In healthcare, the largest cost after labor is represented by medical devices and materials. Recent estimates indicate that medical supplies will outpace labor as the largest expense for hospitals and health systems. The number and criticality of healthcare medical supplies can vary greatly, and factors such as physician involvement in supply selections adds complexity to the supply chain. In general, we can categorize hospital supplies as general medical supplies (GEN) and what are called physician preference (PP) items. Most items purchased by a hospital are typically GEN items, and include items such as syringes, gloves, or IV solutions to name a few. In contrast, PP items are supplies which physicians believe will have a signicant impact on patient care or quality of life. Supplies such as orthopaedic implants and pacemakers are examples of PP items. Physician preference items are some of the most expensive items in hospitals. Studies have noted that PPIs can represent up to 61% of total cost of purchases.
In the case of GEN items, hospital purchasing groups can easily consolidate volume for these items to negotiate pricing from a particular vendor. In contrast, PP items are marketed directly to physicians who make the final purchasing regarding device and therefore vendor to adopt. As a result, it is common for hospitals to source the same PP from several different vendors in order to satisfy the preferences of the different physicians practicing in the hospital. This practice hinders the ability to consolidate volume in order to negotiate better pricing for PP items. Given the limited options purchasing groups have in order to reduce the cost burden of PP items, hospitals have increasingly looked for other ways to reduce the cost of carrying PP items in their facilities. One of the ways in which hospitals seek to reduce inventory cost of PP items is by the use of consignment agreements.
Under a consignment agreement the hospital physically stores inventory while the vendor keeps ownership of the inventory stored at the hospital. Once the inventory is used, the vendor receives payment for the units consumed, typically one or two months after product consumption.
The use of consignment agreements allows hospitals to reduce inventory costs without sacrificing product availability and quality. Hospitals benefit from consignment agreements due to decreased capital tied up to inventory as well as delayed payment. As a result, under consignment hospitals do not carry any cost of capital, but still incur the cost of inventory storage as well as costs related to damaged, missing, and in some cases obsolete items.
Under consignment the vendor is typically responsible for delivering inventory to the hospital according to pre-specified order amounts set by hospital management. The vendor is typically also responsible to respond to any surges in demand in order to avoid product stockouts incurring any resulting costs. Since the vendor keeps ownership of the inventory while it is stored at the hospital, the vendor carries the cost of capital associated with holding inventory at the hospital warehouse. As a result, the vendor experiences an increase in inventory costs as well as a delay in payment making the use of consignment less attractive. The vendor will not agree to such agreement unless a profit sharing contract is in place. Typically vendors will be motivated to enter into a consignment agreement under one of two conditions, increased product per unit cost or increased purchase volume. By either increasing the unit cost or capturing a higher share of hospital demand, the vendor can increase its profits in order to mitigate the increased costs of having a product under consignment.
While consignment agreements can provide significant benefits to the hospital, not all products can be managed using consignment. Consignment agreements need to be carefully negotiated such that both partners may obtain financial benefits. Items under consignment need to be carefully monitored to capture usage that triggers payments to the vendor. Lack of proper oversight of consignment stock in hospitals may result in higher rates of product shrinkage and obsolescence. In some cases vendors do not offer the option to use consignment or the added complexity doesn't justify the use of consignment for a particular item. As a result, hospital management is typically interested in using consignment agreements for items that represent a significant amount of spending. Items that fall into this category are typically PP items or high volume GEN items. %PP items tend to be expensive items with relatively low demand volume and high demand fluctuations. In contrast GEN items tend to be more generic, less expensive, required in higher amounts and exhibit less variability in demand as compared to PP items.
In a study we collaborated with a large teaching and research hospital located in the midwestern United States. The hospital is a level 2 trauma center with over 600 beds and an average annual spending of over $17 million dollars in medical supplies. We obtained detailed monthly spending data for the top 3000 items purchased for a span of six years. Hospital management was interested in understanding the relative cost of managing inventories of GEN and PP items in-house as compared to the consignment option offered by vendors. Furthermore, guidance on the type of item that could benefit the most from the use of a consignment agreement was of interest. We present mathematical models that capture the comparative cost of using in-house and consignment inventory for GEN and PP items. To understand the implications of different consignment agreements, we consider the cases when the vendor charges higher per unit price as well as when the vendor expects higher purchase volume. Based on information provided by hospital personnel as well as current literature we study the financial effect of disregarding the increased complexity of managing consignment stock that may result in unforeseen inventory costs, and analyze its impact on GEN and PP items.
We find that although hospitals will enter into a consignment agreement mostly for financial reasons, disregarding a potential increase in inventory costs will affect GEN and PP items differently. Furthermore, the effect of increased inventory costs will affect GEN and PP items in different ways depending on the type of contract used, price increase or volume increase. This allows us to gain insights into the type of consignment contract that is most beneficial to the hospital depending on whether GEN or PP items are considered. We validate our findings using hospital data and provide practical insights for hospital management to aid in the selection of medical supplies that should be managed under consignment to maximize financial benefits.
