The Wharton School Study of the Health Care Value Chain

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The Wharton School Study of the
Health Care Value Chain
Lawton R. Burns, Robert A. DeGraaff,
Patricia M. Danzon, John R. Kimberly,
William L. Kissick, and Mark V. Pauly
Focus of This Book
This book analyzes developments in the U.S. health care value
chain over the past decade. Wharton School researchers spent three
and one-half years (January 1998–June 2001) studying three major
players at various stages of the value chain: producers (product man-
ufacturers), purchasers (group purchasing organizations, or GPOs,
and wholesalers/distributors), and health care providers (hospital
systems and integrated delivery networks, or IDNs) (see Exhibit
1.1). Manufacturers make the products, GPOs purchase them in
bulk on behalf of hospitals, distributors take title to them and
deliver them, and providers consume them in the course of render-
ing patient care.
In conducting this study, the Wharton School research team had
five broad aims:
1. To profile the major segments in the health care value chain
and some of the key players within them, their resources and
capabilities, and their recent history;
2. To document how the value chain currently operates;
3. To identify and analyze the strategic and competitive issues
facing the three major players;
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THE HEALTH CARE VALUE CHAIN
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Exhibit 1.1
Health Care Value Chain
Fiscal
Payers
Intermediaries
Providers
Purchasers
Producers
Government
Insurers
Hospitals
Wholesalers
Drug Mfgrs
Employers
HMOs
Physicians
Mail-Order
Device Mfgrs
Individuals
Pharmacy
IDNs
Distributors
Medical-
Employer
Benefit
Pharmacies
Group
Surgical Mfgrs
Coalitions
Managers
Purchasing
Organizations
4. To assess the impact of e-commerce on the value chain; and
5. To assess future prospects for partnerships and improved
efficiencies between value chain players.
We believe that an understanding of the first two topics is essential
for addressing the latter three.
Our analysis is more strategic than operational. We do not pro-
vide comparative benchmarking data or measures or standards of
supply chain performance, nor do we identify specific time- and cost-
saving opportunities for improvements in work-flow processes.
Instead, we seek to understand the bases of cooperation and compe-
tition along the value chain, the sources of efficiency in contracting
between suppliers and providers, and the emerging best practices and
strategic alliances along the value chain. Our overall aim is to deter-
mine whether “extended enterprise” models of supply chain collab-
oration found in other industries can develop in health care.
The book is addressed to both academic researchers and industry
executives. We hope academics will find it a useful and compre-
hensive introduction to a huge segment of the health care industry
that is rarely studied, as well as an analysis of the multiple problems
in strategic alliance formation in health care. We hope executives
will find it helpful for better understanding the motivations of their
trading partners and the opportunities for working with them in
cooperative endeavors.

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The Wharton School Study of the Health Care Value Chain
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Why Study the Health Care Value Chain?
Several major developments in the health care industry during the
1990s prompted interest in the health care value chain. These
developments encompassed vertical integration, horizontal inte-
gration, managed care pressures, changes in federal reimbursement,
the rise of e-commerce, and the passage of the Health Insurance
Portability and Accountability Act (HIPAA) in 1996.
First, provider organizations (hospitals and hospital systems) ver-
tically integrated into the health insurance business (for example,
starting up HMOs) and the ambulatory care business (for exam-
ple, acquiring physician practices), and in the process developed
integrated delivery networks, or IDNs. Such efforts represented
attempts to integrate downstream toward the patient, capture a
greater portion of patient flows and insurance premiums, and
develop some countervailing power vis-à-vis health maintenance
organizations (HMOs). With a few notable exceptions, such efforts
were spectacularly unsuccessful. Providers instead began to realize
there may be opportunities to improve their financial position by
partnering with upstream value chain players and, in some cases (for
example wholesalers/ distributors), integrating with them.
Second, every major player along the value chain horizontally
consolidated. Hospitals merged with one another or joined systems;
their group purchasing organizations (GPOs) merged to form super
GPOs; distributors merged to build mega warehouses and achieve
economies of scale; and product manufacturers merged to gain
market share, pool capital and sales forces, and deal with the other
consolidated players just mentioned. By the start of the new
millennium, it was unclear what were the resulting contracting
dynamics within the new, consolidated chain. Was it more com-
petitive or less competitive?
Third, provider organizations were rocked by reimbursement
pressures emanating from large HMOs, which had merged to
develop greater bargaining leverage with employers and to squeeze

