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Technische Universität München

Management Accounting
-Case Study-

Harvard Business Case

Case Study: Owens & Minor

Structure of the Case Study

1. 2. 3. 4. 5.

O&M: Company Profile Costing and Pricing at O&M The Case O&M‘s Proposal Solution of the Case-Questions

© Gunther Friedl – WS 11/12

operating room items. Virginia. e.000 products from about 1. etc © Gunther Friedl – WS 11/12 . Inc: Company Profile Headquarter: Mechanicsville.200 manufacturers. sterile procedure trays.g. intravenous products. wound closure devices.800 One of the leading distributors of medical and surgical supplies 200.12 billion Number of employees 2010: 4.Case Study: Owens & Minor Owens & Minor.S Revenue 2010: $ 8. gloves. U.

Case Study: Owens & Minor Owens & Minor. ) Manufacturer Manufacturer Bulk Products Individual Order‐ Delivery Manufacturer Manufacturer Customer Customers: primarily hospitals. healthcare systems. Logistics Service. etc. group purchasing organizations (= buying groups of hospitals) and the federal government © Gunther Friedl – WS 11/12 . Inc: Company Profile Core Business-Process: Services (Consulting.

Case Study: Owens & Minor 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. 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? © Gunther Friedl – WS 11/12 . plastic totes that go directly to the nursing and surgical units.g.

electronic data) Interest costs from carrying receivables © Gunther Friedl – WS 11/12 .Case Study: Owens & Minor Activity-Based Costing at O&M (introduced at O&M in 1994) Several activites (= Cost Drivers) affect costs per customer and hence customer profitability: Type of service requested Number of lines per purchase order Number of purchase orders generated per month Cost Drivers Number of deliveries per week Method of order (mail. phone.

chapter 5 © Gunther Friedl – WS 11/12 .Case Study: Owens & Minor 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 Markup 7% = Price of the product $ 1.07 * See lecture notes.

Case Study: Owens & Minor 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 © Gunther Friedl – WS 11/12 .

Case Study: Owens & Minor Customer Profitability Statement for Customer Alpha Hospital © Gunther Friedl – WS 11/12 .

Case Study: Owens & Minor 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 © Gunther Friedl – WS 11/12 .

Case Study: Owens & Minor 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: Atlantic Healthcare current supplier subsidiary of a medical supply manufacturer allows them to offer distribution services at extremely low rates these rates would force O&M to operate at loss O&M brand-neutrality higher flexibility than the other competitors bidding for the contract Question for O&M: How to outperform Atlantic Healthcare despite higher direct-costs? © Gunther Friedl – WS 11/12 .

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 © Gunther Friedl – WS 11/12 .Case Study: Owens & Minor 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.

O&M shares its profit line with the customers © Gunther Friedl – WS 11/12 .Case Study: Owens & Minor 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.

Case Study: Owens & Minor Pricing Matrix of O&M © Gunther Friedl – WS 11/12 .

How would you address these obstacles? 6. What is the value-added by O&M? 2. What are the obstacles to successful implementation of ABP at Ideal? 5. how does the pricing matrix work? 4. How has the nature of distribution changed over time? 1. How do the costs in Exhibit 5 correspond to the costs shown in the customer profitability statement in Exhibit 4? 4. Explain Exhibit 5.1. and suppliers. 3.1. What are the services rendered by the distributor to manufacturers and hospitals? 1. Evaluate the impact cost-plus pricing has on distributors. What type of customers will adopt ABP first? 7.Case Study: Owens & Minor Questions 1.1. What effect will ABP have on customer behavior? 4. Why doesn‘t the matrix comprise all the costs shown in Exhibit 4? 5. customers. How difficult or easy is it for O&M‘s rivals to adopt ABP? © Gunther Friedl – WS 11/12 .2.2.

Why is Ownes and Minor adopting a cost-based pricing stragegy rather than value-based pricing strategy? © Gunther Friedl – WS 11/12 . Work through the numerical excercise provided in TN Exhibit 1 by filling in the template provided in TN Exhibit 3 10.Case Study: Owens & Minor Questions 8. What are the risks associated with ABP for Owens and Minor? 9.

