Improved purchasing has played an important role in US hospitals’ efforts to cut costs and raise profit margins in the competitive market of the past decade. Given that a multihospital system with a $1 billion operating budget spends $300 to $350 million a year on medical supplies and purchased services, it is easy to see why. Improving purchasing can, moreover, reap significant savings without the need for job losses.

To date, many of these savings have been made by channeling purchases through group purchasing organizations (GPOs). The buying power of large GPOs is impressive: the three biggest (Premier, VHA/UHC, and AmeriNet) each bought goods worth more than $4 billion in 1997, giving them the clout to exert price pressure on suppliers, particularly for products in lower demand. And as GPOs have consolidated, manufacturers have offered bigger discounts to hang on to their contracts. None the less, hospitals have so far only scratched the surface of a much larger supply management opportunity.

Compared with the sophistication of supply management in some other industries, supply management in US hospitals is undeveloped. The automotive, electronics, and aerospace industries, for example, have earned billions of dollars in pre-tax profits during the 1990s by moving beyond price discounts to the full range of levers that affect spending productivity. Original equipment manufacturers in the automotive business have standardized chassis and platforms across product lines; electronics manufacturers have accelerated product life cycles by involving suppliers in product development; and aerospace companies have outsourced non-core operations. US hospitals, on the other hand, continue to grapple with fundamental supply management issues.

The first is that despite their scale advantages, GPOs have had relatively little impact on vendor rationalization and product standardization—both powerful methods of cutting vendor prices. Second, GPOs have had limited success in improving the way products are used, leaving hospitals struggling to curb excessive consumption. Third, purchased services, the fastest-growing item on many hospital budgets, now represent a greater expense than medical supplies, yet they rarely get the attention they deserve from the supply management organization and are not usually included in GPO contracts. Finally, purchasing departments continue to be a low-profile, disintegrated function in many hospitals, lacking the skills or support systems to capture the next wave of purchasing management opportunities.

All this suggests that GPOs are only one of many levers by which to improve hospital supply management, and not necessarily the most powerful. Hospital executives must move to a more sophisticated level of supply management, particularly as reductions in patient-care labor and administrative overheads have largely been exhausted as a means of cutting costs. Our experience suggests that hospital systems can reduce supply costs by up to 16 percent, making for a source of real competitive advantage.

To harness this opportunity, hospital executives will need to adopt a number of new principles:

Vendor rationalization and product standardization can be more powerful than scale when dealing with suppliers. The typical GPO offers discounts to hospital purchasers because of the scale of its combined purchases. Even the largest commercial hospital chains do not come close to the purchasing scale of GPOs.

Yet a GPO’s size can also hinder it in driving down vendors’ prices. Because membership is so diverse, with different hospitals in different parts of the country stipulating different supply needs, GPOs often find it hard to consolidate purchases with fewer suppliers in return for large discounts. Neither is it easy for a GPO to force all of its customers to use similar supplies. As a result, hospital systems that can drive product standardization and, therefore, vendor rationalization, can often negotiate better pricing directly from the manufacturer than a GPO can.

The theoretical impact of such rationalization is illustrated in Exhibit 1. It shows that a medical supplies manufacturer with gross margins in the region of 60 percent, and whose share of an account goes from 5 to 30 percent, would be able to give a discount of close to 50 percent and still earn the same total profit. If it starts with a higher share of 40 percent, a share increase to 60 percent would result in a "break-even" discount of 20 percent. In our experience, hospitals that can cooperate with clinicians to standardize products and rationalize vendors may negotiate extra savings of 5 to 10 percent over current GPO rates, depending on the item.

Standardization and rationalization are no easy tasks. The medical products and pharmaceutical industries spend enormous sums trying to persuade individual physicians and other healthcare providers to use their products. As the CEO of a $1.5 billion multihospital system says, "On any given day there are over 300 detailers working for all kinds of supply companies trying to influence the physicians in our system, often toward products that represent lower value to us. That is the enormity of the product standardization challenge we face."

Efforts to improve the use of supplies should focus on eliminating worst practice rather than standardizing best practice. For years, hospitals have been pouring resources into establishing "clinical pathways" that aim to identify a set of best practices for a given disease state or condition, and then encouraging doctors to follow them. The aim is to reduce unnecessary consumption of all resources, including supplies, associated with poor or even obsolete practices, and to substitute practices that are best in terms of both treating patients and controlling costs. The results of these efforts have been unsatisfactory for most hospital managers, because what constitutes best practice is often a matter for argument among doctors.

