Supply chain inventory management (SCIM) is essential for doctors who perform a number of similar procedures, those who dispense a fair number of products and surgeons because a medical practice’s profitability will suffer if it has too much or too little inventory of durable medical equipment (DME) on hand. How can a physician determine the proper DME inventory level? One uncommonly used approach is based on the economic order quantity costing (EOQC) method.
EOQC is a century-old accounting formula that determines the point at which the combination of order costs and inventory carrying costs is the least expensive and inventory most profitable. This is the goal of SCIM. There are three key assumptions with the EOQC model: revenues (inventory depletion) are constant, costs per order are stable and just-in-time delivery allows the placement of orders so new orders arrive when inventory approaches zero.
How does the physician determine current inventory costs and proceed to implement a SCIM policy such as EOQC? The approach involves the following steps:
• perform an inventory of all DME in the office, clinic or ASC;
• analyze how much DME inventory is on-hand;
• determine associated inventory and ordering costs; and
• perform an EOQC analysis.
Why are procedurally based practices still not taking advantage of these basic DME inventory processes? Part of the answer is economies of scale as most podiatry practices are still small businesses incapable of large-scale SCIM initiatives. This will change in the near future as the pace of industry mergers, consolidation and acquisitions increases, and multiple offices and clinics form larger enterprise business units that require more DME and improved fiscal control of inventory. Another problem is inaccurate input data. Accurate product costs, activity costs, forecasts, history and lead times are crucial in developing DME inventory models that work.
Understanding The EOQC Calculation
The mathematical formula for EOQC is the square root of two multiplied by SO/C, in which S is the annual usage or purchases in units, O is the cost per order and C is the annual carrying cost per unit.
S = Annual usage or purchase in units. Typically, annual purchases in units and cost per order are based on historic estimates. However, better forecasting and reduced lead times to operate with reduced inventory stock can also decrease inventory levels and annual use.
O = Cost per order. Order cost is the sum of the fixed costs that are incurred each time one orders a DME item. These costs are not associated with the quantity ordered, but the physical activities required to process the order. This would include the costs to enter the purchase order and/or requisition, any approval steps, the cost to process the receipt, incoming inspection, invoice processing and vendor payment. In some cases, a portion of the inbound freight may also be included in order costs.
The time spent checking in the receipt, entering the receipt and doing any other related paperwork would also be included in order costs, while the time spent repacking materials, unloading boxes or trucks and delivering items to satellite offices would not. Inbound quality inspection — in which a percentage of the quantity received is examined — would include the time to get the specifications and process the paperwork, but not include the actual time spent inspecting the DME items.
One must also include the time associated with creating the purchase order, approval steps, contacting the vendor, expediting and reviewing order reports. All time spent dealing with vendor invoices would be included in order costs. Also be aware that e-procurement, vendor-managed inventories, bar coding, radio frequency identification devices (RFIDs) and vendor certification programs can also reduce costs per order.
C = Annual carrying cost per unit. Also called holding costs, carrying cost is the annual cost per average on-hand inventory unit. There are several primary components of carrying costs that may represent a source of lost profits. These include rent, utilities, insurance, taxes, employee costs and the interest rate and opportunity costs of having office space or capital tied up in DME. For the purpose of the EOQC calculation, if the cost does not change because of the quantity of inventory on hand, it should not be included in carrying costs.
Case Example: How To Implement EOQC
Suppose a large tertiary podiatry clinic performs a good deal of surgery and uses 10,000 self-absorbing bone fixation pins every year. Historically, it is known that the cost per pin is $200, and the annual inventory carrying cost per pin is $10. According to the above formula, the EOQC is 632, as follows:
2 (10,000)($200)/$10 = $400,000
Square root of $400,000 = 632
In other words, there are 16 orders per year (10,000/632 EOQC). The time between each order is 3.3 weeks (52 weeks/16 orders). Therefore, the vital economic questions of when and how much DME to order have been answered.
Prior to final implementation, one must run the EOQC numbers using samples that are representative of the office’s DME inventory base. This will help determine the overall short-term and long-term effects the calculation will have on office warehouse space, cash flows and business operations.
Keep in mind that dramatic increases in inventory levels may not be immediately feasible. If this is the case, you may temporarily adjust the formula until you can make arrangements to handle the additional storage requirements and compensate for the effects on office cash flow. If the projection shows a decreasing inventory level and increasing order frequency, you may need to evaluate staffing, equipment and process changes to handle the increased activity. Finally, one should evaluate the values for order costs and carrying costs at least once per year, taking into account any changes in interest rates, storage costs and operational costs.
What About Potential Drawbacks?
EOQC may be a useful technique if there is an opportunity to change the current DME ordering policy of a medical practice or if the current policy is inadequate. Though it may appear that this equation would solidify purchase quantity, there are still other factors to consider.
For example, a medical practice still needs to review the likelihood of a stock shortage, the length-of-time DME is kept on hand, quantity discounts that vendors may offer and product volume within the practice. Moreover, practice goals and strategies may sometimes conflict with EOQC methodology. Measuring DME performance solely by inventory turnover is a mistake. Some practices have achieved aggressive goals in increasing inventory turns only to find their bottom line has shrunk due to increased operational costs.
While EOQC may not apply to every DME inventory situation, some practices will find it beneficial in at least some aspect of their operations. Whenever there is repetitive purchasing of DME, one should consider the proper use of EOQC.
Though EOQC is generally recommended in practices where DME demand is relatively steady, one can apply the EOQC model to items with seasonal demand variability by going to shorter time periods for the EOQC calculation. One can simply divide the year into the increments in which annualized sales are relatively constant (i.e., summer, spring, fall and winter). Then apply the EOQC model separately to each period. During the transition between seasons, DME inventories would either be run down or built up with special seasonal orders. Just ensure that usage and carrying costs are based on the same time period.
EOQC is not a panacea that solves all DME inventory cost problems or easily adds to bottom line profits. There is much to consider before adopting an EOQC policy for all DME across an entire medical business enterprise. However, it is a good SCIM tool to consider when determining the best ordering policy to use for a DME intensive medical organization.
Dr. Marcinko is a healthcare economist, certified financial planner and certified medical planner. He is also the Academic Provost for www.MedicalBusinessAdvisors.com , an online resource center providing financial education to physician clients and support for their business consultants.
Dr. Marcinko can be reached at (770) 448-0769 (phone), (775) 361-8831 (fax) or e-mail at email@example.com .
Editor’s Note: Dr. Marcinko previously wrote “Seven Reasons To Appraise Your Practice” (see page 24, August issue) and “Key Strategies For Protecting A/R Accounts” (see page 76, May issue).
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3. Tersine, RJ. Principles of Inventory and Materials Management. Prentice-Hall, New Jersey, 1993.