The sources of value under managed care.

HEALTH CARE TODAY IS INCREASINGLY BECOMING A commodity world. That is, health care services are reaching an equality of quality. High levels of clinical skill and sophisticated technology can now be found in the community hospital, where it used to be the domain of a few major tertiary providers. Competing in a commodity world requires that health care executives think of value, not cost-cutting. The difference is huge, of course. Value considerations encompass a variety of strategies and options with respect to positioning the organization in today's competitive marketplace. Such thinking requires an overview of both the market and the organization's capabilities.

Our focus here is on value positioning, not planning, so this is not a paper on how to plan, what goes into strategic planning, or what strategic planners ought to do. Positioning an organization to compete effectively is a matter of appreciating what's important to an organization's success, when there are others in the market providing services competitive with our own. It is a topic of particular importance to health care today since this industry is in the midst of two strategic revolutions: one internal and one external. The internal revolution is the accelerating shift of managerial responsibility from traditional administrators to physicians, and the external shift is the change from earlier to later stages of what is being called managed care. Its simple and basic. Since the external marketplace (what we need to do) and our internal organization (how we choose to do it) need to be linked: physicians need to focus on the sources of value to themselves and their organizations in order to see the managed care environment as a field of opportunities instead of a field of threats.

The principles of value

First, value can be defined as the ratio of benefits to the costs of acquiring those benefits. (1) For an organization intent on positioning itself on value, the implication should be clear: only high value added to the customer can command high margins. Yet, in health care today, the common concern among most providers is that their margins are eroding in a world of managed care contracting. The only way to deal with margin squeeze is a value perspective.

Second, a basic tenet of industry evolution is that all products become commodities as industries mature. The health industry is no exception to this rule. As noted earlier, modern, sophisticated medicine can be found in this country virtually everywhere and most clinical services are product extensions, rather than anything entirely new on the scene.

Third, and closely linked with the second tenet, in mature industries it is increasingly recognized that the manufacturer's (read provider's) value is not in the basic (read clinical) service itself, but in service. An equality of quality and a duplication of services among several provider systems suggests that value must be considered outside the clinical service realm.

Fourth, the supplier closest to the customer is the one most visible on the value chain. As managed care entities enter the health care channel, the provider is increasingly removed from regular, ongoing contact with the company or the subscriber. Demonstrating value to the customer is increasingly difficult the farther away one is from that person.

These four principles of a competitive and mature market have altered the way services need to be positioned. Another difficult aspect of value is that unquantified value is unmarketable value. This is a harsh reality in a complicated industry such as health care, where the product is inherently difficult to assess, but premium price (high margins) demands proving value. Finally, it is essential to understand that marketplace value expectations are dynamic and always moving higher. With these aspects of value in mind, let's identify where health care organizations have historically turned to create value and suggest how that view might be broadened.

The sources of value

There are five basic sources of value that pertain to any business or stage of a business. Health care has traditionally been focused on one of the five, namely, assets. In recent years, two others have come into play for the industry to a lesser degree: product-based value (price and performance) and distribution, thanks in large measure to managed care pressures. A final two value sources, brand equity and capabilities, are our vote for where the forces of managed care will converge with the focus of strategic positioning in future years. All five of the sources of value will be discussed, along with their role in the evolution of managed care.

1. Assets

Some businesses own and/or utilize assets that other businesses don't have. The industrial revolution of the 19th Century dramatized, as much as anything, the superior value inherent in having machines to do work instead of just manual labor. Early converts took advantage of having equipment or inventing the equipment and competed quite successfully against those who did not have such assets. In health care, asset values have traditionally held sway. Machines such as x-ray, CAT, and MRI have given significant advantage to those who had them, particularly in the early stages of their development. There were two major reasons for this: Equipment was the source of revenue since charges were generated for their use and CON (Certificate-of-Need) laws were established (for whatever reasons) with the effect of limiting competition by limiting the availability of such assets across geographic regions.

Where asset values prevail, an organization may literally purchase success with a sufficient capital budget and by placing themselves with the "haves" of CON rather than the "have-nots." Assets are an internal source of value in the sense that they are a factor of production under the control of management and remain located inside the confines of the organization as opposed to outside. They tend to decline in value with use and age and are subject to technological obsolescence.

2. Price/performance

This source of value pertains to the products or services provided by the organization, rather than the organization itself. Value can be organized around the price of a service or performance attributes, such as quality, comfort, and speed. For example, health care specialties have argued consistently of the inherent superiority of a service based on specialist care and the specific therapies needed for the subtleties of most disease. "Open" MRIs are another recent example of a technology clearly designed to enhance the comfort of patients more than diagnostic superiority. Price and quality are obvious factors that consumers respond quickly to and organizations can compete on this basis.

