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PART

II CORE CONCEPTS OF STRATEGY

This section explores common strategy theories and concepts and applies them to the healthcare field. In chapter 2, readers learn that strategies must be aligned with an organization's environment and market structures. An organization's relationships to its environment and market structure directly affect its market power and ability to make strategic decisions. The chapter discusses the concepts of monopolies, oligopolies, monopolistic competition, and perfect competition, along with product life cycles and their impact on strategies.

Chapter 3 reviews the concept of business models and potential strategies. Business models define the core components of any company. Organizations must match the parts of their business model to their environment to succeed. Potential strategies include generic strategies that focus on low cost, or differentiation, or both. The advantages and disadvantages of being a first mover or an early entrant into a market also are discussed.

Chapter 4 examines a concept that has become critical in the healthcare field: the strategic use of vertical and horizontal expansion. Vertical expansion—connecting upstream and downstream components of an organization—has become a key strategy for many healthcare providers since the implementation of the Affordable Care Act and often calls for ownership and integration of hospitals, insurance products, physicians, and other healthcare businesses. Horizontal expansion—growth through mergers and acquisitions—continues to be a common healthcare strategy. The chapter explores the methods and challenges of both vertical and horizontal integration.

Chapter 5 considers strategic alliances—strategic nonowner relationships. Various types of alliances, their degree of interdependence, and requisite management skills are discussed. The chapter directly applies these concepts to the healthcare market and illustrates them through examples.

Walston, Stephen. Strategic Healthcare Management: Planning and Execution, Second Edition, Health Administration Press, 2018. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/apus/detail.action?docID=6452271. Created from apus on 2022-04-05 03:52:58.

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CHAPTER

UNDERSTANDING MARKET STRUCTURE AND STRATEGY 2

Since the Affordable Care Act was signed into law, the American healthcare sector has experienced a frenzy of mergers and acquisitions. Regulators are currently reviewing two proposed mergers that, if approved, would reduce the number of top national health insurers from five to just three gigantic companies. Among hospitals, this trend is even more pronounced and could lead to significant price hikes…. Markets where hospitals have a monopoly are exposed to massive price hikes. Hospital prices in monopoly markets are 15.3 percent higher than in markets with four or more hospitals. Hospitals in duopoly markets charge prices that are 6.4 percent higher, and treatment in markets that have a hospital triopoly is 4.8 percent more expensive…. There are increasing signs that federal regulators are beginning to worry about the recent wave of hospital mergers.

—Asher Schechter, “The True Price of Reduced Competition in Health Care: Hospital Monopolies Drastically Drive Up Prices,” 2016

Learning Objectives After reading this chapter, you will

have an overview of the societal environment and its effect on the healthcare market, recognize the effect of technology on the demand for and provision of healthcare, know the components of an external environmental analysis, understand the basic concepts of the market structure of an industry, comprehend the principles of market position as it relates to market structure and competitors, and be familiar with two methods of measuring market concentration.

ll organizations operate in an open system that involves continuous interaction with an external environment that directly and indirectly influences their success. The external

environment comprises many components, including communities of people of different ages and cultures; governments and regulatory bodies; and competitive and collaborative industries and companies comprising numerous products, services, and providers. These influences generally fall into one of two categories: (1) societal factors and (2) market factors. The context in which an organization operates heavily influences its strategies and its ability to achieve its mission and vision. Organizations developing a strategic direction must

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recognize and understand their external environment to be successful.

The Societal Environment

The societal environment encompasses general economic conditions, population demographics, cultural values, governmental regulations, and technology. Healthcare is highly influenced by these factors. General economic conditions have a significant impact on healthcare. As economic conditions improve, people have more disposable income and insurance coverage, which can be used to obtain healthcare services. In the United States, more than half of health insurance policies for persons under age 65 are provided by employers. When the unemployment rate rises, many families lose their insurance coverage along with their jobs. As a result, people cut back on medications, preventive care, and visits to their doctor (Kaiser Family Foundation 2015). For example, the 2008 recession slowed the growth of healthcare spending to the lowest rate in almost 50 years (Hartman et al. 2010).

Population demographics are also important in healthcare. Healthcare spending varies dramatically by age, race, and gender. People older than 65 spend 3.6 times more on healthcare than those between the ages of 19 to 44. (Centers for Medicare & Medicaid Services [CMS] 2016). Across the world, the number of individuals 65 or older is increasing dramatically. There were more than 46 million older adults in the United States in 2014, or 14.5 percent of the population, but this figure is expected to grow to 98 million and 21.7 percent by 2060 (Administration on Aging 2015). Worldwide, 20 percent will be elderly by the middle of the twenty-first century. However, in developed, wealthy countries in Asia and Europe, this number is already much higher. For instance, in 2015, 33 percent of the population in Japan and 28 percent of the population in Germany were older than 60 (United Nations 2015). See exhibit 2.1 for more information.

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As people age, they contract chronic conditions that require intensive treatments from acute care providers. In the United States, about half of all adults and 90 percent of all persons aged 65 or older have at least one chronic condition with more than 22 percent of older people having diabetes (AARP 2017). Chronic diseases are estimated to account for more than 75 percent of US health expenditures (Centers for Disease Control and Prevention 2016a). Spending on healthcare is highly concentrated in specific population groups. Half of the US population accounts for only 3 percent of healthcare costs, while 1 percent spend 20 percent of healthcare expenditures (Schoenman and Chockley 2012).

Racial and ethnic minority groups also tend to use healthcare services differently and experience higher rates of disease. For instance, 12 percent of African Americans have diabetes and 8 percent have had a heart attack. The comparable figures for white people are 7 percent and 4 percent, respectively. African Americans are also 10 times more likely to be diagnosed with AIDS (Ubri and Artiga 2016). Likewise, American Indians suffer from diabetes twice as often as whites do.

Minority groups have less health insurance coverage and often lack a primary care provider; about one-third of Hispanics and American Indians and 20 percent of African Americans are uninsured versus 12.5 percent of whites. Similarly, half of Hispanics and one- fourth of African Americans do not have a regular doctor, compared to one-fifth of whites (Halle, Lewis, and Seshamani 2009). Furthermore, minority populations often express different cultural and lifestyle preferences—such as choice of foods, level of participation in sports, use of tobacco, and openness to discussing disease—that affect incidence of illness and rates of healthcare use. An understanding of healthcare utilization differences among segments of the population is critical to evaluating the external environment.

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Consumption of healthcare varies by gender as well. Women use 32 percent more healthcare services, including visits to primary care providers, emergency and diagnostic services, and specialty care, than men do (Bertakis et al. 2000; Cylus et al. 2010). The number of females between ages 15 and 44 in the population affects birth rates; however, birth rates also are linked to economic and cultural factors. For instance, some have attributed the declining birth rate in the United States to the 2008 recession, and women are having babies significantly later in life. In 1990, mothers older than age 35 accounted for only 9 percent of all births, whereas in 2008 they accounted for 14 percent (Livingston and Cohn 2010). By 2016, the US national birth rate had dropped to an all-time historic low of 59.8 births per 1,000 women, less than half of its peak of 122.9 in 1957. The average age for a first birth was 26.3 years in 2016, as compared to 24.9 in the year 2000 (Park 2016).

To understand health issues in the external environment, healthcare organizations should identify their customers. Those planning should recognize the significant segments and concentrations and examine the relevant trends. Identifying where patients come from and where they go to for care is vital. Market knowledge helps hospitals understand and improve their competitive position, target their services, and better address community healthcare needs. Data or spatial (geographic) analysis, such as a patient origin study, can be used to locate the communities in which customers reside and provide important information to ensure that residents have appropriate access to healthcare services (Office of Statewide Health Planning and Development 2016; Ricketts et al. 1997). Exhibits 2.2 and 2.3 provide an example of this type of study. The proportion of patients residing in different zip codes can be determined and graphed to show primary and secondary service areas.

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To create a patient origin study, divide the percentage of total admissions by zip code and sort them from the highest to the lowest percentages. In exhibit 2.2, the percentages arrayed on the map graphically show where patients originate. The zip codes that encompass 60 percent of total admissions are shaded differently in the second map to denote the organization's primary service area. As further discussed in chapter 10, populations can be segmented by many other characteristics, such as age, payer type, and race.

In healthcare, the identification of intermediate organizations—those between the patient and the provider—is likewise important. As shown in exhibit 2.4, patients may not have the freedom to select a provider of their choice. Physician practices and managed care contracts may significantly influence or direct where a patient goes for care. Organizations should break out use patterns by important intermediaries to determine dependencies and trends. Such segmentation will enable an organization to better understand the location and type of customers it serves; both are important factors to consider when crafting strategic actions.

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Governmental regulations highly influence the healthcare field. Regulations require licensure, training, inspection, and approval of physicians and nurses, healthcare institutions, healthcare financiers, drug and medical products, research bodies, and public health agencies. The US healthcare system is one of its most regulated sectors; almost every aspect of it is subject to federal or state scrutiny (Field 2007).

