Understanding Your Revenue and Cost Drivers
The CEO of a behavioral healthcare organization once told me that he did not like strategic planning because, “Strategic planning does not do anything for us. We make a plan, but it does not help us improve performance or accomplish our goals.” As a management consultant, I considered this blasphemy. How could anyone dismiss the value of strategic planning?
Even though the CEO did not hold strategic planning in high esteem, the executive team did complete a strategic-planning process. The plan focused on new business development, improved customer relations, sustained profitability, improved clinical documentation, and a long-term goal of upgrading its physical plant. At the conclusion of the process, everyone believed that management team members were in agreement that the company was heading in the right direction.
Trouble in the Trenches
A few months into the plan, various staffing and documentation problems within a core business unit began to reach critical mass. Resolution of these issues absorbed the majority of management staff's time and attention. Just as unit managers were congratulating themselves on a job well done, they received their latest monthly financial statement. A huge loss was reported. The executive managing this unit was not only stunned, but he struggled to develop an action plan to bring the unit back to profitability.
Having completed a strategic-planning process only a few months before, could management have avoided this crisis? If we answer no to this question, then we could say that the CEO was correct about the value of strategic planning. However, if we claim that the strategic-planning process should have produced warning signs, we would be acknowledging that something was missing from the planning process that would have made it more effective. Although everyone may be excited about having an organizational strategy, a broad-brush approach to strategic planning may prove to be an ineffective management tool.
What Was Missing?
Effective strategic plans include key financial metrics to monitor organizational activities on a real-time basis. Financial metrics are developed by identifying the revenue and cost drivers of each business unit or activity. For example, revenue drivers for an outpatient clinic include the number of people receiving services, the type of services delivered, and the amount charged for delivering services. Cost drivers for the clinic include staff/labor costs, administrative costs, and facility costs.
Revenue and cost drivers are what really define the business model. For example, in an inpatient or residential setting (the type of facility with the problems I discussed earlier), we know that a certain census is required to generate sufficient revenue to sustain operations. Revenue drivers include the number of beds available, number of client referrals, average length of stay, and the reimbursement rate per bed/day. In a single rate contract, these four revenue drivers make up part of the financial metrics for this business unit. We can complete a similar analysis for the cost side, which includes labor, food, utility, maintenance, facility, administrative, and other costs.
We can focus on separate cost or revenue drivers. The cost drivers for labor are the number of clients, staffing pattern, and wage rates. We then can identify what staffing requirements we need to meet for the number of beds/clients we have in the facility. We can determine the wage rates for that staffing pattern. These cost drivers make up the financial metrics for labor costs.
How Do We Use Financial Metrics?
In preparation for a strategic-planning session, it is important to identify revenue and cost drivers of existing business units. Knowing what activities influence our revenues and costs will allow us to manage organizational strategies for existing (core) and new business.
Financial statements typically report revenue and expenses in gross formats. Revenue and cost drivers are the individual elements that make up those gross numbers. They are different in each business model. Most managers usually can identify specific drivers, but they often don't use them as key management tools.
Sometimes managers will develop a strategic plan and then figure out the related revenue and cost drivers. However, when managers first understand the organizational revenue and cost drivers, they are able to develop strategies that affect those drivers. For example, if we want to grow our residential business revenues, our strategic-planning process should include planning around how to affect the identified revenue drivers, such as number of beds, number of clients referred to the facility, average length of stay, and reimbursement rate. Questions that can help us understand what influences each of these drivers are:
What can we do to increase the number of client referrals? (Who are our current referral sources? What percentage of their referrals do we receive? Can we improve that ratio? What new referral sources can we develop?)
At what point should we consider increasing the number of beds available? (Will demand for existing beds allow us to consider options for increasing the number of beds?)
What affects the average length of stay? (such as changes in service definitions, funding, contract requirements, treatment plans, etc.)
What changes do we expect in our reimbursement rate? (What influence do we have to increase it? Do we have options to offer our beds to other revenue sources at a higher rate? How do we protect the current reimbursement rate from being reduced?)
