Medical Device Link.

Originally Published MX May/June 2002

ADVERTISING, DISTRIBUTION, & SALES

With a focus on value, pricing decisions can become a powerful tool in a device company's overall strategy.

Mahesh Deshpande and Sudhir Gupta

*The complete text of this article is also available.*

When it comes to battling new competitors and protecting their margins, many medical device companies employ such strategies as cutting costs, introducing new products, diversifying their offerings, or accelerating their speed to market. But all too often, corporate strategists overlook one of their best weapons: improved pricing strategies. Although most companies view pricing decisions as important, requiring senior-level attention or approval, they often make such decisions purely on a tactical basis or in response to competitor initiatives.

Medical device companies are in a "relationship" business. The success of any given company depends not only on its products, but also on how those products and their associated services create or add value for the company's relationship partners.

Such relationships should also influence company decisions about the pricing of their products. The closer a company can price its products to their true economic value, the better off it will be. In a relationship business, however, a company should not be expected to be profitable at the expense of its collaborators and customers. In the long run, no company can sustain a price level that does not ultimately create value for the company itself, as well as for its collaborators and customers.

To address the needs of this environment in their pricing decisions, company executives therefore need to pay special attention to the ways that their products—and their company as a whole—can create and distribute value. Medical devices can create different types of value for different constituencies, most obviously in terms of reduced morbidity and mortality among patients. When such varied values are combined to support a pricing decision, they can help a company to increase its own market share while also supporting the overall growth of the market.

This article emphasizes the strategic aspects of pricing decisions, which should be based on the ability of a product to create and distribute value. In our view, medical device companies should adopt a value-based pricing strategy that takes into account not only the individual company's margins (thereby creating value for the company), but also the distribution of that value among the company's collaborators and customers. Such a comprehensive, value-based approach is very powerful because it addresses economic and cost-based issues, while also bringing into play the notions of fairness, goodwill, and the public welfare.

The Customer Perspective

The customers of medical device companies include hospitals, physicians, patients, and third-party payers such as insurance companies. In order for company executives to set pricing levels that respond to the needs of such varied customers, it is important to understand how each group views the interrelated issues of pricing and product value (see Table I). The following discussion of the market for coronary stents illustrates the ways that a new medical device can create value for a hospital or third-party payer.

The fundamental treatment for coronary artery disease is typically to perform a coronary artery bypass graft (CABG). However, bypass surgery is very expensive because it includes extensive physician time, staff time, supplies, and a hospital stay. The development of coronary stents and the associated medical procedures provided surgeons with an altern ative treatment that offers roughly the same clinical outcomes at perhaps half the cost.

The less-invasive stenting method requires less physician and staff time and reduces the time that a patient must stay in the hospital. Consequently, it can save a large amount of resources and healthcare dollars for hospitals and insurance carriers.

In this instance, such savings are possible even when accounting for additional costs associated with new billing mechanisms, training time for physicians and staff, and the perceived high prices of the medical devices themselves. To make up for the perception that stent prices are high, medical device companies often give back some of their share of product value by providing on-site technical service and free training to physicians. Such activities acknowledge the market reality that device manufacturers must be willing to distribute the value of their products among their collaborators and customers.

Additionally, customers also incur so-called "menu costs." Menu costs arise because medical device companies often launch new products—or new generations of the same product—in rapid succession. Such rapid turnover of product generations translates into huge costs for hospitals and insurance companies because they have to change their billing and reimbursement programs and renegotiate contracts with the device companies. These costs erode any savings brought about by adoption of the new product.

For medical device companies, the amount of value destroyed in negotiations with customers each year is huge. For example, the list price of a balloon catheter is typically around $800, but the average selling price for such a catheter is $200. Because contract sales are the norm in the medical device industry, there are significant managerial and menu costs associated with the renegotiation of any contract. Both companies and their customers would benefit by making such contracts as efficient as possible, thereby recapturing value for both parties.

To achieve the goal of adding maximum value for their customers, one option for device companies to consider is that of carefully slowing down the pace of their new product launches, and avoiding the launch of products that don't add substantially more clinical value. Instead, companies should consider how they can create value through concentrated efforts to provide product-related education, greater service, and help with billing and insurance claims. In this way, device companies could create value while also saving menu costs for cash-strapped hospitals.

The notion of slowing the pace of new product launches is certainly contrary to the product-development strategy currently in place at most device companies, and on first view it might also seem to be contrary to the commercial interests of such companies. On closer inspection, however, several factors suggest that both individual companies and the industry in general could benefit from a slower pace of product introductions.

