Owens & Minor

Technische Universität München

Harvard Business Case

Management Accounting

-Case Study-

© Gunther Friedl – WS 11/12

Structure of the Case Study

1. O&M: Company Profile

2. Costing and Pricing at O&M

3. The Case

4. O&M‘s Proposal

5. Solution of the Case-Questions

Case Study: Owens & Minor


Owens & Minor, Inc: Company Profile

� Headquarter: Mechanicsville, Virginia, U.S

� Revenue 2010: $ 8.12 billion

� Number of employees 2010: 4,800

� One of the leading distributors of medical and surgical supplies

� 200,000 products from about 1,200 manufacturers, e.g. gloves,

wound closure devices, sterile procedure trays, intravenous products,

operating room items, etc



Owens & Minor, Inc: Company Profile

� Core Business-Process:

� Customers: primarily hospitals, healthcare systems, group

purchasing organizations (= buying groups of hospitals) and the

federal government


Manufacturer

CustomerBulk Products Individual Order‐Delivery

Manufacturer

Manufacturer

Manufacturer

Services(Consulting, Logistics Service, etc. )


Situation: Change in Customer-Behaviour

� Initially: Service stopped at the hospital‘s loading door: pallets with high number of

units

� Now: low-unit-of-measure or stockless systems become popular at customers:

e.g. plastic totes that go directly to the nursing and surgical units, bypassing the

entire storeroom process

Increasing service-level

Questions for O&M:

� What are the costs of the service?

� How to price the service appropriately?



Activity-Based Costing at O&M (introduced at O&M in 1994)

� Several activites (= Cost Drivers) affect costs per customer and hence customer

profitability:


CostDrivers

Type ofservice

requested

Number ofpurchase

ordersgeneratedper month

Interest costs from

carryingreceivables

Method oforder (mail,

phone, electronic

data)

Number ofdeliveries per

week

Number oflines per purchase

order


Pricing at O&M

� Cost-plus pricing* was the dominant form of pricing in the medical/ surgical

distribution industry

� Customer pays a base manufacturer price plus a markup added on by the

distributor

� Cost-plus fees are individually negotiated with the customer (7% are a usual

number)

Base manufacturer price$1

Markup7%

Price of the product$ 1.07

+ =


* See lecture notes, chapter 5


Drawbacks of Cost-Plus Pricing for O&M

� Cost-plus pricing ties the fee to the value of the product rather than the value of

the service

� Customers avoid paying a high distribution fee on expensive products by buying

them directly at the manufacturer

only products requiring high order-units, high storage room or special

management systems are ordered at O&M

leaves O&M with inexpensive, low-margin products or products requiring a

high service-level



Customer Profitability Statement for

Customer Alpha Hospital



O&M‘s findings with Activity-Based Costing

� There is a wide disparity between the profits made on each customer

� Some customers (particularly those with stockless or low-unit-of-measure

programs) are unprofitable for the company

Fees on a cost-plus system are not ideal for the company



The Case

� Situation (1996): Ideal Health System (hospital chain) announces it is putting its $30

million annual medical/ surgical supply contract up for bid

� Problem:

Question for O&M:

How to outperform Atlantic Healthcare despite higher direct-costs?


Atlantic Healthcare

� current supplier� subsidiary of a medical supply manufacturer

allows them to offer distribution servicesat extremely low rates

these rates would force O&M to operate atloss

O&M

� brand-neutrality

higher flexibility than the other competitorsbidding for the contract


O&M‘s Proposal to Ideal

� Activity Based Pricing

� Basic idea: Distribution fees are tied to activity levels

� if customers can see how their activity levels affect their costs, they want to become

more efficient

O&M saves money in processing, delivery and product handling

O&M is relieved from unprofitable customers since fees and services are aligned



O&M‘s Proposal to Ideal

� Risk: no one in the industry uses ABP – no experience available

� Approach: Pricing Matrix based on two major cost drivers

1) Number of purchase orders per month (tied to O&M‘s fixed administrative fees)

2) Number of lines per purchase order (tied to O&M‘s variable costs)

� To increase its credibility, O&M shares its profit line with the customers



� Pricing Matrix of O&M



Questions

1. What are the services rendered by the distributor to manufacturers and hospitals?

1.1. How has the nature of distribution changed over time?

1.2. What is the value-added by O&M?

2. Evaluate the impact cost-plus pricing has on distributors, customers, and suppliers.

3. What effect will ABP have on customer behavior?

4. Explain Exhibit 5. how does the pricing matrix work?

4.1. How do the costs in Exhibit 5 correspond to the costs shown in the customer profitability statement in

Exhibit 4?

4.2. Why doesn‘t the matrix comprise all the costs shown in Exhibit 4?

5. What are the obstacles to successful implementation of ABP at Ideal?

5.1. How would you address these obstacles?

6. What type of customers will adopt ABP first?

7. How difficult or easy is it for O&M‘s rivals to adopt ABP?



Questions

8. What are the risks associated with ABP for Owens and Minor?

9. Work through the numerical excercise provided in TN Exhibit 1 by filling in the template provided in TN

Exhibit 3

10. Why is Ownes and Minor adopting a cost-based pricing stragegy rather than value-based pricing

strategy?



1. What are the services rendered by the distributor to manufacturers and hospitals?

� Manufacturers: want to ship products in large quantities to few customers

� Hospitals do not want to own, maintain and manage huge amounts of materials

� Distributors solve this conflict

1.1. How has the nature of distribution changed over time?

1.2. What is the value-added by O&M?

� value-added by O&M changed to: providing an all-inclusive material management service to customers

� Activity-based pricing additionally sets O&M in the position to help ist supplier to help cut costs of the entire supply-

chain.



