Cardinal Bases Fee-For-Service Deals On Customer Profitability Analysis

Cardinal's fee-for-service negotiations with drug manufacturers rely on the wholesaler's analysis of each company's profitability, Exec VP-Pharmaceutical Distribution Mark Parrish said.

"We analyzed and achieved a number to understand the profitability of each manufacturer" before entering into discussions on the fee-for-service contract, Parrish told analysts during an investor day Feb. 19.

Cardinal wanted to "ensure that we fully understood the profitability of our customers and the sources of profits in our business" prior to shifting to the fee-for-service model, Parrish said.

The national wholesalers, including Cardinal, are moving from a traditional profit model that relies on forward-buying margins on inventory to one in which manufacturers will pay the wholesaler for its services (¹ (Also see "Cardinal “Fee-For-Service” Model Includes Rx Product Integrity Payments" - Pink Sheet, 27 Oct, 2003.), p. 25).

For Cardinal, the switch will not completely exclude inventory investment gains, Parrish said. "There will always be some component of investment gain from standing inventory. At the most efficient levels, all [agreements] will require us to handle some inventory and that inventory will appreciate in price."

Cardinal fee-for-service contracts will also likely include performance incentives, Parrish added.

Cardinal uses five metrics to assess each customer, "first, on total sales, then on product line concentration, where we look at a manufacturer and we measure the concentration of their sales in their top five product lines," Parrish said.

"We then review the manufacturer's product handling requirements; what combination of significant special handling or conventional handling is needed?"

"We then look at the provider customer channel bias," he continued. "This refers to where in the marketplace we're distributing the customers: are they primarily acute care or are their products being delivered to all points of care?"

"Finally, we look at the line extensions, which are the product of the average number of items ordered and the unit value," Parrish said.

Cardinal uses the criteria to designate which fee-for-service pricing should be applied to the customer.

"This analysis allows us to create eight clusters or groupings of peer companies based on the distribution service requirements, and to evaluate the proper level of compensation for our services from the manufacturer," Parrish said.

Cardinal's fee-for-service negotiations are a five-step process, he said.

Cardinal must first establish "awareness of the services that we provide," Parrish said. "Then we have to educate our partners on the changes that are going on in the marketplace" from a stockpiling model to a just-in-time approach.

"The first two elements of the process are really critical. We as wholesalers are guilty of not doing enough to remind the manufacturers of all that we do," Parrish stated.

To remedy this, Cardinal execs, along with those from other wholesalers, are helping the Healthcare Distribution Management Association conduct a study to demonstrate the value wholesalers add to the pharmaceutical supply chain (² (Also see "HDMA Study To Show “Value” Of Wholesalers As Pricing Model Shifts" - Pink Sheet, 9 Feb, 2004.), p. 15).

The third step in the negotiation process is to "define the terms of the new agreements, which we're calling distribution service agreements," Parrish said. Then "we go through the implementation process of those agreements, and then there's an ongoing refinement."

To date, Cardinal has 47 manufacturers, representing 80% of the company's volume "in some phase of these five-step processes," Parrish said.

The shift to fee-for-service contracts will allow Cardinal to appropriately price customers who have not historically borne the cost of distribution, Parrish said.

"Many manufacturers have paid us fairly historically and...need to be converted to the fee-for-service model, such as Merck. Others who have historically operated greater inventory investment opportunities will pay a little bit less in this new structure."

There is also a "group of manufacturers who have been receiving our services without fully paying for the value we provide, and their products have been subsidized by others. So they, therefore, will have to pay more."