In the present, fast-paced environment, overemphasis on releasing new products that represent only incremental advances over previous products results in the just-as-rapid destruction of the value that a product creates for its manufacturer. Throughout the past half-decade, for example, prices for coronary stents have been dropping steadily by 4% each year as a result of such overheated competition and product proliferation. In fact, the price vector for many device companies is beginning to look like the vector for high-tech commodities such as computer chips. In the computer accessory industry, pricing managers are grateful if they are able to slow down price erosion from 8 weeks to 14 weeks.

Medical device companies should take note of the pricing trends in such high-tech industries and seek to avoid replicating them. Slowing the pace of product introductions—and especially of introductions for me-too products developed and launched merely to fill market space—would help to cool today's overheated environment and reduce the price erosion that it causes.

For device manufacturers and their customers, a slower marketplace could bring about other types of benefits as well. Reduced emphasis on new product launches would enable manufacturers to extract the value of existing products by improving the quality of services associated with those products. Many companies already offer such services as logistics, inventory management, just-in-time delivery, postprocedure patient care, and patient education. By improving and adding to the menu of such services—which are frequently of critical importance to their customers—device manufacturers will be responding to their customers in a way that will ultimately improve their bottom line.

In most respects, the value propositions that apply to physician-customers are the same as those that apply to hospitals and third-party payers (see Table II). As the healthcare professionals most directly responsible for the care of their patients, however, physicians attach very high importance to the performance characteristics of the products they use. As informed intermediaries in the purchasing process, physicians are the customers most likely to place a high value on products that ensure the highest-quality clinical care and the best medical outcome.

For all of these reasons, physicians are frequently quick to adopt new products whose value is only incrementally greater than earlier devices. What value physicians gain through such incremental improvements, however, they often lose in menu costs associated with retraining for the new device. Device companies can add value for physician-customers by redistributing some of their own portion in the form of training activities and sales-related services.

Despite what device companies may think, meeting the needs of these customer groups does not require the rapid development of new generations of incrementally improved products that are launched merely to fill market space. Instead, companies should focus their attention on developing lifesaving devices and new technologies that represent true breakthroughs.

Collaborators

Key collaborators for the medical device industry include government agencies, insurance companies, suppliers, physicians, and patients. Just as in the case of customers, medtech executives should have an understanding of how these constituencies view pricing and product value (see Table III).

Medical devices create value for the government because they improve national healthcare, thereby improving the health and increasing the longevity of the nation's population. The primary contributors to such value are, once again, innovative, lifesaving products.

By contrast, the introduction of products that do not represent breakthroughs can increase government costs in several ways. First, such products must still be reviewed and cleared to market, and such activities require a significant commitment of time from government staff at FDA and elsewhere. Second, the government may need to develop guidelines and related materials to enable various healthcare agencies to provide reimbursement for the new product. This is also time-consuming and takes valuable resources. Additionally, the launch of a new product can have the effect of resetting the price of similar products to a higher level than before, resulting in the government having to pay out more in healthcare costs.

Just as in the case of hospitals and third-party payers, meeting the needs of government agencies can have benefits for manufacturers. By focusing their energies on the development of innovative products, companies will launch fewer products that are perceived as newer and better even though their contribution to value is only incremental. In turn, companies will gain the benefit of greatly reduced product price erosion.

So far as government agencies are concerned, companies can best add value by focusing on truly new and useful products. The consequently reduced number of product launches will then require fewer government resources to handle regulatory and reimbursement issues. Additionally, the costs that companies save can then be used to improve their level of service and education to patients, physicians, and hospitals.

A direct sales force is the type of distribution channel most commonly used by medical device manufacturers. Companies should try to add value for their sales force by providing education, product-related training, and systems to help with reimbursement and billing issues.

Guidant Corp. has recently adopted a branding strategy based on creating value, with even greater emphasis on customer relationship management. This new strategy appears to acknowledge that a company culture devoted solely to creating incrementally improved products can in some cases be harmful to the company, resulting in drastically shortened product life cycles and rapid erosion of product prices.

To implement its new strategy, Guidant's top management created a formal program of culture change. Instead of pursuing the traditional single-minded focus on developing and launching new products, Guidant's new approach is to become a brand player with products. The new program encourages elements of a corporate culture associated with brand management, suggesting that the company is transitioning from an engineering focus to a marketing focus.

Competition

From a competitive perspective, the medical device industry is an oligopoly. Generally speaking, all the firms have similar goals and ambitions, and all them experience the same downward pricing pressures on their products (see Table IV). Not surprisingly, companies also tend to share the same response to competition: to replace existing products by introducing new products with a high margin.

Such a response is, however, only one of the possible responses to competition. Moreover, it is probably a costly response for industry as a whole, because of the costs associated with the launch and adoption of new products for collaborators, customers, and companies.