In most developed countries, the government pays for most of healthcare; in the United States, the government funds about two-thirds of overall healthcare costs (CMS 2015). As a result, governments’ legislation and resultant regulations that almost always influence funding and costs influence the demand for healthcare and the way it is provided. For example, the Patient Protection and Affordable Care Act of 2010 (ACA) significantly affected the healthcare field. The government forecast that the proposed expansion of insurance coverage would increase the demand for healthcare products and services while negatively affecting organizations’ profitability and research efforts (Nexon and Ubi 2010). Likewise, Donald Trump's repeal of the ACA will alter the governmental rules and regulations on which US healthcare is organized to drastically alter Medicare, Medicaid, and private insurance (Wasik 2016).

Technology also has a significant influence on healthcare. Advances in technology, including prescription drugs, have been identified as a leading contributor to the increase in overall healthcare spending. Medical technology is broadly defined as the procedures, equipment, and processes used to deliver medical care. Examples are new medical and surgical procedures, such as implantation of cardiac defibrillators; new drugs; new medical devices; and new support systems. New technology can profoundly change the nature and process of care, which in turn may significantly influence organizations’ strategies. Advances in cardiovascular treatment have reduced the rate of death from heart attack by almost half. Declining cardiovascular disease, although wonderful for the public, has a major impact on the number and type of providers required to care for this population. Similarly, the use of cardiac stents appears to have significantly reduced the number of coronary bypass surgeries performed in the United States—decreasing patient volume for surgeons but placing greater demand on cardiologists (Cayton et al. 2012). As shown in exhibit 2.5, new technology will continue to alter the provision of healthcare radically.

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Market Structure

Organizations exist in markets—places, systems, and processes through which goods and services are exchanged. A basic knowledge of the concept of market structure is important. To understand the principles of market structure, one first should learn the difference between industries and markets. An industry is a particular category of business or economic activities. It is composed of groups of sellers whose products are close substitutes. For example, there is a pharmaceutical industry, a computer industry, and an aviation industry.

However, no hard boundaries distinguish the industry in which a business belongs. For instance, one could argue that home health services should be considered distinct from the pharmaceutical drug and the nursing home sectors because they are not direct substitutes and complement, rather than compete with, each other. Yet in some situations they are substitutes; for example, drugs may reduce the demand for other healthcare services. Therefore, home health, prescription drugs, and nursing homes could be subsumed in a global industry that includes all aspects of healthcare.

The boundaries of nonhealthcare industries are similarly difficult to define, especially as technologies advance and competition changes. For instance, Nokia and Blackberry

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dominated the cell phone industry in the first decade of the twenty-first century, when simple texts and e-mail complemented phone services. With the advent of the iPhone (Apple), competition over apps ensued and the cell phone industry expanded. Today, the phone industry offers such features as cameras, global positioning systems, movie players, data storage, maps, and games in addition to voice and text transmission.

In markets, services and goods may be exchanged for other products and services (barter) or, more commonly, for money. Retail markets may be physical (e.g., shopping centers, malls) or electronic (e.g., eBay). People also sell their labor to companies. Stock markets exchange company shares. Illegal markets for illicit drugs and other unlawful products also exist. An established market facilitates trade by establishing rules and expectations to regulate distribution and pricing.

The number, concentration, and relative strength of organizations in an industry compose its market structure, and the market structure exerts a strategic influence on the intensity and form of competition in the industry. As a result, organizations vary their strategies according to the structure of the market in which they exist. Organizations most often seek market power—the ability to influence prices by exercising control over supply and demand—which is directly related to their market's structure and their relative position in that market (Hitt, Ireland, and Hoskisson 2016).

There are four basic types of market structure, each of which reflects the number of organizations in the market and their degree of market influence:

1. Perfect competition 2. Monopolistic competition 3. Oligopoly 4. Monopoly

Exhibit 2.6 graphically displays the four market types and their relationship to the number of competitors and competitors’ degree of market influence. Markets’ structure rarely adheres strictly to one of the types but rather exhibits characteristics of the types to differing degrees. For example, true perfect competition rarely exists, but some markets more closely resemble this structure than others do. Likewise, few markets are true monopolies; rather, they approach a monopolistic structure. The market for Microsoft's main products is one example of a near monopoly, with almost 90 percent of the operating system market in 2016. Android's dominant 80 percent global market share of smartphones is another (Dans 2016; Hruska 2016). In some states the health insurance market approaches monopolies in the individual healthcare insurance market, with about 90 percent controlled by one insurer in Alabama, New Hampshire, Vermont, and Rhode Island and approximately 80 percent in Arkansas, Maryland, North Carolina, and North Dakota (Kaiser Family Foundation 2014b).

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Perfect Competition Exhibit 2.7 identifies characteristic differences among the market types. The first type, perfect competition, exists when many small organizations produce an undifferentiated, homogeneous product. Consumers may struggle to differentiate the products in such markets, so organizations compete on the basis of price and seek low-cost production solutions. There are few barriers or impediments to entering the market, so new competitors move in and incumbents move out frequently. In ideal perfect competition, consumers have enough information to make informed choices, and the prices they pay are close to production costs. Gasoline, generic drugs, currency markets, and agricultural commodities (e.g., wheat, rice, corn) are examples of markets that closely approach perfect competition. Because consumers often fail to distinguish companies’ products in such markets, price often drives consumers’ purchasing decisions. Therefore, low cost is the primary strategic focus in perfect competition.

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Monopolistic Competition Similar to perfect competition, monopolistic competition is a market involving many organizations. However, this structural type differentiates its products, so differentiation is the organizations’ strategic focus; they seek to distinguish their products from competitors. Differentiation can be achieved by offering products with better or exclusive features, enhancing service, employing more helpful and friendly personnel, boosting distribution channel performance, creating attractive packaging, raising product quality, changing location, or improving the organization's image (McGuigan, Moyer, and Harris 2017). Many products are available to consumers, and competition increases as products and their perceived quality become more diversified. Competition is typically vigorous in monopolistic competition. However, each organization, depending on its degree of differentiation, has some control over the prices of its products. Organizations with greater product differentiation have more power to raise prices over those of their competitors.

Entry into and exit from monopolistic competition is easy. Restaurants, manufacturers of breakfast cereals, and most private physician services in the United States operate in monopolistic competition structures. In the case of private physician services, for instance, physicians differentiate themselves by office location, specialization, and personal relationships with their patients. Because of these and other factors, price generally is not a major consideration when people are choosing physicians (Walston and Chou 2012).

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Oligopoly Oligopolies are market structures dominated by a few large organizations that offer similar or identical products. Organizations in oligopolies focus their strategies on capturing market share, unless they can collude to increase profits by fixing prices or reducing supplies. A global example of collusion by organizations in an oligopoly is the formation of the Organization of Petroleum Exporting Countries (OPEC). In 1960, the large oil producers banded together to restrict the supply and raise the price of oil (Said 2015). Laws exist in many countries to prevent such anticompetitive behaviors (Hawk 2010).

Organizations seeking to enter or exit an oligopoly face substantial barriers. The cost of entry is often great, and the specialized nature of business in oligopolies makes leaving difficult. Consumers have limited choices because the producers of a product or service are limited in number, and buyers often choose services or products on the basis of location or personal preference. For instance, the construction of a new tertiary hospital may cost millions of dollars, require multiple permits, change referral patterns, and necessitate hiring a medical staff. Therefore, generally speaking, few tertiary hospitals compete in a market. Patients have limited choices for tertiary care. They may choose the tertiary hospital closest to their home, referred by their insurance company, or preferred by their personal physician. Examples of oligopolies in healthcare include tertiary hospitals, healthcare insurance companies, drug companies, and group purchasing organizations. Nonhealthcare oligopolies include airline, steel, aluminum, automobile, oil, tire, and beer companies.

Monopoly A monopoly, on the other hand, involves just one organization. As a result, the monopolist has the power to control the type and quality of products and services provided. Competition is almost nonexistent, so the monopolist spends much of its time and strategic efforts creating and maintaining barriers to keep potential competitors out of its market. The service customers receive is often expensive and of marginal or poor quality. For example, as stated in the introduction to this chapter, hospital markets with monopolies charge more than 15 percent more than markets that have 4 or more hospitals.

Another example of monopolistic pricing in the United States is the high cost of pharmaceuticals allowed by the so-called monopoly rights given individual prescription drugs by governmental agencies. The monopoly and other factors make the US per capita spending on prescription drugs more than twice what other developed countries spend ($858 vs. $400) (Kesselheim, Avorn, and Sarpatwari 2016). Drug companies have greater ability to raise costs, with prices increasing at a rate eight times that of inflation. Patients with chronic diseases can spend more than $11,000 per year on prescription drugs. This situation sometimes results in clearly abusive business strategies—for example, when the cost of Daraprim, used to treat serious parasite infections, was raised 5,000 percent in 2015 (Tuttle 2016). Prices appear higher in monopolistic conditions in other healthcare sectors as well. Other examples of monopolies include utility companies, and the National Football League.

Because of the influence concentrated markets (monopolies and oligopolies) have on price and supply, the US government has passed antitrust laws and formed agencies such as the Federal Trade Commission (FTC) to restrict anticompetitive behavior and curb potential

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predation. (For more information, see the FTC's website at www.ftc.gov/tips- advice/competition-guidance/industry-guidance/health-care.)

