The Costs of Doing Business

As the price of oil continues to spiral upward, the effects have been far-reaching and have impacted virtually every aspect of daily life for most individuals. The O&P industry, with a high dependence on petroleum-based products, has been hit particularly hard by the soaring price of oil, reflected in the increasing cost of goods and changes in the pricing matrix.

“The two things that have impacted our business the most over the last year are oil prices, which have driven up the cost of the manufacture of virtually everything, and then the transportation cost of virtually everything else,” said Tony Wickman, RT, OP, chief executive officer of Freedom Fabrication Inc.

The price of petroleum-based raw goods for manufacturing the plastics, foams, resins and adhesives for fabricating O&P devices has risen substantially in the past 18 months, often resulting in significantly increased costs for manufacturers, distributors, vendors and ultimately end users.

“A lot of things that we use in this industry are petroleum-based. If it is not a petroleum-based product, it is the petroleum to get it here, whether it is via sea, land or air,” said Brad Mattear, general manager of O&P1, who noted he has received price increases from numerous vendors, distributors and manufacturers just since August 2007. “The bottom line is the end product is more expensive to manufacture now than it was not only last year, but 6 months ago.”

Because recent changes in the cost of goods and the pricing matrix have resulted in an overall smaller profit margin and a decreased bottom line for many O&P businesses and companies, finding ways to offset these increases can be crucial to remaining in business.

Contractual agreements

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© 2008/ Slobodkin

One way to help offset rising costs is to negotiate contractual agreements for raw good materials. For example, Mattear noted O&P1 negotiated contractual plastics agreements that “were locked into a pricing matrix for our plastics just like the airlines did on fuel.”

Another contracting strategy Mattear used was to send out bid letters that asked companies to quote their best price on items to be used, which he noted was not an accepted O&P industry standard.

“The industry standard was, ‘You tell me how much of these you are going to use and I will tell you what your price and your discounts are,’ and what I did was ‘I am going to tell you I am going to use this, but you are going to give me the best price you can,’” Mattear said. “That way, from our perspective, we are working with the vendors on an honesty-based relationship that says, ‘OK, I am going to use this product. Just tell me the best price you can give me. I do not want to know that if I use 10,000 of them, it is going to be two cents cheaper.’”

By asking for the best price up front regardless of the amount of items needed, a volume-based price can be renegotiated in the future if warranted, Mattear said. In addition, this practice precludes having to purchase supplies from only one company in order to receive a volume discount.

“You are not obligated to buy from one company just to get that discount. There are a lot of companies out there that say, ‘Well, this other company is a good company, but we buy from this company because we want to get our discount,’” Mattear said. “That is what this was set up to avoid, especially in central fabrication because we have got every practitioner wanting something different. I just need the best price. I do not want to know that I have to strong-arm some practitioner to use this because I am going to get a better discount. That is not the way it should be. It should be what the practitioner wants at a good price with great customer service and it is out the door.”

Shipping costs

The rising cost of oil also has been reflected in the increased costs of transporting materials, further impacting the pricing matrix. As a result, freight costs and fuel surcharges are becoming extremely important, especially when vendors offer free freight for large orders, said Frank Friddle Jr., CO, FAAOP, president of Friddle’s Orthopedic Appliances Inc.

“Our margins are smaller due to freight costs, and we are seeing patient care facilities order in larger amounts to take advantage of special freight rates,” Friddle said. “This results in smaller margins for the bottom line.”

Tracking freight and shipping charges can be crucial for large and small companies alike. Companies can negotiate with UPS, Federal Express and DHL for preferential shipping rates. In addition, being diligent and using different trucking companies for freight can be advantageous as one truck line may offer a great rate from one geographical area of the country, but the rate from a different region can be much higher.

“My biggest word of advice to people is to watch freight costs because that is where the change is so volatile right now, and it has the potential to be devastating,” Friddle said. “Our freight costs are evaluated on a continuous basis.”

Employee health insurance costs

While the rising costs of petroleum-based goods and transportation represent two major increases influencing the pricing matrix in O&P, increased health insurance costs for employees is another factor that affects the bottom line.

“This past year, we are dealing with more things other than just the cost of fabrication supplies,” said Ed Grace, president of Grace Prosthetic Fabrication. “Health insurance costs are really going up, and we cannot control that, so what we have to do is we have to cut corners on insurance for our employees.”

Companies can lower their cost for employees’ health insurance benefits by increasing the amount of employees’ copay, which Grace noted is how they handled the rise in health care cost.

“The employees were not happy with the change in the insurance, but you know everybody has to give a little,” Grace said. “Right now we pay 100% for all of our employees, which a lot of companies do not do.”

Another way to hold down employee health insurance costs is to pay the full cost of only employees’ health insurance, with employees absorbing the cost of health insurance for their families.

“We used to offer free health and dental insurance to our employees and their families. We had to drop the family part of it and let the employee pick up that cost out of their pocket,” Friddle said. “Unfortunately, a lot of employees look at a base salary and say, ‘Well boy this is all I am getting, I could probably make some more somewhere else,’ but they do not understand what else they are getting. They do not understand the value of the benefits, and that is the way it is no matter where you go in whatever profession.”

Faced with a 40% increase in the cost of employees’ health insurance this year, Wickman said they were able to keep their costs flat by renegotiating a better rate with the insurance company. However, he noted they basically ended up with less and lower quality insurance for employees, and employees now pay a slightly larger copay than last year.

