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Having My Say by Lynn James Everard, C.P.M. The true test of any investment is its Return on Investment or ROI. Hospital executives planning the future of their non-clinical operations will need to determine if the in-house management and execution of those operations is mission critical or an elective option. Such decisions become easier to make if it can be determined whether those operations produce an ROI or if they simply add cost without producing significant value. By quantifying the materials function’s ROI the hospital director of materials management can gain leverage in the fight to maintain the department’s existence and enhance its relevance. It might be desirable to assume that the materials function is safe from the threats of downsizing or outsourcing, but such assumptions ignore the facts. The vast majority of hospitals have already outsourced significant portions of their supply contracting function to their group purchasing organizations (GPOs). Others have outsourced key supply chain functions such as equipment management, inventory management and distribution. These moves, if they produce real savings as promised, are not inherently bad for the hospital. But if part of the reason they happen is because materials has not effectively presented its own positive ROI, the materials directors may not only be doing themselves a disservice but their hospitals as well. As hospital budgets are increasingly weighed down by factors outside of the materials director’s control materials leaders must get into the habit of using numbers to demonstrate the value of their departments. It can admittedly be an uphill battle. Most hospital CEOs are awash in challenges to their most critical issues: Revenue creation, reimbursement, regulation and retention of key clinical staff. And since the materials management department is not directly involved in any of these key areas it often finds it difficult to compete for the resources it needs to effectively perform its function. A positive supply chain ROI can be one the materials director’s strongest allies in proving the value of the in house materials function. Say it with numbers In simple terms the supply chain ROI can be calculated by dividing the annual savings produced by the materials department by the annual cost of operating the department.
In this example the hospital’s materials department produced an annual supply chain ROI of 1.2. This means that for every dollar invested in the materials function the hospital earned back 120 percent of its investment, making its investment in its in house materials function successful. A result greater than one would be a positive ROI and a result less than one would be a negative ROI. To improve the ROI the materials director would need to increase the cost savings number, reduce materials functional operating expense, or increase cost savings and reduce materials functional operating expense at the same time. Though the calculation itself is rather simple the data that make up the savings and costs components require broad agreement on definitions and sources of the data. 10 savings definitions Cost savings can come from a variety of areas, and as long as the materials department was significantly involved in making them happen they can be claimed as cost savings. Applicable cost savings may be defined as follows: 1. Product price: Any actual reduction in price over the prior year is a cost savings, whether negotiated in house or by a GPO and implemented by the materials department. Please note: A discount is not a cost savings regardless of how high it seems to be. For there to be a savings the unit price per item must have decreased from the prior year or prior contract. 2. Rebate incentive: Any paid rebate earned by the hospital as a part of fulfilling its contract obligations may be counted as a savings. 3. Supplier grants: Any amount of money donated by a hospital supplier is money that is not available for the hospital to receive as a product cost savings or rebate incentive. Therefore, the director of materials management should be permitted to include grant money in his or her cost savings calculation. 4. Outsourcing savings: Any labor savings negotiated by the materials department for any hospital department (except its own) can be listed as a cost savings if the benefiting department can show an actual reduction in headcount or budget as a direct result of the savings. 5. Outsourced distribution: Outsourcing of materials functions to a distributor where the cost is loaded into the cost of the product via a higher mark-up or line fee (such as a low unit of measure program) should be handled as follows. The total of line item fees and/or up charges should be added to the cost of the operation of the materials department. This will be offset by the actual reduction in the department’s labor expense for the period. 6. Product cost avoidance: Product cost avoidance only qualifies as a savings if the price of an item would have definitely increased without the aggressive intervention of the materials department. Process cost avoidance does not fit here since actual cost avoidance will be adequately captured in the materials department’s own operating expense reports as a labor expense line comes in below the budgeted amount. 7. Value analysis: Value analysis originated many years ago in manufacturing organizations as engineers and procurement people worked together to engineer costs out of their products. Often this meant using less expensive materials. Many hospitals are using the same processes to reduce utilization of higher cost products and find less costly products that will do the same job. Any cost reductions identified through the active participation of the materials department in value analysis teams should be included in cost savings as long as the savings is calculated after it has occurred. Future estimates of potential savings are not traceable to the bottom line and should not be used. 8. Inventory reduction: While inventory reduction can greatly enhance a hospital’s cash flow it is only a cost savings to the extent of the carrying costs that will be saved by removing the inventory from the books. For example, if a hospital’s annual carrying costs are 30 percent, an inventory reduction of $100,000 is an annual savings of $30,000. 9. Other savings: Other savings would include savings on freight, equipment preventive maintenance and service programs, and any other savings created by the materials department for any department other than its own. 10. Sources: Actual product savings can never be accurately calculated at the beginning of a contract. Consequently, estimates of potential savings from suppliers or GPOs should not be used to quantify savings. GPO pricing levels and tiers may not match the hospital’s actual results as expected volumes may not materialize or undetected supplier pricing errors may cut into anticipated savings. For that reason only the hospital’s material management information system (MMIS) or enterprise resource planning (ERP) system reports should be the primary source for savings calculations. Sales reports from suppliers can be used to support the hospital’s own information as needed. Materials department Materials department functional costs include any costs that appear on the materials budget and operating expense reports. As noted above, this should also include the total of line fees or up charges from a distributor, in the case of a unit of measure program or other outsourcing service. Also included are labor, equipment and technology, warehouse including utilities, lease costs and fleet costs. One example would be the cost of automated supply cabinets for supplies to the extent that the decision to utilize the cabinets was to improve inventory accuracy and replenishment performance. Whatever portion of the decision was made to facilitate patient charging should be attributed to the department responsible for carrying out that function. This may also include costs that appear in other departments such as software or the cost of other departments performing ad hoc materials functions. For example, if nurses are searching the hospital for supplies and equipment and if the cause was preventable and within the purview of the materials department such costs would qualify as materials department functional costs. There is no doubt that calculating a hospital’s supply chain ROI will take some work. But it may be one of the director’s best ways of demonstrating the viability of his department and his own management ability. Readers desiring to learn more about benchmarking their supply chain ROI with other hospitals can learn more at www.benchmarkingexcellence.com. HPN Lynn James Everard, C.P.M. is general manager of Benchmarking Excellence LLC, a Florida-based supply chain services company specializing in helping hospitals quantify and reduce their materials management functional costs and implement cost reduction tools such as activity-based management. Everard can be contacted at (954) 647-3554 or at leverard@benchmarkingexcellence.com.
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