Most people recognize that there are superior products and services on the market and producers of these services can take advantage of product-based advantages through higher volumes and/or higher prices for their goods. Obviously, product advantages live and die with the life-cycle of the product itself and are prone to obsolescence and erosion through competition. Laparoscopic techniques hold a comfort and perhaps quality edge right now over more invasive and traditional approaches to many surgeries, but the market is catching up quickly.

Michael Porter has written extensively on the sustainability of certain product/service based advantages and, as is the case with all these sources of value, it is good to keep in mind the forces which will either enhance or diminish such advantage over time, such as the power of buyers and suppliers, the possibility of new entrants, and the arrival of substitute products providing similar outcomes. (2)

3. Distribution value

Distribution value comes from delivering a product or service to customers in ways that are most convenient to them. No longer is the source of value in the product, but rather value is derived from delivering the product in the most beneficial way. Even poorer products, when delivered in better ways, can compete successfully. Wal-Mart has been showing people lately the value to be derived from good distribution systems. Catalogue companies are another case. There are no differences in the products catalogues sell versus retail outlets, for the most part--it is merely the way such goods are distributed to customers. E-mail and Internet buying are the next wave of such distribution.

In health care, we use services that are close and convenient all the time, in preference to what might be better services offered farther away. Most of the geographic spread to the suburbs of the late 80's and the 90's advanced the theme of distribution by locating "feeder" satellites for the downtown campuses of many health providers, but its taken managed care to elevate distribution value as a key theme for managed care contracting today. Geographic coverage for a given population of employees is important to employers and is often the basis for which system a buyer will go with in a market.

Importantly, distribution value is derived from advantages in how services get to patients, rather than the services themselves. It is also separate from the organization that produces the services. Customers don't even have to know or see the organization that creates the services, they just appreciate the path by which services are delivered.

4. Brand Equity

There is a different product/service based value besides price and performance, referred to as "brand equity." This is essentially reputational value based on either the organization as a whole or specific products that can be an important buying point to a potential consumer. (3) Honda, for example, was successful at translating its early product success in motorcycles to automobiles, lawn mowers, power generators, and just about anything that involved a small engine. They became known for reliability and certain design advantages in their products.

Now, Honda can release a new product, going against established brands, and still have people buy it because of the reputation of Honda's products in general. Even where a service or product is really no different from that of another provider, it will be perceived by the customer as better, due to brand equity.

Brand equity at first is established by means of one of the other sources of value on our list. However, eventually, it takes on a life of its own and can survive in spite of temporary shortcomings in specific products. In the corporate sector, there's a saying that "no one ever got fired by buying IBM." The meaning is that even where IBM might have an inferior product (something Apple has said for years), people will still buy it because of the name. Brand equity is a powerful source of value with considerable momentum in the marketplace. It is long lasting, pervasive, and often makes its owner a competitive winner.

Brand equity can be won or lost. It can also be purchased through affiliation with some provider already in possession of considerable brand equity. Growing it internally can take time, particularly if there is negative brand equity to overcome. Whatever the case, the power of "what's in a name" should never be overlooked, particularly in industries having overcapacity and which are undergoing a considerable degree of consolidation. Brand equity is often the core value around which restructuring occurs, in an effort to build an integrated health system.

5. Capabilities

Capabilities value is the last source of value and it lies within the organization again, just like assets. However, unlike assets, which are more often tangible and discrete factors of production, capabilities are processes and systems that are valuable to the organization's success and which tend to grow in value through use. Capabilities are human-based sets of skills.

One can think of capabilities in terms of what they are designed to accomplish--functions important to the successful operation of the firm. Various authors describe capabilities in terms of five general categories: (1) integration with the external environment leading to quality; (2) internal integration leading to speed and efficiency; (3) flexibility and responsiveness; (4) continuous experimentation with incremental change; and (5) the ability to cannibalize one's efforts. (4)

Examples of capabilities that represent a competitive and strategic advantage in health care are well implemented information systems, customer service processes, market research systems, and good care paths for treatment. Obviously, an organization with better systems and capabilities is capable of outperforming one without such resources. Capabilities are closely linked to learning and the cultivation of human resources within the firm.