Measuring Market Structure

A common measure of market concentration is the Herfindahl-Hirschman Index (HHI). Federal regulatory agencies examine the HHIs in markets where mergers and acquisitions are proposed. If a market is highly concentrated, the government may deny the merger or acquisition or apply restrictions.

The HHI is calculated by squaring the market share percentage of each organization in a market and then summing the numbers:

For example, if a market included six organizations—one with 50 percent market share, two with 20 percent, one with 6 percent, and two with 2 percent—the HHI would be calculated as follows:

The HHI approaches zero when many organizations of relatively small size compose a market. Conversely, the HHI for a monopoly is 1.0. The US government multiplies this number by 10,000, which changes the range from 0 (perfect competition) to 10,000 (monopoly). Using the latter conversion, the guidelines of the US Department of Justice states that HHIs lower than 1,000 denote unconcentrated markets; HHIs between 1,000 and 1,800 denote moderately concentrated markets; and HHIs higher than 1,800 identify markets that are highly concentrated and promote negative market behaviors (US Department of Justice 1997). On the basis of this index, the example in the previous paragraph would be considered a highly concentrated market (3,344).

The HHI examines organizations’ market share only for a common product or service at only one point in time, so its usefulness is limited. Organizations may offer multiple products and services in distinct market areas. Likewise, technology and market share may shift radically over time, rendering point-in-time HHI analysis almost meaningless.

Markets in healthcare tend to be highly concentrated. Most urban hospital and healthcare insurance markets are oligopolies with HHIs greater than 4,000 (Luke, Walston, and Plummer 2004). Healthcare providers have often effectively implemented strategies to increase their market share and gain greater negotiating power to increase the prices paid by consumers and health insurance companies. Some believe that current legislative efforts to promote integrated care through accountable care organizations could lead to even greater market concentration in healthcare (Berenson, Ginsburg, and Kemper 2010).

A simpler, less sophisticated measure of market concentration is the four-firm concentration ratio (FFCR). The FFCR is calculated by adding the market shares of the four

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http://www.ftc.gov/tips-advice/competition-guidance/industry-guidance/health-care

largest organizations in a market to find their cumulative total output:

For example, the FFCR for the six-organization market used earlier in the HHI calculation would be

A market with a four-firm ratio of 40 percent or less is considered unconcentrated, while markets with ratios greater than 90 percent are highly concentrated. Urban hospital markets and health insurers tend to be highly concentrated; urban hospital markets typically have FFCRs greater than 90 percent, and state insurance markets are generally dominated by one or two large insurance carriers (Cutler and Morton 2013; Furnas and Buckwalter-Poza 2010; Luke, Walston, and Plummer 2004). On the other hand, the top ten world pharmaceutical companies controlled only about 30 percent of the global pharmaceutical drug market in 2015 (Dezzani 2016).

The four-firm ratio does have drawbacks. The four-firm ratio's main limitation is that it considers only the four largest organizations in a market. Urban markets often include far more than four organizations.

Product Life Cycle

Markets also tend to go through cyclical changes. Most products and services go through phases or a life cycle that relates to the rate of sales, number of organizations in the market, and consumer demand. For decades managers and business researchers have seen the product life cycle as a useful framework for analyzing dynamic market conditions and applying more relevant, appropriate strategic alternatives (Day 1981). As shown in exhibit 2.8, it is typically depicted as four stages: emerging, growth, maturity, and decline. Product sales follow an S curve: They begin slowly in the emerging stage, rise precipitously in the growth period, flatten during the maturity stage, and decrease throughout the decline phase.

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Emerging markets can be a difficult environment for organizational growth. Sales in emerging markets are limited because customers often lack adequate product knowledge and must be induced to try the merchandise. Few standards exist, and product quality can vary dramatically, further confusing potential buyers. The few companies initially present in an emerging market spend significant monies on research, advertising, and marketing. As a consequence, the sale of products in emerging markets produces little profit, and companies face a substantial risk of product failure.

Entry into emerging markets can be strategically important. Organizations in emerging markets anticipate the ultimate market structure and position themselves accordingly. Strategic risks are high in emerging markets, but—if the organization can find the correct strategic position—so is the potential for great rewards. Innovative organizations may participate in many emerging markets simultaneously, hoping for big returns in at least some of their ventures. One example is the company Google. Its top-secret laboratory, X, formally Google X, is pursuing “shoot-for-the-stars ideas,” including drone delivery service and driverless cars (Dougherty 2016).

During the next stage—growth—sales increase rapidly. Overall, this stage is the best time for an organization to enter a new market. Competition is relatively low, customers are more forgiving, and businesses can obtain greater profits (Porter 1985). As more products sell, standards are set, customer acceptance increases, and the average cost of products drops because of economies of scale. At the same time, more competitors enter the market, eventually instigating greater price rivalry.

Rapid growth slows at some point, however, and a product enters the maturity stage. In this stage of market saturation, many organizations may consolidate and merge as profits

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decrease because of price competition and flat sales. Organizations increasingly compete for market share by differentiating their products and discounting their prices. Cost management becomes a critical competency, especially at the end of the maturity stage.

Ultimately, the demand for a product decreases because of changing consumer preferences, technological obsolescence, or availability of more effective substitutes. Many popular products have disappeared and faded into obscurity as the demand for them diminished. For example, the Sony Walkman, pagers, the PalmPilot, videocassette recorders, answering machines, and Atari game systems all were prominent products in the past. As consumers modified their preferences and technologies advanced, each product vanished and was supplanted by more effective substitutes (Grobart and Austen 2012). As demand drops, overcapacity leads organizations to exit the market or merge, leaving a smaller number of competitors. Again, cost and price competition dominate strategies in the decline stage.

The product life cycle, although helpful in strategic thinking, has some limitations as a framework for analysis. The S curve is not necessarily a sequential function. Some products skip stages or move back to a previous stage when new markets arise, new uses for the products are discovered, or technology advances. In addition, the duration of each stage and of the transition to another stage is unpredictable. Fad products might grow rapidly, while durable products may experience extended, slow growth. For instance, the sales of Procter & Gamble's laundry detergent Tide grew consistently from its introduction in 1947 through 1976. Over that period, the company modified the formula 55 times to better match consumer preferences (Day 1981). On the other hand, product life cycles are extremely short in the semiconductor, computer, and telecommunication industries today as a result of constantly changing technologies and consumer demand (Goktan and Miles 2011).

Chapter Summary

The external environment of all organizations profoundly affects their ability to operate and prosper. An understanding of the context in which one operates is critical to strategic planning and strategic thinking.

The external environment consists of consumers, suppliers, buyers, competitors, and regulators. The powers and pressures emanating from these sources influence the strategic choices that organizations need to make. These components can be categorized as societal factors or market factors. The societal environment comprises general economic conditions, population demographics, cultural values, governmental regulations, and technology. Market factors include the number of organizations in a market and their degree of market influence. Common market structures include perfect competition, monopolistic competition, oligopoly, and monopoly. Oligopolies exist in many healthcare markets. The degree of market concentration can be determined by calculating the Herfindahl-Hirschman Index or the four- firm concentration ratio.

The product life cycle also is useful for analyzing markets. It identifies the stages through which products progress and illustrates the effects that changes in technology, markets, and consumer demand have on product growth.

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Chapter Questions

1. How does a change in population demographics alter the use of healthcare? 2. Which components of population demographics have the most significant impact on

healthcare? 3. What is a patient origin study, and how can it inform strategic thinking? 4. Which of the four market structures would be most preferable to consumers? To

organizations’ owners? To governments? Why? 5. What intermediaries exist between patients and their providers in the United States? What

purpose do they serve? 6. How have technological advancements changed the provision of healthcare, and how

might they affect healthcare in the future? 7. What are some of the exchanges that occur in the healthcare market? 8. What is the major difference between perfect competition and monopolistic competition? 9. Why do so many oligopolies exist in healthcare? 10. What are the main barriers to entering the healthcare market? Do they vary by type of

organization? How? 11. What are two measures of market concentration? Why might one be preferred over the

other? 12. How might healthcare services pass through the product life cycle? How do the size and

number of organizations in a market affect the product life cycle? 13. What must a firm do to succeed in the declining product market stage? 14. How should the strategic actions of an organization whose product is in an emerging

market stage differ from those of an organization whose product is in the mature stage?

Chapter Cases

Case Studies Either “The Struggle of a Safety Net Hospital” or “The Battle in Boise,” both found in the case studies section at the back of this book, can be used to explore concepts in this chapter.

Herman and Market Structures Herman has been working in healthcare administration for ten years. He has finally taken a health strategy course and learned about different market structures. He wondered why different segments of healthcare respond differently in negotiations. One of his responsibilities is negotiating with physicians, insurance companies, and hospitals in his company's managed care unit. He has found that his ability to exact price concessions from different groups varies dramatically. Primary care physicians’ market structure is a monopolistic competition, while prominent hospitals seem to hold monopoly power. Insurance markets, on the other hand, often are oligopolies. He now believes that the introduction of national quality standards for primary care physicians may make outcomes

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among physician offices easier to compare and thus reduce their differentiation. As a result, he may be able to gain greater price concessions from physicians in the future. Often, however, he almost has to beg prominent hospitals to join his system's network, and in turn he pays full prices. In insurance markets of only three or four major companies, each organization seems to offer the same terms. Herman thinks he now understands better what is happening with each group.

