Technische Universität München Harvard Business Case Management Accounting -Case Study-
Nov 01, 2014
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
© Gunther Friedl – WS 11/12
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
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
Owens & Minor, Inc: Company Profile
� Core Business-Process:
� Customers: primarily hospitals, healthcare systems, group
purchasing organizations (= buying groups of hospitals) and the
federal government
Case Study: Owens & Minor
Manufacturer
CustomerBulk Products Individual Order‐Delivery
Manufacturer
Manufacturer
Manufacturer
Services(Consulting, Logistics Service, etc. )
© Gunther Friedl – WS 11/12
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?
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
Activity-Based Costing at O&M (introduced at O&M in 1994)
� Several activites (= Cost Drivers) affect costs per customer and hence customer
profitability:
Case Study: Owens & Minor
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
© Gunther Friedl – WS 11/12
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
+ =
Case Study: Owens & Minor
* See lecture notes, chapter 5
© Gunther Friedl – WS 11/12
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
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
Customer Profitability Statement for
Customer Alpha Hospital
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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?
Case Study: Owens & Minor
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
© Gunther Friedl – WS 11/12
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
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
� Pricing Matrix of O&M
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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?
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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?
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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.
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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)
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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!
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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.
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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!
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
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
Case Study: Owens & Minor
© Gunther Friedl – WS 11/12
9. Work through the numerical excercise provided in TN Exhibit 1 by filling in the template provided in TN
Exhibit 3
Case Study: Owens & Minor
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 % -
© Gunther Friedl – WS 11/12
Case Study: Owens & Minor
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