Sources of value relative to the stages of managed care

To discuss where to position an organization on the value perspective is naive, without recognizing that the source of value is also a function of market evolution. The country varies widely in terms of the particular stage of managed care that influences local competition. Let's consider the issue of value and strategic positioning in the context of this framework. We will use a description of market stages that was first developed by the University Hospital Consortium (UHC) and later modified by the Voluntary Hospitals of America (VHA). Table 1 shows the four stages defined in this framework and the market characteristics that were identified by the VHA and UHC. We have added to this perspective by elaborating on some of the issues of value and the organizational drivers of that value. (5)

Stage 1--unstructured competition

Most providers remember the world of unstructured competition with great fondness. Hospitals dealt with a medical staff consisting of solo practitioners and independent practices. Buyers put little demand on providers, since the pressure on their prices from employers had yet to materialize. Managed care as embodied by the early HMOs was offered to employees as a care plan side benefit. Few incentives were provided to encourage people to join these managed care plans.

In this world, the health care provider had one focal point--internal. More doctors led to more revenue. Doctors were encouraged to join the staff and medical office buildings were erected to encourage as many doctors as possible to practice close to the hospital and be part of the "system." The primary objective for the health care entity in all this was reimbursement for treatments and more doctors ordered more treatments.

The major source of value in a setting like this is an asset based one. Assets were needed to provide the treatments charged for, diagnostic or surgical and with cost-based payments you didn't even have to fully utilize assets to have them pay for themselves.

Donations in the industry abetted the process. Donors provided the funds for construction and purchase on top of what was earned from revenue, allowing for expansion and growth rates greater than what margins alone would allow. Even the government contributed with Hill-Burton funds and tax abatement. The driver was always to provide "high quality medicine." The managerial incentives were clear: buy more assets of any variety as long as they were reimbursable.

Stage II--loose framework

Our observation is that a majority of market areas around the country are in the stage of loose framework or are recently moved from here to Stage III. At Stage II, pressure begins to come back to the providers. It is the onset for the margin squeeze of managed care contracting typically embodied by negotiating contracts on a discounted fee-for-service basis.

Physicians have seen and felt the organizational focal point at this phase--it is one of internal cost control. Nurse staffing levels are closely monitored. Resources become more constrained in an effort to pare costs. Hospitals join buying coalitions in the hope of further reducing operating costs through bulk purchasing and standardized supplies. Provider networks begin at this stage, when the hospital starts a PHO and encourages all the doctors on the staff to join. In an attempt to find new revenue, joint venturing is the organizational structure that is considered most fruitful, since it aligns physician interests with those of the hospital. Contracting is a price game and the health system driver is one of price response--discount the per diems, discount the fees, and hopefully control internal costs.

This same stage was seen in the airline industry when it was first deregulated. As hospitals go to a world without CONs, everyone will buy similar assets to compete. In the airline industry, price wars erupted and margins were squeezed. Cost cutting became the rule. No meal flights for $99 (or, $89 if you were willing to fly to Newark first on People's Airline) were all part of the strategy to position the organization as the most price responsive. So too, health care providers in this stage cut price, while trying to maintain quality. The value being provided at this stage is one of price relative to performance, where that performance is deemed to be high quality.

Stage III--consolidation

More larger metropolitan markets are moving to, or are in the midst of, stage three III competition. Chicago, Boston, and San Francisco are Stage III markets. Hospitals have closed or are on the verge of such closures. For example, New England Medical Center, a long-standing teaching hospital in Boston, is fighting for survival having been rejected by some other partners and spurned by one of the large managed care systems to have emerged in this market. (6) This is the stage in which we witness large system development and begin to achieve some exclusivity within the systems.

Every health care organization of size now proclaims itself to be an "integrated delivery system." It is also common for primary care physicians to have their practices purchased by a hospital looking to establish such systems. The key organizational driver is restructuring (new physician organizations, occasional foundations, and new partners outside of the traditional groups of hospitals and physicians)--and, the restructuring focuses on access or distribution. For example, physician practices might be acquired to establish a network of primary care satellites to cover the market, not just for its reliable referral patterns, but to offer managed care buyers "coverage" for their enrollees, regardless of where they work or live.

Interestingly, it is at this stage where the organizational focus finally begins to shift from an internal one fixated upon assets (Stage I) or product price and performance (Stage II), to that of customer satisfaction. Such a change is profound and only poorly understood in today's marketplace. Only organizations such as Nordstrom's and Ritz Carlton Hotels demonstrate a perception of what a customer orientation means. (7)

Health care is changing toward a model of customer value, but Stage III is only a beginning. We see this orientation today by formal attempts to publish measures of customer satisfaction. For instance, the American Group Practice Association has begun benchmarking patient satisfaction for doctors at large medical groups. (8)

Indeed, no provider is without their patient satisfaction survey. Therefore, from the buyer's perspective, as the prices of alternative health care plans begin to narrow in the mature stages of competition and there is an equality of quality as outcome studies are demonstrating, the focus is on the customer and whether or not they are satisfied.