Questions 1. How are Herman's perceptions regarding his negotiations and market structure

correct? Incorrect? 2. How would specialist physicians fit into the market structure, and how would Herman

negotiate with them? 3. Could perfect competition exist in healthcare? How would one negotiate in this type

of market?

Chapter Assignments

Identify the market shares for general acute care services, by organization, in a city of your choosing. Determine the HHI and the four-firm concentration ratio for this area. How much monopoly power exists in this market? Would the index vary significantly if you calculated it for a specialty, such as obstetrics or cardiovascular surgery? What if you expanded the area under evaluation to a larger region or state? How would the index change?

Write a one-page paper on the problems of monopolistic power in healthcare. How might the proposed changes in the ACA affect the market power of healthcare providers? What can the government and other stakeholders do to moderate monopoly power?

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CHAPTER

BUSINESS MODELS AND COMMON STRATEGIES 3

Five years from now,” said a hospital CEO to his peers at a recent conference, “our organizations will look very different. They will operate with different incentives, different business models and different footprints.” What does the future look like for community hospitals and health systems—and what are their marching orders?

The hospital business model is under pressure. The costs of physicians, nurses, technology, compliance, and marketing are rising, while payments from all payer types are shrinking, as is inpatient utilization. We anticipate a 12 to 28 percent revenue decline over the next few years.

Many community hospitals, already operating at razor-thin margins, soon may find themselves deep in the red. Although most hospital leaders realize this possibility, their responses to these pressures often betray a lack of focus. They react with across-the-board cuts, a race to acquire physicians, a superficial rebranding, or a search for elusive mergers and acquisitions. These incremental actions are unlikely to move the needle. What's needed is a new way of thinking about form and function.

—Gary Ahlquist, “New Approaches for Community Hospitals and Health Systems,” 2013

Learning Objectives After reading this chapter, you will

understand the concept and use of business models; be able to describe how business models vary in healthcare and how business models may provide a competitive advantage; comprehend generic strategies and their application to healthcare; be familiar with strategies for differentiation in healthcare, including focused factories; and recognize the advantages and disadvantages of first-mover strategy.

rganizations, even direct competitors, may form and pursue strategies in vastly different ways. This chapter discusses how organizations produce value for customers

and how their structure, processes, and strategies influence their success. As discussed in chapter 6, success is relative to the values, mission, and vision of an organization. For for- profit organizations, sustained profits may signify competitive advantage and success. Not- for-profit organizations, however, may recognize other achievements as success. Therefore,

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the desired business outcome must dictate the business model of an organization.

Business Models

Whatever their definition of success, organizations constantly face the challenge of devising strategies that will enable them to enhance the value they provide to their key stakeholders. As stated in the introduction to the chapter, experts expect that healthcare and hospital business models will experience pressure to change. Business models, the underlying structure and function of organizations, build on the idea of value chains and value creation (Morris et al. 2006; Porter 1985). Although a common definition of business model has not been established, Walston and Chou (2012) define it as the core elements of an organization and how it is structured to deliver value to its customers and generate revenues. Business models encompass all aspects of organizations, including their economic, operational, and strategic domains, and successful organizations design their business models around their internal competencies (Morris et al. 2006). Appropriate, competitive business models often succeed when matched against organizations that have better ideas and better technology but a poor business model (Chesbrough 2007).

Most established organizations in the same industry do not have distinct business models. Organizations that compete for the same set of customers frequently copy each other's structures and strategies. Over time, many organizations may come to offer similar sets of products and services. As discussed in chapter 7, barriers commonly restrict entry into an industry, and mobility barriers limit competition in strategic groups. With limited entry of new organizations and similar environmental conditions, incumbents become isomorphic over time, adopting homogenous forms and practices (DiMaggio and Powell 1983). As a result, pronounced differences in business models often emerge only when environmental shifts alter customer preferences, technology, and barriers to entry, thereby allowing new organizations to enter the industry.

New business models do not guarantee success and are often fraught with peril. For example, the US government has encouraged new organizations to experiment with distinct business models. Some experiments, like the Pioneer Accountable Care Organization (ACO) Model program, created accountable care organizations that would provide savings (see exhibit 3.1). However, while many healthcare organizations initially welcomed the new approaches, most seemingly failed and abandoned the program.

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Scholars often discuss business models as four interrelated components: value to customers, organizational inputs, organizational processes, and means of generating and obtaining revenues (see exhibit 3.2). The content and structure of these components should result from strategic decisions; their functions and interactions substantially contribute to the success or failure of an organization. As shown in exhibit 3.1, healthcare organizations moving to a new payment and business model may greatly struggle, and many may fail.

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Customer Value Organizations seek to produce what customers value. This perceived value consists of a range of products and services, a degree of customization, ease of availability and access, and the trade-off between cost and quality. Dissimilar business models may provide a different type of value to customers (e.g., Amazon vs. Walmart). Customers have differing desires and needs. Some may value ease of access and availability, others want low cost, yet others seek high quality. An innovative business model aims to address the needs and desires of all consumers or just a segment. The value provided by successful organizations reflects their mission and vision and differentiates them from competitors.

The following questions can be used to explore the customer value an organization provides:

What value is provided to the customer segments served? What customer problems does the organization's product or service solve? What customer needs does the product or service satisfy? What needs are not satisfied? Does the value created by the organization support its mission and vision? How does this value distinguish the organization from competitors?

Inputs The type and mix of resources organizations use to provide a product or service make up the inputs component of the business model. Resources include personnel, materials, and equipment. Organizations choose a mix of automated equipment and personal interaction and select types and quantities of materials and supplies according to the value they wish to deliver. Some businesses choose to hire personnel to answer phones and greet customers, while others automate customer interactions. Other inputs include organizational core

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competencies—a critical source of competitive advantage—and strategic assets, such as facilities, equipment, location, patents, networks, and partnerships. For instance, many hospitals have begun using hospitalists and intensivists as an input. An organization may change its inputs over time; for example, innovations in technology often trigger a change of inputs.

An organization can use the following questions to examine its inputs:

What key inputs directly contribute to the value of the product or service? Are any inputs inconsequential? Could the organization lower costs or increase value if it changed any of its inputs? Are there new technologies that the organization should consider adding as new inputs?

Processes A process is a series of steps that ultimately transforms inputs into customer-valued products and services. In addition to creating value, processes simplify decision making, increase efficiency, complete tasks, organize functions, and enable an organization to interface with external entities. A process sits between every input and resultant output. Processes are often formalized into policies and procedures and may be categorized as primary, support, or management processes (Rummler and Brache 1995). Each step in a process should add value. Organizations vary widely in their use of processes in their business models.

The following questions can be used to examine processes:

How do the organization's processes differ from those of its competitors? Which processes add value, and which do not? Could processes be redesigned to eliminate unneeded steps? Do processes unnecessarily delay final outputs? Can processes be automated? Is there new technology that could streamline existing processes?

Revenue Generation All organizations must generate sufficient revenues to operate. To survive and prosper, even not-for-profit organizations must produce “profits” or take in more money than they expend. The ways in which funds are generated vary significantly. Organizations may obtain monies directly from consumers or through third parties. Payments for products and services can be made directly (e.g., fee-for-service), through bartering exchanges, via rebates from manufacturers, in advance (e.g., prepayments for a scope of services), and in other ways. Organizations can generate additional revenues indirectly from donations, grants, and taxation. To remain in business, however, its total direct and indirect income must exceed its expenses over time.

Use the following questions to assess the profitability of a business model:

In what ways does the organization generate revenues? If the organization generates revenues in multiple ways, which are the most important? Which will be the most important in the future?

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Could new technology significantly affect the ways the organization generates revenues? Does the organization generate enough revenues to achieve its mission? If not, what needs to occur?

Business Model Innovation and Adaptation

The four components of a business model constantly interact to execute an organization's strategies. To be successful, organizations must be willing to modify their business models as conditions change. However, organizations with established business models find them difficult to change because the four components are interlinked.

The innovative business models of new market entrants are often difficult for incumbents to imitate. For example, many of the major airlines have sought but failed to imitate Southwest's low-cost business model. The inability to copy new organizations’ business models lies in the interconnectedness of the model components. Older organizations commonly try to compete with new organizations by changing only part of their business model, but this approach has consistently proved to be ineffective. For example, Continental Airlines established a no-frills, low-cost service in 1993, only to shut it down in 1995 after expending $140 million. Continental Lite mixed its business model by using its existing reservation system and employees, and even though it charged very low prices, few people flew with the airline (Bryant 1995; Hensel 2004). Recently, legacy airlines such as Delta and United have instituted lower-cost services, called basic economy. Passengers are not given frequent flier mileage points, they are not given the opportunity to select their seats, and small carry-on bags are only allowed under their seats. Many wonder if these changes can be sustained and successfully compete against low-cost airlines (Reed 2016).

