How multiple, unrelated problems can hide behind rising revenue and aggregate profit

The financial figures in this article are approximate, and certain details have been generalized to protect client confidentiality.

Several years ago, the owners of a relatively new home health agency contacted me because something about their financial results did not make sense.

The agency had been started by a physical therapist and a registered nurse who believed they could provide better care for their patients while creating a better working environment for their employees. They had grown rapidly, generating approximately $1.5 million in revenue within their first 18 months and nearly $2.5 million within two years.

Growth was clearly not the problem.

During the agency’s first year, the owners struggled somewhat with profitability, but that was not particularly surprising. Rapid growth requires investment in employees, infrastructure, technology, and working capital—often before the resulting revenue is collected. After reviewing the agency’s early financial results, I agreed that growth likely explained at least some of those initial challenges.

As revenue continued to increase, aggregate profit dollars also continued to rise. However, after the agency reached approximately $1.5 million in revenue, its profit margin percentage began a measurable and sustained decline.

The deterioration continued for some time before it was recognized. The agency’s cumulative, year-to-date Income Statements reported revenue and profit in dollars but did not calculate the profit margin percentage. As a result, rising revenue and aggregate profit dollars concealed the declining percentage of revenue the agency was retaining.

The owners had expected profitability to improve as the agency grew. Instead, the agency was retaining progressively less profit from each additional dollar of revenue.

Aggregate profit concealed the deterioration

The agency had generated approximately $120,000 in profit on its first $1 million of revenue, representing a profit margin of about 12%.

When revenue reached approximately $1.5 million, aggregate profit increased to about $150,000—but the overall profit margin declined to 10%.

At approximately $2.5 million in revenue, aggregate profit increased again, this time to about $175,000. Nevertheless, the agency’s profit margin had fallen to approximately 7%.

Viewed only in aggregate, the results still appeared encouraging:

Approximate revenue	Approximate aggregate profit	Overall profit margin
$1 million	$120,000	12%
$1.5 million	$150,000	10%
$2.5 million	$175,000	7%

Revenue was increasing. Total profit was also increasing. The owners were building a larger agency and generating more profit dollars than they had previously.

However, looking at the profitability of each additional increment of revenue revealed a very different picture:

Revenue increment	Additional profit generated	Incremental profit margin
First $1 million	$120,000	12%
Next $500,000	$30,000	6%
Next $1 million	$25,000	2.5%

This analysis does not mean the first $1 million would always produce exactly a 12% margin, or that every subsequent revenue increment could be isolated so precisely. It does, however, illustrate the magnitude of the deterioration.

The additional $1.5 million of revenue generated only about $55,000 in additional profit. In other words, the next $1.5 million of revenue—50% more revenue than the agency’s first $1 million—produced less than half as much profit.

Each successive increment of revenue was producing substantially less value.

The agency was growing larger, but it was not necessarily growing stronger.

One symptom did not mean one cause

The owners could see that their profit margin percentage was declining, but their cumulative, year-to-date financial statements could not explain why.

As is common among challenged and struggling agencies, management focused primarily on revenue at the top of the Income Statement and profit at the bottom. Because both dollar amounts continued to increase, the seriousness of the developing problems was easy to underestimate.

Profit compression appeared to be the agency’s problem. In reality, it was the combined financial consequence of several separate problems.

Those problems did not arise from a single department or management decision. They developed independently, but each ultimately reduced the agency’s profitability.

Not all revenue has the same value

The first issue involved the agency’s changing payor mix.

When annualized revenue was approximately $1 million, Medicare represented about 95% of the agency’s total revenue. As the agency grew, Medicare declined substantially as a percentage of total revenue because most of the additional business came from other payors.

That did not mean the agency should avoid all non-Medicare business. It did mean that the additional revenue did not necessarily possess the same reimbursement, profitability, or collectability characteristics as the Medicare revenue it was replacing within the agency’s overall payor mix.

The agency had also hired a marketer whose bonus was tied to achieving specified revenue levels. The incentive worked: the marketer brought substantial new business into the agency and earned significant bonuses.

However, the incentive rewarded revenue volume without adequately considering the quality, profitability, or collectability of that revenue.

Management was measuring how much revenue was being added, but not what the agency was required to spend to generate and service it—or how much would ultimately be collected.

Different compensation methods create different incentives

The agency’s clinicians were compensated through a combination of salary, hourly pay, and per-visit rates. Although the compensation amounts were generally consistent with the market, management evaluated productivity primarily from an agency-wide perspective.

That approach did not account for the very different incentives created by each compensation method.

