Michael Stefanic, director of cost management at Owens & Minor (O&M), a medical and surgical supplies distributor and Daniel Borunda, material systems manager at Virginia Mason (VM) Medical Center came together to try to battle healthcare costs and improve the healthcare supply chain. Virginia Mason, a private non-profit healthcare organization based out of Seattle, offered both primary and specialized care and developed the Virginia Mason Production System (VMPS). The VMPS was a modified version of the Toyota Production System that helped VM work towards its goal of being a quality leader, emphasized line-level employee teamwork, and fought for a zero defect rate. The components of VMPS included value-stream mapping (flowcharting), improvement workshops that sought to eliminate waste and improve efficiency, and the “everyday lean idea” used by VM employees in an attempt to reduce waste and add value. They sought to implement their “alpha vendor” idea where a few key vendors acted as partners in the supply chain and provided both goods and services at the lowest cost.
Owens & Minor sought to provide value-added services to its customers while offering expertise in lowering costs for them as well. Such services included inventory management, activity-based pricing, consulting, and outsourcing. The majority of O&M’s customers paid fees on a cost-plus basis (customers paid the base manufacturer price plus a specified percentage mark-up added by the distributor). However, Stefanic wanted to fully explore the advantages of activity-based pricing, instead, believing it to be superior to the cost-plus model. O&M met with VM where Stefanic presented his activity-based idea. As a result, VM decided to collaborate with O&M and engage them as being VM’s medical/surgical supply alpha vendor. Virginia Mason decided to temporarily use the cost-plus pricing model while they discussed how they could capture more costs in the activity-based pricing model with Stefanic. This discussion led to the comprehensive activity-based pricing model, Total Supply Chain Costs (TSCC), developed by Stefanic and Borunda. The TSCC model was developed in order to capture 100% of the fees included in supply chain activities.
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Evaluation of the TSCC Model
The cost-plus pricing model was the dominant form of pricing in the medical/surgical distribution industry. Customers pay a base manufacturer price plus a mark-up fee added by the distributor. For example, a customer pays $150 for a box of merchandise and the distributer added a 10% markup fee making the total price for the customer $165. In this case, the distributor receives revenue of $15 ($150*10%). The percentage used as markup is generally the same regardless of moving, storing, shipping, and receiving costs for the product.
The Total Supply Chain Costs model is a comprehensive activity-based pricing method that seeks to include 100% of fees from supply chain activities. It also helps identify new methods to trace and assign several cost drivers hidden within the supply chain. For example, one of the major cost drivers identified using the TSCC model was the number of stock keeping units (SKU) on hand.This cost driver included inventory cost, interest on inventory, occupancy cost, warehouse cost, and overhead cost of each SKU. Once that cost is totaled it is allocated by the percentage of that SKU the provider purchases. A table listing the pros and cons of cost-plus pricing model compared to TSCC model is presented below.
- Cost-plus pricing
- easier pricing method
- mark-up percentages generally remained fixed
- provides a consistent return
- basis of pricing is on estimated costs, not actual costs
- not accurate costing
- potential for customers to engage in “cherry-picking” leaving distributors w/ only low margin items
- prices are difficult to track by customers
- disregards the consumer’s willingness to pay for item
- ignores actual costs of products within the supply chain TSCC
- more efficient
- less wasted costs
- encourages efficiency across the board
- improves provider, supplier, distributor relationship
- exposes activity based costs associated w/supply chain practices
- allocates hidden costs appropriate cost center
- providers dislike of decrease in SKUs
- Complexity of program
- Increase of costs at start of program
- Gradual return
Effects of the TSCC Model on O&M and VM
Defects created by VM, such as pricing errors due to lack of a contractual agreement with O&M or inadequate communication, were initially blamed on O&M. After the TSCC model was created, VM realized that they and O&M shared in creating the defects and decided to split the cost of rework and appropriate 50% of it to themselves in the TSCC.This deflected any adversarial relationship and helped them both improve the process. The mindset of VM in splitting rework costs 50/50 with O&M also encouraged them to share equally in any real savings from the program. The “gain share contract” incentivized VM to reduce its costs and ensured O&M would implement efficient processes and keep costs low.
The TSCC model also encouraged O&M to want to get other hospitals in Seattle to use it. Stefanic believed that hospitals standardizing their orders would decrease O&M’s on-hand inventory SKUs, thus creating cost saving opportunities for the hospitals. However, O&M’s move towards fewer SKUs has proven a daunting task in the healthcare industry.
Effects of VM’s Lean Philosophy
VMs lean philosophy affected the partnership in many ways. O&M had not openly discussed a pricing method with a customer until TSCC was created. The team created by this partnership used their understanding of activity based pricing model to develop a contract that would benefit both parties. While discussing the details of the TSCC they discovered different ways to trace hidden costs that wasn’t apparent using the cost plus pricing method.
A problem that O&M faced when bringing in new customers was bringing in additional products. Increasing the number of SKUs on hand can cause O&M to lease more warehouse space and incur additional costs. One solution that could be built into the TSCC model is when bringing in new customers, O&M could propose the customers use SKUs O&M already has on hand. O&M can show the new customers savings by exhibiting the total carrying costs of each SKU and how much of the total carrying costs will be allocated to each customer using this specific SKU as compared to the costs associated with the customers using their preferred SKUs. If O&M made this proposal to all prospective customers and they were willing to use SKUs O&M already has on hand, this could be a step towards a mass standardizing of SKUs. In the end, standardizing SKUs can help both O&M and their customers cut costs.
An understanding of the “everyday lean” enterprise-wide change involves transparency with all employees involved in the process. An added improvement to the current TSCC model would be to incentivize the distribution center employees through performance bonuses based on increased efficiency in their everyday tasks. For example, O&M could set a specific quarterly error rate that employees must stay under in order to receive a bonus for that period. Errors would include back orders, wrong items, incorrect products shipped and longer fill rates. As it stands, there aren’t any incentives to motivate the DCs to be more efficient. As a result, O&M may be passing its profits to VM while accounting for the added costs of their own inefficiencies.
While cost-plus pricing may seem to have an immediate advantage with competitive pricing, the activity-based pricing that TSCC is modeled from will have a longer positive impact for both O&M and VM. The TSCC model will uncover costs not previously determined using the cost-plus pricing model and help increase efficiency while decreasing defect rates within the supply chain. For example, if O&M sets a price of $40 for a box of latex gloves when VM negotiates a price of $35 per box of latex gloves with the manufacturer, O&M will be recording a revenue of $5, a 13% markup on the customer’s cost. While you can see the immediate impact of cost-plus in the distributor’s revenue, what you won’t see are the added costs that aren’t accounted for in the markup price. If added costs, such as occupancy costs of $1.30 p/box, warehouse costs of $1.20 p/box, and $1.40 inventory costs p/box, weren’t accounted for until after an occurrence of a transaction under the cost-plus model, O&M really is gaining only $1.10 in revenue (assuming VM only ordered one box of gloves). Since O&M is the distributor, and essentially is the middleman in this case, they would have to pay for the unaccounted costs that the cost-plus pricing model never considered when determining the appropriate markup rate/price. If activity-based pricing model were initially used in considering the appropriate price of the product, then the product price would reflect the cost allocated from each activity related to the product’s supply chain flow.
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