Product Standardization: Playing to Win
Executive Summary
Recent analysis by McKinsey & Company suggests standardization savings already captured by the US health care industry amount only to some 5-10% of total product spending. Benchmarks from other industries imply that an additional 20-25% savings is possible.
<Body>by John Pedersen, McKinsey & Co.
- Providers have only just begun to realize the potential of product standardization, capturing only 5-10% savings on total supply costs. But pressures are mounting to cause hospitals to embrace standardization with ever greater determination.
- Through radical standardization efforts, hospitals on average may be able to achieve an additional 20-25% savings in supply costs. But traditional approaches used by materials managers will require significant change, while traditional forces, most notably hospital buying groups, will play a diminished role in the future.
- The implications of further standardization for suppliers are less straightforward. While standardization will slow the growth of the medical products market, it will also create opportunities for suppliers who know how to turn changes in the environment to their advantage.
Product supply standardization is nothing new. Hospitals have long used hospital group purchasing organizations (GPOs) to improve their purchasing power and to negotiate favorable prices from suppliers. Today, hospitals purchase over $25 billion of medical products, pharmaceuticals, and other products through GPOs, and much has been written about the recent efforts of hospital systems and GPOs to address high cost device areas such as cardiology and orthopedics. But the full savings potential has never been quantified, and hospital executives have been forced to speculate about the size of the remaining opportunity.
Recent analysis by McKinsey & Company suggests standardization savings already captured by the US health care industry amount only to some 5-10% of total product spending. Benchmarks from other industries imply that an additional 20-25% savings is possible. The benefit to hospitals would clearly be significant. In 1995, U.S. hospitals and other health care providers spent some $42 billion in total on medical products. Continued standardization efforts could bring in approximately $8-10 billion in annual savings. For the average hospital, with $50 million in revenues, this translates into roughly $2 million in increased savings—an attractive sum in this era of shrinking hospital budgets and lay-offs.
For suppliers, aggressive standardization will involve critical adjustments to new customers and to new product selection criteria. Some of these changes have already been felt by many companies. Over the past decade, as the responsibility for selecting products has shifted from a clinician-only model to one in which the clinician and hospital administration share responsibility, suppliers have begun to adapt their selling approaches, adding price, product line breadth and solid clinical outcomes data to the traditional criteria of product quality and service level to appeal to the influence of this more “economic buyer.” Clearly, those suppliers who have been the quickest to respond to the new decision makers have fared the best in their battle to seize market share; suppliers who have buried their heads in the sand and continued to rely on a “business as usual” approach have, not surprisingly, experienced eroding market share and profitability.
An $8-10 Billion Opportunity
In health care, standardization has become a trendy catchword used to describe hospital efforts to contain supply cost both through supplier management and supply utilization management. To quantify the magnitude of the opportunity, however, it is more useful to think of it as three separate supply cost reduction efforts: First, supplier standardization of commodity items; second, supplier standardization of clinician preference items; and third, supply utilization management (see Exhibit 1).
Supplier standardization of both commodity and clinician preference items is relatively straightforward. Supply utilization management is, in fact, a combination of efforts to optimize the volume and mix of products used as well as to reduce the cost of purchasing and handling supplies. Moreover, the health care industry has to date really addressed only the standardization of commodity items. Commodity items are products with a relatively minor impact on patient outcome and which require little clinician training. They represent the “low hanging fruit” of standardization. Non-surgical gloves, bandages and dressing are all examples of commodity items. GPOs have played a central role in the standardization of these items because they have enabled hospitals to use their collective purchasing clout to negotiate substantial discounts.
Although successful, standardization of commodity items represents only about a quarter of the potential savings. Benchmarks across industries have in fact demonstrated that cost savings of approximately 25-35% are typically achievable (see Exhibit 2). In these industries, roughly half of these savings were achieved through supplier management (i.e., by reducing the number of strategic suppliers and by negotiating deep discounts) and roughly half through supply utilization (i.e., using the optimal volume and mix of products and reducing the cost of purchasing and handling products). Based on these benchmarks, we believe that hospitals are leaving an additional 20 to 25% possible savings on the table (see Exhibit 3).
