Owens & Minor case for aligning supply chain incentives Essay
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Statement of issues: Due to the changes of business environment, O&M suffered a continuous loss on business. Instead of acting individually, customers formed buying groups and combined buying power to gain advantages in negotiating gross margin with distributor. With the increased popularity of JIT and stockless idea, customers want to shift cost and risk associated with inventory to distributor, and they also want distributor to provide better services at its own expense. Moreover, competitions from private label distributors and manufacturing distributors further squeezed profit margin of our company.
Owens and Minor play a very important role in the entire SC. They are in charge of providing information to manufacturers on product flow. Their services to the hospitals include storing the inventory in their warehouse and making constant shipments based on stockless and JIT strategy, thus taking all the financial risk in inventory handling and storage. They don’t add value to the product itself, but they do add a lot of value to the SC.
The nature of distribution has changed over time. The bargaining power of hospital has increased due to mergers and alliances, pressuring the distributors to reduce their margins. Upstream members of the SC have also put some pressure on O&M to take additional cost in their operations.
If the ABP strategy could be successfully implemented, both distributor’s and customers’ incentives could be allied. Customers would be willing to order expensive products via distributors’ channel instead of buying directly from manufacture.
Generally, customers who could reduce or simplify the activities happened through the supply chain would adopt ABP faster. Also, customers who understood and were willing to develop a sustainable relationship with distributors would adopt the ABP first.
ABP was a new concept and its value had not been proven. Aggressive implementation of new idea such as ABP might drive customers away and fed competitors.
There are internal obstacles exist in the ABP implementation. Hospitals have to restructure its organizational structures to fit in ABP system. Rearranging employees and reallocating facilities would increase the distrust to ABP system. Also, a substantial amount of investment is needed for establishing the EDI system. How to overcome these obstacles and make ABP implementation smooth is a big challenge.
In order to illustrate the idea of ABP more clearly, we have come up a simple pricing matrix based on ABC method. We have identified two cost drivers and separated fixed and variable costs from general cost information. However, for simplicity we have not considered the cost difference of EDI and non-EDI ordering in this simple matrix.
Owens and Minor should carefully deal with its customers’ resistance to the new pricing system by making them truly understand the new system and benefits they would get after the implementation. Owens and Minor also needed to launch a pilot program before full implementation and provide help and support to its customers to insure the success of the implementation.
Statement of issues
Historically O&M was doing very well in the industry, however, for recent years company suffered continuous loss on business. At the end of 1995 O&M had ended with an $11 million loss due to decrease in gross margin and an increase in expense. There are many reasons that caused this result, and we are going to identify the most important ones.
Healthcare industry has changed a lot since 1980. Historically, hospitals purchased healthcare products individually. However, in order to achieve economies of scale and gain more control over supply costs, hospitals joined forces with other hospitals to form large buying groups. With such combined buying powers, hospitals are much more powerful in negotiating gross margins and service levels with distributors. Distributors are forced to cut gross margins and increase service level. A quote from O&M manager can illustrate this situation very well: “whoever had the strongest will would win the price”. Apparently, in current supply chain, the relationship between distributors and customers is not harmonious.
Moreover, with the increased popularity of Just-In-Time and stockless management ideas, hospitals are reluctant to hold large inventory because they wouldn’t benefit from JIT whose primary principle is to lower inventory carrying cost by ordering when needed. Instead, they want distributors provide Just-In-Time delivery service. Also customers require special handlings such as smaller package and different products batching and these services are at distributors own costs.
Distributors also experienced margin pressure from the manufacturing side because manufactures do no compromise on the already low healthcare product price. Competitions in the industry also results profit decline of O&M, especially with distributors who also produce healthcare products entered the market. Those distributors are able to offer extremely low price to customers because they are the manufactures as well. Even though O&M commits to provide better service, it lost many customers because of this.
Analysis of Data
Services rendered by O&M and changes in Distribution.
Owens & Minor play a tremendous role in this industry’s Supply-Chain. They are in charge of providing information to manufacturers on product flow such as: market trends, buying patterns and product penetration, so that their suppliers use this valuable information in order to manage their operations and production schedules. By doing so, manufacturers are able to produce the right quantity of supplies, which in turn reduces stockouts and/or excess stock costs, in other words O&M provide the necessary tools for the upstream members to have adequate inventory production planning.
