One of the most significant and controversial provisions of President Obama’s Affordable Care Act is a 2.3% excise tax on revenue for medical device firms. The argument is that the medical device manufacturers can afford this tax because of record revenues and high margins-- often upwards of 85%-- from their products. The medical device manufacturers are starting to respond to the new tax by optimizing their supply chains in order to maintain the current margins.
The question that most device manufacturers face is this: where can cost savings be made to offset the excise tax? Medical devices are a high margin, high priced, low/medium volume product. Certain neurological devices, which are priced around $20,000 can have a margin of around 80%. Any loss of sales due to a stock out can have significant adverse effects on the device manufacturer’s revenue; in this case a loss of $16,000 per lost sale. Therefore device firms have placed a very high emphasis on preventing stock-outs. This means purchasing excess raw material, producing excess products, and holding excess inventory. However, these tactics inflate the total cost of ownership throughout the value chain, from the procurement of raw materials to the sale of finished products. Thus, manufacturing and purchasing represent substantial opportunities to optimize and garner cost savings.
Strategies to Decrease Production Costs
Procurement: Strategic Sourcing Basics
Firms should focus on enterprise-wide spend aggregation and open communication lines between divisions through an inter-company sourcing or commodity council. Sourcing knowledge should be shared across the organization, and sourcing activities should be implemented as company-wide initiatives. Additionally, companies should research existing contracts in contract repositories across divisions and leverage the best existing contracts.
Purchase on Consignment
Producing in excess to prevent stock-outs incurs heavy raw material costs. Many medical devices use precious metals and other high-value materials in manufacturing. Therefore procurement teams generally use commodity hedging strategies and stock excess raw materials on hand. This means that the unfinished goods sit on balance sheets, affecting the overall financial performance of the company. To counter this, medical device procurement teams must renegotiate supplier contracts to purchase raw materials on consignment—paying suppliers only once finished goods are sold to customers— thus reducing inventory risks and liabilities. This approach would decrease raw material holding costs and positively affect the balance sheet.
Firms should outsource manufacturing processes that are not core competencies. For example, some medical device companies outsource the production of pacemaker components such as production of the titanium body while they retain in house manufacturing of the pacemaker leads, as they are experts in lead production. Although government approval and certifications would need to be obtained for the supplier’s manufacturing facility and tooling may need to be procured on behalf of the supplier, this setup can garner production efficiencies and savings.
The medical device industry is at a crossroads due to new legislation and growing overseas competition. Firms must transform their supply chain practices in order to remain competitive and sustain their enviable margins.