Nonetheless, business models must change when the external environment substantially shifts and organizations must seek different ways to compete and survive. For example, most consider the traditional pharmaceutical business model unsustainable. It consists of large, vertically integrated organizations with large sales forces promoting drugs created from small-molecule compounds (Miller 2008; Tyson 2015). As detailed in exhibit 3.3, experts predict that by 2020, the business model of successful pharmaceutical companies will evolve into a collaborative network of firms that help manage patient outcomes through a so-called medicine-plus approach.

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Some large pharmaceutical companies, such as Eli Lilly, are changing their business models and taking a more collaborative approach. For more than 130 years, Eli Lilly has functioned as a traditional, fully integrated pharmaceutical company. However, in response to skyrocketing discovery costs and other pressures, Eli Lilly instituted Chorus, a virtual network with nonowned companies that manage many discovery programs at a fraction of the in-house cost while significantly reducing the time of clinical trials (PricewaterhouseCoopers 2009).

The following excerpt from a company brochure further explains this new model (Chorus 2009, 3, 9, 10):

Chorus is a small group of experienced drug developers focused on establishing clinical proof-of-concept (PoC) as quickly and inexpensively as possible. Chorus designs and manages drug development plans on new chemical entities….

The Chorus approach alters the balance of risk across the portfolio and enables clinical study of many more candidates at a fraction of the time and cost typically associated with traditional drug development….

Chorus teamed up with an external IT solutions partner to develop a custom, web-based enterprise management system called Voice. Voice enables small, virtual, global drug development teams to securely collaborate on all aspects of a project—including broad planning, detailed implementation, document development and approvals—and provides administrative solutions to numerous internal portfolio challenges….

The Chorus business model is built on the foundation of flexible outsource staffing through TPPs [third-party

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providers], offsetting fixed internal costs. Tactical outsourcing such as staff augmentation, functional outsourcing, and full-service outsourcing is an increasingly common method used by most pharmaceutical and biotech companies to reduce R&D fixed costs. Rather than dealing with inefficient outsource models, such as relying on a small exclusive group of providers, Chorus recognizes the need to leverage a wider group of external global implementation expertise to deliver multifaceted services. This external network provides Chorus with the flexibility to match each project's unique needs and strategic integration requirements to a wider array of global and niche TPPs. To support this more inclusive model, Chorus developed and maintains a large and growing network of providers to support each function. The Chorus external network continues to grow and currently consists of more than 200 global providers.

Since its inception, Chorus has demonstrated substantial productivity improvements in both time and cost compared to traditional pharmaceutical research and development (R&D). Lilly claims that Chorus helped it make decisions about 12 months earlier at around half the cost of comparable industry research. As a result of Chorus's successful track record and the increased demand for capacity, Lilly has expanded in Indianapolis, the United Kingdom, and India (Grogan 2011; Owens et al. 2015).

The principles and components of business models also can be used to examine macro business relationships, and they likewise apply to larger markets and industries. For example, many are calling for fundamental changes to the business model of the US healthcare system (Crean 2010; Lin 2008; Perkins 2010; Porter and Lee 2013).

US Healthcare Business Model

As illustrated in exhibit 3.4, healthcare in the United States conventionally has offered fragmented treatment of illness focused on acute care at the expense of primary and preventive care (Marvasti and Stafford 2012; Shih et al. 2008). Physicians and hospitals have been primarily engaged in curing disease on an individual basis. Little coordination has occurred among healthcare providers, instigating the delivery of duplicate services and driving up costs. American hospitals have become some of the most costly structures ever built and, as the hubs of healthcare provision, have promoted high-cost acute care medicine (Perkins 2010). Yet duplication and the high cost structure have increased hospitals’ profits (Trinh, Begun, and Luke 2008). Insurance companies have taken the role of middleman, receiving monies from businesses and negotiating contracts with providers for healthcare services. The more services providers deliver, the more money they make.

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From a public and consumer perspective, this business model has not produced consistent value. Despite spending more than double per capita on healthcare than any other system in the world, the US healthcare system performs relatively poorly in terms of mortality and morbidity outcomes. Despite the high spending, Americans had relatively poor health outcomes, with shorter life expectancy and more chronic disease. Consistently, the US healthcare system ranked last or next to last on quality, access, efficiency, equity, and health measures. Relative to global averages, the US government also invests little in social services that could potentially stem the tide of healthcare costs (Davis, Schoen, and Stremikis 2010; Squires and Anderson 2015).

The weaknesses inherent in the current US healthcare business model have created a fragmented, inefficient system (Shih et al. 2008, ix):

Unassisted navigation by patients and families across different providers and care settings fosters frustrating, dangerous experiences. Poor communication and a lack of clear accountability for patients among providers lead to medical errors, waste, and duplication of services. The absence of peer accountability, a quality improvement infrastructure, and clinical information systems creates poor overall quality of care.

In addition, primary care practices’ common structure consists of seven-minute visits in which the provider rapidly determines whether to prescribe a pill or refer the patient for a

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procedure or to another specialist. Little wonder primary care physicians are the most dissatisfied among physician specialties (Chase 2013). Some believe that various stakeholders will demand that the US healthcare business model be revised, moving to patient-centered, value-based, or population-based focus and requiring greater coordination of care and a greater attention to preventive and primary care (American Hospital Association 2017; CMS 2016; Friedman et al. 2016). As shown in exhibit 3.5, the largest payer of hospital services, CMS, has moved to a partially value-based payment system by setting aside 2 percent of overall monies for incentive awards based on clinical and service quality indicators. Improving the quality and value of healthcare has become an imperative for all.

To coordinate, manage, and control care more effectively, US healthcare delivery systems—whether owned companies or virtual networks—will need to implement comprehensive information systems capable of capturing both clinical and administrative data. In addition, methods of provider payment must change. Payers may contract directly with systems to establish a fixed rate covering the health of their discrete populations—for example, a fee per person per month or a global payment for a segment of the population. The new business model may leave out many insurance intermediaries. Finally, profits (called surpluses by not-for-profit organizations) will be generated by improving health outcomes, preventing disease, and controlling overall expenses more effectively rather than by providing more services.

One example of a health system that has transitioned to a new model is Western Maryland Health System in Cumberland, Maryland. In 2010, as part of the state of

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Maryland's Total Patient Revenue System demonstration, this system moved to a fully value- based payment that resulted in inpatient admissions declining by 32 percent in four years. Yet the system is enjoying greater financial success. Changes included moving from a “a traditional delivery model, with the hospital and emergency department at the center” to “a continuum of care that elevates the importance of pre-acute services such as retail pharmacies and urgent care centers, and post-acute services, including rehabilitation and skilled nursing facilities, hospice, and palliative care” (Butcher 2014). Western Maryland Health System modified care delivery with resources set aside to manage patients with chronic diseases and high utilizers of services more effectively (Butcher 2014).

The Threat of Disruptive Innovation

Popularized by Harvard professor Clayton Christensen, the concept of disruptive innovations suggests that disruption occurs when organizations successfully combine technological enablers and business model innovation (see exhibit 3.6) (Christensen 1997; Christensen and Mangelsdorf 2009). These factors can destroy existing organizational competencies and spur the rise of new, dominant organizations.

Technological enablers that have prompted radical innovation include the microprocessor, which helped personal computers overwhelm mainframes; the Internet, which gave rise to online news and the development of online retail stockbrokers, such as E*TRADE and Charles Schwab; and advancements in electronics, such as digital photography. As the quality of these new technologies improved, they overtook entrenched

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incumbents by offering better service and lower prices. Companies that previously controlled these markets, such as the Los Angeles Times, Merrill Lynch, and Kodak, are struggling to survive.

Novel business models that use disruptive technology enable organizations to better compete in the market and radically diminish incumbents’ ability to generate profits. As a result, few dominant businesses ever survive disruptive innovation to remain the leading organizations in the new environment. For example, today's movie entertainment outlets used online technology and different business models to dominate the previous rental market king, Blockbuster. In the early 2000s, Blockbuster lost vast amounts of business to Netflix, Hulu, and Redbox and ultimately filed for bankruptcy in 2010 (Sherman 2010). For decades, Kodak produced excellent film for cameras and had expert competencies in chemical engineering. The advance to digital imaging destroyed the value and relative competence of the thousands of chemical engineers employed by Kodak. Electrical engineering skills were needed in the new world of digital imaging, and companies without these competencies failed to adapt to the new reality.

Healthcare has not generated many radical innovations—mostly sustaining discoveries that have benefited incumbents. However, many predict that future innovation, whether driven by legislative dictum (e.g., the Affordable Care Act) or scientific discovery, may disrupt existing healthcare relationships and the ways in which care is provided. It may also reconfigure service offerings to meet customer demand at lower prices (Nam 2016; Walsteijn 2012). Others suggest that the use of new midlevel providers (e.g., dental therapists) or retail clinics as alternatives for physician care might constitute disruptive innovation (Edelstein 2011; Pauly 2011). Advances in genomics, which plays a role in nine of the ten leading causes of disease in the United States, present great potential for disruptive innovation in the diagnoses, treatment, and prevention of disease (CDC 2017b). Clinical molecular testing, pharmacogenomics, and other medical genomics discoveries are rapidly expanding and helping physicians provide personalized medicine and make better prescribing and dosing decisions.