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THE HEALTH CARE VALUE CHAIN
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providers on payments. Providers were also rocked by reductions in
both inpatient and outpatient Medicare payments resulting from
the Balanced Budget Act (BBA, 1997) and the Balanced Budget
Relief Act (BBRA, 1999), which included the Ambulatory
Payment Classification (APC) system.
Fourth, the rise of e-commerce promised a “sea change” and
“paradigm shift” in how trading partners were to transact business.
Business-to-business (B2B) models using Web technology were sold
as the solution to all of the industry’s problems and inefficiencies.
The new technology would speed up transactions; provide visibil-
ity of products and information along the entire chain; and elimi-
nate duplication, paperwork, and processing errors.
Finally, HIPAA developed standards for providers to follow with
regard to the format, use, and security of electronically stored and
transmitted health care information. These standards had enormous
implications for reducing overhead and administrative costs, for the
development of electronic commerce, for transacting business with
trading partners, and for improving the information available for
decision making.
Whereas before the value chain was an unimportant side issue,
the events just mentioned collectively propelled value chain issues
to the forefront. The increasing importance is reflected in recent
consulting firm studies of value chain improvements and efficien-
cies using e-commerce,1,2 and funding for this investigation by
a consortium of large IDNs known as the Center for Health
Management Research (CHMR).
In addition to these developments in health care, the 1990s
witnessed the formation of strategic trading alliances in the U.S.
auto industry. These alliances, also known as extended enterprise
supplier networks, brought together suppliers of component parts
with large auto manufacturers to collaboratively improve quality,
reduce costs, and develop competitive advantage.3 Such strategic
alliances have been held out as examples for the health care
industry to follow.

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The Wharton School Study of the Health Care Value Chain
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What Is a Value Chain?
Michael Porter, an economist at the Harvard Business School, has
popularized the term value chain among academic circles to mean the
entire production chain from the input of raw materials to the out-
put of final product consumed by the end user.4,5 This chain is called
a value chain because each link in the chain adds some value to the
original inputs. There are really two value chains here. The first con-
cerns the stream of productive activities within a given firm that allows
it to manufacture a product or render a service (see Exhibit 1.2).
Thus, a firm acquires inputs (for example, raw materials, labor, capi-
tal, and so on), integrates and processes them in a throughput stage,
and then produces its outputs. The second value chain includes the
stream of activities across firms, where the outputs of one set of firms
become the inputs for another set of firms. Thus, a firm has input sup-
pliers, industry competitors, distributors, and end customers. An
analysis of the value created within a given firm helps to identify its
contribution to the value created along the interfirm supply chain.
Exhibit 1.2
Michael Porter’s Value Chain
Firm infrastructure (e.g., finance, accounting, legal)
Human resource management
Technology development
Procurement
Inbound Production
Outbound Marketing
Service
logistics
operations
logistics
and sales
Supplier
Channel
End-User
Value
Value
Value
Chains
Chains
Chains
Upstream Value
The Firm’s
Downstream Value
Value Chain
Source: Michael E. Porter. Competitive Advantage: Creating and Sustaining Superior
Performance. Copyright © 1985, 1999. Adapted with the permission of the FREE
Press, a division of Simon & Schuster, Inc.

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THE HEALTH CARE VALUE CHAIN
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What Is a Supply Chain?
In industry, the term supply chain tends to be used more frequently
than value chain. A supply chain is a virtual (as opposed to verti-
cally owned) network “that facilitates the movement of a product
from its earliest point of production, through packaging and distri-
bution, and ultimately to the point of consumption.”6 The supply
chain is thus the path traveled by the product; each stop along that
path defines a link in the supply chain.
Supply chain networks may operate to both (1) “push” manufac-
tured products through the chain using sales forces and promotional
campaigns, and (2) “pull” products through the chain to continually
replenish retailers’ inventories and meet customer demand.7–9 In the
former model, manufacturers promote and sell as much product as
they can to customers. In the latter model, customers demand prod-
ucts from the preceding link in the chain; those vendors then
become responsible to manage the customer’s inventories.
Why Do Value and Supply Chains Exist?
Why do value and supply chains exist? There are at least two expla-
nations, derived from industrial organization theory and organiza-
tional theory. First, supply chains exist because there is little vertical
integration of manufacturers into the distribution and delivery of
their products to the end customer. Vertical integration is low
because manufacturers believe that the costs of transacting with the
marketplace for distribution and delivery are much less than
the costs of attempting to take distribution in-house and coordi-
nating all of these exchanges using hierarchical means. That is,
manufacturers believe that it is cheaper for them to “buy” distribu-
tion services from product wholesalers in the marketplace rather
than “make” distribution services in-house. Consequently, manu-
facturers have elected not to enter the distribution business but
rather let specialist firms produce these services for them.

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The Wharton School Study of the Health Care Value Chain
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Second, because manufacturers have left the provision of distri-
bution services to others, they are now interdependent with exter-
nal firms over whom they exercise no hierarchical or managerial
control. Consequently, they need to develop contractual or strate-
gic alliance relationships with these specialist firms in order to get
their products to the end customer. Supply chains thus exist to coor-
dinate and manage the exchanges of firms that are interdependent.
What Are the Objectives of a Value Chain?
Across firms engaged in trading relationships, a value chain is con-
cerned with several theorized objectives:
• Optimizing the overall activities of firms working
together to create bundles of goods and services
• Managing and coordinating the whole chain from raw
material suppliers to end customers, rather than
focusing on maximizing the interests of one player
• Developing highly competitive chains and positive
outcomes for all firms involved
• Establishing a portfolio approach to working with
suppliers and customers; that is, deciding which players
to work with most closely and establishing the
processes and information technology (IT) infrastruc-
ture to support the relationships10
That is, value chains are supposed to be collaborative partnerships
between adjacent players engaged in economic exchange. Such col-
laborative activity includes coordinated planning of production and
distribution to meet the customer’s needs on a just-in-time basis that
reduces inventory levels and delays in product availability. It is also
designed to create a lowest-total-cost solution for the end customer

