The Journal of Healthcare Contracting

What Price Partnership?
As distributor and IDN relationships evolve, both parties reconsider old contracting habits.

For years, IDN materials executives and distributors have talked about being partners with one another. Now, they’re starting to act like it. At last, two factors have converged to turn the talk about partnership into reality:

A growing appreciation by IDN executives of the ability of distributors to help IDNs lower their supply chain costs (over and above simply offering lower product prices or cost-plus percentages).
The growth of more sophisticated and affordable electronic information systems, which give IDNs and distributors accurate data about pricing, usage and inventory levels.

The question for those in the contracting community is this: At what price partnership? Can traditional cost-plus pricing still do the trick, or are new methods of contracting needed?

More Than Moving Products
"[IDNs] are expecting more from their distributors today," says Tim Callahan, senior vice president sales and marketing for Glen Allen, Va.-based Owens & Minor. "Because distribution is such an important part of their supply chain, we’re being asked to go deeper into the hospital, integrating into their systems."

"It’s rare that you find someone looking just for a distribution company today," adds E.V. Clarke, president of McKesson Medical-Surgical’s acute care division. "Now, they’re looking for a supply chain organization.

"It’s not just ‘Lower my cost-plus,’ but rather, ‘Show me how you can help me drive out costs in the physical movement of products and order management, and how I can reduce my cost of goods.’" Continues Clarke, "Customers want to go after the entire supply chain - eliminate touch points, establish a seamless flow of information. They want decision support capabilities and advanced logistics, such as a third-party-logistics model. There’s a whole host of new services they want to look at, ranging from item file cleanup to contract management. In addition, they are requesting outsourcing services as well."

Of course, making generalizations is a tricky business. The recently released "Distributor of the Future" report, published by the Health Industry Distribution Association Educational Foundation, paints a picture of an industry in transition. While some customers remained focused on product price and cost-plus percentages, others want and expect their distributors to bring far more to the table, including help with product selection, standardization and even usage.

Still, IDNs’ expectations of their distributors have changed over the past five to 10 years, says Callahan. "Look at Owens & Minor. We’re involved in process improvement, information management, integrating our [information] systems to those of our customers. It all speaks to the growing sophistication of IDNs."

Executive Suite Involved
That sophistication is reflected in the fact that CEOs, COOs and CFOs are extremely engaged in the supply chain, say those who spoke with JHC.

"It is the CFO’s decision as to whom will be supplying the IDN," says Gary Skura, vice president member services for National Distribution & Contracting Inc., in Nashville, Tenn. "It’s not simply a purchasing decision. It’s a cost-savings evolution.

"I’m convinced more than ever that for every dollar spent on product, another dollar is spent on moving it around in the organization. And I think IDNs are seeing that."

"I think the supply chain has moved well into the vision of the executive office," adds Callahan. "Hospitals are looking for opportunities to save money through process improvement, and they’re spending a significant amount of money on new technologies and information systems."

Owens & Minor has responded with a variety of offerings over and above products and simple distribution services, including its CostTrackSM activity-based management program; WISDOMSM, its Web-based inventory management analytical service; SurgiTrackSM OR inventory management program; and its OM SolutionsSM consulting group.

In some cases, such as the company’s recently signed agreement with the University of Utah, Owens & Minor is developing a consolidated service center, which will handle not only traditional distribution services for the IDN, but also products shipped directly from manufacturers.

Nor is Owens & Minor the only distributor that has created a portfolio of services to address broad supply-chain cost-reduction opportunities. McKesson, Cardinal and other distributors offer information technology and consulting solutions for their customers as well.

If there is a common denominator among today’s distributors, it is their focus on information systems, without which those broad cost-reduction opportunities could not be addressed. And that’s relatively new.

For example, says Clarke, 10 years ago, when stockless purchasing was the industry buzzword, hospitals and distributors lacked the caliber of information systems they have today. As a result, the physical movement of goods was more important than the flow of information.

Adds Callahan, "How can you take cost out of the system if you’re not able to manage the flow of the product tied to it?" Without information systems, which track product usage to the point of use, you can’t.

Cost-Plus Not a Plus
If it’s true that IDNs are demanding more from their distributors, the question for both is, What’s the price of partnership? How much are IDNs willing to pay their distributors for help in reducing supply chain costs?

Cost-plus continues to be a popular basis for contracting. But detractors argue that it is far from ideal, because it hides the true costs associated with various distribution activities, and because it incentivizes the distributor to sell higher-priced products to their customers.

Cost-plus negotiations have led to distributor margins that are not sustainable in the long run, says the HIDA report. "This leads distributors to conduct more ‘selling’ activity to make up for margin shortfalls that degrade contract compliance for the hospital….This disconnect could undermine the relationship between the distributor and their customers."

