of Accreditation of Healthcare Organizations [JCAHO]) considers contrast media to be a drug, thus it must be kept locked in a cabinet or refrigerator and must have orders written for dispensing it.

Some vendors offer turnkey installations. In this situation, the vendor will hire the construction group. Vendors frequently have experience with contractors who are familiar with the imaging requirements. This can be attractive financially, but references should be thoroughly checked.

The areas of potential misunderstanding with outside contractors include:

  • Permissible construction hours
  • Impact on contiguous operations
  • Length of project
  • Staging area requirements
  • Infection control
  • Asbestos abatement
  • Noise control
  • Access routes for construction equipment
  • Federal patient privacy regulations (HIPAA)
  • Magnetic field issues on all sides

Rent

In commercial space, rent is on a square-foot basis. Imaging equipment has much different electrical requirements than office equipment, so discussion with the landlord must make clear how the utility cost will be handled. Hospitals typically roll imaging center space into their overhead. The formula for this is rather complex, since imaging overhead includes expensive construction space, high utility cost, as well as the more typical billing, security, parking, and general lobby and space cost. The overhead for imaging should not subsidize other functions of the hospital to the point where technical charges for imaging procedures are unrealistically high. Note that this "hospital overhead" is in addition to radiology department overhead.

Supplies

The best model to estimate supply use for new equipment is current supply cost on a per exam basis of the type of exam to be done with the new equipment. If volume growth is projected, obviously supply cost will go up.

Labor

Labor cost should be similar to the equipment being replaced, unless there are to be major increases in the number of exams, changes in the operation hours, or changes in function.

Overhead

Imaging department overhead includes scheduling, billing, nursing support, purchase of nonimaging equipment, telephones, and department administration. This can be allocated to a piece of equipment based on a relative value unit (RVU) basis. In other words, if a CT scanner produces 10% of the RVUs for a department, the scanner would be responsible for covering 10% of the total department overhead.

Maintenance

Service contract costs can be used to indicate maintenance costs rather accurately. For the first year, equipment is typically under warranty. Warranties offered by the vendor cover standard hours and basic functions. If extended hours of coverage and extended component coverage are desired during the warranty period, there will be an extra charge. This charge will be part of the operating budget rather than the capital budget. Subsequent maintenance charges are also part of the operating budget. Be aware that as basic equipment is replaced with much more sophisticated equipment, the maintenance cost will go up, which increases the departmental operating cost. The difference between operating budget and capital budget was discussed previously.

Additional PACS cost

This includes not only the networking costs but additional storage and display costs. Engineering to install and maintain the PACS applications will be a significant expense.

Once the allocation of the capital for the purchase of the equipment has been made, detailed planning begins. Preparation of the bid document, which sometimes is referred to as a request for proposal (RFP) can be drafted by one person, then modified on the basis of input from others. An ad hoc RFP team including major users -- technologist, radiologist, physicist, and engineering -- is suggested. Input from administration, the purchasing group, and the legal department will be needed at some point in the process as well.

Components of the RFP include:

  1. Overview of the function and location of the equipment

  2. Component specifications

  3. Options to be listed

  4. Delivery parameters

  5. Any special conditions (e.g., trade-in of current equipment)

  6. Negotiation of maintenance contract: The maintenance contract may be negotiated at the same time as the purchase sale agreement, or separately. If a service contract is intended for the equipment, you have no leverage in discussing service price once the purchase price has been determined and the contract signed.

  7. Negotiation of nonobsolescence terminology: Any nonobsolescence terminology should be negotiated. You should be aware that this is a relatively new concept, and is not a term with universal meaning. Some dialogue will be necessary with respect to what each party understands are nonobsolescence agreements. If you want very broad coverage, you will pay significantly for this.

  8. Electronic storage implications (including image transfer time and compatibility with existing archives)

When the bid document is completed, it is sent by the corporate office to selected vendors. A minimum of three vendors is recommended. The state and federal government facilities usually require invitations to more vendors depending on a variety of regulations. Of the bid document components outlined in the numbered list above, only component specifications will be discussed in detail below. The others are intuitive.