As for their customers, their role is to purchase the products from the manufacturers and ship those medical supplies to their warehouse where they will store them until delivery to the hospitals. So O&M owns and manage the inventory themselves, taking all the financial risk associated with product handling, shipment and storage. “O&M’s main operational functions included receiving, put-away, order picking and shipping”.
O&M don’t add value to the product itself since they just act as an intermediary to pass the products from the manufacturer directly to the hospitals, however they do add value to the Supply-Chain. They enrich the SC with the necessary information needed to avoid phenomena such as the Bullwhip Effect and they bring expertise in stockless and JIT inventory management systems, consequently lowering costs along the chain.
However, it is certain that the nature of distribution, that is, the role of O&M has changed through time and not for the greater good. This change has occurred mainly with its downstream partners the hospitals. They have shifted they costs to their distributors and demanded better and faster service without any additional rewards, this is why O&M relies heavily on its logistics department to make process more efficient. This was made possible for hospitals due to their increase in power by merging or joining forces with other hospitals.
Voluntary Hospitals of America member hospitals represented $1.2 billion in annual revenue to the company, meaning that O&M’s switching cost is too high. They are able to minimize their own costs by forcing distributors to hold their inventory and transport in smaller units, sending it to the nursing and surgical units instead of leaving it at the loading dock as before. Margin pressures have also been present upstream with manufacturers, which were reducing discounts even as small as 0.5%, thus lowering significantly up to 31% distributors net profits before tax.
A main issue taken from this case is that incentives along the Supply-Chain are not aligned. The risks and rewards of doing business are not fairly distributed across the network. Even if the manufacturers and hospitals are better off with the cost-plus strategy, the whole SC still does not have a win-win situation and they might lose against other Supply Chains. The truth behind this issue lies in that there is no trust in the SC, this assumption is made given that nobody wants to share critical information, which enhances
Impact of Cost-Plus Pricing on the members of the Supply-Chain.
On the side of the distributors O&M, engaging in a cost-plus pricing strategy means charging a 7% markup, meaning that profits lie on expensive products, which they don’t have the change to deliver cause Hospitals bypass them and deal directly with manufacturers in order to avoid the 7% increase in prices. The most important aspect to consider about this strategy is that it does not take into account the services added. In addition, this method caused the effect of Distributor giving more and better service holding more inventories, which increases carrying costs and risk of damage during storage. Distributors enforce supply-chain speed without any additional profits.
On the customer’s side, cost-plus pricing implies less risk on inventory carrying cost, creating more incentive for hospitals to order frequently due to flat rate. Nevertheless, there is some unethical activities in which they can participate. They can avoid paying high costs on expensive products to their distributors by jumping them through the SC and dealing with manufacturers instead, an activity called “cherry-picking”.
Finally, the manufacturer engaging in cost-plus strategy needed to handle some shipment to deliver, mainly expensive products, to hospitals. This resulted in inefficiency for both parties due to the fact that manufacturers required hospitals to buy in bulk and they did not have the space or management systems as distributors did to handle the product. Mishandling, damaging and loosing expensive items often occurred in the “cherry-picking” process.
Alternative Courses of Action for O&M.
Based on our five quantitative and qualitative decision criteria: cost, time, ease of implementation, customer satisfaction and future benefit for the company, we are able to compare the advantages and disadvantages of each alternative and help us make the best decision.
1)Status Quo: The easiest option for O&M is to keep operating as they are, which is not the best alternative for them for financial reasons. They currently have customers who are not profitable for the company, customers who keep asking for higher service at the same price that would keep profit margins low as personnel costs increase. For the year of 1995 they incurred a net loss of $11.3 million, which compared to last year’s profit of $7.92 million represents a dramatic and also unstable change. Based on this data, the assumption is that the upstream and downstream partners will not change their business habits and incentives will keep unaligned and that the company will not be able to reduce costs to an extent where they can offset service costs and generate profits.
O&M will keep generating loses for the company and will ultimately yield to bankruptcy. The time to implement is inexistent, since no actions are made. The cost of implementation is also inexistent; nevertheless the company’s cost on the long run will be very high because cost-plus strategy is not profitable for them. There is no ease of implementation. The customer’s benefit is high, since they don’t have to pay additional service and inventory carrying cost. The future benefit for the company is very low, might loose contract with clients because of their lack of ability to fulfill all products and keep taking all the costs.
