Hospitals can cut materials costs by managing supply pipeline

Healthcare Financial Management, April, 1989 by Robert J. Berling, John T. Geppi

Hospitals can cut materials costs by managing supply pipeline

As payment pressures have increased, hospitals have become better consumers of medical supplies by focusing on product purchase price, high quality, and volume discounts.

Although much effort has gone into lowering per-unit costs, attention to an entirely separate component of materials management--the cost and effort associated with moving supplies from the factory floor to point of use--has been largely restricted to theoretical discussion rather than practical implementation.

Hospital materials management costs (defined here as the purchase price plus all the costs associated with ordering, moving, storing, and paying for the material) account for as much as one-third of all hospital expenditures, making it the second largest portion of the hospital budget behind salaries and wages. Because a substantial portion of that amount covers all of the elements other than the unit price, hospitals have begun to consider more than simply price.

THE SUPPLY PIPELINE

Financial managers should step back from the limited perspective of their single institution and observe the entire materials distribution system. From the new vantage point, relationships between the players in the distribution chain become apparent, and the financial effect of moving supplies from the factory floor to the point of use can be analyzed.

The supply pipeline in the healthcare industry is designed to move products from the factory to the patient. Pipeline members include the manufacturer, the distributor, and the hospital. Each faces its own cost and pricing considerations (see Exhibit 1), but each member affects the total cost of distribution within the system through its accumulation of inventory, transportation, handling, and transaction costs.

For instance, a hospital that significantly reduces its inventory--and associated storage and carrying costs--requires more frequent deliveries from vendors. This increases the vendors' transportation costs. Hospitals are often unaware of the effect their decisions have on the system as a whole, just as manufacturers and distributors are unaware of their particular influence on system-wide costs.

Supply pipeline costs include the manufacturer's cost to produce (product price) and logistics costs. Logistics is defined as all of the cost-generating activities needed to move supplies from their source to their point of use. Logistics costs include transportation, inventory storage, administration, handling, financing, transaction costs, personnel, space, equipment, and opportunity costs (spending money that otherwise could be used in revenue producing areas).

Historically, each link in the supply pipeline has been managed separately. This duplicates effort and unnecessary costs that are ultimately borne by all three participants in the pipeline. Overlapping warehouse facilities among hospitals, distributors, and manufacturers, for example, duplicates inventories and carrying costs. Cost-generating activities also set in motion additional events that compound total system costs. For instance, every order for supplies initiates more cost-generating actions on the receiving end, such as handling, administration, and transportation. By reducing the frequency of cost-generating activities, system-wide costs fall, and capacity for new services increases.

Each member of the healthcare supply pipeline naturally focuses on its own business. The business of hospitals is patient care. From the materials manager's outlook, that translates into getting medical supplies to the patient when they are needed. Large inventories ensure that supplies will be on hand, but they also burden the hospital with needless financing, handling, and opportunity costs.

Hospitals have frequently ignored the interactions of the supply pipeline in favor of narrower strategies aimed at lowering the product purchase price, such as group purchasing, product standardization, and centralized purchasing. But a focus on per-unit price ignores the costs of materials management within the hospital and the duplication of inventories and related functions by the manufacturer, distributor, and hospital.

Cost benefits to each member of the supply pipeline peak when total system costs are reduced, which does not necessarily result from the lowest per-unit pricing. When the pipeline's focus shifts to the lowest total system costs, materials management expands into supply pipeline management.

The ultimate goal of supply pipeline management is to reallocate to the lowest cost provider the investment and effort required to move supplies through the pipeline, while maintaining high service levels. This will lower the total costs of the major distribution investments (facilities, equipment, and inventories) and activities (transportation, handling, and administration).

INVENTORY

MANAGEMENT

Two inventory management programs--"just-in-time" (JIT) and "stockless" inventory--emphasize the importance of overall system costs rather than per-unit costs. These programs take materials consumption information from the point of use and communicate it to the various points along the supply pipeline.