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Getting Serious about Costs

Kaufman

Blog from the Chair—May 5, 2017

Warren Buffett famously said that if a farsighted capitalist were present for the Wright brothers’ first flight, that person “would have done his successors a huge favor by shooting Orville down.” Historically, operating an airline profitably has been one of business’ biggest challenges. Between 1979 and 2016, 57 airlines filed for bankruptcy.

Southwest Airlines has been the exception to this grim track record, as pointed out in a Slate article. For 44 consecutive years, Southwest has been profitable. The reason: Southwest thinks about running an airline in a very different way from its competitors, and the foundation of that thought process is containing costs.

Where competitors use a hub-and-spoke model for their routes, Southwest uses direct flights, resulting in shorter travel times. Shorter travel times allow higher density seating, which results in lower per-seat costs. Where competitors use a variety of aircraft, Southwest uses only variants of the Boeing 737, which reduces costs for training and maintenance. Where competitors use major airports, Southwest prefers less-expensive secondary airports. Where other airlines book flights through third parties, Southwest sells directly to consumers.

Each of these choices radically lowers the airline’s cost structure, allowing lower fares, a more streamlined consumer experience, higher market share, and higher profitability.

No Regrets

The degree of uncertainty in healthcare is higher than ever. Under the Trump Administration and the 115th U.S. Congress, uncertainty surrounds health policy, tax policy, and payment levels. Uncertainty surrounds the trajectory and structure of value-based payment. Uncertainty surrounds the influence of new healthcare models such as direct primary care and medical homes. Uncertainty surrounds the effect of new technology such as artificial intelligence and genomics. Uncertainty surrounds the potential influence of new competitors, from giants like IBM and Apple to digital health start-ups.

It is natural for people to want to reduce uncertainty, to base strategy on a clear sense of the future. Amazon CEO Jeff Bezos says that people frequently ask him what will change in the next 10 years. A more important question, he says, is what’s not going to change, “because you can build a business strategy around the things that are stable in time.” For example, Bezos said, “It’s impossible to imagine a future 10 years from now where a customer comes up and says, ‘Jeff, I love Amazon, I just wish the prices were a little higher.’”

What will not change in healthcare is the need for lower costs—dramatically lower costs. The central role that healthcare plays in the U.S. budget deficit demands dramatically lower healthcare spending. Constrained government budgets demand dramatically lower healthcare expenses. Employers burdened by double-digit increases demand dramatically lower health insurance premiums. And consumers, who are experiencing premiums and out-of-pocket expenses rising far faster than wages, demand dramatically lower healthcare costs. These demands will only get more intense as healthcare’s share of the gross domestic product—already at record highs—continues to increase. As one small-business owner recently told The New York Times, “People can’t afford the healthcare they need, and that’s becoming a crisis.”

In a time of uncertainty, a no-regrets strategy for hospitals is to reduce costs—dramatically. Imagine the competitive advantage of a provider being able to approach a large employer and offer, for example, direct contracting for treating their highest-cost conditions along with top-quality outcomes at 30 percent lower costs.

However, for an industry that has been working on costs for decades with limited success, the question is: how?

A Legacy Company Tackles Costs

Southwest shows that low costs are best achieved when they are built into the company’s mission, business model, and operating model. However, Southwest had an advantage that legacy organizations, including America’s hospitals, do not have. Southwest built the company from the ground up around the principle of low cost. In contrast, legacy organizations need to make major changes in culture, structure, processes, skills, and technology to achieve a dramatically lower cost position. For large organizations in complex industries, this degree of change is incredibly difficult both to conceptualize and execute.

The experience of Ford shows what is involved. In 2006, Ford lost $12.7 billion. Testifying before Congress in 2008, Ford’s then-CEO Alan Mulally presented a veritable tutorial in how a legacy organization can transform its costs.

It used to be that we had too many brands. Now we have a laser focus on our most important brand: the Ford blue oval….It used to be that our approach to our customers was: If you build it, they will come. We produced more vehicles than our customers wanted….Now we are aggressively matching production to meet the true customer demand. It used to be that we focused heavily on trucks and SUVs. Now we are shifting to a balanced product portfolio, with even more focus on small cars and the advanced technologies that will drive higher fuel economy in all of our vehicles. It used to be that our labor costs made us uncompetitive. Now we have a ground-breaking agreement with the UAW to reduce labor costs….It used to be that we had too many suppliers and dealers. Now we're putting in place the right structure to maximize the efficiency and the profitability for all of our partners….We have moved our business model in a completely new direction, in line with the most successful companies—and competitors—around the world.

