An MD&DI June 1997 Column
How successful medical device companies manage costs and deliver superior products and services.
Medicare poured $178 billion into the United States health-care industry in 1995. That amount represents almost all the revenue for home-health-care agencies, hospices, and renal dialysis facilities. It constituted 25 to 75% of the revenue of clinics, laboratories, and ambulance services. It is the single largest source of revenue for hospitals and device manufacturers.
Of that $178 billion, approximately 17.9%, or $31.9 billion, flowed through hospitals, clinics, laboratories, ambulance services, home health care, and the like to manufacturers of disposable products, therapeutic and diagnostic devices, and nonmedical supplies. Medicare dollars, in other words, accounted for approximately 72% of the industry's 1995 U.S. revenues of $44 billion.
Medicare is the single largest source of revenue for the medical device industry. The implications of this are clear for equipment and device suppliers to long-term and home-health-care providers, renal dialysis facilities, clinics, ambulance services, and hospitals. When Medicare catches a cold, medical device manufacturers get pneumonia. Device manufacturers must not only absorb their share of the reduced funding but also bear the burdens of complying with federal regulatory requirements and meeting health-care providers' increased need for quantifiable data.
WHAT TO EXPECT FROM WASHINGTON
In two words, no relief. The debate between Congress and the White House is not and never was about which group was going to pay for Medicare's projected shortfalls. Last year both the administration and Congress suggested reducing the rates Medicare pays to doctors and hospitals. With hospitals, doctors, and manufacturers facing potential lower Medicare revenues, profit margin erosion will surely follow for many device companies, especially those with thin operating margins or high fixed costs.
Last year, President Clinton proposed reducing the projected increase in Medicare spending by $124 billion. Of that, $89 billion would extend the solvency of the Part A hospital insurance trust fund from 2002 to 2006. Clinton's most recent proposal would wrangle $138 billion in savings, up from the $124 billion proposed last year but still down from the $158 billion proposed by the Republicans.
Both the administration and Congress propose reducing the rates Medicare pays to doctors and hospitals. Underneath all the political bickering, both sides appear ready to craft a bipartisan Medicare reform package. Medicare will be reformed and possibly saved for the 38 million citizens on the plan. But this will come at the expense of the health-care industry and, more specifically, of the 300,000 workers in the medical device industry. The Medicare-led squeeze on costs is about to worsen.
SURVIVING MEDICARE REFORM
Over the last few years, some common strategies have emerged among the more successful manufacturers in the device industry in response to the institutionalization of cost containment. The following is my list of the top ten of those strategies.
Use Your Inventive Technologies to Create Value. Get more use for the same price. If your customer wants to reuse your disposable product, innovate to help that customer better manage the costs of the product. If that's not enough, use your development programs to lower your cost of sales and to increase product differentiation. "The best way to predict the future is to invent it."--Acuson Corp., (Mountain View, CA), 1995 Annual Report.
Differentiate Your Products. The trend toward smaller buy lists and reduced duplication is putting everyone's product differentiation claims to the test. Use independent testing services if you must, but quantify your product's unique features, and use your R&D dollars to increase its differentiation.
Reduce Manufacturing Costs by Streamlining and Outsourcing Many Production Processes. For some companies, such as ADAC Labs, a Milpitas, CAbased manufacturer of medical imaging systems for hospitals and clinics, total quality management (TQM) is an answer. A well-established tool for improving operational efficiency, TQM is not the only or even always the best answer (each company must determine what is best for its unique circumstances), but it works for most firms. I have seen TQM transform average performers into exceptional performers. Any well-proven system embraced by a company can create more efficient production processes. The payoff at ADAC, in addition to its 37% gross profit margin, was the Malcolm Baldrige National Quality Award in 1995. Imagine how effective your company could be as the cost and quality leader.
Cut Product Duplication. Two years ago, Eugene Corasanti, CEO of Conmed Corp., a manufacturer of disposable medical products based in Utica, NY, launched a long-range project to consolidate duplicate product offerings. His goals were to enhance the company's manufacturing efficiency and to merge the best qualities of his duplicate products to make one product. With Medicare revenues being squeezed, such efforts are appreciated by hospital administrators and purchasing agents. Corasanti's achievements have helped place his firm at the forefront of companies supplying products to hospitals. On December 9, 1996, Conmed announced that Premier, the nation's largest health-care alliance enterprise, had selected Conmed as its main supplier for electrosurgical products used for cutting and coagulation.
