OMGT 6213

Case 1:

Supply Chain Partners: Virginia Mason and Owens & Minor

Group 3:

Peter Balent

Joseph Kissinger

Paige Norris

Michael Snetzko

Section 1: An Overview of Cost-Plus Pricing

Cost-plus pricing is when a margin of the cost is added to the fixed price of a product.

When using a cost-plus pricing strategy the margin added to the price is typically negotiated and

determined prior to signing a contract. Contracts typically last anywhere from one to three years.

Hospitals have an incentive to use distributors with this pricing model because they can negotiate

a relatively low mark-up percentage if they have a good relationship. Distributors have an

incentive to use this pricing strategy because it allows for products to have a guaranteed profit

margin instead of negotiating per order. Cost-plus can be appealing to distributors and hospitals

due to its very little use of additional market research or additional resources. The additional

resources and research are not needed since the cost of creating a product is something

distributors and manufacturers are aware of and have readily available.

        While cost-plus pricing is simple and easy to use it does have some flaws. First, in

Virginia Mason’s case, cost-plus pricing allowed for costs to be generalized. For example, a

cost-plus invoice for VM consisted just of product purchases and no breakdown of costs

associated with that purchase. Second, cost-plus pricing creates little incentive for

manufacturers/distributors to cut costs since they have the guarantee of a target rate of return.

Manufacturers/distributors may have no reason to cut cost and become a cost-efficient company

if costs are what drives their profit. So while the hospital is concerned with cost-efficiency, the

distributors aren’t concerned with efficiency at all. The misalignment of goals between the

hospitals and the distributors can lead to higher costs for both parties involved. For example,

distributors who have innovative pricing strategies are capable of lowering prices and cutting

cost which results in more sales and higher customer satisfaction. A distributor who is committed

to cost-plus pricing strategies cannot compete in a constantly changing pricing environment like

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a distributor with an innovative pricing strategy can. This will lead the distributor using a cost-

plus approach to have higher costs and less sales over time (leading to less profit and potential

loss of customers). On the other side of that example are hospitals like Virginia Mason who

focus on being as lean as possible. Choosing a distributor who prices with a cost-plus strategy

would not allow Virginia Mason to be as lean as they possibly could be. This leads to extra costs

for the hospital and essentially for the patients.

        In the supply chain, distributors can provide some value-adding services to the hospitals

that they have contracts with. Consulting, outsourcing, computer systems, software sales, and

inventory management are some of the options that hospitals can evaluate and choose from prior

to signing a contract. These services are a way for distributors to take some of the work off of the

hospital’s hands as far as inventory and products go. Since these distributors charge for these

services it was also a way for them to make more money off of the hospitals and raise their

revenue.  

Section 2: An Overview of Total Supply Chain Cost (TSCC)

        TSCC grew out of the CostTrack program developed by O&M, the difference was that

TSCC is completely supply chain efficiency driven.  It was designed as an activity-based pricing

model that was tied to specific products supplied in the medical field, rather than a quantity and

line cost that other vendors and customers were used to.  It provided both O&M and VM with

operational efficiencies, supply chain understanding, and the ability to compare vendors when

selecting specific products.

As part of operational efficiencies, TSCC was first implemented at O&M in June 2006 as

a test platform to determine where costs were coming from for the items VM purchased.

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Immediately on each order, O&M could see the breakdown of costs related to SKU cost (which

included items like inventory costs, warehousing costs, picking costs, and IT), and delivery costs

among others.  TSCC was eye opening for everyone involved and showed where significant cost

savings and additional efficiency could be derived from.  In the case of VM and O&M in an

alpha vendor model, VM would purchase a limited number of SKUs from O&M, and in return,

receive the best price because the carrying cost was tied to the particular client.  The amount of

volume purchased of a particular item over a period of time, dictated how much of the fee a

particular customer paid.  TSCC was also developed for driving the limitation of SKUs that

O&M had to carry because when only one customer required a particular SKU, all of the costs

would be associated with that customer and the price was significantly higher.  TSCC promoted

economies of scale while showing VM that purchasing the same SKUs that others were, would

reduce their costs for those products.  TSCC also led to an operational efficiency in how the

orders were placed, pulled from inventory, and shipped. O&M placed an employee on-site at

VM who eliminated discrepancies and made sure the orders were sent to O&M without issue.  In

doing this, he streamlined the ordering process so the warehouse could pick the product quickly.

