Chapter 11. Supply Chain & Inventory Management

Chapter 11.
Supply Chain & Inventory

Management
Chapter 11: Quantitatve

Methods in Health Care Yasar A. Ozcan 1
Management
Outline
Healthcare Supply Chain
Manufacturers/Suppliers
Distributors, Wholesalers
Group Purchasing Organizations (GPOs)
e-Distributors
Flow of Materials in Supply Chain
Supply Chain Management Issues for Providers
Contemporary Issues in Medical Inventory Management
Just-In-Time (JIT) & Stockless Inventories
Single vs. Multiple Vendors
Traditional Inventory Management
Requirements for Effective Inventory Management
Inventory Accounting Systems
Universal Product codes (UPCs)
Lead Time
Costs
EOQ Model
Reorder Point
Management
In healthcare organizations, supply chain is a new way
of conceptualizing medical supply management.
A supply chain is defined as a virtual network that

facilitates the movement of product from its
production, distribution and consumption (McFadden
and Leahy, 2000).

Management
Need for Healthcare Supply Chain Management
Improve operations
Increasing levels of outsourcing
Increasing transportation costs
Competitive pressures
Increasing globalization
Increasing importance of e-commerce
Complexity of supply chains
Manage inventories

Management
Figure 11.1 Healthcare Supply Chain
Manufacturers/ Pharmaceutical
Medical-Surgical
Suppliers
Devices
Upstrea
Wholesalers
m
Distributors Group Purchasing Organization (GPOs)

e-Distributors
Hospitals
Hospital Systems
Downstream
Providers Physicians
Integrated Delivery Networks (IDNs)
Patients/Individuals
Employers
End Users Insurers
HMOs
Drug Benefit Agencies
Government

Management
Manufacturers/Suppliers. Manufacturers of medical
supplies can be classified in three categories:
1) drugs/pharmaceutical,
2) medical-surgical supplies, and
3) devices.
Some manufacturers produce supplies in more than one

category or in all categories.

Management
Well known pharmaceutical manufacturers include Abbott,
Aventis Pharma, Bristol-Myers Squibb, Eli Lilly, Merck,
GlaxoSmithKline, Hoffmann-La Roche, Janssen,
Johnson & Johnson, Pfizer, Schering-Plough and Wyeth.
Twenty-five percent of pharmaceutical products are

distributed to providers (hospitals and other institutional
settings) via distributors.
Medical-surgical companies produce items such as injection

syringes and needles, blood and specimen collection kits,
hospital laboratory products, wound management products,
and intravenous solutions.
3M, Abbot, Baxter, Johnson & Johnson are a few of the well
known medical-surgical companies that sell majority of
their products through distributors.

Management
Medical devices can be described as very high priced,

technologically sophisticated and advanced apparatus that
are used for diagnosis and therapies.
Medical devices include surgical and medical instruments

And apparatus, orthopedic, prosthetic and surgical
appliances (for example, shoulder, knee, and hip
replacements), X-Ray apparatus, tubes, irradiation
apparatus, electro-medical and electro-therapeutic devices.
Dupuy, Ortho Biotech, Medtronic, and Zimmer are examples

of the companies that manufacture such devices (Burns,
2002; p.244).

Management
Typical Supply Chain for a Healthcare Service
Supplier
Supplier
} Storage Service Patient
Implants
Replacement knee Operating Room
Replacement valve

Management
Distributors
Distributors for
andmedical-surgical
Wholesalers supplies are independent
intermediaries who operate their own warehouses; they
purchase the products from manufacturers/suppliers to sell
to providers.
Similarly, pharmaceutical intermediaries

purchase the drugs/pharmaceuticals from manufacturers
and wholesale them to pharmacies or to providers. Well
known distributors of pharmaceuticals include
AmriSource/Bergen Brunswig, Cardinal Health/Bindley
Western and McKesson.
The intermediaries are called distributor or wholesalers

depending on whether the products final resale has another
layer before reaching the customer (Burns, 2002; p.127).
Cardinal Health, Owens&Minor, and McKesson are major
distribution companies in hospital market.

Management
Electronic Data Interchange (EDI)
Linking providers through electronic communication to their
distributors is formally defined as electronic data interchange
(EDI).
EDI provides direct, real-time computer to computer electronic

transmission of purchase orders, shipping notices, invoices and the
like between providers and distributors.
Over seventy-five percent of distributors use EDI, and seventy to

eighty percent of their business volume is handled through EDI
(Burns, 2002, pp.130-131).
EDI is also proliferating to manufacturer transactions with other

parts of the health care supply chain; more than one-third of their
business transactions use EDI.
The cost for standardized EDI transactions for a purchase order, as

compared to costs with manual systems, saves operational costs
for both providers and distributors.