2) Vertical Integration: Our second proposed alternative is vertical integration, which means to acquire a manufacturing plant. By using this strategy, O&M would be able to create its own healthcare product brand and reduce the purchasing price on that. Thus, O&M could offer a more competitive price to its customers and might get some recovers from the high operating costs. However, there are some problems associated with this alternative. O&M had to spend time on finding suitable acquiring target, understanding manufacturing process and integrate the manufacturing plant into the company system. Therefore, this strategy requires a relatively longer time period to get things work. On the other hand, in order to do vertical integration, O&M had to prepare a huge amount of cash. Based on the fact that O&M’s current cash flow was very tight, acquiring a manufacture would have a big impact on company’s financial health. Implementation of this strategy would be quite difficult as well.
Since O&M had no experience on healthcare manufacturing, it has to get familiar with the process from very beginning. Also, how to control manufacturing cost at a competitive level is a new challenge to O&M. Because O&M can create its low-cost private label products under this strategy, it has the incentive to promote private label products to hospitals. However, hospitals do not like private label products since it limits the scope of choice so under this strategy customer satisfaction level is low. In general, vertical integration is effective in reducing company’s cost on healthcare products purchasing but requires a substantial investment and long implementation period. Customer satisfaction is also low in this case.
3)Selected ABP: Another alternative that O&M could use is to use ABP system only on certain type of customers. More specifically, O&M could choose unprofitable customers to implement ABP and keep its profitable customers status quo. The time required for this alternative will not take too long, less than 6 months would be a reasonable estimation. The majority of time would be spent on the analysis of profitability of customers. The challenge of implantation this alternative is to make sure the customer profitability analysis would be done under a proper and correct result would be produced. To estimate customer satisfaction after the implementation, we needed to split our customers into two groups.
Those customers determined as “profitable” to us under current cost-plus system would likely to maintain the current satisfaction level, but customers viewed as “unprofitable” would feel less satisfied since they would have to pay more after ABP implemented. The downsides of this alternative are the risk to drive some customers away and the increased complexity of our pricing system which might lead increased error rate. The good side is that O&M would benefit in the long run because of the elimination of unprofitable customers. If O&M would have all the information and could develop correct ways to conduct the analysis, this alternative would be a possible choice to lead O&M succeed.
4)ABP for all Customers: this final alternative considers implanting ABP to all customers, both profitable and non profitable. The cost of this option is higher than “Selective ABP” previously mentioned, due to the fact that all customer base will be subject to EDI technology and connecting to all of them takes organization within the company and thus training cost by employees for both O&M and hospitals. The time to implement will be longer compared to Selective ABP; however based on our assumption that O&M will be located higher on the learning curve, their time per implementation per customer will be less the more customers they have previously served. The easiness of implementation therefore is not easy due to the large customer base dealt and new systems and training needed. However, the future benefits, not only for O&M, but also for the entire SC will be substantially improved in the sense that incentives would be aligned.
Based on previous analysis on alternatives, we conclude that “ABP for all customers” is the most feasible solution that can maximise company’s profits, as well as aligning the incentives along the SC. This is important not only for the short term, but also for the long term of the entire chain.
Impact of ABP on Customer Behavior.
Before the implementation of ABP (activity based pricing), the current dominant form of pricing in the medical/ surgical industry was cost-plus pricing. If the ABP strategy could be successfully implemented, both distributor’s and customers’ incentives could be allied. Under ABP, the distribution fee was no longer based on the value of item but the value of service. In that way, Owen & Minor’s customers would begin to think about the real cost of various activities through the supply chain.
Instead of wanting to order as less as possible per time and increasing order frequency, customers would begin to seek a way to reduce the order frequency to reduce the distribution fee charged by Owen & Minor. Also, since now the fee was not determined by product value, customers would be willing to order expensive products via distributors’ channel instead of buying in bulk directly from manufacture. So the possibility of mishandling, damaging and lost of expensive items would be reduced. From the distributor’s side, it would be more happy to provide good service because it would be paid based on the service it provided not the value of item.
Of course, it’s unlikely to ask all Owen & Minor’s customer to turn to the new pricing system at the same time. Depends on the type of customers, some of them might be adopt the ABP quicker and with less resistance. Generally, customers who could reduce or simplify the activities happened through the supply chain would adopt ABP faster. First, customers willing to simplify or reduce the order frequency would be more likely to adopt the ABP. By doing that, the fee charged by distributor would be decreased.
