Owens & Minor, Inc. (A)

It was January 1996. Jose Valderas, divisional vice president for Owens & Minor (O&M), a $3 billion distributor of medical and surgical supplies, was driving back to his Savage, Maryland office. His mind was processing the news he had just heard. Ideal Health System, a not-for-profit hospital chain that for the last 10 years had purchased supplies from a rival distributor, announced it was putting its $30 million annual medical/surgical supply contract up for bid. In an environment where healthcare consolidations were the norm, resulting in ever-larger contracts that were fewer and farther between, Ideal would have all the major distribution companies in the region vying for its business.

In operation for 114 years, O&M was a Fortune 500 company and one of the nations largest distributors of medical and surgical supplies such as gloves, gowns, wound closure devices, and other operating room items. Through its 49 distribution centers nationwide, O&M warehoused and delivered over 300,000 products from roughly 3,000 manufacturers to nearly 4,000 hospitals, integrated health care systems, and group purchasing organizations.

Valderas knew that tearing Ideal away from its current supplier, Atlantic Healthcare, would be a challenge. Atlantic was a subsidiary of a medical supply manufacturer. The high margin from sales of its parents products allowed Atlantic to offer distribution services at extremely low ratesrates that would force O&M to operate at a loss. Valderas had bid forand lostIdeal two years ago to Atlantic for just that reason. The fact that the business was coming up for bid again gave Valderas hope that maybe this time Ideal was ready for a change. Valderas explained:

Although beset by cost pressures, medical and surgical supply was a growing sector, since expenditures in the healthcare industry in the United States were expected to continue to rise. The Health Care Financing Administration estimated that after ranging from 13.5% to 13.7% of gross domestic product (GDP) in the mid-1990s, healthcare expenditures would account for $2.2 trillion (16%) of GDP from 1998 through 2002. Healthcare industry growth was tied to demographic trends the aging of the U.S. populationand advances in medical technology.

Changes in the medical/surgical supply industry reflected the evolution of U.S. healthcare in general. As managed care brought attention to costs, health care providers took a number of steps to reduce expenses, some of them directly affecting the medical supply industry. Several consulting groups sprang up to help hospitals manage inventory and supply costs. As Ed Petrella, director of logistic and support services at O&M, described:

As providers solidified their partnerships with other facilities, they formed buying groups that represented vast numbers of member sites. Sales to Voluntary Hospitals of America (VHA) member hospitals, O&Ms largest buying-group customer, represented approximately $1.2 billion in annual revenue, or 41% of net sales, for O&M in 1996. With such combined buying power, these groups were able to force suppliers and manufacturers to cut margins. As Michael Stefanic, director of budgets, forecasting and cost management at O&M explained:

Our negotiations with the customer entailed them trying to get our fee down to 6% of the product price and us trying to get it up to 8%. There would be no discussion of a change in services; it was simply that whoever had the strongest will would win. When customers started banding together to form these large integrated healthcare networks, they became more powerful, and they had a bigger stick to wield. There was always the threat that your customer could take all their volume to a competitor.

Distributors also experienced margin pressure from the manufacturing side of the supply chain. In an industry where the margins were already lowone industry trade journal reported that distributors 1993 pre-tax profit was an average of 1.6% even a .5% reduction in discounts could mean a 31% cut in net profit before taxes. 3

Many distributors struggled financially with these reduced margins. In 1995, unable to meet contracts calling for lower margins, Owens and Minor instituted an across-the-board 1% price increase. Although most providers absorbed the increase, O&M lost some business as a result of the price hikes.

Cost-Plus Pricing

The dominant form of pricing in the medical/surgical distribution industry was cost-plus. Cost- plus meant the customer paid a base manufacturer price plus a mark-up added on by the distributor. For example, the buying group negotiated with the manufacturer a price of $1.00 per box of bandages. The distributor added a 7% fee, charging the customer $1.07 for the delivered product. The percentage was the same regardless of the costs to receive, move, store, and ship the product. As Valderas explained:

With cost-plus, our fee was based entirely on the price of the product from the manufacturer to the customer. A large box of adult diapers that cost $30 would generate, on a cost-plus-7% fee, $2.10 in revenue. In contrast, a small box of cardiovascular sutures that cost $800 would generate $56 in revenue. There was a huge difference in the cost to handle large boxes versus small ones. There was not much money in large, bulky packages, but a lot on small items.

Valderas went on to explain the genesis of cost-plus pricing:

In the 1980s VHA, the nations first and largest group purchasing organization, introduced large-scale cost-plus pricing to the medical/surgical supply industry. Before cost-plus, distributors used a variety of ways to drive pricing. There were not a lot of prime vendor agreements, business was fragmented between distributors. VHA changed all that. It drafted the first national cost-plus distribution agreement. It was a committed contract, which meant that the member hospitals agreed to commit all their traditionally distributed business to one distributor. We had one cost-plus fee of 7% for all products. VHA chose O&M as one of its preferred distributors, which greatly fueled our growth throughout the 1980s and 1990s.

One drawback to cost-plus for distributors was the potential for customers to engage in cherry- picking. As Petrella explained:

Cost-plus tied our fee to the value of the product rather than the value of the service. To avoid paying a high distribution percentage on expensive products, the customer would buy them directly from the manufacturer. That left us with only the low-margin, inexpensive product. Buying direct wasnt efficient for the customer either, since the manufacturer would require them to buy in bulk and they didnt have the space or management systems in place to handle the product. Often expensive items were mishandled, damaged, or lost.