Component specifications

There are three levels of specification writing that may be used:

  1. General specifications

    Advantages

    • It's fast to prepare for the buyer.
    • It's fast for the vendor to respond to.
    • There is maximum opportunity for the vendor to showcase a product.

    Disadvantages

    • The buyer is open to salesmanship.
    • It requires spending the most time with the vendor.
    • Desirable details may be overlooked.
    • This is usually only suitable when the buyer has full decision authority.

  2. Moderately detailed specifications

    Advantages

    • It requires less time by the buyer than full-detail specifications.
    • Point-by-point vendor comparison is possible.
    • It ensures that the product is matched to the needs.
    • Good price comparisons are available.

    Disadvantages

    • More preparation time is needed than for general specifications.
    • More vendor time is needed for response than for general specifications.
    • Desirable features may be omitted through simple oversight.
    • This level is appropriate when the user has a major voice in the decision process.

  3. Full-detailed specifications

    Advantages

    • It enables a point-by-point comparison.
    • When the user has little or no input into the final decision, this is the most appropriate, and, since the vendor must meet specifications, a decision can be based on price.

    Disadvantages

    • Preparation by the user takes the most amount of time.
    • The response time by the vendor is greatest.
    • Writing appropriate specifications requires thorough knowledge by the user.
    • Comparing quotes is time-consuming. Since more detail is stipulated in the RFP, the response will require that more items be compared.

Purchasing team

The department head and administration (hospital, imaging center) must have a strategy for acquiring capital equipment. The department head can directly participate in all phases, or delegate components of the process and retain either final decision authority or share the authority with the business side of the organization. In each situation, there will be variations, but input from direct users -- radiologist and technologist, department management, physicist, and maintenance and construction personnel -- are very helpful. For certain categories of equipment, such as mobile fluoroscopic devices, getting input from the surgeons familiar with the operating requirements can be extremely beneficial. Keeping these constituencies involved throughout the process will facilitate a smooth acquisition and installation process. The business side of the acquisition requires the engagement of legal, purchasing, and finance but they need not be involved in the early detail. The purchasing group may have access to comparison pricing information and access to user satisfaction surveys, which can be very helpful.

With any multimember group, face-to-face meetings are difficult to arrange, so group mailings sharing input, and a few two-to-three-member meetings can be used for decision-making. It is essential that the major users be comfortable with the operational features of the equipment. Site visits, which will be discussed in more detail later, can be very helpful in gaining familiarity with the operational features.

Comments on single vendors

There are two basic ploys used by vendors to get around the bid process. These are both very seductive, so it is important to be alert to both of them. One is a long-term "demonstration" on loan, which can be done with ultrasound units, contrast injectors, mobile C-arms, and mobile radiographic units. Ultrasound and C-arm fluoroscopic devices are the most expensive, so these are the ones that the buyer is most susceptible to. The equipment will be new, there will be special pricing, the images will be better than what you are accustomed to, and the salespeople will bring doughnuts for the technologists, but you will not have looked at competitive equipment, and no competitive negotiations will have taken place. Management in charge of purchasing, in either the hospital setting or in the private practice arena, should rightly tell you "no deal" on arrangements of this type, even if you have the money.

The other vendor ploy is actually attractive and may be ethically and legally acceptable. This involves a major upgrade to existing equipment and works best if it is prebudgeted as such. Major upgrades should prolong the useful life to at least five additional years and cost no more than one-third the price of new equipment. If it costs one-half as much and adds one-half of the expected 10-year life, there is no benefit over buying new. Also, an upgrade should require no construction. Upgrades at less than one-third of the cost of replacement may be helpful in MRI, with respect to new applications or shortening exam times.

Single-vendor purchasing may be justified when doing fleet purchases, such as mobile fluoroscopic devices and mobile radiographic units. In this situation, familiarity of operation is very important, prices are usually similar, and the vendor track record will be clear. Another special situation is with respect to CR. Due to the complexity of this equipment and the importance of integration, it would probably be a disadvantage to have more than one CR vendor in a department.