Salaried and hourly employees do not ordinarily receive additional compensation for completing more visits. Without appropriate productivity expectations, their visits may decline while their compensation remains relatively fixed. Holding all else constant (ceteris paribus), as visits decrease, the agency’s average cost per visit increases.

If salaried or hourly clinicians do not complete the necessary visits, the agency may also need to engage per-diem or per-visit staff to perform work that existing employees had the capacity to complete. The agency then incurs both the fixed compensation and the additional per-visit cost.

Per-visit clinicians generally have the opposite financial incentive. Completing more visits increases their compensation. Although that may help the agency meet demand, consistently excessive visit volume can create other costs and risks.

The immediate cost is higher aggregate compensation without a reduction in the unit cost of each visit. The longer-term risk is that excessive workloads may contribute to declining documentation quality. If those patient encounters are later selected for review, inadequate documentation could lead to payment denials, additional documentation requests, or more serious compliance concerns.

The agency needed productivity expectations appropriate to each compensation method—not a single aggregate measure that allowed offsetting behaviors to remain hidden.

The financial infrastructure had not grown with the agency

Another problem existed within the agency’s accounting and collection processes.

The owners had employed a bookkeeper from the agency’s beginning and were comfortable with—and protective of—her. However, she had limited accounting experience and became increasingly overwhelmed as the agency’s volume and payor complexity grew.

Some non-Medicare payors delayed or resisted payment. Rather than escalating the collection problems or requesting assistance, the bookkeeper began discarding statements and unilaterally writing off receivables. The write-offs were not recorded properly. Various expense and Balance Sheet accounts were used in ways that obscured what was occurring.

Our review found no indication that payments had been stolen or diverted. Nevertheless, the agency’s inadequate oversight and weak internal controls created an environment in which financial misconduct could have occurred without being promptly detected.

When the payors were contacted, they confirmed that payment had not been made. Receivables still within timely-filing or appeal limitations were pursued, but amounts outside those limits could not be recovered.

The underlying problem was a combination of insufficient expertise, inadequate oversight, and weak internal controls.

The bookkeeper had learned enough about the accounting software to appear knowledgeable when speaking with owners who were not accountants. She had not learned enough to manage the increasingly complex financial demands of a rapidly growing agency.

The agency’s clinical operations had grown. Its revenue had grown. Its workforce had grown. Its financial infrastructure had not.

Why correcting one problem may appear to accomplish nothing

Each of these issues required a different corrective action.

Changing the marketer’s incentive plan would not correct clinical productivity. Establishing productivity standards would not improve the payor mix. Replacing the bookkeeper would not recover receivables that had already exceeded filing limitations. Strengthening internal controls would not, by itself, ensure that new revenue was profitable.

This is what makes multiple causation so difficult to identify and correct.

Management may discover and address one legitimate shortcoming, reasonably expecting profitability to improve, only to see little or no change. The corrective action may have worked exactly as intended. But if the issue addressed was relatively immaterial—or if several more significant problems remain active—its effect may be nearly invisible within the agency’s overall financial results.

Management may then conclude that the attempted correction failed when, in fact, it addressed only one part of a much larger problem.

Correcting one problem is not the same as completing the diagnosis.

Financial statements combine consequences—not causes

Financial statements combine the consequences of every operating activity into a relatively small number of financial results: revenue, expenses, and profit.

They do not distinguish between margin lost through an unfavorable payor mix, poor productivity, uncollectible revenue, inappropriate incentives, or weak internal controls. Each problem may originate in a different part of the organization, but its financial consequences eventually flow into the same bottom line.

Cumulative, year-to-date financial statements can make the identification even more difficult. Changes occurring during the current month are absorbed into the accumulated results from all preceding months. When revenue and aggregate profit are still increasing, emerging deterioration can remain concealed for an extended period.

The Income Statement showed the owners the combined consequence of the agency’s problems. It could not identify the individual causes.

That required connecting the financial results with the operational activities, incentives, processes, and controls that produced them.

Is the agency becoming larger—or stronger?

The owners were correct to question why their profit margin percentage continued to decline as revenue and aggregate profit increased. Their concern ultimately led to the identification and correction of several unrelated problems that threatened the agency’s continued success.

The lesson extends well beyond this particular agency.

Revenue growth tells you that an organization is becoming larger. Aggregate profit tells you how much it retained. Neither tells you whether deterioration is occurring beneath the surface—or how many separate problems may be contributing to it.

Healthy growth should be evaluated not only by the amount of additional revenue generated, but also by the quality and collectability of that revenue, the resources required to produce it, and the incremental profit ultimately retained.

Growth can conceal deterioration—particularly when management sees only its combined financial consequences.

The question is not simply whether your agency is growing.

The more important question is whether that growth is making your agency stronger.