As part of the supply chain improvement, after the order was placed and picked, it was

double-checked by an on-site member of VM’s team at the distribution center.  This added

reliance that the right product was being sent to the correct location and the customer was getting

exactly what they expected.  This step improved accuracy rates and reduced defects, which drove

efficiency in the program.  Additionally VM moved their method of ordering from each item to

boxes of items which reduced the number of purchase orders, lines per order, and made picking

inventory faster.

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In addition to driving operational efficiency, it also allowed customers to do supplier

comparisons between vendors.  A particular product could be disseminated into the various

carrying components based on quantity and frequency of order to compare between vendors.  In

the case of Virginia Mason, this process was used to compare the purchase of sutures for the

hospital.  In this case, it was one of the most expensive products carried by O&M.  Even though

the cost-plus pricing from the other vendor was lower than O&M, based on the alpha vendor

model and the fact that VM shared in the cost of O&M carrying the product, along with the

quantity discounts, TSCC was able to show that O&M was still in fact cheaper than the

competitor when looking at the bigger picture and taking into account the efficiencies in the

supply chain.

TSCC changes the behavior of Owens and Minor as well as Virginia Mason by making

efficiency of the supply chain the driver to cost savings for both companies.  O&M saw their

fulfillment accuracy increase and warehouse picking time decrease through TSCC, and VM got a

single alpha vendor to use for all of their medical supply ordering.  By providing the detail that

TSCC shows, both vendors and customers can reasonably make the best decisions for their

supply chains and bottom line.  Additionally, TSCC helped O&M get better control over the

number of SKUs they stocked and how much of a particular item they stocked since cost would

be tied to particular customers as well as turnover of that item.  TSCC reduced the number of

defects leaving O&M’s facilities and increased accuracy of orders being shipped.  Placing staff

from both companies in the warehouse and purchasing departments prevented errors before they

could inconvenience either company.

For both companies there were significant improvements.  For VM, it meant keeping

track of their ordering and the costs of those orders, since they would be tied directly to the

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products VM and the other customers purchased by the SKU.  TSCC also provided a better

breakdown on paper of where the particular costs were hiding.  Where prior in the CostTrack or

cost-plus models, there was no insight into why a product cost what it did.  For O&M, it allowed

them to make more profit by eliminating excess stock and reduce the number of SKUs in

inventory.  By limiting SKUs, O&M could reduce the size of the warehouses, and improve

delivery efficiency when picking orders and shipping them.

Section 3: What it Means to be Lean & the Virginia Mason Production System (VMPS)

Lean is the outcome of systematic processes that companies use to eliminate waste such

as redundancy, defects or errors, and the unnecessary uses of resources in order to improve their

financial status while delivering a better product or service. Ultimately becoming lean will make

a company more efficient which leads to an increase in the value of the organization’s product or

service. Companies that want to become lean are always looking for improvement on a day to

day basis in order to gain a competitive advantage and we see numerous examples of VM and

O&M becoming lean throughout this case.

In terms of distribution O&M realized they had to learn new efficient processes that

would allow them to maintain profitability in a highly competitive low margin business. On the

provider side, VM was already a company that was practicing a lean model while using a

modified version of the Toyota Production System, so they had to find the right distribution

partner that would work with them in perfecting and integrating their supply chain. As a lean

company VM was already working towards communication with their distributors about

decreasing defects which fit right into what O&M was looking to do. O&M had realized that of

the money they spent on distribution and purchasing functions, 7.4% of that money was rework

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money. O&M offered expertise in lowering costs for providers through “services designed to

streamline the supply chain” and their inventory management expertise included just-in-time

services which is exactly what VM practiced on a daily basis. However, they found out early on

in the process that their JIT model was not exactly working as well as they liked with VM. But

with any lean practicing company they were willing to analyze the process and come up with

solutions that were more efficient.

Together they became lean through what they call an alpha vendor program. An alpha

vendor program consisted of creating exclusive relationships with a few key vendors that would

act as partners in the supply chain which would offer the best prices on goods and services.

O&M identified high cost drivers such as stock keeping units (SKUs) on hand and supplier

inefficiency. With their partnership they were able to decrease the amount of SKUs and through

an evaluation process identified the most efficient suppliers which they encouraged VM to use.

Other areas where the supply chain process became lean included automating the process of

manual “line forcing” which moved inventory reserve to back-ordered lines, and placing totes on

the truck and the dock in the order that they were scheduled for delivery by the VM employee.

All of these changes together were able to improve efficiency, reduce rework and decrease

defects. That is the definition of a lean organization.