Purchase contracts

The vendor will have a standard contract. This will be included with a quotation, at the back, in fine print. For simple inexpensive equipment, this may be acceptable. It will be worded in favor of the vendor to a marked degree, however, so for expensive equipment, changes should be negotiated.

There are several common areas of potential change:

  1. Shipping costs, vendor or buyer

  2. Rigging costs, vendor or buyer

  3. Delivery to loading dock or place of installation: Liability is with the vendor to the delivery point with respect to any transportation damage.

  4. Warranty conditions

  5. Terms of liability for patient or personnel injury

  6. Performance guarantees during warranty

  7. Payment schedule (down payment, delivery payment, turnover payment)

  8. Collaboration regarding construction

  9. Acceptance testing/turnover testing: Acceptance testing is a point of special emphasis. This should provide verification by a physicist of the vendor specifications and include radiation output and electrical safety, as well as all state regulations (federal regulations are typically delegated to the states for monitoring and enforcement). The vendor must file a compliance certificate with the state, but this should not be relied on. The installation crew will frequently be independently contracted so details can be overlooked. Outsourcing happens at this point due to the sporadic nature of equipment installations. The rule "if anything can go wrong, it will" applies. Installation of the correct grid, correct grid positioning, tube filtration, tube anode position, and all components are simple examples of easily overlooked issues.

  10. Remedies for prolonged nonperformance

  11. Integration with buyer's PACS systems

Service contracts will overlap with the purchase contract in areas of liability for injury and performance guarantees penalties. The usual remedy for uptime falling below a stipulated level is to receive "free days" of service. The formula is negotiable but should be based on logic. It should be recognized that the vendor and buyer both want a mutually beneficial relationship. Mutual fairness should be standard.

Whether to have a service contract with specific details depends on several circumstances. Some advocate multivendor service contracts. However, having service companies that are also serving competitors has its limitations. For example, while this may be appropriate for basic equipment, there are concerns about this type of arrangement for complex equipment, since it tends to result in longer downtime. The inconvenience of downtime is not felt in your administrative office, or in the administrative office of the vendor, but by the end user -- you.

The value of the service contract to the vendor is that it provides a steady income stream, so the service manager can hire personnel and order equipment, in comparison to a "time and material" rate (in which time is billed at an high hourly rate and parts are billed at a high list price). The advantages to the buyer are that expenses are known and budgeted. The buyer should not have to pay a premium for this service and should end up paying less than the cost of time and material; there should be less downtime due to preventive maintenance. Therefore, a service contract can be appropriate if the price is reasonable, compared to time and material.

Special features of the maintenance contract include:

  1. Hours of coverage: There is a premium for other than standard hours, that is, 40-hours-per-week coverage. Emergency department (ED) coverage should be extended, while individual circumstances should dictate whether extended coverage is appropriate for non-ED areas. (Most experienced service personnel do not routinely work nights or weekends, so extended hours of service will be done by less experienced service engineers.)

  2. Service contract: Service contracts should include certain upgrades, usually including software upgrades.

  3. Glassware coverage: Glassware coverage is the largest component of the service contract and includes the x-ray tube and image intensifier. Image intensifiers rarely fail, and x-ray tube life is determined largely by usage. Local experience should be reviewed to determine price appropriateness.

  4. Response time: Response time includes telephone time and time for a service engineer to be onsite.

A few more rules of thumb regarding maintenance contracts:

  • A basic x-ray equipment service contract should be 6% to 8% of the purchase price.
  • For equipment with expensive tubes, the service contract should be 10% to 12% of the purchase price.
  • Computer-based equipment should be about 15% of the purchase price, and software upgrades should always be included.

These rules of thumb presume average discount on purchase price, average hours of coverage, and average use. Coverage for PACS is a special situation, since hours of operation are conducted under the standard rule of 24-hour, seven-days-a-week, 365-days-a-year coverage.