Also, those customers often ordering large amount of expensive items would adopt the ABP first. By doing that, it shits the risk of mishandling, damage and lost to the distributor. Compared with previous fee charged by item value, now they would more likely to pay less but get better service. Furthermore, those customers who understood and were willing to develop a sustainable relationship with distributors would adopt the ABP first. They understood that if distributor was losing money because of the improper pricing system, the entire supply chain would collapse someday and both of them would be hurt finally.
There were also risks associated with ABP for Owens and Minor. ABP was a new concept and cost-plus pricing system was still a dominant form in the medical/ surgical industry. It was hard to convince customers adopt the new and even unproven concept. Some customers might turn to other competitors and the relationship that needs built over long time might get hurt.
Proposed ABC pricing matrix
In order to have a better demonstration, O&M designed a simple pricing scheme using activities-based costing. The pricing scheme is based on two major cost drivers–number of purchase orders per month and number of lines per purchase order. The number of orders was tied up to O&W’s fixed administrative costs and number of lines was tied to variable costs such as the labour handling cost of different products. This is a very primitive matrix because it only listed two cost drives and priced based on them. In reality, there should be a price for every value-adding service provided by distributor and the number of cost drives is huge. However, this simple pricing matrix could effectively show our clients that their operating cost is associated with level of service they demand, and lower cost is achievable if they can optimize their behaviors. Because we designed this pricing matrix based on two cost drivers, costs included in matrix are directly related to number of orders and lines.
For example, fixed order costs such as procurement, labeling, account management fees and variable costs like shipping & handling, delivery, interest cost are all included. However, some costs are not comprised in the matrix. O&M believes all costs associate with number of orders are fixed but there are variable costs incur in placing orders. Activities such as taking orders, processing and staging & processing are not free so in the future we need to include these costs in more sophisticated pricing matrix. Moreover, operating cost of an EDI system and a non-EDI system are very different. For simplicity reason we just ignore the difference and assume identical prices for both systems but actually using non-EDI system would incur more cost due to high level of manual works.
We have worked out some simple examples on ABP and it shows that company’s profitability increased dramatically under ABP system. Please refer to exhibit #1 fro more details.
Risks & Challenges.
Although this selected alternative presents many future benefits for the company and the Supply-Chain, certain risks are involved.
Risk associated with ABP for Owens and Minor. ABP was a new concept and cost-plus pricing system was still a dominant form in the medical/ surgical industry. It was hard to convince customers adopt the new and even unproven concept. Some customers might turn to other competitors and the relationship that needs built over long time might get hurt.
Customer’s entire internal system such as budgeting and incentive programs are formed based on old cost-plus system, and a change in pricing structure is very time consuming.
Restructure of pricing system will also affect customer’s buying personnel because their compensation was related to the percentage they negotiate with distributor, and under ABP structure that percentage disappeared
Employees on the customer side might have problems understanding the system and change their behaviors to reap maximum savings. Organizational structure will be adjusted to fit ABP which means some employees will be reassigned or resigned, but this decision will have negative impact on morale and productivity.
EDI system implementation requires a substantial commitment in resources.
Sharing valuable information with customers can be misused at their advantage with O&M’s competitors.
The main challenge will be to build mutual trust among the parties involved.
The successfully have a fully implemented ABP system; we suggest the following action steps:
1.Establish ABP System within the company first and find out cost drivers (services which incur costs). Upgrade IT infrastructure to facilitate further implementation steps.
2.Analyze the benefits of SC based on ABP, benefits such as: improvement on inventory management, aligned incentives to efficiently compete with other Supply Chains, reveal hidden costs on activities, and build long-time relationships, among others.
3.Communicate to selected customers with the previous benefit analysis.
4.Initiate ABP pilot program.
5.Setting up EDI and give continuous support.
6.Adjust and upgrade ABP system based on feedbacks from pilot program
7.communicate to all customers with the success of pilot ABP system
8.Full ABP implementation.
(For suggested time-line refer to exhibits.).
In general, we do see huge potential benefits on the implementation of ABP system. However, risks and challenges will emerge from this alternative and opposition will be strong on the customer side. The implementation steps provide an easy guideline to have a successful ABP system in the SC.