While revenue plays a huge part in the profitability equation, everyone knows that the other side of the equation for maximizing profitability lies in controlling costs and making your organization “scalable”.
The basic formula for measuring client profitability is no secret and could be:
Total Client Contribution = Client Gross Revenue – Client Variable Cost – Allocated Fixed Cost.
A typical PEO would define the components of this equation as follows:
Gross Revenue = Administrative Fees + Work Comp Premium Billed + Taxes Billed + Other Insurance Premium Bills + Ancillary Product Fees + Billable Services + Surcharges (setup fee, etc)
Client Variable Cost = Work Comp Premium Paid + Taxes Paid + Other Insurance Premium Paid + Ancillary Product/Service Costs + Materials + Variable/Contract Labor
Allocated Fixed Cost = (Personnel Salary & Benefits (Payroll, Ben Admin, HR, Finance) + Facility + Operating Costs) * (Client Gross Payroll / Total Gross Payroll or Client WSE / Total WSE)
In the previous article, we explained the notion that all revenue is NOT created equal. I made some suggestions on how to “adjust” the revenue side of the equation to better define the “Client Contribution” and value your book of business. I’d like to make some similar suggestions on how to better measure the cost of servicing a client in order to better assess each client’s overall contribution (or value) to your PEO.
Client Service Cost:
For most PEOs and service firms in general, the largest expense is the cost of payroll, taxes, and benefits for their internal staff. Most of this staff will likely be focused in some form or fashion on servicing your clients (onboarding new clients, running payrolls, maintaining employee records, compiling and paying taxes, dealing with HR issues, managing work comp claims, etc). Most companies allocate the “fixed” cost of internal staff to their client profitability statement using an easy to figure method such as the WSE count or gross payroll of the client. But the Pareto Principle likely applies to this situation; 20% of your clients take 80% of your staff’s time.
Keeping track of the time your staff spends on servicing a client is important and a key component to measure to accurately determine your client’s contribution to your bottom line. In order to measure cost of service, your staff must keep track of service items that they are processing. Many people call these “tickets” or “cases”. Tickets should be system generated wherever possible or manually created when issues arise that could not be predicted. Your staff should spend their day working through and resolving these tickets. There are a couple of ways that metrics can be applied to this data.
Actual time: Some PEOs encourage, or even require that their service personnel accurately measure time spent on client issues down to the minute. This is the most accurate way to measure as long as all the issues are logged. But it is also a challenge to get everyone on board and compliant with this process. If the process of accurately tracking time is not widely adopted by your staff, the value of the data is quickly diminished.
Estimated time: Tickets can be classified into categories that carry an estimated time (average time) it would likely take an employee to complete the task. Employees should be able to override the default if a specific ticket to significantly more or less time than the standard. This method is very effective at comparing the general effort level at a client level and can also be effective used in a cost allocation formula.
Regardless of the method used to capture service time spent on client’s behalf, the costs will then need to be allocated to the client level P&L statement to determine client contribution. Clearly, allocating the cost of service personnel and related overhead using one of these methods makes complete sense. This allocation method may also make sense for allocating other costs as well. Facility costs, technology (hardware and software, infrastructure, etc.), communication costs are largely driven by the personnel that service clients.
Applying an appropriate cost rate to the time spent based on the employee (or category of employee) that completed the service will more accurately reflect real costs since the type of service being supplied could carry significantly different costs; for example, a client that requires a significant amount of legal support to defend an EPLI claim would cost more than a client that requires a similar amount of HR support to write an employee manual.
Hours spent on client * Cost Rate for employee (or category)
Allocating total cost proportionally based on time spent will insure all costs are allocated to clients and will give a good picture of the overall effort your staff expends for each client.
Hours spent on client / Total hours spent * Total Fixed Operating Costs
Either method is effective with pros and cons for both. Getting service costs measured and allocated in the first place is a big step in the right direction. Compare the allocated cost to the adjusted administrative fees for the client to determine if enough revenue is being collected to cover the cost of servicing the client.
An important topic when it comes to the cost of client service is the concept of making your business scalable. If your business is scalable, your revenue can increase at a much steeper curve then your related operating expenses. Many PEOs benchmark the number of internal employees per 100 co-employees or the ratio of their gross operating expense to their gross payroll. These indicators provide a good measure of how efficiently the PEO is operating. As new clients are brought on board, the PEO’s existing staff is able to absorb the additional service volume.