Management
Electronic Data Interchange (EDI)
Increased productivity
Reduction of paperwork
Lead time and inventory reduction
Facilitation of just-in-time systems
Electronic transfer of funds
Improved control of operations
Reduction in clerical labor
Increased accuracy
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Management
Group Purchasing Organizations (GPOs).
Group purchasing organizations provide a critical financial

advantage to providers, especially hospitals and hospital systems,
by negotiating purchasing contracts for products and non-labor
services.
A typical GPO has many hospital organizations as its members and

uses this as collective buying power in negotiating contracts with
many suppliers: of pharmaceuticals, medical-surgical, supplies,
laboratory, imaging, durable medical equipment, facility
maintenance, information technology, insurance, food and dietary
products and services.
The contracts usually last three to five years, giving providers price
protection (Burns, 2002, pp. 60-64).

Management
Group Purchasing Organizations (GPOs).
Over 600 GPOs operate in the United States; perhaps half of them
focus their business on hospitals.
The two largest GPOs are Novation and Premier, which are
nonprofit. AmeriNet, HSCA and Consorta are the other sizable non-
profit GPOs.
The two investor-owned, for-profit GPOs are HCA/Health Trust and

Tenet/BuyPower.
A provider may be member of multiple GPOs. The average Hospital

GPO membership ranges 1.6 to 2.6 GPOs in US.

Management
e-Distributors.
e-commerce in health care can be viewed from different

perspectives. Here we will concentrate on two aspects:
business to business (B2B) commerce and business to
customer (B2C) commerce.
Examples of B2B firms are: Medibuy, Neoforma, MedAssets,

OmniCell, and Promedix.
These firms provide e-Catalog, e-Request for Proposal (eRFP),

e-Auction, and e-Specials.

Management
Flow of Materials
It is important to note that depending upon the type of
medical supply, the flow of materials in the supply chain may
take more direct routes to providers or end users. Suppliers
may bypass GPOs by not contracting or negotiating price
arrangements.
High-end implants and medical devices, specialty items of

low volume but high price, are good examples of such
medical supplies for which suppliers use direct delivery,
usually via express services (like FedEx, UPS, or DHL) or
have their own local/regional sales representatives make
the just-in-time (JIT) delivery and serve as consultants to
physicians. In some cases, the companys representatives
provide technical participation with surgeons in implanting
devices surgically.
Other cases in which suppliers may bypass GPOs in

contracting are for small-volume, esoteric items, and for the
brand-name, specialty drugs used to treat cancer and
cardiovascular problems.

Management
Contemporary Issues in Medical Inventory Management
Just-In-Time (JIT) and Stockless Inventories.

Inventory management in healthcare organizations is
becoming increasingly decentralized. JIT means that
goods arrive just before they are needed.
Stockless inventory means obtaining most of supplies

from a single source (a prime vendor) in small
packaging units ready to be taken to the user
departments.
Single versus Multiple Vendors. The essence of the

purchasing function is to obtain the right equipment,
supplies and services, and of the right quality, in the
right quantity from the right source at the right price
at the right time.

Management
Traditional Inventory
Management
Inventory Is. . .
STOCK OR STORE OF GOODS
Or Stock Keeping Items (SKUs)

Management
An Inventory Disaster!
Imagine the following scenario, in which the healthcare
supply chain manager has to explain to a member of senior
management why the emergency room found itself without
the syringes.
..Sorry sir, but when she (the patient) came into the ER,
we were out of syringes. Our anticipation stocks were
depleted because we hadnt corrected the ordering
patterns for seasonal variations. Then, the snow delayed
shipments from supplier, and our safety stocks just werent
good enough! You know we usually order in bulk to take
advantages of large economic lot size and lower our
ordering cycle. Our last order was especially large because
we wanted to hedge against predicted price increases! In
the final analysis, our inventory just wasnt sufficient to
permit smooth operations

Management
The COOs Response
(i.e., Inventory objectives and requirements)
I hope you do realize that it is

your duty to both maintain a high
level of customer service and
minimize the costs of ordering and
carrying inventory! All I ask of
you is that you make two
fundamental decisions-- when to
order and how much to order.