But these additional savings can only be realized through aggressive efforts which focus primarily on the standardization of clinician preference items and on better product utilization, both areas that have largely been untested until now. Standardization of clinician preference items, for example, has only just begun. A recent survey by one major system of its member hospitals showed that only one in four hospitals has even attempted to standardize angioplasty catheters or orthopedic implants—two items widely thought to be clinician preference items. Similarly, hospitals, who are notorious for wasting products and using expensive items where less expensive substitutes exist, have only started to address product utilization. But this will have to change if today’s hospitals and hospital systems are going to survive in an intensively competitive environment.
Finding New Approaches
While significant savings potential from standardization still exists, traditional approaches to standardization will not be successful going forward. In particular, hospitals will have to rely less on GPOs to drive additional savings and more on internal initiatives in their own system. But such initiatives will require fundamental changes in the decision making process, changes that their traditional materials management department may not be capable of making. Finally, we expect materials management to build new skills and, as it does so, to wield greater influence throughout the hospital.
In the past, hospitals have relied heavily on GPOs to standardize suppliers for commodity items and to negotiate substantial discounts. And they will continue to do so. But although GPOs are now attempting to contract for preference products— and are providing services to help member hospitals address product utilization—their role in these two areas will likely be less productive. Standardization of preference products and reduction in supply utilization require significant changes in clinician behavior, and GPOs are simply less well positioned to drive such changes than they are to use their purchasing power to negotiate discounts on commodities.
The recent efforts of GPOs to drive supplier standardization in orthopedics provides a case in point. Orthopedics is a $3 billion market of products that have strong clinician preference. Most GPOs have negotiated tiered pricing structures that reward hospitals with higher discounts as volume is shifted to select suppliers. To date, however, GPOs have failed to secure significantly better discounts than hospitals have achieved on their own. Indeed, most current GPO contracts have succeeded only in situations where minimal changes in physician behavior were needed to move the hospital from one level of tiered discount to the next. Typically, these were situations where a majority of the hospitals’ physicians were already using the GPO-contracted product. In these cases, the only thing a hospital really had to do to qualify for the higher discount was to change the practices/behavior of a few surgeons.
There are very few examples in orthopedics where hospitals have been able to get a large number of surgeons to convert to GPO-contracted products not already in use. In those situations where surgeons are using products not covered by the GPO contract, it is actually easier for the hospital to cut a separate deal with their current supplier than to try and enforce compliance with a new product. This is true because non-GPO suppliers have generally been willing to slash their prices to match GPO-negotiated prices.
Large hospital systems such as Columbia/HCA and Kaiser Permanente are probably best suited to achieve savings through standardization of clinician preference products, both because of their size and because of their ability to enforce compliance. These institutions can purchase large volumes (Columbia buys over $2 billion in products for its 340+ hospitals) and potentially can use their direct influence to force clinician behavior to change (see Exhibit 4). However, even Columbia/HCA has reportedly had difficulty driving compliance in its orthopedic contract suggesting that even proprietary systems may be reluctant to challenge surgeon preference in some cases. The ability to change physician behavior is key to any program whereby hospitals hope to achieve standardization of preference items and supply utilization management.
Upgrading Materials Management
Since GPOs alone cannot address the untapped opportunities in product standardization, changes in physician behavior must be accomplished at the hospital and hospital system levels where materials managers will have to play an increasingly important role. But the traditional materials management skills, together with the status, reporting relationship, and role of the materials management function in most hospitals limit the materials managers’ ability to drive change.
Interestingly, in contrast to health care, in other industries where high levels of efficiency in product sourcing have already been achieved, materials management is regarded as one of the more important management functions. In the Japanese auto industry—an admittedly extreme illustration of this enhanced role—the materials management function is deeply involved in the day-to-day engineering and manufacturing teams that decide how products should be designed and produced. As a result, the impact of design and production changes on materials costs are closely monitored to keep materials costs in check. Although it will sound unfamiliar to most hospitals, the materials management function is so important in Japan that it is often considered a prerequisite experience for promotion to senior management.
In hospitals, of course, the materials management function has never been this influential. Compared to those of physicians and nurses, the viewpoint of materials managers is rarely a factor considered in matters affecting patient care. Not surprisingly, materials managers are some of the lowest-paid hospital executives (see Exhibit 5). Unless this view of the materials management function changes, and the materials manager is given a greater role in promoting compliance to the more advanced forms of standardization, hospitals will find it impossible to reap the additional savings such standardization can bring.