Investment in technology is the most obvious way that a PEO (or any business) can increase productivity and effectiveness which will drive the scalability of the organization. However, without proper process and workflow engineering to precede or coincide with the technology investment, the expected return on investment will likely fall short. Technology to drive broken or ineffective processes run by a dysfunctional team is unlikely to make the organization more scalable and contrary will often significantly hurt effectiveness in the short term.
Workers’ Compensation Claim Cost:
Another critical cost measurement for a PEO to track at the client level is workers’ compensation claim incurred value. Most PEOs invest significant time and effort on the risk underwriting process to insure their book of business is maintained at a risk level with which the business is comfortable. However, I have found it interesting in working with many PEOs, large and small, that there is a widely differing view of the importance of, and related allocation of resources to, active risk management of work comp claims. Some PEOs invest heavily in personnel and systems to actively manage each claim to closure and measure the strengths and weaknesses of their risk portfolio. Other PEOs seem content to keep an eye on the claims using loss runs supplied by the carrier without any significant internal effort to control the outcome and cost of the claim.
Why does the value of this business activity seem so widely different between companies in the same industry? The obvious answer to this difference would be the type of Work Comp policy the PEO uses, guaranteed cost, high deductible, whether or not there is a dividend to reward disciplined loss control results, etc. But I would argue that this activity should be one of the core functions for any PEO. While the policy type is certainly the primary driver when viewing the impact from a short term perspective, the reality is that loss control should be important to all PEOs, regardless of policy type, when viewing the business from a longer term perspective. Inability to measure and control losses will catch up to the PEO eventually.
Whether the PEO has sophisticated methods and systems to track work comp claims or they are relying more on analysis of data supplied by the carrier, working to decrease the frequency and severity of claims is critical. Procedures to monitor timeliness of reporting claims, uncover potential fraudulent claims, monitor medical care and job activity of the injured employee, and identify opportunities to provide safety training and guidelines can translate to significant decreases in loss ratio which will directly affect the bottom line. In a guaranteed cost program, uncontrolled losses may not directly affect the bottom line in the current year, but you can guarantee that premiums will be increasing in the coming years making it more difficult to compete profitably.
Critical risk management measurements to focus on include:
Loss ratio: the ability to measure the ratio of losses to premium billed. This is the client’s most effective measure of the risk they add to your portfolio. The lower the loss ratio, the better the client’s risk
Average Time to Report: the more quickly an injured employee reports an injury and the claim management process begins, the more likely costs will be contained.
Loss frequency: if loss claims are more frequent than industry averages, this would likely indicate poor safety measures or inadequate training procedures are in place.
Severity of losses: claims that see the incurred value significantly increase from the original reserves on a repeated basis for a client would indicate poor loss control/claim management procedures
Unemployment Claim Cost:
The other significant cost item that can significantly affect the bottom line of any PEO is the cost of state unemployment taxes for their business. Similar to the prior discussion, increases SUTA claims may not affect the bottom line in the short term and therefore is prone to mismanagement. However, increased claims activity can dramatically increase the following year’s SUTA rate making it difficult to compete in the market profitably. Once a downsizing company is added to the book of business, it is difficult to control the negative impact on the PEO’s SUTA experience rating. Early detection of signs of distress and properly managing the employee’s paper trail and claim paperwork and follow up of a filed case can help to control this exposure.
Though it is becoming increasingly difficult to win a disputed against a filed unemployment claim, proper termination and human resource procedures could discourage an employee from filing a claim in the first place and could minimize the exposure of the PEO. More importantly, recognizing signs of distress for client companies and taking proactive measures to terminate the PEO relationship prior to mass terminations is the best way to control SUTA rates. There are often warning signs that appear well in advance of the terminations but these signals must be identified and systems developed to address issues as they arise.
Measuring the Total Client Contribution and taking action to improve the average client contribution is an important activity for a PEO to maintain a healthy and profitable book of business. Some consultants and business gurus recommend that a typical company should terminate 20% of their workforce every year to maintain the most effective personnel strategy. Perhaps PEOs should take a similar approach with respect to their client book of business.
While no PEO should take its responsibility to its client companies lightly and should recognize that terminating the PEO business relationship may put the client company in a difficult situation, responsibly shedding the “dead wood” in the book of business is a wise exercise to grow a healthy and profitable PEO. Implementing a system and procedures that enable important measurements of Total Client Contribution to be quickly derived and analyzed will set the PEO apart from the competition and is the secret to profitable, long-term growth.