Management
Effective Inventory Management
The requirements for effective inventory include:

A system to keep track of inventory
A reliable forecast of demand
Knowledge of lead times and lead time variability
Reasonable estimates of inventory holding costs,
ordering costs, and shortage costs
A classification system for inventory items

Management
Inventory counting systems can be

either:
Periodic
Perpetual
Batch
Line

Management
Inventory Counting Systems
Periodic System
Physical count of items made at periodic intervals
Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item

Management
Inventory Counting Systems (Contd)
Two-Bin System - Two containers
of inventory; reorder when the first
is empty
Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
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Management
Inventory Counting Systems (Contd)
Universal Product Codes (UPCs). The UPCs have
been around since late 1970s and are used in
industry. A UPC can have up to 20 character
numbers that uniquely identify a product, for
example, of pharmaceutical or medical-surgical
supply, using bars with different variety and
thickness that can be read by scanners. The
order of the information in UPCs identifies the
type of product, its manufacturer, and the
product itself.
Chapter 11: Quantitatve 214800 232087768

Management
Universal Product Codes (UPCs).
Only 26 percent of medical-surgical products can be scanned on nursing

units, and only fifty percent of drugs have bar codes for unit doses.
According to the final regulation issued by the Food and Drug

Administration (FDA) in 2004, drug manufacturers must adopt bar coding
to single-dose units within two years, and hospitals must eventually
implement bedside scanning systems.
The FDA estimates, however, that it may take up to two decades for all
hospitals to implement such systems because of their high costs: from $.5
to $1 million. Only a few more than 100 hospitals currently them.
Yet bar code systems would significantly improve the quality of patient
care through reduction of medication errors. It is estimated that over a 20-
year period, fully implemented bar code systems would prevent about .5
million medical errors. Moreover, by improving the cost-efficiency of
medical supply management, hospitals would also reap $90 billion in
savings, which would help to pay for the technology (Becker, 2004).
Management
Lead Time
Inventories are used to satisfy demand requirements, so

reliable estimates of the amounts and timing of demand are
essential. It is also essential to know how long it will take for
orders to be delivered (Stevenson, 2002, p.547).
Now that healthcare organizations increasingly rely on their

vendors to maintain adequate inventory levels in their
facilities, their data relevant to demand must be transferred to
their vendors.
Healthcare managers also need to know the extent to which

demand and lead time (the time between submitting an order
and receiving it) may vary; the greater the potential
variability, the greater the need for additional stock to avoid a
shortage between deliveries.

Management
Costs of Inventory:
Holding (carrying costs)-- interest, insurance,
depreciation, obsolescence, deterioration,
spoilage, pilferage, warehousing costs
Ordering costs-- associated with ordering and
receiving inventory
Shortage costs-- when demand > supply on
hand; opportunity costs of lost customers
loss of goodwill; death of a patient and
potential lawsuits

Management
The A-B-C Approach: Classifying inventory according to some
measure of importance and allocating control efforts
accordingly.
A relative importance
classification system
A - very important (15-
60 20% of items; 60-70%
% of of $$$s)
Annual 40
B - moderate
dollar A
volume 20 C - least important (60-
B 70% of items; 10% $$
0
$s)
20 Tightest controls and
% of C
Items 40 management should be on
A items
60

Management
Table 11.1 A-B-C Classification Analysis
Item Annual Unit Annual Percent

Demand Cost costs of Total A-B-C
Classification
1 20800 2.50 52000 1.2% C
2 83200 0.50 41600 1.0% C
3 9100 37.50 341250 8.0% B
4 13000 3.50 45500 1.1% C
5 13000 1.75 22750 0.5% C
6 790 1290.00 1019100 24.0% A
7 78000 2.25 175500 4.1% B
8 114400 0.65 74360 1.8% C
9 66040 0.95 62738 1.5% C
10 6240 12.50 78000 1.8% C
11 11440 2.00 22880 0.5% C
12 18200 1.50 27300 0.6% C
13 910 1300.00 1183000 27.9% A
14 315 2700.00 850500 20.1% A
15 65000 3.75 243750 5.7% B
Total Annual Costs 4240228

Management
EOQ Model
ECONOMIC
ECONOMIC ORDER
ORDER QUANTITY
QUANTITY model--
model--
It
It answers
answers the
the question,
question, How
How much
much
should
should II order
order?
? by
by allowing
allowing you
you to
to
determine
determine anan optimal
optimal order
order quantity
quantity in
in
terms
terms of
of minimizing
minimizing the
the sum
sum ofof certain
certain
annual
annual costs
costs that
that vary
vary with
with order
order costs.
costs.
Remember what the costs are?