According to Hwang and Christensen (2008), healthcare is prone to fragmentation of care, coordination of care is difficult, consumers lack the proper incentives to shop for care, and many regulatory barriers exist. For these reasons, disruptive innovation does not easily take root in healthcare. Nevertheless, with steadily increasing costs and rampant inefficiencies, healthcare needs radical surgery, and strategists must recognize the possibility that new business models will emerge and bring about major change. “By coupling technological advances with appropriately matched business models, disruptive innovation has brought affordability and accessibility to industries ranging from steel making to personal finance, and it is the right prescription for the ailing U.S. health care system—a treatment that is desperately needed and long overdue” (Hwang and Christensen 2008, 1335).

Healthcare's unique structure, with intermediaries and ubiquitous governmental regulation, makes disruptive innovation more difficult. However, to be disruptive the innovation must do the following:

Cure disease. Most innovations treat symptoms of disease. Disruptive innovation cures and

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resolves disease. For example, the introduction of the drug Sovaldi (and its successor Harvoni) was disruptive, as it cures 80 to 90 percent of those infected with hepatitis C. Transform how medicine is practiced. Disruptive innovation changes the practice of medicine. Examples include drug-eluting stents that made heart surgery less invasive and vaccines for polio and smallpox. Take root deeply. The effect (disruptive or sustaining) of a technology depends on how it is applied—many technologies, such as big data, sensors, and other tools have the potential to be disruptive, but only if applied to change radically the practice and cost of care (Nam 2016).

Generic Strategies

Decades ago, Michael Porter (1980), professor of business administration at the Harvard Business School, proposed three generic strategies from which organizations may select. Others have since increased the number of generic categories to five (Bourgeois, Duhaime, and Stimpert 1999; Hill and Jones 1998; Thompson et. al 2016). Most authors define the generic types of strategy as combinations of a target market (a small, focused customer base vs. a large, general customer base) and the type of competitive advantage sought (low cost vs. differentiation). Exhibit 3.7 lists the possible combinations and provides examples of organizations that have adopted each type of strategy.

Broad Low-Cost Strategy An organization with a broad low-cost strategy targets a wide customer segment and seeks to achieve competitive advantage in the market by maintaining low costs and underpricing its competitors to earn higher profits. Low-cost positions can be gained by economies of scale; experience curves; efficient value chain management; effective bargaining; elimination of unnecessary features; and rock-bottom product costs through appropriate outsourcing,

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vertical integration, and information systems. Use of the term cost frequently causes confusion because authors at times refer to cost

as both the expense of producing a product or a service and the price charged for a product or a service. Although low-cost and low-price strategies ideally go together, organizations may adopt one but not the other. Low-cost strategies may be pursued concurrently with some aspect of differentiation to offer reasonable prices, coupled with some unique characteristic (e.g., quality, service, access), while a true low-price strategy may need to offer the lowest price in the market (Yip and Johnson 2007). Although low production costs often do have a relationship with low prices, in this book low cost refers to the cost of production.

Broad low-cost strategies are most effective in markets where cost is more important than reputation or product characteristics or where large economies of scale exist. Firms producing commodities, such as wheat, oil, gold, and sugar, may more easily use a low-cost strategy. Likewise, companies that can exploit large economies of scale, such as manufacturers of computer chips, can compete on the basis of cost. As a result, organizations using a broad low-cost strategy strive to maximize their market share. However, low-cost products and services still must maintain a certain level of quality and differentiation. Consumers must perceive the lowest cost for the value received. Organizations often take one of the following approaches to create this perception:

Product line narrowed to standardized, no-frills goods. Organizations pursuing a broad low-cost strategy may eliminate low-volume products and services from their offerings and retain only those that generate the greatest sales and profitability. They keep production costs low by using standard components, limiting the number of product models, and minimizing overhead and indirect costs. Noncore components may be outsourced. For example, specialty hospitals narrow the wide product line of general hospitals, standardize products and processes, and eliminate some services, thereby lowering their costs. High asset turnover. Organizations make optimal use of their assets and resources by managing large volumes efficiently and operating their facilities at full capacity. Examples include table turnover in restaurants, airlines’ maximization of the time its planes are in flight, and maximization of actual surgical time in operating rooms. Control of purchases and procurement. Organizations seeking to keep costs low generally exercise control over their supply chain and purchases to minimize expenditures. Purchasing in bulk, consigning products (vendor-managed inventory), negotiating high discounts, and using just-in-time purchasing can significantly lower costs. Hospitals have often used consignment, especially for surgical implants (Crans 2009). Low-cost distribution systems. The logistics of the supply chain, including distribution, inventory management, sterilization, transportation, and so on are now the focus in the effort to lower costs in healthcare. Some systems, such as the University of Pittsburgh Medical Center, have established centralized, system-owned warehouses to limit costs, while others are working with medical and surgical distributors to distribute and store inventory more cost-effectively (Rubenfire 2016).

The costs of distribution are significant for many products and services. Low-cost

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strategies call for a wide distribution system at a minimal cost. Instead of using personal contact, organizations may use online sales and marketing tools to reach customers. Sophisticated software systems promote efficient distribution, and some organizations bypass distributors and sell directly to the consumer to reduce costs—for example, Dell and Apple. Customers order computers from low-cost-focused Dell via the Internet or phone. While Apple's customers may order computers these same ways, they also can visit one of Apple's many local stores and consult with service representatives. Likewise, manufacturers of generic drugs may market only to wholesalers, while brand-name drug companies have large, owned sales forces and market directly to consumers and physicians.

Focused Low-Cost Strategy An organization adopting a focused low-cost strategy competes on the basis of costs but targets only a subset of the mass market. This strategy refines the broad low-cost approach by narrowing its customer base and—possibly—undercutting the pricing of generalists. In highly competitive markets, smaller, low-cost organizations may find a niche in which the larger rivals cannot compete. For example, ALDI and Walmart are both large, international chains. Walmart employs a broad low-cost strategy, while ALDI employs a focused low-cost strategy. Yet their business models are similar in that both focus on cost and reasonable quality. ALDI, however, offers only a limited assortment of groceries and related items targeted to customers with low to moderate incomes and can often price these products almost 20 percent lower than Walmart (Pettypiece 2016). On ALDI's website, the company states that it “has been named the Low-Price Grocery Leader for the second straight year!… As a two-time low-price leader, we know that everything you buy should be of the highest quality. That's why all our products are backed by our Double Guarantee” (ALDI 2013).

As shown in exhibit 3.8, ALDI's strategy differs from Walmart's strategy mostly with regard to inputs and processes. Both offer low-cost groceries. However, Walmart sells dramatically more products and multiple brands, while ALDI sells relatively few products and only one brand of each product. ALDI also greatly minimizes personnel costs by having customers bag their own groceries and displaying products in cartons, among other techniques.

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Low-Cost Strategies in Healthcare Low-cost strategies succeed better in some segments of healthcare. The difficulty with a low- cost strategy in healthcare is the perception that low cost equates to low quality. Consumers want more than low cost in healthcare, especially if their health or the health of their family is in jeopardy. In such situations, quality almost always trumps cost. As Porter and Teisberg (2006, 98) state, “Minimizing costs is simply the wrong goal, and will lead to counterproductive results.” Few would desire to have their loved ones undergo surgery in a hospital that promotes itself as the low-cost option. Likewise, patients generally prefer cutting-edge technology, even if the costs are higher.

Nevertheless, many ambulatory surgery centers (ASCs) and specialty hospitals and clinics promise to provide services at a unit cost lower than that charged by general hospitals. The lower costs have been attributed to reorganization into integrated practice units, breaking down silos with multidisciplinary teams that focus on patient outcomes and value (Porter and Lee 2013)

In segments where consumers are more price sensitive, low cost may help organizations achieve competitive advantage. For example, in obstetrics, plastic surgery, and the health insurance business, prices (costs) may have a greater influence on consumers’ choices. Consumers with high out-of-pocket costs more often compare prices, choose lower-cost

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healthcare services, and select less expensive drugs and healthcare services (Buchmueller 2006; Penn Medicine News 2016; Ungar and O'Donnell 2015).

Broad Differentiation Strategy Organizations using broad differentiation strategies offer products and services that have unique features and appeal to a wide segment of a market. Consumers purchase products and services that have singular characteristics or features they value, and they often will pay more for those valued features. Broad differentiation strategies tend to be most effective in large markets where

buyer preferences and values are diverse, many organizations offer common products, and product innovation is rapid (Hitt, Ireland, and Hoskisson 2016).

Nearly all products and services can be effectively differentiated. Companies spend millions of dollars annually to differentiate both basic products, such as salt and soft drinks, and complex merchandise, such as microprocessors and automobiles. Differentiation can be based on characteristics of a product or service or on the attributes of an organization's personnel, distribution channels, and image.

Exhibit 3.9 lists many ways an organization may choose to differentiate its products and services. A pharmaceutical company might alter the size, texture, reliability, and duration of its medications; accelerate ordering and delivery; or improve the responsiveness and friendliness of its sales personnel. A radiological equipment manufacturer may elect to focus on ease of installation, customer training, maintenance and repair, and its personnel's credibility and reliability.