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and the manufacturer. Lowest total cost is achieved using demand
planning, which relies on information gathered from the customer
that “pulls products.” Demand planning works backward from the
customer toward the manufacturers and their suppliers and original
equipment manufacturers (OEMs). This is all in contrast to tradi-
tional supply chain management, which starts with the manufac-
turer that “pushes product” (for example, using marketing and
advertising campaigns) and works forward toward the customer.
Here the manufacturer’s aim is not achieving lowest total cost but
increasing product sales, greatest product differentiation, and lowest
delivered cost.
Value Chains and Extended Enterprises
Value chains are also supposed to develop as strategies of competi-
tive advantage in which one set of trading partners (input
supplier–product manufacturer–distributor) seeks to create more
value (for example, higher quality and/or lower-cost products and
services) than a rival set of trading partners. Recent research on
value chain alliances in the auto industry suggests some of the essen-
tial ingredients for success.11
One key ingredient is dedicated asset investments in one’s sup-
ply chain partners in order to increase productivity. These can
include dedicated managers and account representatives who accu-
mulate substantial understanding and know-how through long-
standing relationships with trading partners. Another type of asset
investment is the development of capital investments tailored and
customized to a specific trading partner.
A second key ingredient is effective management of knowledge
and knowledge flows among trading partners. This requires sharing
of information (both explicit and tacit knowledge) rather than
secrecy. This is accomplished through supplier associations, learn-
ing teams, on-site consultation, joint-study groups, problem-solving
teams, and interfirm employee transfers. In this manner, suppliers

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provide input to product development and process improvement
initiatives.
A third key ingredient is trust among trading partners. The pres-
ence of trust lowers the necessity for contract enforcement and sur-
veillance and thus reduces transaction costs. Specific means to foster
trust include selection of suppliers based on their capabilities and
track record for performance (rather than competitive bidding)
and previous contracting relationships, establishment of long-term
contracts, stability of employment of managers involved in con-
tracting, extensive two-way communication, financial investments
in one another, and evaluation of the relationship on a broader scale
than just unit price of inputs.
Research on the auto industry suggests that the presence of these
three ingredients allows the formation of extended enterprises that
span manufacturers and their suppliers. Such enterprises achieve
competitive advantage over other manufacturers (that lack such
alliances) in terms of the speed of product development, product
development costs, transaction costs in procurement, product costs,
quality, market share, and profitability.
Do Value Chains Exist
in the U.S. Health Care Industry?
In the health care industry, this view represents more aspiration
than reality. Despite all of the attention paid to the health care
supply chain over the past decades, few of the elements just out-
lined exist today. To be sure, there are organizations operating
at each stage in the supply chain (see Exhibit 1.1). Among pro-
ducers (manufacturers), there are pharmaceutical companies,
medical-surgical products companies, device manufacturers, and
manufacturers of capital equipment and information systems.
Among purchasers (intermediaries) there are group purchasing orga-
nizations, pharmaceutical wholesalers, medical-surgical distributors,
independent contracted distributors, and product representatives

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employed by some manufacturers. Among organized provider cus-
tomers (hereafter referred to as providers), there are hospitals, sys-
tems of hospitals, integrated delivery networks (IDNs), and
alternate site facilities (for example, physician offices and ambula-
tory surgery centers). What is lacking, however, is coordinated effort
among these parties, widespread strategic alliance formation, knowl-
edge sharing, interfirm trust, and competing value chains oriented
to delivering the greatest customer value at lowest total cost.
Indeed, some industry executives baldly state that the word partner
does not really exist.
Everard has recently made a similar point, claiming that supply
chain management does not exist in the health care industry. He
defines supply chain management as
the intervention of supply chain links and players in
determining the cost and value of exactly when and how
a product moves, in what quantities it is moved, who
moves it and how it is moved, who stores it and how it
is stored, and when and how it is made available to those
who consume or use it. Everything that happens to a
product as it moves through the chain either adds cost
or reduces cost. It either adds value or reduces value. The
ultimate goal for any product moving through the chain
is to reduce cost and add value at the same time.12
Within health care, information on the value or cost added at each
link is severely lacking. Indeed, the current state of knowledge on
product value/cost among producers may be so low that meaning-
ful knowledge sharing is impossible. Moreover, there is some con-
sensus that multiple links may perform duplicative functions or
wasteful, non–value adding functions due to this lack of informa-
tion or reluctance to share information. Finally, there is some con-
sensus that the supply chain acts more to push products down the
chain rather than pull them from the customer, due to this lack

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