The alternative is to focus on eliminating worst practice, about which there tends to be more consensus. Moreover, eliminating worst practice requires fewer doctors to change their ways. An analysis of 11 surgeons’ use of sutures for a particular procedure, for example, showed that the average cost of suture supplies was being pushed up by the practice of just two surgeons. If the way in which these two worked could be altered to reflect just the average use of the remaining group, then suture expenses for the group would fall by 14 percent.

To change doctors’ behavior, managements will need to collect comprehensive practice data and present it in a way that enables doctors to compare individual practices. When presented with the facts, doctors are likely to fall into line with their peers, reassured that they can reduce costs without compromising quality or service. The difficulty is that many hospital information systems cannot easily provide this kind of feedback.

Service vendors should be managed as rigorously as medical suppliers. GPOs do not generally negotiate service contracts for linen, housekeeping, security, and electricity (or for clinical services such as dialysis or perfusion), because vendors tend to be local or regional. Yet a study of more than 300 US hospitals showed that purchased services are often the fastest-growing item on the operating budget, and that many hospitals now spend more on services (17 percent of total expenses) than on medical supplies (15 percent).

Most hospitals lack well-established procedures for evaluating, negotiating, managing, and monitoring service vendors. More often than not, individual departments negotiate with vendors independently of the supply management organization. So a group of hospitals within the same system may well find itself paying vastly different prices to different vendors for the same service (Exhibit 2). This must change; as the trend toward outsourcing accelerates, supplier management could become a core competence that improves productivity and forms the basis for competitive advantage.

To improve their handling of service vendors, managers first need to understand the economics and competitive dynamics of vendors’ industries. Grasping subjects such as cost drivers and contribution margins, excess capacity, market share, and the percentage of the service vendor’s local business that a hospital represents are all crucial to a sound negotiating strategy. This knowledge puts a hospital in a position to extract more value, the aim being to buy less, pay less, and receive deliveries more efficiently. Exhibit 3 shows the process used by one multihospital system to make 20 to 30 percent savings and secure better services.

Hospital purchasing needs to be an integrated organization with a higher profile. A multihospital system with a $1 billion operating budget may spend a third of it on medical supplies and purchased services, yet the importance of the purchasing organization in terms of spending is seldom reflected in the way the department is organized, or in the status conferred on purchasing managers. The typical hospital still has a director of materials management who purchases basic medical consumables, a pharmacist who handles pharmaceutical purchases, and a nurse director in the operating room who buys many frequently used items. All are likely to be two or three rungs down in the managerial hierarchy.

This structure serves the hospital well in terms of specialization, but each supply manager typically reports to different senior managers with different perspectives. The result is often an uncoordinated, sometimes divisive set of purchasing practices that vendors are quick to exploit with legions of sales representatives who may be able to drive a wedge between physicians and the purchasing department. Critical components of supply management, such as basic information flow, the development of negotiating skills, the ability to drive compliance, and even the leveraging of scale, are underexploited. As the most senior person in the purchasing chain is usually at least two levels down from the CEO, the function rarely attracts high-performing executives—or, given its potential to improve hospital finances, due attention.

Hospital systems therefore need to create a role for a senior purchasing executive who reports directly to the CEO or COO and is accountable for the hospital’s entire non-labor expenses. This executive will require an integrated database and the support of purchasing specialists—but vendors should understand that it is the person at the top who makes all the final purchasing decisions.

In addition, many hospitals need to upgrade purchasing professionals’ skills. Purchasing executives too often play a largely administrative role, their time taken up by purchase orders, accounts payable, reconciliation, and expediting. Few have the clinical or technical background or skills to engage with clinicians and focus on high value-added activities such as developing sourcing strategies, understanding the nature and dynamics of supply markets, finding and developing new suppliers, and working with users.

GPOs have created tremendous value through their scale advantages, giving smaller hospitals the opportunity to buy like big hospitals and big hospitals the chance to buy like mega-chains. But it is now time for the hospital industry to move to a higher level of purchasing performance by considering more sophisticated methods of supply management. Who will create the opportunity remains unclear: GPOs might offer new services, or hospital systems might choose to act independently. It is also feasible that entirely new industry participants will step in. What is clear is that the ability to focus on a fuller range of purchasing performance levers is becoming a productivity imperative.