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“Overall, a firm using the differentiation strategy seeks to be different from its competitors on as many dimensions as possible” (Hitt, Ireland, and Hoskisson 2016, 123). Porter (1980) suggests that an organization must have strong marketing capabilities and a perceived reputation for quality or another unique characteristic for a broad differentiation strategy to be effective. Organizations must understand and offer what buyers need and value to succeed through differentiation. Competitive advantage often is short lived and must be constantly renewed, so innovation and an ability to change are critical factors. An organization is using differentiation successfully if

it can charge premium prices, sales are increasing, and customers become loyal to its brand (Thompson et al. 2016).

Certain hospitals have achieved a strong, broadly differentiated position and are able to use it to their competitive advantage. They have carved out “must-have” market positions that enable them to extract higher payments. A must-have hospital is one that insurance companies must have in their network; else, they face the possibility of losing customers. These hospitals, such as Cedars-Sinai Medical Center in Los Angeles, have established excellent reputations and most often provide unique, specialized services. In negotiations with insurance companies, the must-have hospitals demand and frequently receive premium reimbursement rates (Berenson et al. 2012; Berenson, Ginsburg, and Kemper 2010).

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On the other hand, there is some value to adopting strategies similar to those of competitors and not appearing different. Conformity sometimes enhances performance and promotes long-term survival. Customers see that the conforming organization's product is consistent with those of its competitors and may be more willing to try the new product. In fact, competitors quickly copy and imitate successful differentiation strategies to conform. An organization seeking to sustain a differentiation strategy must develop strong creativity and innovation by integrating its marketing and production and by hiring and retaining creative personnel (Shenkar 2012).

Focused Differentiation Strategy Focused differentiation strategy targets a narrow industry niche or customer segment. Companies can differentiate their product and services via the means listed in exhibit 3.8, but the differences are perceived as unique to a narrow group or population. For example, Rolls- Royce, Rolex, Saks Fifth Avenue, Harrods, Chanel, and Tiffany & Co. focus their products on the luxury market segment. They offer high-quality, prestigious products at high prices. Such organizations refrain from expanding into unrelated businesses and offer specialized products.

Some have long suggested that healthcare should be organized in a more specialized, focused way and should move away from its broad, unfocused strategies, which have led to quality and cost problems (Herzlinger 1997). A potential solution, focused factories, is a term that dates back to the 1970s and initially described a manufacturing strategy that concentrated on core (often single) products and a defined set of technologies and customers. Some scholars have suggested that this strategy was a major factor in the past revitalization of US business fortunes (Herzlinger 2000; Pesch 1996).

The creation of healthcare focused factories in the United States has been limited to separating common services, such as cardiology and surgery, from general hospitals and placing each service in its own facility. Examples include ASCs and specialty hospitals, both of which have rapidly increased in number. These focused healthcare organizations are often owned by physicians (in contrast to public ownership of most general hospitals), offer a relatively narrow line of services, and may attend to only one type of disease. For example, David Cook and colleagues found that the “focused factory model was appropriate for 67 percent of cardiac surgical patients.” If implemented more widely, this system would reduce “resource use, length-of-stay, and cost,” as well as variation (Cook et al. 2014, 746). Other possible focused factories may include diabetes clinics, cancer clinics, asthma clinics, and orthopedic surgery.

Focused differentiation has emerged in healthcare in other forms as well. As shown in exhibit 3.10, some physicians have devised a means of narrowing their customer focus and increasing their incomes by offering differentiated primary care. In this arrangement, patients pay an annual fee in addition to regular clinic charges to obtain greater access to their physician and more personalized care. Similarly, various health systems and hospitals have sought to highlight their differentiation and specialties by establishing luxury services to attract wealthy domestic and foreign patients. Differentiating services include uniformed valets, professional greeters, 24-hour room service, and spas (Pourat 2016).

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Although critics have raised ethical concerns about physician abandonment of patients who cannot pay the additional fee and the creation of a two-tiered system of care in which the more affluent receive better healthcare, the number of physicians entering concierge medicine has rapidly grown. By 2016, there were about 12,000 physicians practicing concierge medicine in the United States. Companies have been established to provide turnkey and franchise services for physicians desiring to convert to this practice style (Colwell 2016). Two journals, Concierge Medicine Today and Concierge Medicine Journal, have also been organized to promote the concept.

Middle Strategy Middle strategy is also called best-cost strategy or integrated cost leadership/differentiation strategy because it intends to offer customers the optimal mix of distinctive value and attractive costs simultaneously. Middle strategies are more successful in markets where buyers desire a degree of product differentiation but at the same time are price sensitive (Hitt, Ireland, and Hoskisson 2016). A perennial example of a firm employing a middle strategy is Southwest Airlines, which combines low costs with measured differentiation. Porter (1980) initially cautioned against this strategic position, believing efforts to achieve one facet would contradict the other and the organization would get “caught in the middle.” He reasoned that efforts to lower costs would make differentiation more difficult and that greater differentiation would increase costs; as a result, businesses would alienate both high-volume customers demanding low prices and high-margin consumers desiring distinct products. Others have since noted that in some markets, a middle strategy may be effective, and recently, many large corporations have been employing it (Baroto, Madi Bin Abdullah, and Wan 2012; Luke, Walston, and Plummer 2004; Parnell and Lester 2008).

Middle strategy may in fact be the strongest position for many consumer product markets, including groceries, apparel, and hardware, and for many hospitals. Traditionally

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low margins—just 1.8 percent in 2008—force grocery stores to reduce costs. Yet they also seek to differentiate their services and products through coupons, unique ethnic products, in- store babysitters, fresh vegetables, cleanliness, and other features (Hiiemaa 2016). Many community hospitals selectively invest in sophisticated technology and offer “good enough” quality at generally lower prices than those charged by high-quality academic medical centers and tertiary referral hospitals (Luke, Walston, and Plummer 2004). Of course, the challenge for organizations with middle strategies lies in the difficulty of distinguishing themselves from competitors. Middle positions are copied more easily by competitors, and differences in cost and quality are often difficult to define to consumers clearly. For example, patients normally see little quality and cost differences among community hospitals.

The Dynamics of Competitive Strategies

Intense competitive and environmental pressures often encourage organizations to shift their competitive strategies. An organization with a low-cost strategy may add new features and products to increase its differentiation, while an organization with a middle strategy might provide a low-cost alternative.

For example, the ALDI grocery chain, which employs a low-cost strategy, now owns Trader Joe's. While Trader Joe's employs a more focused differentiation strategy, it also integrates many of ALDI's low-cost strategies. Trader Joe's offers specialty foods that have been described as “yuppie-friendly,” exotic, affordable luxuries, such as Belgian butter waffle cookies and Thai lime-and-chili cashews (Farfan 2016; Kowitt 2010). As another example, high-cost academic medical centers may seek to develop low-cost clinics in large retail stores, such as Walmart.

As illustrated in exhibit 3.11, strategic positions may shift among the dimensions of cost and differentiation. Few organizations implement strategies at the extremes, and most organizations, even those with low-cost strategies, proffer a degree of differentiation. Although any strategy may be difficult to achieve, some are much more difficult to develop and maintain. For example, sustaining a high-cost, low-differentiation position may be problematic. A successful firm must constantly be willing to examine and alter its position as required by competitive pressures (Luke, Walston, and Plummer 2004, 155): “In a competitive and turbulent environment…the requirements for occupying one or another position will change…. Therefore, organizations need to be vigilant about sustaining established positions and, in competitive market environments, work to improve those positions. Positioning threats can come from similarly positioned rivals; from rivals located in other, stronger positions…or from rivals that need to improve on weak positions.”

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Organizations usually shift their position only marginally, trying new products, pricing, and features to improve their business. Those that try to move from one extreme to another may not have the appropriate internal resources and competencies to transition successfully. For example, Tesla has faced immense challenges while shifting its cars from high-priced luxury vehicles to a more mass-produced, midrange, $35,000 product (DeBord 2016). Likewise, organizations moving from one strategic position to another must be careful not to abandon their mission. For instance, intense competitive pressures are moving many academic medical centers to develop integrated networks and reduce their costs to compete on price more effectively, which may distract them from their teaching and research missions.

Organizations desiring to try a radically different strategy may consider creating a separate organization (subunit) or a distinct brand name and managing it differently, external to the operations of the parent organization. The new organization can then build the competencies and resources necessary to provide the different product or service. Toyota created Lexus to offer high-end products. As mentioned earlier, Chorus, consisting of only a small number of employees, exists as an autonomous division of Eli Lilly to advance drug research more rapidly from discovery through clinical proof of concept (Chorus 2017). Rigid business strategies will not survive in today's volatile, turbulent market. Long-term success depends on agility and responsiveness to market and environmental conditions. If an organization's existing business strategy does not meet environmental and market pressures, it must be adept enough to change. Exploring new strategic positions with a view to exploiting opportunities and avoiding threats created by market conditions may be a pragmatic, realistic approach.

