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Owens & Minor, Inc A Case Solution
Owens and Minor (O&M) was the nation’s largest distributor of medical and surgical supplies. The firm had 49 distribution centers nationwide. It warehoused and delivered over 300,000 products a year from suppliers to the hospitals. It was critical for O&M’s survival to secure and maintain profitable customers. However, with the increasing customer demand there is also an increasing pressure to reduce distribution fee. In 1996, Jose Valedera was the divisional vice president. In order to secure a deal with Ideal Health system, a not-for-profit hospital chain, he recommended a shift from cost-plus pricing to Activity based pricing (ABP). The analysis of this suggestion shows that as ABP was more transparent to the customers, the new costing and pricing should be adopted.
Following questions are answered in this case study solution:
What are the services rendered by the distributor to manufacturers and hospitals?
Evaluate the impact of cost-plus pricing has on distributors, customers and suppliers.
What effect will ABP have on customer behavior?
Explain Exhibit 5. How does price matrix work?
What are the obstacles to the successful implementation of ABP at Ideal? How would you address these obstacles?
What type of customers will adopt ABP first?
How difficult or easy is it for O&M’s rivals to adopt ABP?
Owens Minor Inc A Case Analysis
1. What are the services rendered by the distributor to manufacturers and hospitals?
Usually, the manufacturers prefer to sale large quantities of products to the customers. However, the customers cannot manage high inventory and supplier contracts. The distributors buy the products from the manufacturers in bulk, break the bulk and deliver to customers as per their requirements.
i. How has the nature of distribution changed over time?
O&M buy in bulk from several manufacturers or suppliers and distributed them to different customers based on individual orders. O&M main customers were the customers who had a contract with O&M for the delivery of medical supplies. The customers for O&M were the hospitals, healthcare systems and federal government.
At first these hospitals used to buy in bulk and maintained inventories. However, over the years, in order to reduce the cost the hospitals started to order smaller quantities but more frequently. These hospitals became the just-in-time (JIT) customers. This way they shifted the inventory maintenance and warehousing cost to the distributors. They also facilitated the customers by providing material management and usage information support.
Distributors also provided its customers the end-user kits. Hence, O&M went retail after years of wholesaling.
ii. What is the value added by O&M?
O&M created value by maintaining relations with suppliers and customers. They bought in bulk from the suppliers and delivered the goods to customers based on individual orders. Buying in bulk facilitated in securing discounts on the purchase. The purchases were than stored by O&M as inventory. The storage costs were all borne by the firm. The bulk purchase was broken down and delivered to different customers as per their orders. The delivery cost was also borne by the distributor.
Additionally, O&M also tracked and verified prices of contract purchases for the customers. It also monitored the agreements between the manufacturers and the end users. The database maintained by O&M was very valuable for manufacturers and customers. O&M also provided customers with credit of up to 90 days.
2. Evaluate the impact of cost-plus pricing has on distributors, customers and suppliers.
Under the cost-plus pricing, the price was based on the product cost. A markup was charged on the product cost to come up with a price. For a customer, the cost-plus pricing could lead to an overconsumption problem, when customers are not charged for the services they utilize. In other words, the customers would demand enhanced services from distributors for the same price.
Another problem with cost-plus pricing is that it causes a behavioral distortion. This is because as the pricing of distribution are based on costs the customers can purchase the most expensive products from the suppliers, directly. Manufacturers will also prefer this if they get a higher price than that from the distributor. This would cause the problem with the supply chain and cause major problems for the distributors.
As a supplier, the cost-plus pricing would be highly profitable as the distributors will not negotiate the price of the products much. Conversely, cost-plus pricing would be disastrous for the distributor. This is because the markup of the cost price does not cover all the delivery and storage expenses. Furthermore, they are unable to negotiate with the suppliers or charge extra to customers for increased service.
3. What effect will ABP have on customer behavior?
Unlike cost-plus pricing, in ABP, the price would be based on the activities and their costs. The ABP alleviates the problem of overconsumption of services by internalizing the costs of the service demanded in the price.
Furthermore, in the medical supply industry, it was a norm to use cost-plus pricing. Therefore, the customers, who are unable to get more services from the competitors offering cost-plus pricing, would most probably shift to O&M as their distributor. Similarly, those customers who prefer minimum services would also shift to O&M as they will get better prices from O&M than from other distributors.
Once O&M start using ABP, the customers will have an incentive to improve the efficiency of their operations. If the customers do try and improve, this move to ABP will help optimize their costs and service level.
4. Explain Exhibit 5. How does price matrix work?
The price matrix in Exhibit 5 is related to two cost drivers. These are number of line orders per month and number of purchase order per month. These cost drivers determine the activity fee level charged to each customer.
i. How does the cost in Exhibit 5 correspond to the costs shown in the customer profitability statement in Exhibit 4?
The horizontal axis shows the number of lines ordered per month. This shows the size of the order, and it is the cost drivers for the variable costs. Hence, the higher the number of lines orders per month, the higher are the variable costs. Moreover, the number of lines is the total line cost in Exhibit 4.
The vertical axis shows the number of purchase orders per months. This shows the frequency of the orders. This is the cost driver for the fixed administrative costs. The higher frequency of purchase orders, the higher are the fixed costs. Therefore, the number of purchase orders relate to the total order cost in Exhibit 4.
ii. Why doesn’t the matrix comprise all the costs shown in Exhibit 4?
Using the price matrix, the distributors charge different prices to different customers. The price charged could only be based on two costs as more than two costs would increase the complexity of the matrix. Total line cost and the total order cost are the highest cost shown in Exhibit 4. Therefore, due to their materiality they are included in the matrix. Other costs like interest cost and shipping and handling deliveries are ignored.
5. What are the obstacles to the successful implementation of ABP at Ideal? How would you address these obstacles?
There are several obstacles to the successful implementation of ABP. The most important obstacle is that the medical supplies industry uses the cost-plus pricing. So, all the hospitals use the cost-plus pricing for all the accounting procedures like budgeting and compensations. The internal (transfer) pricing among hospital departments would also be based on cost-plus pricing. These procedures might be more complicated under ABP than under cost-plus pricing. Additionally, the electronic data input systems would also be programmed on cost-plus pricing. A change in pricing by one supplier would cause the hospitals to change their entire procedures and systems. The culture of the hospital might also prefer cost-plus pricing. Hence, only a few hospitals would be willing to change their working due to O&M. Only the hospitals who are willing to change and reduce cost would accept ABP.
In order for O&M, to keep the customers after shifting to Activity based costing and ABP, it would have to convert the ABP to a cost-plus equivalent. Similarly, O&M could engage its logistical team to work closely with customers and help them to move to ABP to optimize service levels and costs.
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