2. 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. © Gunther Friedl – WS 11/12 .1. How has the nature of distribution changed over time? 1. 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 supplychain.Case Study: Owens & Minor 1.

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.Case Study: Owens & Minor 2. Evaluate the impact cost-plus pricing has on distributors. high volume items directly to the end-customers (hospitals) © Gunther Friedl – WS 11/12 . customers.

Case Study: Owens & Minor 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! © Gunther Friedl – WS 11/12 .

interest costs.2. Reason: Concerns about compexity if all costs were included as variables © Gunther Friedl – WS 11/12 . 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. 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.Case Study: Owens & Minor 4. etc. 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. account management. Explain Exhibit 5. fixed costs (occupancy. group fee expenses).1.

g. surgeons have different preferences for many operating room supplies) 5.Case Study: Owens & Minor 5. 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. © Gunther Friedl – WS 11/12 . 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. Culture of hospitals (e.1. What are the obstacles to successful implementation of ABP at Ideal? Internal systems at hospitals (e. compensation) were tied to cost-plus percentages.g. equipment and warehousing space. budgeting.

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 © Gunther Friedl – WS 11/12 .Case Study: Owens & Minor 6.

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 © Gunther Friedl – WS 11/12 .Case Study: Owens & Minor 7.

Otherwise the costs associated with the provision of the services remain! © Gunther Friedl – WS 11/12 . What are the risks associated with ABP for Owens and Minor? When more and more customers start reducing the services they consume.Case Study: Owens & Minor 8. O&M hast to be willing to take hard decisions on letting people and resources go.

logistics/material management consulting). Why is Ownes and Minor adopting a cost-based pricing stragegy rather than valuebased 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. O&M does not use ABP but does value-added pricing © Gunther Friedl – WS 11/12 .Case Study: Owens & Minor 10.g.

58/deliver 8.000 991 1. 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 Non-EDI Order Cost Line Cost Delivery Cost Interest Cost Emergency Cost Shipping and Handling Cost Activity Levels Sales/month Orders/month Lines/month Deliveries/month % EDI orders Accounts Receivable Emergency Orders/month Vendor Discounts Cost-Plus % $4.000 750 15.000 12 25% $300.66/line $457.486 1. $25/emergency order $130/delivery Alpha Hospital (1) $ 150.000 400 11.50/edi order $ 9.035 15.a.000 20 $4.01/non-edi order $0.035 Customer Level Costs Procurement Labeling Account Mgmt Occupancy Group Fees 1.64% p.00 % Alpha Hospital (2) $150.Case Study: Owens & Minor 9.000 6 $4.000 7 95% 75.007 750 © Gunther Friedl – WS 11/12 .

150.50 75%x750x$9.560 910 3.187 169.72% x 2 months Side-Calculation 150.64% per year –> 0.000 991 1.500 172.035 = sum of all costs! 1.160 25%x750x$4.560 5.710 180 7.000 receivables per month x 0.491 500 2.000 4.000 991 1.500 150.007 750 -4.58 20x$25 DSO: 60 days.000x$0.068 9.000 Given 4.007 750 4.486 1.01 15.000 + 15% Alpha Hospital (2) 150.72%/month.66 12x$130 12x$457.Case Study: Owens & Minor Alpha Hospital (1) Product Sales Cost-Plus Margin Total APB Fees Total Revenue COGS Vendor Discounts Gross Margin EDI Order Costs Non EDI Order Costs Line Costs Shipping and Handling Delivery Cost Emergency Orders Interest payments on receivables Procurement Labeling Account Management Occupancy Group Fees Net Operating Profit 150.535 844 5.486 1.203 150 1.900 1.000 22.035 © Gunther Friedl – WS 11/12 .000 0 19.187 150.035 26. r = 8.222 Given Given Given Given Given 1.