Case Background:
Who: Jose Valderas, divisional VP for Owens & Minor (O&M) What: How does O&M sell ABP (activity based pricing) to Ideal? Could they implement ABP to help Ideal? Why: O&M needs to improve margins; by understanding where costs are derived from, they can then pass those costs onto the customer. O&M needs to eliminate the cost-plus system and would like to move to cost-plus zero with monthly fee based on activity levels
Case Overview:
* O&M is a medical and surgical supplies distributor. They focus on distributing one core business line (medical/surgical supplies) rather than expanding to other lines. This gives them an advantage over the competition by being able to offer better products, prices and services to customers. Their customers are predominately hospitals/hospital networks. * Through acquisitions over the years, they have presence across the country and became leader in low cost distributor of healthcare products * They have 49 distribution centers in the US, which warehouse over 300,000 products from over 3,000 manufacturers to over 4,000 customers; each division served customers within a 100-150 mile radius using owned/leased fleet. Customers on average receive 2-6 deliveries/week * At Savage the (Maryland) division, they carry over 50,000 line items, with 120 customers. They serve an area with nearly 12 million people within one hour *
* The sector is growing, but more and more cost pressures; led to customers demanding reduction in supply costs and improving of inventory management. Customers forced distributors to carry more of the inventory and make more delivers in lower quantities. Distributors were being squeezed from both sides to reduce margins: customers/hospitals one side, and manufacturers the other side. * Medical supply industry competitive, with fewer customers (as consolidations have occurred, leading to large contracts but fewer in number) * Pricing currently done on a cost-plus model, which is based solely on the cost of the product and does not factor in the costs of distribution; there is only a % distributor mark-up on the base manufacturer price of the product *
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* By 1995, SG&A costs were increasing again above 7% of sales, and interest expense had increased by over 100% from previous year; inventory costs in 1994 and 1995 were almost triple that in 1993, and A/R around double * To address the cost reduction initiatives of their suppliers and customers, O&M shifted to a ABC structure * Focus in 1996 was to improve service quality and control inventory costs; as well increase gross margin by putting higher prices to services that demanded more resources * They are preparing a proposal to a potential new client, Ideal Health system (which purchases $30million annually for medical/surgical supplies) * O&M created a matrix that was based on two major cost drivers: number of purchase orders per month and the number of lines per purchase order in a pursuit to get Ideal to use ABP
Challenges:
* Challenge within the industry is that many of the competitors are subsidiaries of manufacturers, thereby allowing them to offset their distribution costs to customers with their high margin from sales of manufactured products. However, what this meant was that these competitors didn’t offer the variety of products that O&M could provide (as only sold self-manufactured products) * Cost plus system tied the fee to the distributor to the value of the product rather than the value of the service; Cost Plus was entrenched throughout the industry * The pricing structure within the industry was exceptionally complex and made it difficult to track actual product costs or compare quotes * A/R runs average 90 days which is high
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* Customers demanding system of distribution that was easier and immediate, and even bypass the storeroom process; this demand for JIT and stockless drove O&M SG&A costs up * The acquisition of Stuart Medical hurt O&M, largely because they were leader stockless and JIT * Challenge was to tie distribution fees to activity levels and make the customer aware of these, thereby in hopes that they would become more efficient * ABC was new, so how do you get them to understand benefits of ABP
Activities that affected O&M profitability were:
* Type of service requested
* Number of purchase orders/month
* Number of lines per P.O.
* Number of deliveries/week
* Method of order
* Interest cost from carrying receivables and inventory
Case Questions:
1. What are the services rendered by the distributor to manufacturers and hospitals? * O&M purchases materials from the manufacturers and sells them to hospitals. * Under cost plus system, rates are negotiated between the manufacturer and the customer, and the distributor manages those contracted rates (and adds % to the cost)
* How has the nature of distribution changed over time?
* Because of a focus on cost reduction within hospitals, customers are now demanding JIT and/or stockless. By having materials delivered on an as-needed basis, they are able to reduce their inventory costs * Distribution has shifted to supplying large buying groups, as opposed to individual hospitals; this combined purchasing power enables them to get best possible prices by forcing manufacturers and distributors to reduce their margins
* What is the value-added by O&M
* O&M is able to meet the needs of customers looking for JIT and/or stockless * O&M is willing to own and manage the inventory; they are responsible for all returns, etc., and run the risk of outdated/obsolete goods * O&M is not limited to selling one brand (i.e. self-produced products) *
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2. Evaluate the impact cost-plus pricing has on distributors, customers, and suppliers. * For distributors, they face higher operating costs (in 1995 was 7.6% of sales), and huge inventory carrying costs. In 1995, quick assets ratio for O&M was 1.02. Interest expenses steadily climbing as a result of large inventories. * For customers, simplifies the budgeting process by knowing exact costing for products
* For suppliers, is there an impact???
3. What effect will ABP have on customer behavior?
The goal with ABP is to provide incentive for customers to change their purchasing habits. By providing financial incentive to encourage a change in behavior (in this case, reduce the number of orders and reduce the number of line items), the control of cost savings is in the hands of the consumer.
4. Explain Exhibit 5. How does the pricing matrix work?
The fewer the number of lines and the fewer number of orders would reduce the cost to the consumer (as this is then lowering the fixed and variable costs to O&M).
* How do the costs in Exhibit 5 correspond to the costs shown in the customer profitability statement in Exhibit 4? The number of orders impacts the Total order cost (all costs under order cost are impacted by an increase in the number of orders placed).
(??page 10 says the admin costs are fixed??)
The costs of Picking are tied to the number of lines; the fewer the lines, the lower the cost).
* Why doesn’t the matrix comprise all the costs shown in Exhibit 4? They have focused on those areas with the highest cost, and therefore are those that have the greatest impact to reducing overall operating expenses and increasing margins.
5. What are the obstacles to successful implementation of ABP at Ideal? * Ideal’s budgets currently have product prices with distributor fees built in, so they would need to modify their entire budgeting system * Internally they also use cost-plus for transfer prices; they will now have to implement ABC throughout internally to be able to appropriately charge departments. * Internal changes are required: how staff purchase, store, and use supplies; as well have to identify how to eliminated fixed costs *
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6. What type of customers will adopt ABP first?
* Companies that need to reduce costs
* Flexible systems to easily allow for changes in system, such as price changes in budget, staffing, etc. * Smaller companies that are not part of the larger networks and therefore don’t already have the buying power to demand reduced costs *
7. How difficult or easy is it for O&M’s rivals to adopt ABP * Probably tougher as most of the competitors have several business lines, whereas O&M only has the one business line (medical & surgical supplies)
8. What are the risks associated with ABP for O&M?
* Is there really a necessity for the larger clients like Ideal to switch; they can already demand the lowest prices while ensuring their other costs (e.g. inventory, labor, etc.) are minimized.
