Are You Aiming for the Right Target?

 By Peter DeHaan

February/March 2009

"My labor percentage is down to twenty-eight percent," boasts the owner of a mid-sized medical answering service, seeking affirmation.

"Twenty-eight percent!" I exclaim with raised eyebrows. 

"So, it's good?" he probes, seeking validation.

I carefully consider my response.  "No, no," I aver, slowly shaking my head.  "It's terrible." 

"Terrible?" he inquires incredulously.

"Yes, terrible," I seriously confirm.  "How are you going to fix it?"

"Fix it?" he responds, stupefied.  "I've worked hard for three years to get to below thirty percent.  I can't get it any lower."

"It needs to be higher," I state matter-of-factly.  After pausing for dramatic effect, I add, "With your labor at 28%, your overhead -- those things not directly relating to providing service -- is at 72%.  That is excessively high and must be much lower.  Your answering service is suffering from an inflated overhead; it needs to be reeled in."

There is a faint glimmer of comprehension, but wanting to avoid further challenges to his entrepreneurial idealism, he mumbles a reluctant thank you, hastily retreating to find a more hospitable conversant.

I never actually said those things -- but I sure have wanted to!  The truth is that when answering service managers and owners focus on labor percentages, they are often looking at the wrong thing for the wrong reason.

True, it is correct that labor costs will escalate when left unchecked, running out of control.  As such, skyrocketing operator expense is the most likely cause of the fiscal demise of an answering service.  Conversely, aggressively slashing labor costs is the most likely cause of the quality demise of an answering service.  Therefore, a requisite balance exists between cost and quality that is all too often out of balance, sacrificing customer service on the altar of cost-containment.

The Situation: To illustrate, let's consider a fictitious, yet realistic, situation for a typical mid-sized medical answering service.  To keep the math simple, we'll assume annual expenses of $1 million and that half of the budget is for operator labor.  For simplicity's sake, we will lump everything else into the broad category of overhead.  Although a generalization, this assumption is not unjustifiable, as it is an answering service's operators (labor) that provide the service; everything else, albeit important, is ancillary or indirect.  In summary, the answering service's simplified financial picture looks like this:

Expenses:       $1,000,000       100%

Overhead            $500,000         50%

Labor:                $500,000         50%

Therefore, we have a $1 million answering service spending $500,000 (50%) on labor and $500,000 on overhead.  To ensure profitability, it has been determined that overall costs need to be reduced by 10%.  Now what?

Scenario 1: According to conventional wisdom, you address the biggest cost area, which is operator labor.  Additionally, labor is a variable expense, which means that it is relatively easily to cut (fixed expenses are harder to reduce).  Plus, the effects of any labor adjustment can be recognized quickly, generally within a month. 

In any schedule, there are debatable details.  These include the number of operators required at certain times and the length of specific shifts.  Even by eliminating all of these disputable items, there is still considerable -- and painful -- cutting to do.  Eventually, the sagacious scheduler will be able to make the required cuts, resulting in the target reduction of 10%.  The annualized results look like this:

Expenses:          $900,000       100%

Overhead            $500,000         56%

Labor:                $400,000         44%

The targeted 10% cost reduction has been accomplished, profitability has been restored, and things are good, right?  Not necessarily so.  The 10% reduction was completely realized by cutting operator labor.  With overhead remaining unchanged, operator labor itself was actually subjected to a 20% reduction.  This will result in a noticeable drop in customer service levels, both measurably by the answering service and perceptibly by the doctors.  This will increase complaints, add work for customer service staff, and further tax operators, who are now working harder than before.  It is also likely that some doctor defections will result, causing income to decrease and the newfound profits to evaporate.  This scenario exemplifies the adage of "winning the battle, but losing the war."

To extend this scenario to reach the preceding, overly ambitious goal of 28% labor cost, operator labor would need to be reduced an additional $205,556!  This would result in:

Expenses:          $694,444       100%

Overhead            $500,000         72%

Labor:                $194,444         28%

Scenario 2: The prudent businessperson, however, will realize that the answering service's carefully crafted operator schedule -- the primary determining factor in quality service and client satisfaction -- is essentially correct.  Once it has been determined that the operator schedule is on track, the cost reduction efforts must focus on overhead -- that is, those activities not directly affecting service quality.

It is noteworthy that while operator labor is highly monitored and scrutinized, overhead receives less attention, less frequently.  Therefore, these areas are much more likely to be inflated, meriting reduction.  That is not to suggest that cutting overhead is easy.  It's difficult, especially since any slashing resides much closer to management.  Perhaps unneeded perks have crept into the budget; these can be axed without a detrimental effect on service.  Likewise, there are probably expenditures that are no longer necessary but have continued unabated.  Other costs have escalated over time and need trimming to a more reasonable and appropriate level.

Lastly, there is a labor component in the overhead category as well: management and support personnel.  It could be that a certain position is no longer needed but has been retained because everyone likes the person filling that position.  Other jobs could have become bloated with unnecessary effort or busywork that produces no real benefit.  Bureaucracy and self-preservation activities are also prime targets for elimination.  Finally, there is the possibility that complete departments or management levels might no longer be necessary or at least warrant major reductions.

These types of cost reductions are not easy to make, and they are often harder to spot.  However, they can be made with the least impact on the doctors -- who are why the service exists.  In reducing costs by focusing on non-operator labor, service quality is not directly affected.  The annualized numbers become:

Expenses:          $900,000       100%

Overhead            $400,000         44%

Labor:                $500,000         56%

An Outrageous Extreme:  In the first scenario, we looked at reducing the labor percentage.  By slashing labor by $100,000 and then by another $205,000, the resultant 28% labor figure was realized.  There is another way to accomplish this same result.  By holding operator labor constant and increasing overhead by $780,000, a 28% labor figure can also be achieved!

Expenses:       $1,785,714       100%

Overhead         $1,285,714         72%

Labor:                $500,000         28%

There are two ways to reach a 28% labor figure: detrimentally slashing labor or obscenely increasing overhead.  However, in both instances the wrong target is being pursued for the wrong reason.  Instead, the intent should be to establish an operator schedule that will produce the proper service level to doctors and then shrink overhead to the minimal level -- right and worthy goals for any answering service.

To read other articles written by Peter DeHaan, go to Vital Signs or check out his blog at blog.peterdehaan.com.  In addition to publishing AnswerStat and Connections Magazine, Peter is offers custom publishing and Internet publishing (www.MyArticleArchive.com).  He may be reached at dehaan@answerstat.com or www.PeterDeHaan.com.