Each question explores different aspects of the revenue drivers. Some drivers can be influenced in the short term. In our example, the number of referrals is the revenue driver that may be the most volatile. Depending on what services are offered, average length of stay may or may not be a short-term factor. Rate increases may change only annually, and increasing the number of beds available, which involves new facilities, may be least likely to change in the short term.
Why Does This Matter?
If we build strategic plans that focus only on long-term objectives, the plans tend to sit on the shelf. However, if we build strategic plans that include short- and long-range objectives, and monitor those revenue and cost drivers on a regular basis (daily, weekly, monthly, quarterly), our strategic plan becomes an active part of our management activities.
In our residential scenario, if our long-range goal is to increase our market share and capacity for residential services, we can do that by increasing the demands for our services. We are in a better position to achieve our long- term goals when we develop action plans and monitor short-term goals or strategies designed to increase referrals, referral sources, and demand for services.
Frequently measuring performance allows us to know if our actions are meeting our strategic goals. If not, we can make corrective actions during the current year rather than waiting until month- or year-end to evaluate our performance. The frequency depends on a monitored driver's volatility and how quickly management needs to respond to aberrations in performance.
An ongoing challenge for managers is being able to see the forest for the trees. It is very common to be so caught up with day-to-day operating issues that we don't see what is happening to our organizational performance until after the fact—usually when the financial statements appear or even later. By examining your financial metrics on a daily or weekly basis, you will know how you are performing on a more real-time basis and will be able to make adjustments sooner rather than later.
Application
Returning to our residential services provider example, the management team took four basic steps to maximize their strategic-planning process. Each is outlined below.
Step one: Identifying revenue and cost drivers. First, they identified the unit's revenue drivers. They found that their census was running under budget, but no one was paying attention to it. They were too focused on resolving other operational issues and believed that the census was a short-term aberration, so no attention was given to it. They also were looking at the raw census numbers. If they had looked at the census trend, they would have noticed that the census was in a gradual decline for some time.
Second, they identified their cost drivers. They found that their labor and food costs were running over budget. Human resources, in an effort to assist operations staff to better manage their labor cost, had been comparing current period and year-to-date budgets with actual labor costs, but no one had been reading these reports. Food for the unit was provided on a per-meal cost by an outside vendor, yet there was no matching of the number of meals budgeted with the number of meals charged.
Third, they monitored the program completion rate as an important revenue driver related to ongoing referrals. The organization's treatment programs include voluntary participants, so monitoring the completion rate is an indicator of the level of client satisfaction.
Step two: Setting targets. First, they established short-term goals to increase the daily census. This meant setting targets on making referral calls and following through to make sure that placements were actually made. They developed a weekly monitoring process on the two cost outliers, labor and food costs, and they monitored for other cost outliers on a monthly basis. They also developed a reporting process for the voluntary treatment program.
Step three: Initiating continual monitoring. Management monitored census on a weekly basis, referral calls weekly, client enrollment and discharges weekly, and voluntary clients’ program completion rate monthly.
Step four: Reporting performance and taking action. Performance was reported to the management team on a weekly basis. To quote Thomas S. Monson, a publishing executive, “When performance is measured, performance improves. When performance is measured and reported, the rate of improvement accelerates.” It is not enough to just monitor performance; it requires managers to seek explanations for performance indicators. The organization also developed a specific performance-improvement action plan for each focus area.
Part of the organization's long-term plan is to upgrade its residential facilities. Achieving this goal will require a substantial amount of community support. They will be in a better position to build a compelling case when they can demonstrate success in their short-term goals of maintaining a high demand for services and a high level of client satisfaction. The revenue drivers will provide the primary data to support their case to their potential donors. Monitoring and controlling cost drivers will demonstrate the organization's ability to sustain ongoing operations.
Niels Eskelsen is a Senior Consultant at OPEN MINDS, a research and management consulting firm for the behavioral health and social services field.