Management
Figure 11.2 The Inventory Order Cycle for Basic EOQ Model
Order Quantity, Q
Cycle 1 Cycle 2 Cycle 3 Cycle 4

Q
Level of Inventory
Depletion or
Demand Rate Average inventory
Q Q
2 2
R (ROP)
0
Required Time (days)
Reorder Point safety stock
Reorder Time Order Received
Lead Time

Management
Average inventory level and number of orders per year are
inversely related. WHY?
Average Inventory
0
Many orders, but low average inventory.
1 year
0 Average Inventory
Few orders but high average inventory.
Management
To refresh memory. .
Basic EOQ models minimize the sum of the holding
and ordering costs of inventory.
Several assumptions are important to use for the
model:
Only one product is involved
Annual usage (demand) requirements are known
Usage is spread evenly throughout the year so that
usage rates are fairly constant
Lead time does not vary
Each order is received as a single delivery
There are no quantity discounts.

Management
Annual Cost Holding & Ordering Costs Conceptualized
Annual Cost
QH DS
2 Q
Order Quantity Order Quantity
Ordering costs (S) are inversely

Carrying costs (H) are linearly
and nonlinearly related to
related to order size (Q).
order size (Q).
Q D
Annual Carrying Cost = H Annual ordering costs = S
2 Q

Management
Figure 11.3 The Economic Ordering Quantity Model
Q D
Total cost TC H S
2 Q
Annual cost
Minimum
TC Q
Holding cost 2 H
Co'
Co
D
Qo Flexibility zone for Ordering cost Q S
Packaging requirements
Qo
Order Quantity, Q
Marginal cost for
packaging requirements
Economic Ordering Quantity (EOQ)
Management
EOQ Model
ECONOMIC
ECONOMIC ORDER
ORDER
QUANTITY
QUANTITY model--
model--
It
It answers
answers the
the
question,
question, How
How much
much 2 DS
should
should II order
order?
? by
by Qo
allowing
allowing you
determine
you to
determine an
to
an optimal
optimal
H
Q
Q00..

Management
Example 11.1: Syringe Inventory
An orthopedic physician group practice uses 12cc syringes from
Sherwood for their cortisone injections. During the each of last two
years, 40000 of them were used in the office. Each syringe costs
$1.50. The physicians office annually discards, on average, 500 of the
syringes that have became inoperable (broken, wrong injection
material, lost). The syringes are stored in a room that occupies 2% of
the storage area. The storage area constitutes 10% of the leased
space. The annual office lease costs $60,000. The group practice can
secure loans from a local bank at 6% interest to purchase the syringes.
For each placed order, it takes about three hours for an office assistant
(whose hourly wage is $9.00 and who receives $3.25 in fringe benefits)
to prepare, and communicate the order, and place its shipment in
storage. In addition, each orders overhead share of equipment and
supplies (phone, fax, computer, stationary paper) is approximately
$4.50. In the past, the office assistant always placed 5,000 syringes in
each order. The deliveries are made in boxes of 1000 syringes and are
always received three working days after the order is placed.
What should be the EOQ for the 12cc syringe?
What are the inventory management costs for these syringes?
What are the investment costs?
How many times in a year should an order be placed?
Management
Solution:
To calculate EOQ, we need to estimate the holding and ordering costs.
Annual holding cost
1) Cost of inoperable syringes 1.50 * 500 = $750.

2) Storage cost (60000 Lease) * .10 (storage area) * .02 (syringe) = $120.
3) Interest on a loan used to purchase 5000 syringes: 5000 *1.5*.06 = $450.
Total annual holding costs = 750 + 120 + 450 = 1320.

Annual holding cost per syringe: 1320 40000 = $.033.
Ordering cost
Office assistants time 3 hours * (9.00+3.25) = $36.75.
Overhead $4.50.
Total ordering cost $36.75 + $4.50 = $41.25.
Using formula the EOQ formula:
2 DS
Qo
H
2 * 40000 * 41.25
Q0 10,000
.033
Management
Solution:
Total inventory management cost calculated using formula:
10000 40000
TC .033 41.25 or
2 10000
TC 165.00 165.00 $330.00.
Investment cost:
Investment costs = Order quantity * price of the item, or
= Qo * p = 10000 * 1.50 = $15,000.00.
Investment cost is the amount committed to purchase the

syringes. It is cycled as the cost of the syringes is recovered
from patients and/or third party payers.
Order Frequency is calculated using formula:
Q0 10000
Length of Order Cycle .25 years or every three months
D 40000
In other words, order frequency is four times a year.

Management
Summary
The two decisions were how much to order, and
when to order. To determine how much to order,
you use an EOQ model that minimizes the sum of
the total ordering and carrying costs.
When to order?
Should we order when you are almost out
of inventory?!

Management
When to Order?
The reorder point occurs when the
quantity on hand drops to a
predetermined amount.
There are 4 determinants of the
reorder point quantity:
Rate of demand
Length of lead time
Extent of demand and lead time
variability
Degree of stock-out risk acceptable
to management.
Demand Rates and LeadTimes can
be constant or variable.

