Recently, I structured an equity development plan — our safer alternative to partnerships — for a practice owner and an associate dentist. I assumed that they were happy and doing well until I received a call from the owner that the associate was making too much money and the owner was losing money. Apparently, while still less than six months into the relationship, the associate was producing $50,000 per month and continuing to increase.
The owner anticipated the associate would produce as much as $70,000 per month before the end of the first year. He and his accountant were seriously concerned about the losses he would incur as a result of paying an associate commission of $250,000 or more, along with the rising overhead costs for the additional production that the owner would have to pay.
This owner and his accountant’s concerns are not unusual when dentists believe the traditional view that overhead is a fixed percentage of total income. While the overall practice overhead of many general practices may be close to 65%, that figure —while accurate — is also misleading. The principle that provides the most insight into the most successful management of a practice is the incremental income principle.
The incremental income principle at work
Here’s how the incremental principle works in dentistry. This principle realizes that most dental practices have a break-even point in the range of $200,000. This means that the overhead on the first $200,000 is 100%. This initial $200,000 of revenues covers the fixed costs, such as rent, insurance, utilities, telephone, etc., and the associated variable expenses for that production such as salaries, laboratory costs, supplies, etc.
Some people consider salaries to be a fixed expense, but I consider them to be variable, because unlike rent, utilities, and insurance, salaries can be adjusted almost immediately by hiring or laying off employees. Salaries also bear a proportional
relationship to gross revenues.
Additional increments of income of $100,000 only incur the variable expenses required to produce that amount. The fixed expenses have already been paid whether any additional revenues are produced or not.
The only extra expenses on these additional revenues are laboratory costs, supplies, and other miscellaneous expenses, which are generally no more than 25% in most practices. Therefore, additional incremental income blocks of $100,000 will yield around a 75% net or $75,000 of net income for each $100,000 of production. This is why it is less risky to spend more money to buy a large practice than to spend less money to buy a small practice. Larger practices — while having a greater debt exposure — have a lower risk because there is a greater margin over the break-even point.
Small practices, which have less debt exposure, are much riskier because the gross revenues are closer to the break-even point, and a slight drop in revenues can wipe out any and all profitability while a small drop in a large practice will still yield a large net income.
Now, let’s apply the incremental income principle to associateships.
When deciding whether to add an associate to a practice, I look for what I call the “phantom practice.” The phantom practice is the potential for available incremental income. If there is no available excess production for an associate to treat, there is no need for an associate. Attempting to add one in this situation would only result in a frustrating experience for the owner, the associate, the staff, and the patients.
The phantom practice represents the treatment the owner cannot or will not produce. It may involve any endo, perio, surgery, or other treatment modalities the owner chooses not to do. It can also include the patients that cannot be seen on a timely basis because the owner is already booked out too far. The only way the phantom practice can be realized — and the incremental income and profitability made real — is by adding an associate dentist to treat these “surplus” patients and do those services currently not being performed in the office.
If there is a phantom practice present and an associate is brought in to service it, the extra expenses for such production are only the variable expenses that accompany incremental income, plus the commission paid to the associate and a salary for an assistant. While the total variable overhead expenses for the phantom practice may approach 75%, this still results in a 25% profit from the associate’s production.
Money lost or money found?
Getting back to our dentist owner with the dilemma of losing money on his associate, I scheduled a conference call with the owner and his accountant. We set up an Internet meeting so everyone could view and work with a spreadsheet that I had created to find out where the money was being lost.
In addition to the expected extra variable expenses in this practice, I found additional fixed expenses that needed to be considered. New office space for the associate had to be built out at an extra cost, and extra rent and utilities were incurred. An additional highly paid assistant was also hired, and new equipment was purchased. Additional expense items included increased marketing and benefits for the associate.
The teleconference with the owner and his accountant was an interactive session, with input from all parties included in the analysis. By the end of the meeting, all of the data, assumptions, and calculations were agreed to and accepted by the owner, his accountant, and myself.
In spite of the extra expenses for additional rent, equipment, salaries, employee benefits, and marketing, as well as the typical additional variable expenses for lab and supply costs at the associate production level of $50,000 per month, our calculations showed the owner would still realize an annualized profit of $163,000 per year — a 27% profit.
The owner’s concerns about high expenses resulting in large losses to him when the associate’s production reached $70,000 per month were examined as well. His concerns were allayed when we found the profit increased to more than $280,000, or 33% of revenues. If the owner were not required to rent more space, buy more equipment, and spend more on marketing, the profit for both income scenarios would be increased by $72,000 per year.
The key to understanding associateship profitability is the incremental income principle. While the traditional 65% overhead statistic may be true in an overall sense, it ignores the tools for making the best informed decisions regarding income and expenses in your practice. This can result in inaccurate decisions that are very costly, or worse, missing a very successful opportunity.
An example of being misled by the traditional 65% head statistic is the story of a new graduate who started a practice from scratch some years ago. The first year’s revenues were $150,000, which was the break-even point for that practice, so the first-year net income was zero. The young dentist had been told that a practice should have an overhead of 65% or less, and a net of at least 35%.
As a result, he figured that he should have netted approximately $50,000. He concluded that there was something wrong with this practice, so he started a satellite practice in the second year to increase income. The second year he grossed $150,000 in the original practice and $150,000 in the satellite practice. His net income from the two practices was still zero.
Had he understood the incremental income principle, he would have concentrated his efforts on his original practice, realizing that there was nothing wrong with it, and that any increase in that practice would have resulted in an 80% net. Instead, he started a second practice with a second break-even point to make.
Another established dentist was considering terminating his associate because he felt he wasn’t making any money from the associate’s work. The associate was doing the endo and perio in the practice. The owner “knew” that his overhead was 60% and he was paying the associate a 40% commission for the work he did, so he thought there was no profit for him. I asked the owner if he would do the perio himself when he fired the associate, and he said no, he would refer that treatment out.
Then I asked the owner what other expense he incurred from having the associate, and he said there were none, as the associate paid for his own supplies and assistant, and there was no lab expense. We came to the conclusion that out of a 100% increase in incremental income, the only expense was 40%, leaving a profit to the owner of 60% of the associate’s revenues. Once the owner realized he was making a 50% higher percentage net for the work that the associate was doing, he decided to keep him.
The benefits of knowing and using the incremental income principle are critical in the management of dental practices. The conventional wisdom of “knowing overhead is traditionally 65%” could lead a practice owner to abandon considerable profits by terminating a productive associate, or starting a satellite office with another large break-even gross to meet without netting any additional income. On the other hand, applying the incremental income principle can help dentists make the safest and most profitable decisions for their practices.
Earl M. Douglas, DDS, MBA, BVAL