In particular, tackling standardization in clinician preference products or in product utilization will require new skills on the part of materials managers. In order to drive standardization of preference items, for example, materials managers must compile and evaluate product outcomes data. Armed with this data they then need to confront physicians who are reluctant to switch from the products they’ve always used. In addition, materials managers will need the ability to organize and lead product review committees made up of doctors and nurses. She or he will have to inspire these committees to openly evaluate new products and consider the cost implications of product selections. Materials managers also must be able to create systems for monitoring and rewarding compliance. Finally, as they address product utilization, materials managers will need to negotiate and price risk sharing contracts; redesign (or, in some cases, create) inventory management, logistics and billing systems; and develop the supply component of clinical pathways—all of which require new skills on the part of most materials managers.
Creating Change at the Hospital Level
Leading a hospital through such change is complicated and highly dependent on the unique situation of each institution. However, in our experience, hospital change efforts require a revision of the materials management function. At the same time, successful change programs share three key elements: 1) ambitious goals; 2) cross functional teams that drive implementation; and, 3) quantitative means of measuring and rewarding compliance.
The process of change at the hospital should begin by setting aggressive, long-term savings goals. A 20-30% percent goal, for example, will translate into significant annual savings that will grab the attention both of the administration and of the clinical leadership. Getting the buy-in and commitment of these individuals will be the single most important step in the program’s overall success. Unless the hospital administration and the clinical department heads all believe that significant savings opportunities exist and are worth pursuing, change simply will not take place. But once consensus and resolution are achieved at the top, they should be reinforced by aligning the hospital leadership’s incentives to the attainment of the savings targets. This can best be done by linking significant incentive compensation amounts to achievement of the stated goals.
Balancing the clinical and economic issues of product selection will require input from multiple constituents within the hospital. As a result, implementation should be driven by cross functional teams with representation from the physicians, the nursing staff and materials management. These teams should be organized in the areas of the hospital which represent the greatest opportunity for savings. The cardiac cath lab, the operating room, and radiology, for example, are often ripe targets. These teams will need to meet regularly to identify and implement specific supply savings programs. It should be noted that building physician support is especially critical during this phase.
Finally, measuring and rewarding compliance to supply cost savings programs is essential to any change program’s success. Compliance with the change program should be periodically monitored and clinician product use patterns profiled. Select investments in information technology will often be required to collect the requisite compliance data. Columbia/HCA, for example, has invested in systems to measure individual hospital compliance daily.
Not all hospitals will be able to match Columbia/HCA’s technological and management sophistication. But they will launch their own successful compliance programs. Some hospitals have achieved surprising compliance rates simply by illustrating the difference in practice patterns across their physician group and by encouraging the bottom performers to improve. Other successful compliance programs use a portion of the savings to fulfill shared physician/hospital goals. For instance, several hospitals earmark a portion of the standardization savings to replace aging capital equipment and/or to fund teaching positions.
This three-part change program is ambitious, but not unrealistic. Columbia/HCA has implemented standardization programs that resulted in a savings of $300 million in 1994 alone. Indeed, Columbia/HCA’s supply cost management program allows it to achieve some 20% savings in the hospitals it acquires.
Supplier Response to Standardization
The implications of standardization efforts for suppliers are dramatic. Standardization will involve new decision makers, new buying criteria, and lower prices. Successful suppliers will respond to these changes in four ways: by reducing costs, redoubling innovation efforts, providing solid outcomes data, and, where possible, redefining their offering to customers by adding value added services to the products they sell.
Supplier cost reduction efforts are critical for a number of reasons. Firstly, standardization will drive prices down. Secondly, suppliers will need to invest in information technology to help hospitals streamline billing, ordering, and inventory management. Thirdly, suppliers will need to increase their investment in innovation to prevent the commoditization of their products. To maintain their margins and fund these investments, suppliers will be forced to address their cost structures.
For most suppliers, sales/marketing and manufacturing represent the greatest opportunities for cost reduction, since such areas typically account for as much as 85% of total costs. Sales/marketing represents the most difficult challenge for cost reduction, as suppliers must choose between either dramatically reducing the cost of the current approach or completely redesigning the sales model (e.g., exploring new channels). No matter which approach is selected, it may be disadvantageous to be the first in a given market to reduce sales and marketing expenses. This is true because such reductions significantly increase the risk of lowering sales and service levels relative to the competition. In the orthopedics market, for example, the efforts of companies like DePuy to move to a lower cost, direct sales force (from distributors) have left them vulnerable to competitors (like Johnson & Johnson or Biomet) who have retained their indirect sales forces which can offer customers better service.