Management
Constant Demand Rate and Lead
Time
There is no risk of a stock-out created by increased demand of
lead times longer than expected. Thus, ROP equals the
product of usage rate and lead time; no cushion stock is
necessary.
Example 11.2
An orthopedist surgeon replaces two hips per day. The
implants are delivered two days after an order is
placed, via express delivery. When should the supply
chain manager order the implants?
Solution:
Usage = 2 implants daily.
Lead Time = 2 days.
ROP = Usage Lead Time = 2 * 2 = 4.
Thus, order should be placed when 4 implants are left!

Management
Variable Demand Rates and/or Variable
Lead Times
Safety Stock-- stock held in excess of expected demand
when demand rate and/or lead time is variable
ROP = Expected demand during lead time + safety stock
Example 11.3
A dentist office uses an average of 2 boxes of
gloves (100-glove boxes) per day, and lead
times average 5 days. Because both the
usage rate and lead times are variable, the
office carries a safety stock of 4 boxes of gloves.
Determine the ROP.
Solution:
ROP = 2 boxes/daily 5 day lead time + 4 boxes
ROP = 14 boxes.
Management
Variable Demand Rates and/or Variable Lead
Times
Service Level-- probability that demand will not exceed
supply during lead time.
Service level is the complement of stock-out risk; 95%

service level means a 5% risk of stock-out.
The greater the variability in either demand rate or lead

time, the greater the amount of safety stock needed to
achieve that service level.

Management
Summary Again
The two decisions were how

much to order, and when to
order.
To determine how much to order,
you use an EOQ model that
minimizes the sum of the total
ordering and carrying costs.
When to order is determined by
a reorder point model, and varies
according to knowledge of lead
times and demand.
Management
The End

Management

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Chapter 11.

Supply Chain & Inventory

Chapter 11: Quantitatve

A supply chain is defined as a virtual network that

Chapter 11: Quantitatve

Chapter 11: Quantitatve

Distributors Group Purchasing Organization (GPOs)

Chapter 11: Quantitatve

Some manufacturers produce supplies in more than one

Chapter 11: Quantitatve

Twenty-five percent of pharmaceutical products are

Medical-surgical companies produce items such as injection

Chapter 11: Quantitatve

Medical devices can be described as very high priced,

Medical devices include surgical and medical instruments

Dupuy, Ortho Biotech, Medtronic, and Zimmer are examples

Chapter 11: Quantitatve

Chapter 11: Quantitatve

Similarly, pharmaceutical intermediaries

The intermediaries are called distributor or wholesalers

Chapter 11: Quantitatve

EDI provides direct, real-time computer to computer electronic

Over seventy-five percent of distributors use EDI, and seventy to

EDI is also proliferating to manufacturer transactions with other

The cost for standardized EDI transactions for a purchase order, as

Chapter 11: Quantitatve

Group purchasing organizations provide a critical financial

A typical GPO has many hospital organizations as its members and

Chapter 11: Quantitatve

The two investor-owned, for-profit GPOs are HCA/Health Trust and

A provider may be member of multiple GPOs. The average Hospital

Chapter 11: Quantitatve

e-commerce in health care can be viewed from different

Examples of B2B firms are: Medibuy, Neoforma, MedAssets,

These firms provide e-Catalog, e-Request for Proposal (eRFP),

Chapter 11: Quantitatve

High-end implants and medical devices, specialty items of

Other cases in which suppliers may bypass GPOs in

Chapter 11: Quantitatve

Just-In-Time (JIT) and Stockless Inventories.

Stockless inventory means obtaining most of supplies

Single versus Multiple Vendors. The essence of the

Chapter 11: Quantitatve

Chapter 11: Quantitatve

Chapter 11: Quantitatve

I hope you do realize that it is

Chapter 11: Quantitatve

The requirements for effective inventory include:

Chapter 11: Quantitatve

Inventory counting systems can be

Chapter 11: Quantitatve

Chapter 11: Quantitatve

Chapter 11: Quantitatve

Chapter 11: Quantitatve 214800 232087768

Universal Product Codes (UPCs).

Only 26 percent of medical-surgical products can be scanned on nursing

According to the final regulation issued by the Food and Drug

Inventories are used to satisfy demand requirements, so

Now that healthcare organizations increasingly rely on their

Healthcare managers also need to know the extent to which

Chapter 11: Quantitatve

Chapter 11: Quantitatve

Chapter 11: Quantitatve

Item Annual Unit Annual Percent

Chapter 11. Supply Chain & Inventory Management

Chapter 11. Supply Chain & Inventory Management