An HFMA Healthcare Financial Pulse Resource
Jonathan J. Clark
When optimizing margins, most institutions prefer to initially go after non-labor costs. Non-labor cost reductions avoid the emotional and political battlefields that lay-offs, restructuring, or job redesigns can produce. They can even be exciting, given the potential realization of considerable financial success.
This article provides a framework for healthcare organizations seeking to maximize non-labor costs savings. It:
Describes how to
create a value analysis team to lead a cost reduction initiative
Defines supply cost savings approaches, including
Contract management
Value analysis
Inventory management
Defines purchased services savings approaches, including
Create a Value Analysis Team
Start your non-labor cost reduction initiative by setting up a core value analysis team (VAT) in the Purchasing department. Key steps include:
Identifying who is on the VAT
Deciding whether a single or multiple VATs are appropriate
Creating a steering committee to oversee the VAT’s work
Who is on the VAT?
For larger hospital systems, this team is typically composed of:
The function of the VAT is to identify and implement cost savings opportunities and monitor key performance indicators. VAT members work closely with vendors to negotiate pricing and secure contracts and pricing agreements. They also work closely with key department directors who assist in identifying, approving, and implementing cost saving opportunities.
Single or multiple VATs?
While many hospitals successfully employ a single core VAT, others employ additional VATs, one for each major department or service-line. In this second model, each department director oversees their own team to identify and implement cost savings projects.
Multiple VATs can be extremely effective since they add a much greater number of resources and experts to the cost savings initiative. However, in order to keep all the teams engaged over long periods of time, this model requires tremendously strong and steady leadership.
Creating the steering committee
After the VAT is in place, the next step is to create a steering committee that provides governance to the entire non-labor cost saving initiative. The steering committee should be composed of:
The role of the steering committee is to:
Set and monitor cost savings targets
Identify, approve, and prioritize cost savings initiatives
Hold the VAT and appointed directors accountable to goals and timelines
Hold monthly update meetings
Create policies and procedures (e.g., vendor, tendering, blanket order, standing order policies)
Facilitate removal of implementation barriers
Monitor key performance indicators
Key performance indicators monitored by the steering committee include non-labor expense budget variances, supply expense as a percent of net revenue, supply expense per adjusted discharge, and supply expense per patient day. These KPIs should be monitored for the overall organization and for key departments and service lines.
The constant oversight of an institution’s non-labor costs by a steering committee, and the daily effort of a single core VAT or multiple service-line VATs is a highly effective way to realize significant cost savings and optimize margins.
Supply Cost Savings Approaches
Supplies are typically broken down into pharmaceutical supplies, medical/surgical supplies, and other supplies (including office, food and dietary, facilities and engineering, and miscellaneous).
Approaches to saving money in each of these supply categories are basically the same, although some special considerations apply to pharmacy costs (see Pharmacy Savings Tip Sheet). The main approaches for supply cost reduction include:
Contract management
Value analysis
Inventory management
Contract management
Contract management typically offers the “low-hanging fruit,” where fast and significant cost savings can be realized. Initial improvements in this area can even fund the resources required for value analysis and inventory management.
In practice, contract management is actually a broad term describing three distinct sub-components:
Contract management
Contract negotiations
Contract compliance
A consistent approach to contract management, negotiation, and compliance--beginning first with your highest spend items--can lead to fast cash in large health organizations, often to the tune of several million dollars. A contract manager and one or two contract coordinators can usually maintain these three functions for larger healthcare organizations.
Contract management
Contract management ensures that a contract or pricing agreement is in place for every vendor a healthcare organization is purchasing supplies from. It also ensures that every contract is carefully monitored to know when each contract will expire and needs to be renewed.
Every vendor contract should include:
- A clause stating that, once the contract expires, current pricing remains in effect until a new contract is established. This clause
- Prevents a vendor from raising prices back to list price after the contract expires.
- Puts the onus on the vendor to begin contract renegotiations
- Protects your organization from sudden price increases that will affect your bottom line.
- A maximum term of no more than three years. This ensures that your organization will not be locked into a long-term agreement if superior technologies or supplies are developed.
Contract negotiations
The goal of contract negotiations is achieving the best pricing for supplies. Use group purchasing organizations, benchmark pricing, volumes discounts, and solid negotiating principles to help attain the best pricing.
When negotiating contracts:
Omit clauses stipulating that pricing information is confidential, which disallow purchasers from sharing pricing information with benchmark companies.
Remember that pricing based on a certain volume tier may become outdated as volumes increase over time. Provide for price reductions based on volume increases.
Request that large primary medical/surgical and pharmacy supply vendors propose ways to reduce costs through value analysis and inventory management.
In many cases, primary suppliers will even provide cost savings guarantees, if requested in RFPs. In the case of medical/surgical and pharmacy supplies, guarantees can involve several million dollars in savings if the vendors are allowed to participate in cost saving initiatives.