2. Evaluate the impact cost-plus pricing has on distributors, customers, and suppliers.

� Cost-Plus made it easy for customers to demand higher service-levels since they were not paying for resources O&M

consumes to provide the enhanced service level

� they shifted their inventory-costs to the distributor

� Cost-Plus Pricing: caused a schism between what the customer wants and what the distributor is willing to

provide

� Distributors: were motivated to provide the lowest level of service needed to maintain the customer relationship

� Manufacturer: were motivated to ship high priced, high volume items directly to the end-customers (hospitals)



3. What effect will ABP have on customer behavior?

� ABP connects O&M‘s fee to the level of the service they provide

� Customer is motivated to keep its activities down to a minimum level and only order services that he really

needs

� Customers who want to extand their service-level can get this because there is a way for O&M to price a higher

service-level

� ABP helps customers to optimize their service-level and hence their costs!



4. Explain Exhibit 5. How does the pricing matrix work?

� Two major cost-drivers: number of lines per month and number of orders per month

� Activity fee level is connected to these cost-drivers

4.1. How do the costs in Exhibit 5 correspond to the costs shown in the customer profitability statement

in Exhibit 4?

� Purchase Order‘s per month: include all of the items under „order cost“

� The Lines per PO include all of the cost items under „line cost“

4.2. Why doesn‘t the matrix comprise all the costs shown in Exhibit 4?

� Matrix does not include other activity costs such as shipping and handling deliveries, interest costs, account

management, fixed costs (occupancy, group fee expenses), etc.

� Reason: Concerns about compexity if all costs were included as variables



5. What are the obstacles to successful implementation of ABP at Ideal?

� Internal systems at hospitals (e.g. budgeting, compensation) were tied to cost-plus percentages.

� Product prices with cost-plus percentages were used to determine transfer pricing between hospital departments

� Technological barriers: Customer has to change to an EDI system (electronical data input)

� Hospital would have to change its systems and procedures for material handling

� For a hospital to benefit it would have to be willing to change and shed personnel, equipment and warehousing

space.

� Culture of hospitals (e.g. surgeons have different preferences for many operating room supplies)

5.1. How would you address these obstacles?

O&M‘s response:

� Offered to convert the activity fee to a cost-plus equivalent

� O&M‘s logistical services worked closely with customers moving to ABP to help them realign processes and institute

cost savings.



6. What type of customers will adopt ABP first?

� Customers who do not wish to pay for services that they do not consume

� Customers who are willing to pay for services hat they would like to consume



7. How difficult or easy is it for O&M‘s rivals to adopt ABP?

� They first have to do an ABC analysis to figure out their cost drivers and driver rates

� Setting up advanced cost and IT systems is necessary would take a non-trivial amount of time



8. What are the risks associated with ABP for Owens and Minor?

� When more and more customers start reducing the services they consume, O&M hast to be willing to take hard

decisions on letting people and resources go.

� Otherwise the costs associated with the provision of the services remain!



10. Why is Ownes and Minor adopting a cost-based pricing stragegy rather than value-

based pricing strategy?

� All prices of O&M are based on costs

� No consideration is paid to what the particular activity/ service is worth to the customer

� This pricing strategy is meaningful only for commodity services with low entry barriers

� For more value-added services (e.g. logistics/material management consulting), O&M does not use ABP but does

value-added pricing



9. Work through the numerical excercise provided in TN Exhibit 1 by filling in the template provided in TN

Exhibit 3


Activity Rates

EDI Order Cost $4.50/edi order

Non-EDI Order Cost $ 9.01/non-edi order

Line Cost $0.66/line

Delivery Cost $457.58/deliver

Interest Cost 8.64% p.a.

Emergency Cost $25/emergency order

Shipping and Handling Cost $130/delivery

Customer Level Costs

Procurement 1,486

Labeling 1,000

Account Mgmt 991

Occupancy 1,007

Group Fees 750

Activity Levels Alpha Hospital (1) Alpha Hospital (2)

Sales/month $ 150,000 $150,000

Orders/month 750 400

Lines/month 15,000 11,000

Deliveries/month 12 7

% EDI orders 25% 95%

Accounts Receivable $300,000 75,000

Emergency Orders/month 20 6

Vendor Discounts $4,035 $4,035

Cost-Plus % 15.00 % -



Alpha Hospital (1) Side-Calculation Alpha Hospital (2)

Product Sales 150,000 150,000

Cost-Plus Margin 22,500 150,000 + 15% 0

Total APB Fees - 19,187 = sum of all costs!

Total Revenue 172,500 169,187

COGS 150,000 150,000

Vendor Discounts 4,035 Given 4,035

Gross Margin 26,535

EDI Order Costs 844 25%x750x$4,50 1,710

Non EDI Order Costs 5,068 75%x750x$9,01 180

Line Costs 9,900 15,000x$0.66 7,560

Shipping and Handling 1,560 12x$130 910

Delivery Cost 5,491 12x$457.58 3,203

Emergency Orders 500 20x$25 150

Interest payments on receivables

2,160 DSO: 60 days, r = 8,64% per year –> 0,72%/month; 150,000 receivables per month x 0.72% x 2 months

Procurement 1,486 Given 1,486

Labeling 1,000 Given 1,000

Account Management 991 Given 991

Occupancy 1,007 Given 1,007

Group Fees 750 Given 750

Net Operating Profit -4,222 4,035

Owens & Minor

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