Here too, one can see such changes in the strategic positioning going on in the airline industry. Now, some 20 years past the early days of deregulation, the number of start-up, no-frills airlines has greatly diminished. Consolidation has resulted in a few major carriers in the United States. Prices have tended to stabilize and $29 flights from New York to Boston are vague memories. The shift is toward customer satisfaction. A recent article in The Wall Street Journal reported that Delta's CEO found his contract was not renewed, in part, because the cost cutting at Delta had "gone too far," according to the Board. Delta recently wooed away the head of customer service from Continental in order to restore some value to the customer. (9, 10)

Stage IV--managed competition

Stage IV is capitation and/or discounted fees with large, efficient providers. Integrated systems manage patient populations with regard to patient health status, rather than the volume of services provided. Minneapolis and Albuquerque are a couple of the very few markets where this stage of evolution could be said to exist. The focus at this point is truly external--it is the end-line customer that the health care system is now responsible for managing. No longer can one organization necessarily own all the resources needed to take care of a family member for a year, so the organizational structure shifts from the acquisition and/or internal development of capabilities to an "alliance" of capabilities, including the home health agency, the senior center, or the neighborhood health club. The driver is truly one of creating customer value, based on organizational capabilities and brand equity.

In this stage, we also witness the phenomenon of "functional shifting," as it is known in the marketing literature. The rule is one can always eliminate the middleman, but the functions can never be eliminated. The functions merely shift somewhere else in the channel. As large health care systems form with their own managed care plans, the question becomes which functions does it want to accept, versus those it wants to shift to others.

In contracting with an independent managed care plan, a health care system is paying some percentage of its revenue to have the managed care plan act as a consolidator of subscribers and as a risk minimizer. That is, the managed care plan says it will bring some percent of the market to the provider system and it spreads the risk by acting as "insurer" for this population.

Yet in stage IV, a large health care system may decide to have its own sales force to perform the task of taking and consolidating subscribers. The system may also seek strategic alliances with other large systems in order to spread the risk of any adverse selection of care within its subscriber base. If two or three large health care systems with their own managed care products developed strategic alliances to shift risk, it is quite possible that it would no longer be necessary to contract with the middleman of this arrangement, namely, the HMO.

Airlines again have shown the way. Attempts at functional shifting are occurring now within the industry. American Airlines has developed their own Interactive Travel Network to allow passengers to book tickets by picking the most convenient flights, reserving their preferred seat location, and charging the ticket from their home computer. The Interactive Travel Network is clearly an attempt to gain back some margin by shifting functions: those of booking and scheduling flights from the travel agent to the consumer, and those of ticketing from the travel agent to American Airlines.

This shift in functions requires the organization to develop new capabilities centered around functions seen directly by consumers. The integrated health system that manages by focusing on the patient might have an online medical library to provide current information to their subscriber base, online appointment booking, and patient feedback on lab results and treatment paths right on their Home Page. It's long been found that health status correlates with education level. The integrated system of tomorrow might view itself as the ongoing health educator of its subscriber base, in order to improve the health status of the population for which it is responsible.

This concept of functional shifting also ties in closely with another of the value drivers: brand equity. When a health care organization contracts with multiple managed care products, the rationale is clear. The organization does not want to be locked out of any large portion of the potential market. At the same time, however, what the provider system is doing is diluting its brand equity. A potential subscriber in the market can see that regardless of the managed care plan they join, they will have access to this same large, well-known provider. The choice is easy--choose the cheapest plan. The health system with multiple contracts has turned itself into a commodity. Brand equity has disappeared as it loses any exclusivity. Pressure on profit margins will increase.

By understanding stage IV competition, this equity can be maintained and this value can contribute to margin. An organization that has the equity, need not be the lowest price provider. If a subscriber wants to have access to this well known health system, he or she will have to sign up with the one plan with which the integrated system is aligned. The value generated by this arrangement is then shared with the managed care plan and the provider in a complementary fashion. Stage IV sources of value are in terms of both capabilities and brand equity.

Moving to the value stage

As the market evolves from Stage I to Stage IV, the organizational focus clearly must shift from one of asset management toward capabilities. The organizational driver must move from delivering high quality medical care to one of delivering high quality services and customer value. In the old world of health care, the game was one of attracting volume and pruning cost; in the new world, the successful organization is the one which offers the most value to the customer. Historically, the focus started from the perspective of clinical service delivery; in the world described by Stage IV, the focus will begin with the end user.