WHY MEDICARE IS BECOMING INSOLVENT
Part A and Part B are the two parts of Medicare. Part A is funded by FICA payroll deductions. Part B is funded by the general fund and payments from participants in the service. Part A covers hospital costs. In 1994, the average Medicare cost per enrollee of the Part A hospital trust fund was about $2900. Unfortunately, the average payroll tax revenue per beneficiary was about $2600. That $300 shortfall is being funded by a trust fund that, in 1995, still had $134 billion in it. At the rate Part A is losing money, however, that trust fund is expected to be empty in about four years.
Develop a Culture That Rewards Efficiency. As you scrutinize the basic processes in your operation--typically starting with manufacturing--expand that effort elsewhere. Ongoing cost-improvement programs must address product change, operating procedures and automation, changes in raw materials and suppliers, and administrative activities. Terrence Wall, CEO of Vital Signs, Inc., Totowa, NJbased manufacturer of single-patient-use medical products for anesthesia, respiratory, and critical-care areas, said of his company's efforts: "We made it systematic, rethinking and redesigning every fundamental business process, that is, 're-engineering' in its true sense, not just 'downsizing.'" Wall instituted an incentive program that awarded annual bonuses to employees based on the percentage of improvement in operating earnings. Not coincidentally, earnings from operations in fiscal 1995 improved $8 million (51%) over those in fiscal 1994. Furthermore, the culture of cost improvement created an environment in which all employees collaborated to reduce manufacturing costs by nearly $1.5 million in 1995.
Walk a Mile in Your Accountant's Shoes. Reducing costs while maintaining quality care is the challenge hospitals face today. This quest has resulted in greater involvement by finance and administration in product purchasing decisions. The parallel challenge to device manufacturers is to speak the language of finance and administration. To walk in their shoes is to develop information systems that quantify the costs, outcomes, resources, and alternatives of your products. This is the raw material from which you and your customer can create compelling business solutions. These solutions often become product standardization programs, invoice- and paperwork- cutting programs, and improved customer/vendor coordination programs. Such solutions translate into profits for your customer and orders for you.
Develop Alliances with Hospitals, Group Purchasing Organizations, and Distributors. Most manufacturers do not have a large enough market share in their respective product lines to be able to sell directly to hospitals and clinics. Just to get to the negotiating table, small to medium-sized manufacturers must adopt a buddy system with a major distributor or large purchasing organization. Such alliances enhance your company's value to end-users. As purchasing agents move toward one-stop shopping, bigger distributors will become increasingly important. Companies that invest the time and personnel needed to combine their product and manufacturing strengths with the strengths of well-established distributors will successfully capitalize on these new realities.
Increase Obsolescence. Even if you've built and maintained an identity as a small, focused manufacturer with a wealth of knowledge and experience in a particular area, you will undermine that hard-won reputation if you fail to keep innovating and improving your products. But progress must be in sync with the dominant trends in improved patient outcomes, better resource use, more cost-effective solutions, less-invasive procedures, and reduced overall liabilities. By constantly reinventing your products and your company to satisfy these basic health-care needs, you will ride the wave, not be swamped by it.
Maintain ISO 9001 and Other Certifications. These accreditations are not routine, and hospitals and buying groups know it. To achieve such recognition, manufacturers must meet very exacting quality and process standards. In an environment of shrinking vendor lists, third-party recognition improves your chances of surviving any purchaser's cut and also significantly improves your credibility and respect in overseas markets.
Prepare for the End of Managed Care. Managed care is a transitional strategy. As the news out of Washington demonstrates, the real point is institutionalized cost containment. Managed care is just one strategy to contain costs. In the foreseeable future new systems and strategies will arise that, in the ag-gregate, may be referred to as disease management. For example, Mutual of Omaha Insurance Company began funding a study of patients who needed heart-bypass or angioplasty operations. The study used a classic disease management approach. Patients were put on the Ornish program, which incorporates a number of lifestyle factors, including a 10% fat diet, stress management, and exercise. Nearly two-thirds (65%) of the participants reported that their chest pain was gone after one year, and the progression of artery blockages was stopped or reversed. Mutual of Omaha found that annual medical costs were $3826 for the Ornish participants versus $13,927 for nonparticipants. As one cardiologist who used to do balloon angioplasty said, "I've hung up my balloons and I'm doing the Ornish program." Similarly, the DNA-mapping program known as the genome project may give physicians the ability to make earlier diagnoses and is a powerful tool to begin disease management programs.
Medicare's lesson of cost containment continues to be taught by a relentlessly political Congress and administration. It has been repeated for so long and in so many ways that it is now an institutionalized reality. In response, device manufacturers must change the way they operate their businesses. Successful device manufacturers will employ back-to-basics business skills and common sense and will understand that the only constant in this world is change.
Robin R. Young, CFA, is senior healthcare analyst for Stephens, Inc. (Little Rock, AR), an investment banking firm.