Many distributors will try to sell a customer by saying they will get cost plus 4%. Well, maybe thats true for, say, the top 10 items they purchase, but then theyre paying up to cost- plus 20% for other thingsitems they dont track as closely. The result is the customer ends up paying an average of something like cost-plus 12% and they dont realize it until two years later when someone does a cost analysis.

O&Ms main operational functions included receiving, put-away, order picking, and shipping. Most warehouses used a hand-held radio frequency device (RF unit) to communicate and control inventory levels and workflow. Each RF unit had a scanner that read barcode labels on pallets of incoming product, bin locations, and shipping pallets. The RF units recorded changes in inventory levels and locations immediately to the divisions central computer. Very little paper was needed to exchange information.

Warehouses were divided into several different zones. Bulk zones held full pallets of product, hand-stack zones were for boxes of product, and low-unit-of-measure zones housed eaches of product. There was also a clean room for sterile products such as wound-closure units, and a high- velocity zone for the products that accounted for the top 56% of warehouse activity. These were palleted and hand-stacked items that represented the facilitys top 650 items by velocity.

Divisions maintained two shifts. The 6:30 a.m. to 3:00 p.m. shift was primarily responsible for receiving and inventory control. The second shift did the picking, packing, and loading of product. Drivers left the facilities in the early morning hours to make delivery to most customers before 8:00 a.m.

Manufacturers have to rely on distributors for information on product flow. Our manufacturers sell large quantities of product that comes to us by the truckload. We break it down and deliver it to the customer. We supply customer usage and sales numbers back to the manufacturers. We provide information on market trends, buying patterns, and product penetration that manufacturers use to manage their operations and production schedules.

Rebates are another complicated aspect of the supply chain. The manufacturer sells O&M a box of product for $1, but the manufacturer may have negotiated a different price for the same item to different customers, such as $.75 for one customer, $.73 for another, and so forth. The negotiated price is what we receive from the customer. We have to collect the price information and claim the price differential from the manufacturer using debit memos twice a month. Maintaining price changes is also quite time-consuming. Manufacturing sales people often negotiate new prices and fail to notify us. Sometimes, we get updated pricing contracts from the customers themselves. All this activity requires us to maintain an army of contract people. We have 60 employees in contracts at the home office and their full-time job is to monitor and maintain pricing contracts and claim price rebates.

Financial Performance 1984-1995

For the last ten years, O&Ms financial picture reflected the opportunities and challenges of the health care industry. While the company enjoyed a constant increase in net revenue, its gross margin as a percent of net sales declined from 14.5% in 1984 to 9.7% in 1994 (see Exhibit 3 for selected financial data).

The company responded to the downward pressure on margins by instituting internal cost control measures, specifically cutting sales, general and administrative (SG&A) expenses. The company was able to cut SG&A expenses from 12.5% of net sales in 1984 to 6.8% in 1994. In 1995, however, the company spent more on SG&A expensesprimarily personnel costsin order to meet new contracts that called for enhanced service levels such as stockless and just-in-time services. Stockless and just-in-time systems required more labor, deliveries to customer, packaging, and material handling than traditional systems. As O&Ms 1995 Annual Report explained:

The increase in SG&A costs as a percentage of net sales was primarily a result of increased personnel costs caused by new contracts providing for enhanced service levels and services not previously provided by the Company, a significant increase in the number of SKUs distributed by the Company, system conversions, opening or expanding 11 distribution centers and reconfiguring warehouse systems. This was mostly the result of absorbing Stuart Medical.

Coupled with a $42.8 million restructuring cost associated with the acquisition of Stuart Medical and a decrease in gross margin, the rising expenses took a toll on the company, resulting in a net loss of $11.3 million. The 1995 Annual Report described coming through the toughest two quarters in the Companys history.

ABC at the Savage Center

O&M first began to explore activity-based (ABC) costing in 1994, under the guidance of Michael Stefanic, who had been hired to create and head a cost accounting department at O&M. In order to better understand and control costs, Stefanic initiated an ABC pilot project at the Richmond division. With the lessons learned from that early iteration, Stefanics team moved on to Valderas distribution center in Savage, Maryland. The Savage center employed 120 people and carried over 50,000 line items in its 121,000 square-foot facility. Savage utilized 12 tractor-trailer trucks to deliver product to its 120 customers. In 1995, the center grossed $111.5 million in revenues. The market served by the Savage facility was extremely dense, nearly 12 million people lived within one hour of its location. As a result, it had one of the lowest delivery costs in the company.

The Proposal to Ideal

Activity-Based Pricing

Valderas, Petrella, and Stefanic worked together to make the leap from activity-based costing to activity-based pricing (ABP). They believed that, if O&M tied distribution fees to activity levels and if customers could see how their activity levels affected their costs, customers would want to become more efficient. Better customer efficiency saved O&M money in processing, delivery, and product handling. The team hoped that an activity-based pricing system would align fees with services, relieving O&M of the burden of unprofitable customers. They knew O&M needed to eliminate the cost-plus system and offer what was essentially cost-plus zero with a monthly fee based on activity levelsbut no one in the industry had done such a thing before. Valderas decided to hedge his bets by offering both ABP and cost-plus, hoping that Ideal would appreciate O&Ms flexibility in offering two vastly different approaches to distribution.

The number of orders was tied to our fixed administrative fees and the number of lines was tied to our variable coststhe number of times a worker had to go to a product rack, etc. It was a very primitive way to identify our fixed and variable costs, but it was effective in showing the customer that they could lower costs if they changed their behavior.

Valderas sat in his office in the summer of 1996 wondering if the ABP proposal would be successful. Would Ideal commit time and resources on activity-based pricing? Had he presented the costs and benefits of ABP well enough? How could he answer Ideals concerns?

Why is Owens and Minor facing the pricing problem? What is the fix?