What must be done to manage a family's or individual's health for a year? This perspective emphasizes not only internal productivity, but also value to the customer. Products and services will represent health benefit to the consumer, provided by networks of care with considerable brand equity and capability. Organizations will realize that service motivated employees and the systems that educate them will represent a much stronger competitive advantage than having assets and technology that is available to anyone. As the health care marketplace evolves, organizations must develop a strategic position which will provide such value and for which the customer will be willing to pay.

TABLE 1 The Evolving Stages of Value

                   Stage I               Stage II
                   Unstructured          Loose
                                         Framework

Market             independent           excess inpatient
Characteristics    hospitals;            capacity;
                   independent           hospitals/physicians
                   physicians;           witness price
                   unsophisticated       pressure;
                   purchasers;           networks formed;
                   under 10% managed     hospital margins
                   care penetration      erode; 11% to 30%
                                         managed care

Focal Point        internal production   internal control

Organizational     staff privileges      joint ventures
Structure

Organizational     reimbursement         price
Objective

Organizational     quality               price response
Drivers

Sources of Value   assets                price/performance

                   Stage III            Stage IV
                   Consolidation        Managed
                                        Competition

Market             few large            employers form
Characteristics    HMO/PPOs;            coalitions to
                   networks             purchase care;
                   consolidate;         integrated
                   hospital closures;   systems manage
                   integrated systems   patient
                   form;risk shifted    populations
                   to providers;
                   31% to 50%
                   managed care

Focal Point        system               individual/
                   development          family

Organizational     buying practices     strategic
Structure                               alliances

Organizational     customer             health status
Objective          satisfaction

Organizational     reorganization       customer value
Drivers

Sources of Value   distribution         capabilities/
                                        brand equity

--Robert Kauer, MPH, MBA, PhD, and Eric Berkowitz, PhD

References

(1.) Adapted from Earl Naumann, Creating Customer Value, Cincinnati, Thomson Executive Press, 1995.

(2.) See, for example, Porter, Michael, Competitive Strategy, The Free Press, 1980, pp. 3-33.

(3.) See David Aaker, Managing Brand Equity: Capitalizing on the Value of a Brand Name, The Free Press, 1991.

(4.) See, for example, Stalk, Evans, and Shulman, "Competing on Capabilities: The New Rules of Corporate Strategy," Harvard Business Review, March-April, 1992, pp. 57-69. Another excellent source for capabilities investing is Baldwin, Carliss and Clark, Kim, "Capabilities and Capital Investment: New Perspectives on Capital Budgeting," Journal of Applied Corporate Finance, volume 5, issue #2, Spring, 1992, pp. 67-82.

(5.) See also, Coile, Russell C., Jr., "The Five Stages of Managed Care: Strategies for Physicians in Health Care's Market Revolution," The Physician Executive, volume 23, issue #5, May/June, 1997, pp. 27-31.

(6.) John Morrissey, "Boston Hospital Wants In," Modern Healthcare, April 7, 1997, p. 24.

(7.) For one of the best descriptions of what service means, see Schlesinger and Heskett, "The Service-Driven Service Company," Harvard Business Review, Sep-Oct, 1991, pp. 71-81.

(8.) Mary Chris Jaklevic, AAGPA Creates Satisfaction Standards," Modern Healthcare, April 29, 1996, p.65.

(9.) "Why Delta Airlines Decided it was Time for CEO to Take Off," The Wall Street Journal, Friday, May 30, 1997.

(10.) For a good description of cost-cutting disillusionment in industry, see "Call It Dumbsizing: Why Some Companies Regret Cost-Cutting," The Wall Street Journal, May 14, 1996.

Robert T. Kauer, MPH, MBA, PhD, is a faculty member in the Department of Banking and Finance at the Weatherhead School of Management, Case Western Reserve University, in Cleveland, Ohio. He is also Associate Director of the Health Systems Management Center, a joint research and educational center of the Schools of Management, Law and Medicine at Case Western Reserve University. Dr. Kauer serves as Director of Strategic Planning for the Weatherhead School. He can be reached at 216/368-2938 or via fax at 216/368-4776.

Eric Berkowitz, PhD, is a Professor in the Department of Marketing at the University of Massachusetts' School of Management in Amherst. He also serves on the ACPE faculty for the Physician in Management Seminars. He can be reached at 413/545-5663 or via fax at 413/545-3858.