Assessing the financial feasibility of outsourcing - includes related article on simultaneous equations - Cover Story

Healthcare Financial Management, April, 1996 by Robert Kee, C. Michele Matherly

COST MANAGEMENT

Healthcare organizations frequently outsource support services--such as housekeeping, laundry, and collections--to manage costs while maintaining or improving quality. When evaluating the financial feasibility of outsourcing, financial models can be helpful in measuring the cost to the organization of the service being targeted for outsourcing.

The financial model described in this article incorporates the direct costs of the targeted service and the hidden costs incurred by other departments that contribute to the service's operations. It thus provides comprehensive financial information that can be used to reach more informed outsourcing decisions.

Outsourcing is an increasingly popular strategy that healthcare organizations can use to control the rising costs of providing services. With outsourcing, an external contractor assumes responsibility for managing one or more of a healthcare organization's business, clinical, or hospitality services. Because the contractor specializes in providing a specific service and can achieve economies of scale, it may be able to provide a service more efficiently and less expensively than the healthcare organization. Outsourcing services peripheral to the organization's primary operations also may enable healthcare administrators and staff to concentrate more effectively on their organization's core business.

Outsourcing in not a new strategy for healthcare organizations. Outside contractors have been used to operate departments and provide specific services for years. In one survey of healthcare organizations published in 1994, 63 percent of the respondents reported having at least one department managed by an outside firm--an 8 percent increase over the findings of a survey conducted the previous year(a). Functions commonly outsourced included food services, laundry, housekeeping, collections, and physical therapy.

The most frequently cited reasons for outsourcing services were anticipated cost savings, a need for specialized expertise, and a need to staff hard-to-fill jobs(b). Conversely, reasons cited for not outsourcing were that the healthcare organization could perform the activity as efficiently as an outside contractor, outsourcing creates another layer of management, and a bad experience with a prior outside contractor. Few of the respondents to the 1994 survey, however, reported dissatisfaction with the performance of their outsourcing firms. Furthermore, about half of the respondents indicated that their organizations planned to renew their contracts when they expired.(c)

How outsourcing decisions are made

Surveys of healthcare organizations provide little evidence of how the decisions to outsource are made. A respondent to one survey said the organization had incurred significant savings from outsourcing, although it was unable to measure those savings.(d)

Surveys of other industries, such as transportation, provide scant evidence of the methods used to evaluate the economic feasibility of outsourcing. One study illustrated the cost effectiveness of using an outside contractor by comparing the cost of an internal support function with an outside vendor's bid to offer the service.(e) This method is not accurate, however, because the direct cost of a service incurred within a department represents only a portion of the total cost of the service. The total cost of a service actually is comprised not only of the cost incurred within the department but also of the costs incurred by other departments in supporting the service.

For example, activities required to support a cafeteria service include executing purchase orders for goods and services and performing routine maintenance--activities performed by the purchasing department and maintenance department, respectively. Consequently, when analyzing the feasibility of outsourcing a service, the actual cost of the service should be calculated by adding the cost of the service's operations to the costs of resources used by other departments that support the service--costs that are difficult to determine because of their indirect relationship to the service being evaluated.

Computing the actual cost of outsourcing

To illustrate how to compute the actual cost of a service being evaluated for outsourcing, consider the experience of General Medical Center, a hypothetical medical center that includes an acute care hospital, an ambulatory care clinic, and a physician's office building. The medical center needs to evaluate the economic feasibility of outsourcing its cafeteria service.

A review of General Medical Center's cafeteria service records indicates that each month, an average of 33,750 meals are served to patients and 4,250 meals are served to visitors. Operating costs for cafeteria services during a typical month are: food and supplies $45,600; direct labor $43,200; and overhead $129,600--for a total operating cost of $218,400. Overhead consists of all indirect costs of operating the cafeteria that are attributable to the cafeteria itself, such as benefits for cafeteria personnel, equipment depreciation, supplies, and insurance.