What’s more, the report says that the industry’s reliance on cost-plus is "hamstringing its ability to get to the next level of efficiency and value. Cost-plus allows hospitals to place all their costs in a very large bucket and hope it all averages out in the end. It does not require knowledge of costs, data collection or alignment between clinical and purchasing staffs."

That said, cost-plus will probably continue to be the preferred method of pricing "for those customers focused on pricing instead of the costs associated with product procurement or utilization," says the HIDA report. In addition, it provides a relatively easy way for IDNs to compare competing proposals for services.

What’s more, risk-sharing agreements, in which the distributor and IDN share in cost-savings but split cost overruns, constitute - by their very nature - a risk for both. That’s something that few customers are willing to take, notes Skura.

Even so, Owens & Minor reports a trend away from cost-plus pricing among its customers. In fact, 34 percent of the company’s business is based on activity-based costing, in which it assigns charges for individual services, such as more frequent deliveries.

Multiple Classes of Trade
As IDNs integrate both acute care and non-acute care centers into their purchasing and materials systems, they face another set of pricing problems: First, do they contract with just one distributor for both classes of trade? Second, do they pay the same price for the products and services to both? And if they do, will that price be folded into a uniform or blended cost-plus arrangement for all of the IDN’s facilities?

The fact is, traditional acute-care distributors, such as Owens & Minor, are being asked to provide distribution services to the non-acute care facilities of the IDNs with whom they contract, says Callahan. But today’s IDN materials managers recognize that distributors incur higher costs servicing smaller, non-acute care facilities than large acute care centers, and that they must charge accordingly, says Callahan.

What’s more, IDNs recognize that their distributors must at times differentiate between the costs of servicing individual acute care facilities, even when they belong to the same IDN. Callahan cites an example of one IDN customer for whom Owens & Minor provides low-unit-of-measure service to one hospital (which lacks sufficient warehouse space), but traditional bulk distribution to another.

One part of the equation that can’t be ignored is the manufacturing community, which remains reluctant to extend acute care pricing to non-acute care providers. In this case, "non-acute care" refers not merely to physicians’ offices and clinics, but to long-term care facilities as well.

Steve Skoronski, president of Associated Medical Products in Indianapolis, Ind., notes that group purchasing organizations are attempting to make inroads into the extended care market, including nursing homes, subacute care facilities, and even home care. Associated serves more than 1,100 non-acute care customers throughout the country. However, GPOs’ success in doing so has been limited by their inability to extract from manufacturers what Skoronski calls the "hyper aggressive" pricing that one sees in the acute care side of the business.

"It’s logical," he says. "[Manufacturers] are moving product at or near cost in acute care, so they’re protecting margin in their extended care or alternate care businesses." Even so, nursing home chains are more aggressive than ever in attempting to hold down product costs, despite the fact that medical-surgical supplies constitute only about 3 percent of their revenues.

The Sales Representative
Integral to the discussion about the changing relationship between IDNs and their distributors is that surrounding the role of - and compensation for - the distributor representative.

As the relationship between distributors and IDNs evolve, so too does the role of the representative. As a result, he or she may have to be compensated in new ways.

"It’s up to the distributor’s management team to sell the [IDN’s] CFO, CEO and materials manager on whether [the distributor] can service the IDN or not," says Skura. "The sales rep is very instrumental in getting the appointment, but it’s up to management to close the deal."

Once the agreement has been signed, it’s important that the field rep have a "go-to" person in management to whom he or she can direct questions, he adds.

Within the IDN, today’s distributor sales rep often assumes a consultative role, says Skura, particularly if the deal involves some kind of cost-sharing or risk-sharing provisions. The rep may be called on to help the IDN standardize on certain products. "If they’re married to their primary GPO, then standardization is easier," he says. "But if they’re not, they will look for more consultative work from the rep to assist them in picking more aggressively priced products."

Just like their acute care counterparts, distributors serving nursing home chains are being asked to help their customers standardize products, says Skoronski. Naturally, the benefits flow both ways: Not only does the customer recognize savings, but the distributor does too, in the form of fewer SKUs to inventory, ship and bill for.

Long-term care distributors such as Associated traditionally have limited influence in the two biggest product areas purchased by their customers - incontinence products (briefs and underpads) and enteral feeding products. "Those are judgments that facilities make on their own," says Skoronski. However, Associated has been able to help customers standardize on a variety of other products, including advanced wound care products, and needles and syringes.

Selling in a cost-plus environment is very different than managing a relationship in a fee- for-service environment, says the HIDA report. "If a customer has both a strong focus on cost reduction and influence on clinical preference, then it is potentially a highly profitable, sophisticated customer with tremendous long-term value to the distributor. The right type of sales reps must be aligned with these types of accounts to mine the opportunity. They must be compensated appropriately for their role with the customer."

