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Understanding Your Revenue and Cost Drivers

June 1, 2006
by Niels Eskelsen
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A strategic plan will take your organization no where if it doesn't take into account 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?)

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