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From Dr. Scott Sampson's Understanding Services Businesses Book (click for table of contents)
—[in Unit 7: Cost Issues]— Next⇒SBP 7b: Potential Operating Objectives

SBP 7a: The Costs of Utilization

With many services, the variable costs of production are minute. Simultaneous production and consumption implies that even “direct” labor is often a fixed cost. Thus, cost advantage can also be realized through increased volume and utilization. However, the variable cost to the customer is typically higher than for a substitute goods product, which inhibits utilization of the service provider.

Why it occurs

This principle occurs because many of the variable inputs are provided by customers, who do not charge the service provider for those inputs (keeping variable costs down). Simultaneous production and consumption implies that we need to plan labor staffing for forecasted demand, and time-perishable capacity implies that we need to pay scheduled workers even when there are no customers to motivate production. Thus, service labor costs tend to be largely fixed.

Details

This Service Business Principle implies that service providers will generally be more cost-competitive if they have higher utilization. Unfortunately, having high utilization is not so simple. For one thing, the higher our utilization, the more likely a “blip” in demand will disrupt our ability to serve. Simultaneous production and consumption coupled with uncertain demand implies that we need to have a certain amount of “safety capacity” just in case demand is larger than expected.

Cashier Also, many researchers have observed that in manufacturing environments, when utilization approaches 100 percent of capacity, quality problems grow exponentially. This phenomena also occurs in service situation. For example, if a cashier can serve ten customers per hour, and an average of ten customers per hour arrive at independently random intervals, then the science of queuing theory reveals that the waiting line length will grow to unwieldy proportions! (Queuing theory is discussed in Appendix C.)

Further, there are customer forces that hinder higher utilization. For example, customers who need the service frequently are the ones who are most likely to do it themselves! (see SBP: Competing with Customers). Why is this the case? Because from the customer's perspective, allowing the service provider to fill the need represents a greater variable cost but a lower fixed cost than buying the equipment and serving herself (time cost notwithstanding). (see SBP: Servier-Ownership Perspective) For example, imagine that homeowner A has her carpet steam cleaned once every couple of years, and homeowner B has her carpet cleaned once each month. Which of the two is most likely to hire a carpet cleaning service, and which is most likely to purchase a carpet cleaning machine? We would have to agree that, notwithstanding time costs, homeowner B would find purchasing her own carpet cleaning machine to be more cost effective than A would–making B less likely to be a customer. Unfortunately, it is people like homeowner B that carpet cleaning companies would love to serve!

Some service industries such as retail and custom home building have high variable costs. In such situations, utilization is significant but does not have as dramatic effect on profitability as when variable costs are low.

How it affects decisions

Service providers need to decide on how to manage capacity and the utilization of capacity, given the nature of the cost structure. High fixed costs and tiny variable costs means that unutilized capacity is costly, and insufficient capacity is costly.

What to do about it

There are a number of strategies for managing capacity and demand in service settings. Capacity can be controlled through utilizing customer labor in the production process, subcontracting capacity (such as through outsourcing), or developing flexible capacity (such as by cross-training employees). These and other examples are discussed in Fitzsimmons2 chapter 13 on Strategies for Managing Capacity.)

With some services, demand can be scheduled to smooth demand out so that it is more in line with capacity. For example, doctors offices will schedule patient appointments in accordance with expected capacity, which may mean patients during times of high demand may have to wait quite some time to receive service.

In other cases, demand cannot be scheduled but it can still be influenced. For example, by promoting off-peak demand or offering price incentives (discussed in Fitzsimmons2 chapter 13 on Strategies for Managing Demand).

In some situations it is desirable to simultaneously control demand and capacity in order to maximize overall revenues. A technique for accomplishing this is known as “yield management.” Yield management uses information about the probability of specific types of demand occurring over a specific time periods to calculate the price to offer different classes of service to certain customers at certain times. Sound complicated? Well it is. Yield management is why on some airlines, every passenger on a given flight may have paid a different amount from every other passenger.

For example

upload.wikimedia.org_wikipedia_commons_4_4a_emergency_room.jpg Why does it cost so much more for an emergency room visit than for a visit to a regular medical clinic? Is it because emergency rooms expend more supplies for an typical visit? Probably not. By and large, the difference comes down to utilization. At medical clinics that accept patient appointments, patient demand can be scheduled to match the capacity of the clinic (including number of physicians, number of rooms, etc.). On the other hands, emergency rooms need to staff for highly uncertain and uncontrolled patient demand. As a result, emergency room capacity is generally utilized to a low degree. In a sense, when you see an emergency room physician you are paying not only for the physician's time at your attention, but for his or her time waiting for you to show up.

Believe it or not, the variable costs of service at even the most expensive hotels are almost nothing. Even if the room-cleaning labor is paid by the hour, the wages are not very high and most housekeepers are quite efficient (due to tremendous repetition). The other variable costs include laundering of towels and linens, a little electricity for the climate control and vacuum, and a few small soaps, etc. for the bathroom. But the fixed costs of a hotel can be tremendous. In fact, it is the cost of the supporting facility (the building) that drives the price of the hotel. It was reported that one hotel magnate said that the average rate for night's stay in a room should be roughly $1 for every $1,000 of building construction costs (probably based on breakeven and investment payback analysis). The point was that construction costs drive the pricing of rooms. Further, utilization of the hotel property will be key to financial profitability (since low utilization provides little variable cost savings, but the fixed costs remain).

My airline example

Southwest Airlines As alluded to previously, airlines are often the most flagrant appliers of yield management. Why? Because in 1997 a new jet cost $30 million or more, but the variable cost of production was and is pretty much “peanuts” (plus a little fuel and a soft drink or juice). The name of the game for airlines is covering the fixed costs, which is most often attempted through yield management.

Southwest Airlines takes a slightly different strategy than other carriers. Instead of adjusting fares to squeeze every penny out of particular flights, they offer a handful of basic fares. Then, they focus on cost savings by increasing utilization of their fixed assets. The airline example given in SBP: The Ephemeral Secret Service alluded to Southwest's operating strategy for quick turnaround of jets at airport gates. Southwest's turnarounds typically take less than half the time than those of other carriers. Further, airlines like Southwest tend to start flights earlier in the morning and finish later in the evening. It may seem like an inconvenience to offer flights at those odd hours, but it allows the fixed cost of the jet to be allocated over more flights. The result is having planes “in the air,” producing air transportation and revenues perhaps twice as great as competitors. Even with the same percentage of seats filled, the result is a greater utilization of each jet, enabling significant cost savings.

How manufacturing differs

With manufacturing, major inputs include raw materials, parts, and direct labor, which are quite variable. Since production is scheduled, labor is often a variable cost–if there is no production scheduled for a particular hour, the hourly wage employees are not required to report.

Analysis questions

  1. What are the variable costs of production?
  2. What are the fixed costs of production?
  3. What is the cost impact of increased production? How would profitability be impacted by increased utilization of capacity?
  4. Are there disincentives for high utilization by individual customers?

Application exercise

Construct a breakeven analysis for your company. (See the “Quantitative Analysis” section of this Service Business Principle for a discussion of breakeven analysis.) What are the variable costs of production? (List cost names and estimated per-unit amounts.) What are the fixed costs? How much of the fixed cost is allocated to a given year? What is the average expected revenue per customer? How many customers need to be served over a given year in order to cover the fixed costs? What capacity utilization does this imply? (i.e. what percent of overall capacity needs to be spent in actual production in order to cover fixed costs and make a profit?)