ABC Aligns Buyer and Seller

Edition: September 2001 - Vol 9 Number 09
Article#: 1042
Author: Mark Thill

DENVER—Approximately 25 percent of Owens & Minor's business is billed on an activity-based basis. But judging from the favorable reception of a company-sponsored seminar at the recent conference of the Association for Healthcare Resource & Materials Management, that number could climb. Activity-based costing means that instead of selling its products and services on a cost-plus basis, the distributor charges based on its costs to receive, pick and deliver items. The more activities and items, the higher the charge.

Owens & Minor Senior Project Manager Jennifer Edwards laid out the rationale for activity-based costing by asking the audience, Should a real estate agent really get paid four times as much commission for selling a $400,000 house instead of a $100,000 one? Does he or she really work that much harder to sell the more expensive one? (In some cases, he or she might actually have to do more work to sell the cheaper one.) Likewise, is it fair that a distributor charge $60 for shipping one box of sterile trays (assuming a 6% commission on the sale price of $1,000), but only 60 cents for shipping a $10 box of bandages (assuming the same cost-plus rate)?

Doesn't make sense, said Edwards. And she brought along an associate professor from the Harvard Business School – V. G. Narayanan – to drive the point home.

Using a Harvard Business School case study, Narayanan painted a picture of a beleaguered Owens & Minor in the mid-1990s. ''Like most medical and surgical distributors, O&M was feeling squeezed by customer demands for more services and lower distribution fees,'' said the case study. At one time, the company was striving to meet customer demands for low-unit-of-measure delivery, increase SKUs and digest its acquisition of Stuart Medical. Sales, general and administrative (SG&A) expenses were rising, and gross margin was shrinking. The company ended 1995 with an $11 million loss.

Owens & Minor began exploring activity-based costing in 1994. Simply put, it had to understand its own costs better so that it could properly price the enhanced services it was providing to its customers.

The Problem of Cost-Plus

Owens & Minor came to understand that much of its profitability was tied to several key customer activities, called ''drivers.'' They include:

•Type of service requested (e.g., stockless, traditional bulk delivery, etc.)

•Number of purchase orders generated per month.

•Number of lines per purchase order.

•Number of deliveries per week.

•Method of ordering (e.g., EDI, fax, phone, etc.)

•Interest cost from carrying receivables and inventory.

As O&M came to understand its internal costs, it began to realize that there was a wide disparity between the profits it made on each customer. It had two choices: It could raise the cost-plus percentage, though customers would resist. Or it could begin to charge customers on the basis of the services it provided them and on how efficient the customer was. In short, the company had to separate the price of the box from the price of moving that box from Point A to Point B.

The problem with cost-plus pricing, said Narayanan, is that it puts the seller and buyer at odds. The hospital considers the ideal distributor to be the one that brings a wide array of products to its door every hour, while the distributor considers the ideal customer to be the one that wants one delivery a week or less. ''There's a disconnect,'' he said.

Activity-based costing, however, gets the two moving in the same direction. For example, it incentivizes the customer to order electronically whenever possible, or to combine more lines per purchase order. In other words, it forces the buyer to become more efficient in order to get lower prices from the seller. The seller – in this case, Owens & Minor – benefits too, because as the buyer becomes more efficient, the cost of serving him goes down.

A Live Taker

Joining Edwards and Narayanan on the dais was Gary Wagner, assistant vice president of materials management for Inova Health System in suburban Washington, DC. Inova's OR department entered into an ABC pricing relationship with Owens & Minor as part of its effort to clean up its own act, said Wagner.

The department was buying from thousands of suppliers, holding too much inventory and spending too much time ordering supplies, said Wagner. It saw activity-based costing as a way to achieve internal efficiencies and drive down distribution fees. The IDN coined a term, ''smart unit of measure,'' to help it determine the most efficient order quantity for individual items. And it went to work cutting SKUs, inventory levels, and the time it spent ordering and managing supplies.

After working internally and with O&M, Inova reduced OR inventory 71 percent and reduced the time it spent managing inventory from forty hours a week to less than four. Better yet, as Inova became more efficient, it found time to manage utilization and contract compliance. And as service to its internal clinical customers improved, so did those customers' trust of materials management.

Activity-based costing carries with it some strategic value as well, said Wagner:

•It encourages the partners to bring value to day-to-day operations.

•It provides an opportunity for buyer and seller to determine their own cost-effective core competencies.

•It helps buyer and seller focus on the bigger picture of total cost instead of purchase price.

But it only works if the distributor understands the hospital's business, he said.