Rather than pushing products, the distributor rep may play a greater role identifying alternate sources of value for the customer, suggests the report. It’s a big change.

"The skill sets required in today’s environment are very different than those required five to 10 years ago," says Clarke. "Just five years ago, the [sales rep’s job] called for problem-solving skill sets and product knowledge. Now, they are required to have a broader understanding of the financial drivers of a [provider] organization, particularly materials management. And they have to be versed on how we as a company can address them.

"They need knowledge of the physical supply chain and what we can do to improve it. And they need to find clear metrics for their customers - for example, understanding supply expenses as a percent of patient revenues - and how our relationship contributes to that."

Last year, Owens & Minor launched Owens & Minor University in part to help train its people on how to sell in this new environment.

"The distributor is more a partner of the IDN than ever before," says Callahan. "That point person, the field representative, becomes a critical piece for that. They need to know who and when to bring in people with expertise - product knowledge, systems expertise. Their historical role - dealing with customer service issues and product issues - is changing, just as the market has changed."

Distributors and GPOs: A delicate Balance
Even before the days of the VHA Supply Co. in the mid-1980s - when VHA (now Novation) set up a system of regional distribution agents, or RDAs, to distribute contract items to VHA members - GPOs and distributors have been working hard to figure out how to be good supply chain neighbors.

Here’s the rub: Unlike medical products, the quality of distribution services depends largely on the people delivering them - sales reps, customer service reps, warehouse people, drivers, etc. Service levels can vary from one region of the country to another. It’s not like contracting for products. After all, a box of needles and syringes in Alabama is pretty much the same as one in Massachusetts.

What’s more, the relationship that a provider forms with its distributor (be it the local branch of a national company or a local/regional distributor) is highly personal. Trying to disrupt that relationship with a national contract tends to get people upset.

That’s why GPOs approach the matter delicately. Most feel they have a role to play in helping their members secure cost-effective, high-quality distribution services. Yet they understand that there are limits to what a national GPO can do.

Better Left to the Customer "Our philosophy from Day 1 has been that distribution decisions are better left in the hands of the individual customer," says Bud Bowen, president of St. Louis-based Amerinet. "It’s a very local or regional decision. A national GPO has no business establishing a single source of distribution for any product nationwide."

That’s not to say that Amerinet shies away from signing distribution agreements for its customers. On the contrary, it has many such agreements in place. In fact, sometimes the GPO signs contracts with more than one distributor - for example, a national distributor and local company - in a given geographic area.

"We will do committed contracts with distributors when a group of our members gets together and asks us to do that for them," says Bowen. "But more often than not, Hospital A in the area likes Distributor 1, but Hospital B likes Distributor 2."

"[Distribution contracts] provide our members a safety net," says Bowen. That applies to pricing as well as quality of service. "We expect our distributors to provide a high level of service to our members," he says. "If a member calls us and says, ‘I’m having trouble with the distributor,’ then we hold the distributor accountable for that."

A Different Approach Dallas-based Broadlane takes a different approach. The company has a national agreement - effective through December 2006 - with Owens & Minor in Glen Allen, Va. "We feel that the national contract meets local and regional needs," says Hank Ffrench, director of medical-surgical contracting.

It’s true that Broadlane has local distribution contracts in place, primarily to help its customers meet prior commitments, he says. In addition, the GPO signs regional contracts for its non-acute care members.

"I don’t disagree that sometimes there are local terms and conditions that people have with a distributor in a specific area," says Ffrench. National agreements simply can’t cover every value-added or extra service that individual hospitals want.

"But basically, a distribution agreement is a distribution agreement," he says. In other words, Broadlane feels comfortable signing a blanket agreement for delivery of goods to its members, but leaving the negotiation of value-added services up to individual facilities.

Contracting aside, Broadlane is particularly active managing the flow of information between distributors, members and itself. "There’s no doubt this has been a link in the chain that’s been broken for a long time," says Ffrench. "And it’s very difficult to fix, because there are so many spokes in the wheel."

For example, if a new contract has been signed or a price change put into effect, that information must flow to the distributors, GPO and individual members as quickly as possible, lest all sorts of accounts payable problems develop. And if that information isn’t communicated in a timely fashion, distributors stand to lose some of the rebates to which they’re entitled.

"We try to minimize price changes, of course," says Dan DeTorrice, vice president of business information services. "But when they happen, we make sure everyone is properly notified."

Broadlane has made strides in solving another headache - that is, making sure that distributors know which of their customers do indeed belong to Broadlane and hence, are entitled to that organization’s contract prices. That information is available to vendors on the Web.

"We’ve really moved to a more dynamic way of doing things," says DeTorrice. "We set up eligibility on a contract-by-contract, facility-by-facility basis. We have a dynamic list, the idea being to make it easy for our business partners to identify which facilities have access to which contracts."