Q&M Medical Supply's pricing strategy: ABC versus cost-plus

Logistics

This case study presents the situation that Q&M, a major U.S. medical supply distributor, had to face with in 1996, just before making an important bid for a distribution contract, valuable for the company's future on the market. We will analyze together the two pricing approaches the company can use - ABC (Activity-Based Pricing) and Cost-plus. After closely observing each alternative's strengths and weaknesses we would propose a final offer and implement the pricing strategy that better suits the company's interests.

Brief environmental analysis

The Medical Supply industry is a growing one, offering companies huge incomes due to the social phenomena of aging population and breakthroughs in medical technologies, leading to the development for new drugs and devices that people can use in order to cure different diseases and medical conditions. However, the distribution companies, like O&M, were put in a delicate situation in the mid 90s. As the distributors aimed at selling to important health facilities such as, hospitals, clinics and individual drug stores, these entities had seen the opportunity to unite and form one conglomerate buyer, so that could reap off the benefits of external and internal economies of scale, consolidating relationships with the suppliers, and cutting distribution margins.

This is the economic environment Q&M had to face, in a critical stage of its development. After being one of the top distributors of medical supplies in U.S., the company was forced by aggressive competition (especially by Atlantic Healthcare which had an advantage due to the fact that it was a subsidiary of a medical supplies manufacturer and was able to offer incredibly low distribution fees on the account important sales made by the mother-company) to find ways to cut back on its expenses, without neglecting the needs and wants of the customer. Q&M was witnessing, at the level of the year 1996, huge expenses incurred due to the fact that customers concluded heavily negotiated contracts with low distribution fees (around 7%), but with expectation of additional services, such as the distributor must deliver on a stock-free basis products in reduced packages, so that it could be used directly and in due time in hospitals by physicians.

Summary of the impact on Logistics supply chain management

In the previous paragraph, we presented the Cost-plus approach. O&M management introduced a pricing method entitled "Activity-Based Pricing," which was aimed at reducing the expenses for the company and also at inducing the idea to customers that they should be more efficient in ordering different products from the supplier, even if this solution assumes renouncing to the zero-inventory strategy that was used before. ABC pricing strategy would match the distribution fees with the services rendered by the company so that the hospitals and clinics could use more efficiently the ordered products. In this way, the waste of financial and time resources will he highly reduced, so O&M can better analyze the actual incurred costs, and on the long-run it can run on enhanced profits.

In order to have a clearer image on the advantages presented by the ABC approach and its reduced expenses for both commercial entities, we chose to select Exhibits 4 and 5 from the Case Study.

In Exhibit 4 the case for Cost-plus pricing technique is presented. It is computed that at 150,000 dollar-order, the distribution fee and commission represent and extra margin of 22,500 dollars. After adding the extra expenses, like administrative, order processing, general and other expenditures, the Total operating expenses end up at the level of 30,759. On the other hand, in Exhibit 5, the statistics for the Activity-based pricing method is presented in the form of a pricing matrix. The two determinants of the distribution fees, according to O&M management, are the number of monthly purchase orders (PO), and the number of lines ordered per month. So, as a result, if we proceed with the data from Exhibit 4, namely Total expenses of 30,759 dollars, the customer could make an average number of purchase orders of 111 to 130, and an average monthly number of lines order of 3250 to 3749. This fact raises an important issue as the, first of all, the company could monitor closely its costs, and subsequently could match the costs incurred to the distribution fees charged to the customer, and the customer also may induce an efficiency in his procurement activity, leading to reduced costs according to the monthly product orders.

Implementing the optimal solution

This Activity-based pricing method will be submitted by O&M as a bid for the medical supply contract to Ideal. The strengths of the O&M proposal are the fact that the company could provide a large variety of products and brands, which the competition cannot, as they are subsidiaries to a manufacturer and their product lines are limited to the products of the manufacturer. Secondly, the offer may permit both companies, the Distributor and the Customer to better track their costs, and make their activities more efficient, as the elements of the pricing matrix- number of monthly purchases induce the fixed administrative costs, while number of lines purchased match the variable costs. Their proposal is considered a very flexible one, able to better suit the interests of the customer, and adjusting in turn his costs to actual needs for medical supplies and devices. Also the distributor-customer relationship will be consolidated through the transparency assumed by this proposal, due to the fact that the customer will have access the O&M financial performance statements to better observe the costs and level of revenues of its supplier.

However, this pricing strategy may encounter difficulties in being actually implemented on the market. The client may have complaints about the fact that Cost-plus strategy was a common practice within the medical industry, and the entire budget forecasts and provisions were computed based on the Cost-plus pricing strategy. The employee's of the customer may have little incentives of being efficient in their activity so the new approach would not bring as many benefits for the customer. This issue can be resolved through the introduction of employee policies regarding the use and procurement of medical supplies and the reintroduction of storage spaces, so that the Supplier would gradually renounce to the zero-inventory distribution.

As a conclusion, taking into consideration the advantages and drawbacks of the ABC pricing method, the Distributor and Consumer must find way to an agreement. Reducing expenses on both sides is a mandatory condition for staying into business in a competitive market, with low margins and extensive services offered to the clients. But on the long-run, both companies could profit from this approach, and also get a stronger and more durable working relationship.