“We pay 100% of our health care coverage for all our employees, so they are charging us 40% more than they did last year, and then we are able to bill for less than we did the year before,” Wickman said. “It is weird paying that much more for health care and at the same time being able to bill for essentially less than we have in the past for reimbursement.”

He noted the company’s health insurance costs for employees had surpassed taxes, representing a major cost of doing business today.

“The health care industry has gone up substantially but then the medical industry is getting lower and lower reimbursement rates,” Wickman said. “It is just crazy to pay that much more into the health care system and be able to take less out. Where is that margin going?”

Inventory management

Freight costs and fuel surcharges are important, especially when vendors offer free freight for large orders.

Examining other potential profit drains in your business can reveal ways to trim costs and realize savings. Revamping business processes such as inventory management and employee training can keep costs down.

“We have done a number of things, not so much on the financial side because we have always been pretty conservative,” Wickman said. “Our conservative management of our accounts payable has really helped us keep our costs down, but we have definitely rearranged our model for how we manage our inventory.”

Previously, keeping one of everything in stock was standard operating procedure, which Wickman noted meant there was a lot of capital sitting on the shelf “collecting dust.” However, even as transportation costs have risen, the logistics of having supplies shipped quickly has become easier, negating the need to keep an endless supply of stock on hand.

“We have basically used up all our existing inventory and sent back what inventory we could, and now we run as lean as we possibly can,” Wickman said. “We get stuff here when we need it, so we have more of our capital freed up to pay our bills and negotiate with our suppliers for better rates, rather than having it just sit around on the shelf in the form of parts we may or may not ever use.”

In some instances, keeping less stock on hand occasionally may necessitate having parts flown in from suppliers. However, Wickman noted that less floor space is used for inventory and that inventory is a lot easier to keep track of, with much less capital sitting on the shelf.

Employee training

In addition to realizing savings by changing how inventory is managed, Wickman also has reduced costs by changing the way new employees are trained. New hires are trained to do more specific jobs, which takes more employees at a slightly lower skill level to do the same tasks, but volume is increased whereas costs are decreased.

“In the past, we have always been the company that did stuff nobody else could or wanted to do, and you cannot do that with an assembly line process. It takes a deep pool of broadly skilled individuals to be able to pull off these things, and it is just at the point where the economy of scale will not allow us to do that any more,” Wickman said.

Instead, new employees are trained more finitely to become skilled in one area that then becomes their area of expertise.

“Now we are able to arrange people in a manner that lets them use their particular skills, but because they are less highly trained, they generally demand a slightly lower wage and allow us better through put,” Wickman said. “So basically we have got the same 10 guys but now our production is up 20%.”

Other cost-saving measures

Shipping supplies quickly has become easier, negating the need to keep an endless supply of stock on hand.

Always looking for other ways to cut costs can help keep a company’s bottom line from shrinking in the face of rising costs. Taking advantage of different programs offered by distributors can be one way to help keep costs down.

“Distributors are trying to be more creative by offering different programs, which is great for us,” Mattear said. “I would suggest really working with distributors to get the best package available, whether it is shipping, whether it is discounts up front or whether it is rebates at the end of the year.”

One short-term option that can help offset rising costs is to pay less in dividends to owners.

“In 2007, things got to be tighter than in the past, so where we took the hit was the owners could not take any dividends for that year, and that was where the money was tight,” Grace said. “We made sure everything else stayed the same. There were times that I did think about having to lay off and cut hours and things like that, but we were able to weather the storm and get past that.”

Cutting back, delaying or even eliminating capital improvements also can help offset a reduced profit margin.

“Regrettably, as a company, I think what hurts the most is our inability to invest directly perhaps in some capital expenditures that we might otherwise enjoy,” said Ted Smith, purchasing manager for Knit-Rite Inc. “We are not in a position usually where we can afford to give up anything but the luxuries. When it comes to supporting our customer, that is always on our front burners.”

Because reimbursement rates have not kept pace with the rising cost of goods in the O&P industry, Wickman noted, “the pressure falls to us. If they cannot afford to pay more for our goods, then we cannot charge more for our goods.” He added that negotiating with suppliers and paying them more quickly to get a better rate has helped keep prices down, but that “the margins for our customers are getting slimmer and slimmer all the time.”

Ultimately, though, there is only so much that can be absorbed before the costs have to be passed on to customers. Manufacturers and distributors eventually have no choice but to increase their prices or risk going out of business.

Proactive business plan

Perhaps the most important strategy of all is for companies to have a proactive business plan in place.

“We are coming more on to the business side of things where you have to be proactive in your business plan. You have to foresee — not that anybody has a crystal ball — but you have to foresee what is happening,” Mattear said. “The good business practices might have noticed or foreseen the slowed down economy maybe a year ago or 6 months ago and properly planned for that.”

Mattear noted such planning might consist of cutting back or eliminating some perks, moving business finances around or even downsizing, adding, “A good business model is to weather the storm and foresee or forecast this a little bit and set yourself up for the future.”

Mary L. Jerrell, ELS, is a correspondent for O&P Business News.

Editor’s Note:
This story includes a small representative sample of individual companies and products. O&P Business News does not intend to promote individual companies or their products, nor to achieve an industry-wide consensus on the issue. Companies contacted in developing this story were randomly selected.

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