Downtime penalty

Vendor contracts typically indicate a guaranteed uptime percentage. The starting point in the negotiations may be 95%. We believe this is much too low since it is approximately one day per month of downtime. Uptime should be at least 98%, or only three hours per month of downtime. Most vendors will agree to this if preventive maintenance is not considered downtime. For downtime greater than this, penalties of increased service contract time without charge can be stipulated. The downtime can be averaged over a three-month period to avoid excessive bookkeeping. At first consideration, it may seem to be to the buyer's advantage to have downtime calculated on a 24-hour, seven-days-a-week basis. Except for ED equipment, this may not be true due to the size of the denominator.

If the service contract is not "24 by 7," there needs to be a provision for overtime rates in those circumstances when night or weekend service is essential to maintain operations. The rate should be substantially less than the standard time and material rate, typically about 50% of it.

An economic fact: You do not want to pay for overtime service if you have enough capacity to handle the volume with minor inconvenience. If you can handle planned downtime for preventive maintenance, do not insist on weekend preventive maintenance. However, if every Monday through Friday preventive maintenance costs you significant lost revenue, it can be good business to pay for weekend preventive maintenance.

Any contract is a compromise. Long, drawn-out contract negotiations will delay equipment replacement and may create bitterness. It is helpful to have frank discussions with potential vendors at the RFP stage so that they are fully aware of your terms beforehand, in which case they may not wish to bid. The reality is that some equipment failures cause patient injury, and the buyer must be protected in this event. Another reality is that some equipment does not perform as intended, so the buyer also must be protected from this situation.

General comments about vendor relations

Relationships between radiologists and vendors are based on ongoing use of modalities, so there is sustained contact after the equipment turnover. This usually means that there are periodic discussions about satisfaction or dissatisfaction with performance and service. These discussions can be helpful to the radiologist, in that problems are addressed, and helpful to the vendors since customer concerns may result in design changes in future models.

There is a danger in too much friendly contact between buyer and vendor in that congeniality may lead to bias in the decision-making process. Socializing with vendors should be avoided. Many buyers unfortunately feel that vendors should provide perks as a thank you, but the buyer is legally and morally obligated to use objective criteria when spending government (Medicare and Medicaid) money. Consultantships, perks, and social contact have the potential to compromise objectivity.

Site visits are helpful and occasionally essential in evaluating equipment performance. When possible, these should be day trips to avoid the expense of hotel and dinner. If there are travel expenses, these are usually paid by the vendor and must be reported to the buyer's legal office, so that monitoring can be done. Money spent on equipment is ultimately patient's money or the taxpayer's money.

Most site visits are accompanied by a vendor representative. Bear in mind that these are artificial, as the vendor would not take you to see an unhappy customer. The customer, even if lukewarm about the product, will not admit to a mistake to a stranger. If you have a relationship with a radiologist at a site, a private telephone call may be more revealing than a visit.

Before you visit a site, study the brochure first. The more prepared you are, the more valuable the visit will be. If possible, have with you on the visit at least one other radiologist and a technologist. Depending on the specific situation, it can be very helpful to have an engineer or physicist with you as well, to raise questions that you as a radiologist may not think of. When at the site, mentally go through several exam situations for which the equipment will be used and move the equipment around. Put yourself in the position of the patient and have the technologist operate the equipment. Ask about interfaces to PACS. Make sure to see some images produced by the equipment. Get the names of the people at the site and write a thank-you note to them the next day.

By Dr. Bob Gayler
AuntMinnie.com contributing writer
October 17, 2007

Dr. Bob Gayler is an associate professor in the department of radiology at Johns Hopkins University in Baltimore.

Related Reading

'Purchasing Capital Equipment,' Part 1 -- Radiology as an overall hospital component, October 9, 2007

Equipment maintenance insurance as a strategic financial tool for imaging centers, June 8, 2007

Equipment Service, Part I: Making the most of equipment service personnel and contracts, March 1, 2007

Equipment Service, Part II: Equipment uptime and workflow efficiency begins with service, March 1, 2007

Refurbished equipment helps imaging facilities do more with less, March 1, 2007

Copyright © 2007 Elsevier

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