The Magic of Margin in Deal Making

Many hospital supply chain managers have stated that device makers’ margins are too high. Typically, cost/margin data from the pharmaceutical industry is utilized as a benchmark, These data indicate some pharma margins that are still elevated in spite of spending 75% of the “cost of the drug” on promotion and advertising. This argument is deeply flawed, and has some significant inconsistencies.

If we take a closer look at device companies spending, most report medical education and research funding as promotion. These services directly offset the costs for clinical and medical education for many providers, and directly increase the amount of revenue a research based institute generates. Cutting these “costs” from the commercial relationship between suppliers and healthcare institutions will have a deleterious effect on the provider community.

Furthermore, the net cost of salespeople and the compliment to their efforts in marketing is substantially lower. Many device and drug companies are publicly traded, and investors scrutinize expenses and margins. If 75% of costs were in one category, marginal profit would be approximately 75% lower than actual. This is because device and drug companies capitalize many of their development expenses, allowing the “profit margin” on the approved and consumed goods to be near 80-90%. This is the gross margin, against which other capital and promotion costs are charged, which would yield a much lower operating margin.

Still, common sense would suggest that spending even 25% of costs on promotion is extravagant and possibly wasteful. But here again there are some business characteristics that differ between providers and suppliers. Providers are best managed by focusing on the firm’s income statement; revenues minus expenses equates to operating profit. In contrast many suppliers are best managed by focusing on the balance sheet and increasing owners equity. The focus of financial management creates significant differences. It forces hospitals, especially “not-for-profit” institutions, to scrutinize input costs, specifically, supply and drug costs.

Suppliers, which are “for-profit”, scrutinize the present value of the “yield” on their capital investments, e.g. drug or device development costs. Consequently, suppliers can be deal prone (give a very good price) based on where they are in the lifecycle of the product, how much of the capital investment has been covered by ongoing sales, and whether the deal makes sense in the long term.

What is missed is the true drivers of operating costs for providers (labor and overhead). For suppliers, deal-based price variation increases their cost (Sales and General Administrative expense).

Next, the argument that “margins are too high” falls apart when attention is focused on reducing Sales and General Administrative (SGA) expense for the supplier, typically, by cutting sales and marketing costs. Doing so invariably increases margins for the firm in the short-term. Passing those savings along to the customer would still keep margins the same, i.e. “too high.”

It is important to note, that in most contracting situations, the supply chain management process works best with large suppliers and multiple sources of a commodity. Pricing-focused supply chain processes are much more difficult to successfully apply when products are unique or new, or even significantly different in configuration. But, because price in inherently quantitative, it gets a lot of attention and the provider’s threat to suppliers is switching the business.

We will dig into the flaws in that reasoning next.