Measuring Supply Chain Costs

The bad news: This turns out to require a fairly major effort the first time through. The good news: Subsequent cost studies tend to be much simpler and faster. Thankfully, we are at last well into the good news phase.

Cost Components

Supply chain costs for medical and surgical supplies have four primary components:

1. Physical handling costs
2. Transaction costs
3. Capital costs (inventory carrying costs)
4. Storage and space costs

Physical Handling Costs___These costs are driven mainly by purchase order (PO) lines. Each PO line requires a specific set of activities to be performed. You have to do at least dock receiving, internal distribution, detailed receiving, and item putaway. Also required with some percentage of lines is exception or problem resolution — misplaced and expired items, damaged items, wrong items.

Transaction Costs___These costs are generated by activities dealing with the business and documentary aspects of supplies purchase, expediting, stock keeping, usage tracking, invoice payment, and similar administrative process steps. Transaction costs can often exceed the cost of physical handling as well as the product cost itself.

Capital Costs___Capital costs show up as book inventory and must be financed along with other current assets such as receivables. Inventory carrying costs for expensive products, such as physician preference items, can add up to a substantial capital requirement in times where capital cost is rising and access to new capital is shrinking.

Storage and Space Costs___Space in hospitals is often very costly if viewed from an alternative use standpoint. In patient care areas and operating rooms, especially, floor space is prime revenue-generating space. Adding stockroom space that removes any significant block of patient care space is typically difficult. Automated storage systems are also quite costly—often adding costs of several hundred dollars a year per cubic foot of space.

Our simulation model includes each of these four primary cost-generating processes. Physical handling and transaction costs are allocated to PO lines as a first approximation. Inventory carrying costs are based on a model-calculated average inventory quantity valued at purchase cost. Space costs are estimated using a floor space cost allocation to each storage cabinet, which is then allocated to stored items based on their storage volume ("cube") requirements.

Measuring Labor Costs

Once you have a good picture of the physical flows of supplies throughout the hospital, you can begin to allocate costs to each item's flow. Labor is generally the dominant cost component.

This is not as simple as it might appear. Only a few staff positions are fully dedicated to supplies. Many positions have some time spent on supplies-related activities. The trick is to build up a reasonably complete picture of how much time each position typically spends on supplies activities.

You first have to build a complete list of all significant supplies-related processes and activities. Then you have to identify the staff positions that are involved in each activity and the percentage of time that each person spends on the activity. This is a major task for any large hospital with thousands of employees in hundreds of departments.

You will find, for example, that patient care area nurses may spend as much as 10% to 20% of their time getting supplies, dealing with local stockouts, and resolving problems like expired items or misplaced items. Head nurses or their assistants may spend several hours a week requisitioning supplies, particularly physician preference items.

Why not just sample a few "typical" hospital units and use these to represent others like them? Sounds good in theory but doesn't work out so well in practice. We learned that superficially similar units can have dramatically different activities and supply chain requirements.

For example, we recently analyzed a floor with three nursing units that seemed quite similar at first. As we learned more, we found that one unit specialized in post-operative care for urology patients. Another handled IV therapy. The third was what we saw as a "general" nursing unit. There were major differences in operation, supplies used, and needs.

In any case, once you have an initial set of data on time spent by activity and position, you can apply average pay rates and benefits burdens to each activity. We may also add some variable overhead — such as education, cell phones and pagers, conferences, and similar line items — where it can be identified and costed.

Allocating Costs to PO Lines

The final step involves allocating activity costs to each order line that flows through the activity. This gives you a set of cost per line for each primary supply chain path.

Cost per line may have to be further broken down by the type of material being handled. For example, certain items such as especially costly or critical ones may require special receiving inspection.

We may also add a cost increment for order lines that involve a high quantity of "eaches" — individual items that must be counted (but are often not counted or are miscounted). These can generate headaches and costs in payables and purchasing in order to reconcile quantity differences between purchase order, invoice and receiver.

Data Requirements

Besides data on staffing by position and location, our data requirements typically include: a three-month sample of purchase order transactions by line, central supply transactions by issue line, and, if available, point-of-use transaction detail data such as that generated by automated storage and ordering systems like Omnicell and Pyxis. We also ask for inventory snapshots, item master files, and location master files. For additional information, please see Typical Data Requirements.

Practice:   3. Action

Once you have the basic data, you can begin to develop action plans for reducing supply chain costs. Here are a few ideas ... Action Plan for Supply Chain Costs ...

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Close Enough is Good Enough

A common mistake in measuring costs is to attempt to get everything worked out to the penny. This results in much wasted effort.

To identify the major pools of cost takedown opportunity, you only need to be roughly accurate. These opportunities will be large enough to be apparent despite any minor measurement inaccuracies.

Consequently, we can make many reasonable estimates based on knowledge and experience and then check any that raise questions. This dramatically reduces the time and cost of measurement without reducing the value of what is found.

If an cost takedown opportunity is so close to the edge that more accurate measurements are needed, then it is probably too close to be worth pursuing.