Between 2006 and 2008, Ford did the following:

  • Divested $3.7 billion in non-core assets, including selling Aston Martin, Jaguar, Land Rover, and most of its ownership stake in Mazda
  • Closed 17 plants, with six more planned for closure
  • Reduced its workforce by 50 percent, downsizing by 12,000 salaried employees and 44,000 hourly employees
  • Canceled all bonuses and merit increases for North American salaried employees
  • Reduced its number of dealers by 14 percent
  • Reduced its number of suppliers by 53 percent
  • Invested $14 billion in advanced automotive technologies focused primarily on fuel efficiency.

Since that time, Ford has continued to fundamentally rethink the company’s purpose, repositioning itself as a “mobility company” rather than a car company, launching a subsidiary focused on self-driving cars, offering 30 semi-autonomous features, and pledging to mass-market a self-driving car for ride-sharing by 2021.

In 2016, Ford’s net income was $4.6 billion.

Implications for Healthcare

The Southwest and Ford examples present three key lessons for healthcare:

Low costs must be designed into the business model
That design will look very different from the traditional one
Incremental steps will not get big results

Over time, hospital costs have tracked very closely with revenues. As revenues decline, costs have declined proportionally, the result of hard work primarily on managing supply and labor costs. However, as revenues increased, costs have crept back in—a sure sign for the industry as a whole that no fundamental changes have been made to how business is done, and most cost reductions have been incremental.

The kind of dramatic cost reduction needed requires a more fundamental approach:

Reconfigure the portfolio. Health systems need to do a top-to-bottom review of demand and performance for every one of their facilities and services. They must be willing to make tough decisions about selling, converting, or closing facilities that do not have sufficient volume or are otherwise unable to perform up to necessary financial or clinical standards. They must be willing to divest service lines that are not delivering value for the organization and community. They must be willing to consolidate services that are performed at multiple locations in close proximity. Radical approaches to facility design should be considered to ensure a match between patient needs and appropriate levels of care. Older facilities have inherent inefficiencies and an inability to evolve with changes in care delivery, while newer facilities often are designed based on backward-looking perspectives. For most hospitals and health systems, facilities and services grow over time, often without a governing plan. Hospitals need to ask themselves what a completely redesigned system would look like—one that meets demonstrable community needs in the most streamlined manner possible. Then they must be willing to take action based on these insights.

Redesign the care model. Waste resulting from problems with care delivery design, coordination, and standardization cost the U.S. between $285 billion and $425 billion annually, according to a study by Donald Berwick and colleagues in JAMA. For healthcare organizations, redesign of care delivery holds great promise to both reduce costs and improve quality. This redesign should include the sites of care, who delivers the care, and standardization of clinical protocols and operations. For example, at Kaiser Permanente, more than half of primary care visits are performed virtually. Kaiser sees many hospital services in the future being performed in the home. The result of clinical care redesign will be greater efficiency and a better experience for both caregivers and patients, and reduction in unwarranted variation that can undermine quality and increase costs. These are perhaps the most difficult changes for a provider organization to make, but are at the core of making leaps in improving quality, patient experience, and efficiency.

Reconfigure use of labor. Hospitals need to leverage the highest cost (per unit and in total) resources to their highest and best use. The clinician workforce is highly trained and expensive. Unfortunately, the application of its skills often is inefficient at all levels (for example, physicians doing excessive paperwork, nurses transporting patients). Optimally matching expertise to the tasks at hand is inherently difficult in such a complex system, but the potential payoff is enormous.

A New Mindset

The existing culture of not-for-profit healthcare tends to value incrementalism, avoid political sensitivities, and allow autonomy. The kind of radical shift in costs that will truly distinguish an organization requires a new mindset. Health systems need to function as operating companies, rather than holding companies, with system executives having the authority necessary to implement changes and influence performance at the facility level. Throughout the organization, executives and physicians need to be held accountable to transparent measures of performance. Hospitals should be run as cost centers, with tight focus on operations. As with Ford and Southwest, there needs to be a leadership commitment to thinking differently about the purpose and design of the organization, and to making the major changes necessary.

In a time of great uncertainty, a no-regrets strategy for hospitals focuses on core principles. And for healthcare, the dominant principle is the need to reduce costs—dramatically. 


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