Another response might be for competitors to cooperate and form alliances that could reduce the costs of product R&D. Joint development of technologies and joint work on reimbursement and outcomes issues would be beneficial to the companies that participate in the partnership. In this way, companies could develop better products while sharing the costs of product development and reimbursement planning.

Another common response to competitive pressures is the use of complex pricing, including contracts that call for bundling, volume discounts, and so on. Such programs enable companies to cross-sell and up-sell high-margin products with low-margin products, and would therefore seem to add value to a company's overall product sales. However, it is uncertain whether such practices add value to a company or its products.

Some bundles add value for customers, because they are “bundle as you like it” programs. When manufacturers must handle a very large number of bundle combinations for various customers, however, the result can be a significant increase in menu costs. In effect, what such complex pricing structures achieve in margins can be lost in decreased operating efficiencies on the part of both the customer and the company.

Another nonpricing response to competition is to increase branding and improve product or service differentiation. In the medical device industry, this approach is not currently being used to the extent that it could be.

Finally, another competitive issue that can erode value is patent litigation. By sharing product-development costs, companies could prevent this value from being destroyed. In turn, the savings could be deployed to improve such other elements of the value proposition as service, technical support, or pricing capital.

The Pricing Process

In the medical device industry, the way that pricing decisions are made typically depends on whether the company is the first to market or a follower (see Table V). There are tremendous costs associated with being first to market, especially for issues relating to coding, coverage, and reimbursement decisions. A second-to-market company, on the other hand, can simply follow the pricing lead of the first-to-market company.
A first-to-market company must be prepared to undertake a wide range of activities in support of its reimbursement strategy. Such activities may include applying for new diagnosis-related group (DRG) or common procedural terminology (CPT) codes for classifying a medical procedure in payer databases. They may also include performing complex outcomes analyses, lobbying legislators, and even rallying public opinion in support of a product.

To handle this complex and time-consuming process, some companies now have dedicated staff who are collectively called the reimbursement and outcomes group (ROG). For the most part, only large, market-leading companies have the resources to maintain a full-time ROG. To get over the reimbursement hurdle, smaller companies may choose to follow a market leader, form an alliance with a larger company, or outsource the required tasks among consulting experts in the field.

In general, the organizational structures of medical device companies do not include a person dedicated to making pricing decisions. Companies in the airline and consumer retail industries almost always have a person who is designated as the pricing manager. In the device industry, however, none of the large companies we studied for this article had a specific person whose title or function was to be the company's pricing manager. Instead, pricing decisions are typically made by the ROG, together with the company's sales manager, product manager, and others. Decisions are made on a product-by-product basis, and nearly always apply only to the official list price of the product. The actual prices to be paid by hospitals and group purchasing organizations (GPOs) are the subject of extensive contract negotiations with those entities.

In the major companies where do they exist, ROGs generally have a low profile. However, such groups could usefully play a much larger role in determining a pricing strategy. ROGs characteristically offer a good base for this activity because they already possess the necessary human resources (staff trained in government regulations, healthcare administration, and economic analysis) and systems (e.g., computer databases).

Where most ROGs are currently weak is in their social capital—their ability to form useful networks within and outside the company. In order for such a group to adequately drive a company's pricing strategy, it needs to have a relatively high profile. It should also include at least one staff member who is capable of working as the company's pricing manager, and who should be given responsibility for compiling and maintaining a portfolio of the company's product pricing and reimbursement decisions.

Once the members of the ROG are in place, they should establish networks with others in the company, including especially members of the sales group (who understand the psychological aspects of pricing) and the product managers (who understand the products).

Conclusion

Medical device companies should view pricing decisions not merely as a means of setting a purchase price for their products, but also as a strategic decision. Viewed in this manner, the setting of a particular price is as important as any of the other elements that go into building a relationship with a company's stakeholders.

Companies that do not consider how the value of their products is created—or how it should be distributed—can unintentionally end up losing or even destroying some of that value. Alternatively, they may appropriate to themselves a portion of the product value that collaborators perceive as unfairly high—thus causing resentment and, eventually, loss of customers.

Faced with a competitive marketplace, device companies should resist the temptation to respond with ever-more rapid—but clinically meaningless—new product launches. Instead, company leaders should explore alternative methods of creating value, including improved service and help with reimbursement and billing.

Companies that successfully implement such a strategy should be able to significantly improve the value proposition for all of their stakeholders. At the same time, they will have created a loyal customer base that can generate revenues to support meaningful product R&D well into the future.

Mahesh Deshpande and Sudhir Gupta are both recent MBA graduates of the Carlson School of Management at the University of Minnesota (Minneapolis).