In a near-unanimous response, 92 percent of the home medical equipment providers surveyed for HomeCare's 2004 Forecast (December 2003) said they intend to cut their costs this year. That is fantastic, because cutting costs is a requirement for the new era this industry has entered with passage of the Medicare Prescription Drug Act.
Nearly all of the cost-cutting methods providers reported, however, were centered on buying practices. For example, 47 percent of providers said they plan to buy products in bulk. But in spite of the old adage that declares, “You make your money when you buy, not when you sell,” buying in bulk may not produce the result providers desire.
There are a few important facts to consider before embarking on bulk purchasing practices. There is truth in the adage, but it doesn't tell the whole story.
The Rest of the Story
Just as accounts receivable represents cash in the checking accounts of payers, inventory represents providers' cash sitting on a shelf. Most providers work hard to collect AR and to get that money into their own checking account rather than letting it stay in the payer's account.
So why put inventory on a shelf? The logic most often used is that bulk, or volume, purchases reduce the cost per unit. That may be true, but it takes a pretty steep volume discount to offset the cost of holding inventory.
An analysis of the activity costs and financial statements of a significant number of providers shows that it costs 6 percent of the purchase price of the goods to hold them for the 45 days that providers typically hold inventory. That means a provider making $1 million worth of purchases in a year and holding the goods for 45 days spends $60,000 to let them sit in the warehouse.
If the same provider increases the holding period to 90 days as a result of bulk purchases, that holding cost will grow to $120,000. The conclusion is that for the average provider, the volume discount must be greater than 6 percent to be profitable.
In addition to the profitability issue, there may be a cash flow issue. With normal profit margins and inventory turns, a provider with annual sales of $1 million will have about $51,000 tied up in inventory on hand. If the same provider were to increase its volume of purchases by 50 percent, the average amount of inventory would increase to $76,000, or an increase of $25,000. That same provider typically has about $22,000 in the company checking account. If $25,000 moves from checking to a shelf in the warehouse, the checking account will be overdrawn.
Inventory is not always marketable. If a provider were forced to make a choice between having cash tied up in AR or inventory, AR would usually be the better choice. The reason is that inventory may become obsolete, lost or damaged while in the warehouse.
Good Buying Sense
Buying practices that could make more sense for providers include reducing the number of vendors, purchasing through buying groups, purchasing through wholesale distributors and cutting product selection. What makes even more sense is using combinations of good methods to reduce costs.
Purchasing through buying groups almost always creates a net savings to small- and medium-sized providers, even if no other benefit is available. Wholesale distributors often allow purchasing in small volumes. If an item purchased from a wholesale distributor can be sold on or near the same day it is received, a provider could easily justify paying 5 percent more.
Finally, 25 percent of the respondents to HomeCare's survey indicated they would give attention to their operations as a source of cost reductions — but more providers than that need to look there.
Wallace Weeks is founder and president of The Weeks Group Inc., a Melbourne, Fla.-based strategy consulting firm. He can be reached at 321/752-4514 or by e-mail at email@example.com.