The Virginia Mason Production System (VMPS), as stated earlier, was a modified

version of the Toyota Production system that VM began implementing in 2002. Their overall

focus was on line-level employee work groups that were always working towards a zero defect

rate, which is the ultimate goal of Toyota’s production system. Within their production system

VM takes a specific and well defined process and starts its value-stream mapping by creating a

flowchart of everything that goes into that process. The key to this is that you can visually see

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where each piece connects to another in the process and begin to see where your redundancy

may be occurring and what steps may not be needed.  After the mapping is completed VM brings

in their work teams to do a five-day rapid process improvement workshop (RPIW) that finds

ways to eliminate the waste and improve the efficiency of that process. The work teams are

usually not comprised of your high level management, but more of your front line employees as

they carry out the process each and every day so they have more knowledge of what actually is

going on. In addition to this there is a lean culture that existed within the VMPS in which an

“everyday lean idea” concept was practiced by all employees. Employees were encouraged to

always look for ways to reduce wastes and add value in their jobs and all employees were trained

and educated on VMPS, which established a commitment to continuous quality improvement

very early on in an employee’s tenure at VM. As time went on the VMPS infrastructure was

expanded in 2005 to include the kaizen promotion office which led RPIWs and lean initiatives in

corporate, hospital and clinic environments.

By 2007 VM was able to launch an amazing 116 RPIWs. To put that in perspective they

spent 580 workdays at 8 hours per day working on improving their processes within their

hospital. That comes out to 4640 hours and if there was an average of 8 employees in each RPIW

then that was 37,120 hours that VM paid their employees in 2007 to improve their organization.

Even though that is a huge amount of resources that VM put towards their VMPS, it was

resources well spent as their length of stay went down, wait times to have a surgery and to see a

physician decreased, and financially their patient care net revenue, operating income and profit

margin all grew substantially from the year before. If there is one word to describe the VMPS it

would be successful.

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VMPS required that there be a tremendous amount of interaction between the two

companies and that the responsibility of the supply chain be shared. With this model there was

constant communication in which they were always talking about eliminating defects and

reducing costs. It had to be that way due to the VMPS being based on a lean methodology.

VMPS also required a tremendous amount of resources and investment in the future, which other

companies were not willing to commit to. Also, an employee of O&M was expected to be on site

at VM to work through any problems that occurred.

Another requirement that the VMPS imposed on this partnership was the least unit of

measure (LUM)/JIT model that VM used in their ordering system. VM keeps a low inventory

due to their lean methodology so they wanted zero defects and little to no backorders. All of this

was a struggle early on because the Seattle distribution center of O&M was not set up to handle

LUM/JIT customers. They were about to have their lease come up at their distribution center and

it did not make sense to put in all the resources to the building at that point.  A final requirement

was the use of Global Healthcare Exchange (GHX), a company that processes orders from

providers to distributors to manufacturers. Overall, collaboration and communication were

requirements in order to drive this partnership and make it successful for each company. Both

companies had to be willing to work together to benefit both of them.

Section 4: Proposed Changes to the TSCC Program

The basis for the creation of the Total Supply Chain Costs activity-based pricing method

was to reduce rework and inefficiencies in Virginia Mason and Owens & Minor’s supply

relationship. To ensure a healthy working relationship, VM and O&M tried their best to make

sure neither party was harmed in the TSCC contract. If something was found to be harmful to

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one party, the two firms would work together to correct the TSCC model. After nearly a year,

VM and O&M finally had a TSCC model and contract that they felt would work.

Although the firms spent a significant amount of time working out a contract and trying

to find the most effective TSCC model, there were still inefficiencies in the supply chain. One of

the first issues to arise was in the Seattle Distribution Center. VM and O&M failed to consider

the capabilities of the distribution center in their supply chain model and it reflected

immediately. Sally Stewart, the O&M DC warehouse teammate in charge of the VM

replenishment, recalled the first few months working with VM as chaos. Specifically, she said

she would never forget the first night they filled the VM order.

The problem at the Seattle DC was a lack of communication and integration between VM

and O&M before implementation. O&M did not have any JIT people available in the warehouse

when VM came online, which created a challenge or, as Sally Stewart put it, a “nightmare”. The

warehouse didn’t receive the list of items from VM until two weeks before they went online and

had no knowledge of which items were “high velocity” or of any par levels. The first night it

took the Seattle DC, plus some help from people who worked at the Portland DC, three hours

just to get enough items into the JIT area of the warehouse before orders could even begin to be

picked.