Contract compliance
Once a contract is in place, contract compliance ensures that the prices stipulated in the contract match the actual prices charged by the vendor on the invoice. Because overlooked vendor billing mistakes can cost purchasing organizations millions of dollars, a zero-variance policy is best.
Value Analysis
Value analysis involves evaluating supplies so that those of the best value can be purchased at the best price. Basic value analysis strategies include:
Standardization and consolidation
Identifying less costly alternatives
Ensuring proper utilization
Standardization and consolidation
To get to the best possible price, healthcare organizations should look for opportunities to standardize and consolidate supplies to achieve volume discounts. This allows a healthcare organization to purchase a single item in higher quantities from one vendor, rather than multiple items from multiple vendors.
For example, some hospitals purchase many different kinds of medical/surgical gloves from various vendors. Standardizing them to fewer (or even one) types of glove can save thousands of dollars annually in volume discounts.
Standardizing supplies also creates inventory management efficiencies by reducing the number of inventory items to manage. It also reduces the number of processes, equipment, and procedures involved for certain operations, such as the use of reagents in lab test processing.
Identifying less costly alternatives
Identifying less costly supplies that perform at the same or better levels can lead to significant savings. For instance, less expensive generic products can often perform at the same levels as expensive name brand products. Reprocessing single-use items such as pulse oximeters can also lead to cost savings.
Ensuring proper utilization
Proper utilization of supplies helps prevent waste and overuse that would otherwise unnecessarily escalate costs. For example, operating rooms regularly incur excessive expenses as unused supplies and instruments are routinely discarded. In surgical procedures, a cardiologist may use three expensive coronary stents to keep arteries open for blood flow when only two are needed.
Inventory Management
When purchased supplies are stored, they become inventory, and must be managed carefully to ensure products aren’t damaged, stolen, wasted, or spoiled due to outdated or expired products.
Inventory levels must not be too low or too high:
Deficient inventories cause operational delays and bottlenecks while an operation waits for supplies to arrive.
Excessive inventories result in inaccessible funds, tying up cash that could otherwise be invested. If feasible, high dollar physician preference items and implants should be placed on consignment to eliminate tied up funds.
High inventory levels can generate high carrying costs, such as storage, maintenance, and security costs.
Warehousing, shipping costs, and internal distribution must be carried out efficiently and economically through smart logistics and optimal means of transportation. Automated storage and retrieval systems and control systems may be necessary to protect and monitor high dollar or high volume inventories.
Purchased Services Savings Approaches
Purchased services are services outsourced to external vendors. They can include everything from landscaping to legal. To achieve savings in purchased services, you must:
Vendor contract review
A first step in achieving purchased service cost savings is a systematic review of the services provided and the associated costs. Request a 12-month “vendor spend summary report” from your Accounts Payable department that includes:
A listing of all vendors your organization has purchased services from over the past year.
The amount of money spent with each vendor, the business owner who contracted with the vendor, and the department or cost center purchasing the service.
A sorting of vendors in descending order of total spend, so that vendors who were paid the most money are at the top of the list.
When you have received the report:
Ensure that a current vendor contract exists for the services performed by each vendor. Most initial cost saving opportunities will be with expired or expiring contracts where costs or vendor utilization may be too high.
Evaluate the vendor’s services in terms of how they met their contractual obligations to determine whether you want to renew the vendor’s contract.
Assess the vendor’s costs to determine if renegotiating opportunities exist. Benchmark information may exist from associations, benchmarking companies, or group purchasing organizations to assist with renegotiations.
Determine if alternative means exist for sourcing certain services. You may be able to consolidate the services of two or more vendors to obtain volume discounts, perform the services in house, or use the services less often.
Specify performance outcome expectations
Once you have completed your vendor spend summary report evaluate, you can decide whether purchased services from particular vendors should be discontinued, modified, consolidated, or performed with alternative means.
Whether you are renewing an existing contract or negotiating a new one, you should clearly specify performance standards and expected outcomes for the vendor and hold the vendor accountable for these outcomes. Write all vendor contracts to include:
Clearly defined performance outcome expectations.
A requirement that the vendor is responsible for monitoring and reporting key performance indicators for the services provided.
Penalties for failure to meet performance outcome expectations. Because the purchasing organization can also be at fault for underperformance of a service contract, the contract should provide guarantees if underperformance is not the vendor’s fault.
Over the course of the contract, discuss with the vendor any negative variances between actual and expected performance outcomes to determine why problems are occurring. When purchased services are critical to the outcomes of an operation, be sure to have a secondary or backup vendor in place (a good idea for critical supply vendors as well).
By establishing a value analysis team and pursuing savings opportunities in both supply costs and purchased services, your organization will be on track to realize significantly improved financial outcomes and margins.
Jonathan J. Clark is Senior Partner, TRCLARK, LLC, in North Salt Lake City, Utah. He can be reached at jclark@trclarkglobal.com.