Product innovation will continue to be a fundamental source of value creation for medical product suppliers, but the bar defining successful innovation will be raised. One reason why successful suppliers will have to redouble their innovation efforts is that new technologies are needed to slow down the inevitable commoditization of products. Given the downward pressure on prices, incremental innovation which only creates subtle product improvements will no longer result in higher margins. This type of innovation will increasingly be viewed merely as a cost of doing business. As a result, commoditization and falling product margins will be avoided only if suppliers concentrate R&D efforts on technologies that significantly improve patient outcome or which reduce the cost of patient care. For many suppliers, this will mean a higher level of investment (often through alliances) in next generation technologies.
A second reason why suppliers have to intensify their innovation is to better meet hospitals’ growing demand for full product lines. As hospitals increasingly reduce the number of companies they do business with, suppliers will have to broaden their product lines to offer one-stop shopping within product segments. Successful suppliers will create full product lines through a prudent combination of investments in internal development and, in particular, acquisitions and in-licensing agreements, especially where there is a perceived need to create full product lines quickly.
Providing Outcomes Information
Introducing the hospital administration or economic buyer into the decision process will dramatically increase the need for data to compare the impact of various products on patient outcome, including cost. While many medical products suppliers provide information which describes their products’ impact on patients’ outcome over time, few studies exist today that compare patient outcomes across products or that attempt to measure cost effectiveness. In the absence of such information, the hospital administration must rely on the clinicians’ viewpoint – which is often much more anecdotal and less objective than one might expect.
In some cases, outcomes studies may prove problematic for suppliers, as the data suggests that their products are no better than competing products or alternative drug therapies. Still, enormous opportunity exists for some suppliers to differentiate their products and to protect their margins by investing in clinical outcomes studies that provide the data needed to demonstrate improved patient outcome or reduced treatment cost. In many cases, this type of data can be obtained through short-term, event-specific studies or studies using retrospective data. Although the industry is in the early stages of determining how to measure outcomes, several medical information companies, including APACHE, MediQual, Summit Medical Systems and Value Health, have recognized the great unmet need for more comprehensive outcomes data, and they are partnering with medical device companies and provider organizations to deliver it.
Finally, select suppliers will take advantage of standardization by enhancing the value they deliver to clinicians and hospitals. These suppliers will redefine themselves in the eyes of their customers by bundling various services with their products. Many suppliers are already attempting to do this today by creating value added services which cater both to the needs of clinicians to remain viable in the managed care environment and to the needs of hospitals to reduce costs and remain competitive. Such programs include providing doctors with practice management automation systems, helping physicians to market themselves to managed care health plans, and assisting hospitals to implement clinical pathways, as well as a variety of other cost reduction programs.
But while many suppliers are currently investing in these areas, many of these efforts will not succeed for a number of different reasons. First, suppliers are viewed by many hospitals as lacking the skills required to deliver quality services. Second, competitors can often easily replicate the quality of the programs that the supplier offers. Third, many hospitals justifiably question the objectivity of advice coming from suppliers. And fourth, hospitals realize that these programs cost money to develop and do not want the expense passed on to them.
Given these reservations on the part of hospitals and hospital systems, suppliers should first consider the alternate strategy of investing in innovation and outcomes data to strengthen the value inherent in their products before trying to enhance their value through added services.
A Threat and an Opportunity
Despite being a relatively familiar notion, standardization efforts have in fact only just begun in earnest. For hospitals, the opportunities in standardization are large but will require major changes, particularly in the skills required by materials managers, who will play an ever larger role in standardization as the influence of GPOs wanes.
For suppliers, standardization represents both a threat and an opportunity. Although 1995 was a record year for medical product supplier profitability, it will be increasingly difficult to maintain these historically high levels. On a risk adjusted basis, supplier profitability has outstripped (for profit) hospital profitability for 14 of the last 17 years. This trend will not be as easy to continue going forward. The good news is that all change creates a potential opportunity for those who anticipate the new environment and who respond appropriately. Successful suppliers will be those who are able to bring their cost structures into line with the changing realities of the health care industry, who can create innovative products backed by solid outcomes data, and who can become true partners in their customers’ success. These players will seize market share and will continue to thrive. Less responsive competitors will continue to play by the old rules, will fight the hospitals in their attempts to standardize, and will inevitably experience eroding profitability and market share.
John Pederson is a senior engagement manager in McKinsey & Co’s Boston office.