It was apparent after the first night that it was going to be difficult to integrate a fully lean

company with a non-lean company. VM used the lowest unit of measure, “each”, which was

something new to the DC staff that found itself counting each product requested by VM and

placing them in specific boxes so they wouldn’t get lost. Since VM was only ordering what they

needed and O&M was limited in space, it was a difficult situation. The nurses needed to trust

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that the products would be there on time, and the DC staff had to make sure the products made it

to the right location when they needed it without any errors.

Another problem arose out of the inventory management at VM. Because of the lack of

integration in VM, O&M, and GHX’s databases, there were often discrepancies in orders that

needed to be worked out before the order was released. One source of discrepancy came from

backorders. To rectify the backorders, O&M filled orders with products from their reserve

inventory. Because the reserve inventory did not show up in GHX’s Client Server Warehouse,

O&M had to “force” the purchase orders manually so they could be picked. This process created

redundancies and strayed from the objective of eliminating rework. To better the situation, each

of the firms involved need to integrate their databases to make each other aware of their

respective levels of inventory. To do this, there would need to be an agreement on pricing

measures, units of measure, and SKU numbers as they were currently major sources of

discrepancies.

Because there was a lack of integration along the supply chain there were discrepancies

every day and backorders were not effectively eliminated, which stemmed heavily from a lack of

trust and open communication. Some days VM would order cases of gloves and others they

would order boxes of gloves, which caused redundancies as O&M would have to call VM to

correctly identify which measurement they intended to use. Lack of communication was also a

major cause of backorders, as there were occasions when VM would have a spike or unexpected

usage of products that caused for O&M’s staff to worry and feel the need to carry more safety

stock. However, increasing safety stock would be costly and go against the principles of low unit

of measure and lean inventory.

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Here arose another problem, as nurses did not trust O&M because they did not deliver

products on the weekend. This caused nurses to hoard items and call for emergency rush orders

which were costly to both parties. To get the emergency orders from the DC to VM, O&M used

cabs that charged high fares for the unnecessarily rushed orders. This caused the supply

relationship to lose balance as O&M’s profitability was now being negatively impacted as they

tried to meet the needs of VM who was trying to meet and exceed the needs of their customers.

Finally, an issue arose when VM was offered sutures at the lowest cost-plus fee they had

ever seen from a specialty distributor. Under the TSCC, O&M was still the low-cost provider,

but on paper it seemed like a no-brainer to switch to the specialty distributor. This caused a

problem as VM’s goal was to push as much product through O&M as possible. The advantage of

switching distributors was the low cost-plus fee offered to VM. The disadvantage was that

without the proper mix of products in a cost-plus system, there was potential for VM to become

unprofitable. Thus, it seemed that the only viable way for VM to switch to the specialty

distributor would be if they also chose to purchase additional products from the same company.

If VM chose to make this switch, O&M would lose money on the alpha program and therefore

be forced to increase their cost-plus percentage to offset expenses. Because the costs are passed

on to the customer in TSCC, and the cost savings are an annuity, we believe it would be best to

stick with the TSCC model and to continue to build on the progress VM and O&M had made

over the last year. Even though it is simpler to go with a cost-plus contract, there were real cost

savings that the TSCC model identified and attempted to mitigate. Though the cost-plus model

looked better on paper, VM would lose control of their costs and be forced to negotiate for lower

costs rather than attempt to improve processes and the supply chain as a whole to reduce

inefficiencies, redundancies, and ultimately costs.

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To improve the TSCC model, VM and O&M need to achieve better collaboration. To do

this, each company would have to be willing to share their inventory data with each other, as

well as GHX. With more open communication, each company would be able to better anticipate

the needs of each other and be prepared for any problems that are sure to arise. If O&M knows it

won’t be receiving a certain product because of say, manufacturing issues, they need to let VM

know ahead of time so that they could work together to find another supplier. On the other hand,

VM needs to better communicate its expected usage of products and more carefully place orders

using a consistent unit of measure. This is where GHX comes in, as they are the universal plug

that would provide data as to current prices at other suppliers. Also, GHX could be seen as a

neutral partner whose objective could be to monitor the effectiveness of the current supply chain

and act as a scorekeeper, keeping both VM and O&M in check.

In order for the TSCC model to provide the highest results, VM, O&M and GHX need to

eliminate boundaries and create open communications to build trust that will therefore reduce

inefficiencies and costs in the long run.  

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