Implications:
CS agreements are used by hospitals seeking to reduce the cost of keeping and managing medical supplies. The use of CS is typically seen as a way to reduce overall inventory costs for items such as high-cost physician preferred items or high-volume general medical supplies. The use of CS can bring financial benefits when its overall impact is properly understood and accounted for. On the contrary, when hospital management disregards the potential impact of the use of CS on factors such as obsolescence, lost or damaged goods, as well as maintenance costs, savings may not be perceived. Empirical data obtained for this study corroborates the fact that contrary to what hospital management may expect, hospitals may not experience a decrease in overall inventory costs as a result of the use of consignment particularly for PP items. Hospitals manage a wide range of products, which necessitate a careful consideration of inventory management policies based on their underlying characteristics. Contrary to the expectation that CS will result in lower expenses for PP items than if these items are maintained in inventory, the results from the analyses of empirical data suggest that healthcare organizations are not obtaining cost savings for PP items maintained as CS. On the other hand, GEN items benefit from the use of consignment based inventory policies. These preliminary findings formed the basis for a closer examination of the underlying mechanisms at work.
Extant literature in healthcare has indicated that PP items hold the greatest potential for savings in hospitals by involving physicians and surgeons in standardization and utilization management decisions such that they take into consideration the cost of the supplies along with their experience with the product, quality of the item, and their relationship with manufacturer representative. We agree with this direction but also recognize some of the structural issues that limit the ability of supply chain managers to get physicians and surgeons on board with regards to product standardization and utilization management. Many of these reasons, such as whether the physician/surgeon is an employee of the hospital system, are beyond the control of supply chain managers in a healthcare organization. Our study focuses on aspects that are within the purview of healthcare supply chain managers and offer directions to strengthen their ability to structure favorable CS agreements with vendors for PP and GEN items.
The mathematical models developed and analyzed in this paper capture typical CS contract conditions, increased per-unit price and increased purchase volume. Using our models we study the effect of increased shrinkage rates on overall inventory costs as a result of the use of consignment. We show that each type of contract, increased per-unit price or increased purchase volume, will affect overall inventory costs differently depending on whether general medical supplies or physician preferred items are stored. In the absence of data to determine the impact of the use of consignment on shrinkage and maintenance costs, we prove that independent of the inventory policy used, an increased volume contract can lessen the negative effects of an unforeseen increase in consignment costs.
Our theoretical results highlight the implications of disregarding additional shrinkage and maintenance inventory costs associated with CS and show that the implications will differ based on the underlying demand pattern of the product under consideration. The lack of information pertaining to higher inventory shrinkage and maintenance levels can still enable hospitals to gain the advantages commonly attributed to the consignment agreement for GEN items. However, ignoring these costs for PP items can result in unfavorable contract conditions that could result in higher costs. Since hospitals typically do not have a good understanding of these hidden costs associated with consignment agreements, we assert that hospitals might be encountering higher costs for PP items that are being managed as CS therefore reducing the financial benefit they could obtain from CS. Future studies that consider data from multiple hospital systems could build on this preliminary insight.
Our results also point to conditions when supply chain managers might enter into a CS contractual agreement that involves unfavorable demand allocation. For products characterized by high variability and high per unit cost, the demand allocations under CS contractual agreements tend to be unfavorable and can therefore result in higher costs. PP items typically have high variability and high per unit cost, which necessitate greater care in determining appropriate demand allocations when a hospital is consolidating across multiple items and negotiation contracts with vendors. Demand allocations can also be unfavorable for products that have high variability and high demand, irrespective of their cost. Once again, these are also more likely to be PP items but some GEN items can also have these characteristics. Future empirical studies that classify healthcare supplies in terms of their average demand, variability of demand and per unit cost could shed further light into our theoretical prediction.
Our study has few limitations that are worth noting. The empirical data was obtained from one hospital; hence, we do not claim the generalizability of the empirical findings. Additional research is needed, however, our empirical results coupled with the analytical models provide a good foundation for future research studies to build on. The analytical models are constrained in terms of its focus on only hospital's decisions. Future studies should consider a game-theoretic framework to obtain equilibrium conditions for the hospital and the vendor when they are engaged in negotiations for CS contracts for PP items and GEN items. Finally, in our analytical model we assume that a hospital will be able to allocate demand between two vendors such that they can increase their purchase volume from the vendor with lower per unit cost. Future studies can account for potential objection for this reallocation by physicians/surgeons by considering an additional cost parameter.
Source: Rosales, C., Nair, A., Pal, S. "Managing General and Physician Preference Medical Supplies with In-stock versus Consignment-Stock Inventory Policies: An Empirically-Grounded Analytical Investigation. Working paper.