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When an organization moves into a product market early, it is using a first-mover strategy. The speed with which organizations enter new markets greatly varies. First movers (also called early entrants) consistently search for innovation opportunities and attempt to gain first-mover advantages by being among the first to enter a new market. Others wait, watch, and analyze competitors’ actions and move later into new markets.

Although the first-mover advantage is a well-known strategy concept, authors have mixed opinions of its long-term benefits (Lieberman and Montgomery 1998; Suarez and Lanzolla 2005). Organizations seeking first-mover advantage move quickly into an unoccupied or uncrowded market segment or product space. First movers may enjoy durable advantages for many years, or the advantages may quickly fade as later entrants take over a market. One factor critical to the success of a first mover is its ability to establish barriers to entry by other organizations. First movers often can create entry barriers and sustainable advantage from

technological advantage, acquisition and control of scarce assets, and reputation.

First, an early entrant can develop competitive advantages from having superior technologies. The technological advantage can come from patents, improved distribution channels, and learning. First movers may create innovative competencies that produce technical knowledge superior to that of competitors. Organizations learn by doing and not only develop innovation but also advance along a learning curve to better produce a product. When an organization first offers a new product or service, the unit price is generally high, especially in a new market where the processes for creating the product or service and necessary features are not well understood and the customer base is small. Over time, the organization can lower its unit price by developing more efficient processes and standardizing its products or services. Thus, first-mover organizations may gain technological and cost advantages over potential later entrants and discourage market entry.

A historical example of technological advantage is Richard Arkwright's invention of the modern factory system for spinning cotton. He developed original patents for spinning cotton in 1768, quickly built factories across England, and licensed his technology. By 1774, he employed 600 workers in 15 mills in England. Although he eventually lost control of his patents in 1785, he used the time before his patents expired to improve and position his mills, and competitors never caught up to him during his lifetime (Musson and Robinson 1960). Likewise, Xerox, Coca-Cola, and Nike leveraged their first-mover strategies into global leading companies.

Second, first movers may tie up critical, scarce resources, such as location, employees, and crucial partners, making it more difficult for new organizations to enter the market. Thus, speed alone is not sufficient to be successful as a first mover; such organizations must add the correct critical resources. Successful businesses gain competitive advantage by both speed to market and the ability to mobilize needed resources. Companies that gain market dominance, as Microsoft did by partnering with Intel, tie up critical resources when rapidly going to

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market. Third, first movers often cultivate a base of loyal customers. One approach to retaining

customers is to make it inconvenient or expensive to switch to later entrants’ products. First movers should seek to gain a positive organizational image and reputation with customers and establish their product as the market standard. By raising the bar in terms of features and quality, first movers set a precedent that other organizations must surpass to enter the market successfully. All of these tactics, if executed appropriately, discourage other organizations from entering the market, which strengthens the first mover's advantage.

First movers often receive extensive free publicity and gain public name recognition and visibility. Sometimes the first mover becomes so prominent that the name of its product or service becomes the name used to describe all other products or services of the same type. For example, Twitter became the standard for micromessaging. It rapidly developed a large following and established the norm for this social networking medium. It has become so popular that tweeting is the term used to describe the action of sending a micromessage, regardless of the networking site used. As stated in 2011, “[Twitter was] among the most recognized brands on the Internet and a bona fide cultural phenomenon, with as many as 400 million monthly users” (Colorado Springs Gazette 2011).

On the other hand, as stated earlier, first movers may gain only temporary advantage or fail completely. Those that hurry to be the first in a market may not test their product designs and sell defective products or products with limited customer appeal as a result. Alternatively, some first-mover products may raise tremendous demand and overwhelm the organization's capacities. For example, although Twitter was initially highly successful, innovations from Facebook, Instagram, WhatsApp, Snapchat, and WeChat caused Twitter's growth to slow, and, given its executive turnover and financial struggles, many question its long-term viability (Topolsky 2016).

Some claim that subsequent entrants, or fast followers, succeed more often than do first movers because a level of demand already exists and consumers understand the benefits of the product (Shankar and Carpenter 2013). Secondary entrants may be able to imitate or “freeload” on first movers’ research and initial investments. Later entrants also do not sustain the risk involved in creating a new customer base and are able to follow existing industry standards.

The success of the CT (computed tomography) scanner, a widely used radiological diagnostic tool, is a good example of how fast followers can succeed at the expense of a first mover. The sales and service of CT scanners generate huge profits. In 2007, healthcare organizations performed an estimated 72 million CT scans in the United States alone (Gonzalez et al. 2009). In the early 1970s, a British company, EMI, was the first to successfully develop and market a CT scanner. Primarily a music company, EMI had little experience in the medical equipment market. It estimated that it would sell up to 50 scanners in the product's first year and have three to four years to establish itself in that market before competitors arose. By 1977, the organization had achieved phenomenal success and had an order backlog of more than 300 units. However, rapid technological advances ensued and benefited later entrants, such as industry giants GE, Toshiba, and Siemens. In the early 1980s, EMI abandoned its investments in scanning technology and returned to its core music

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business (Alexander and Gunderman 2010). Suarez and Lanzolla (2005) suggest that the relative short- and long-term success of a

first mover may depend on two factors: the speed of technological advancement and the rate of market demand. As depicted in exhibit 3.12, first-mover advantage is sustained only in markets characterized by slow technological change. Rapid technological change poses serious challenges to first movers and enables new entrants to leap ahead of the quality and features of first movers’ initial products.

In summary, being the first in a market does not necessarily translate into first-mover advantage. Sustained advantage depends on a combination of speed of entry, resources, speed of technological change, and market growth.

Chapter Summary

This chapter examines the different ways organizations can strategize to achieve their missions. The underlying structures of an organization make up its business model. A business model includes the value produced for customers, the types and combinations of inputs, the processes used to create products, and the means for revenue generation. Changing business models may increase an organization's competitive advantage and enable it to distinguish itself from its rivals. An organization also must change its business model to compete effectively when its environment shifts.

Organizations use a variety of strategies to position themselves in different ways.

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Generic strategies include dimensions of either a focused or general market (customer base) and a dimension of cost (low vs. high) or quality (degree of differentiation). Low-cost strategies may succeed in some segments of healthcare. Differentiation strategies seek to provide unique features for which the consumer is willing to pay more. Differences may include product characteristics, service, distribution channels, reputation, and image. Concierge medicine is an example of focused differentiation in healthcare. Some organizations employ middle strategies, which offer a desired mix of distinctive value and attractive costs. Many general hospitals seem to use this type of strategy.

Many organizations seek to gain advantage by being the first to enter a market. Being a first mover may be a durable advantage or become a liability as later entrants learn from the first mover's mistakes. First-mover advantage may be gained from technology, acquisition and control of scarce assets, or superior customer reputation. The rate of technological advancement and market growth significantly affect first movers’ ability to sustain their advantage. Markets characterized by slow technological change are positive environments for first movers.

Chapter Questions

1. How do the four components of a business model affect each other? For example, how can the depth of value to customers influence the means of revenue generation?

2. What difficulties does an organization face when seeking to change its business model? In your opinion, why have Barnes & Noble and Kodak struggled to shift their business models?

3. How can a new business model become a competitive advantage for an organization? 4. What changes could hospitals, physicians, pharmaceutical companies, and insurance

companies make to their business models to position them more advantageously for the future?

5. Generic strategies’ dimensions include type of competitive advantage and target market. In your opinion, how would a focused strategy differ from a broad strategy?

6. Are middle strategies most commonly used? Why or why not? 7. What actions can an organization take to offer a product at the lowest cost? 8. When is low cost a viable strategy in healthcare? When would it not be viable? 9. Which shift in strategy would be most difficult in your opinion: moving from low cost

and high differentiation to high cost and high differentiation, or moving from high cost and high differentiation to low cost and high differentiation? Why?

10. A first mover can sustain its market advantage through technology, control of scarce resources, and reputation. Look at the first movers you are familiar with. Which of these approaches have they taken?

11. How does technological change affect a first mover?

Chapter Cases

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Case Studies “Move to a Concierge Model or a Direct Primary Care–Medicine Business Model?” “The Case of Humana and Vertical Integration,” and “An Orthopedic Group Decides to Construct a Specialty Hospital” may be used to explore material in this chapter. They are found in the case studies section at the back of the book.

Integral Healthcare System and Proton Therapy Integral Healthcare System (IHS), a not-for-profit organization with a strong, service- oriented mission, is one of the largest care systems in its region. Although highly profitable, it has seen its market share in certain specialties slip. The decline has been most prominent in oncology and cardiology because of the establishment of specialty hospitals and care centers by competitors. IHS's executives have attempted to differentiate the system and recoup its market share by setting up centers of excellence, recruiting physician specialists in these areas, and using extensive media advertising, but to date none of these strategies has reversed the market decline.

Recently IHS was approached by National For-profit Company (NFC) proposing a joint venture proton therapy center. In 2010, proton therapy became eligible for reimbursement by most insurance companies and Medicare. This service involves sending a beam of protons to irradiate diseased tissue, mostly cancers. The protons appear to effectively kill cancer cells and cause less collateral damage to normal tissue. However, medical professionals question whether it is any more effective than traditional radiation therapy. For this reason, only six proton therapy units exist in the United States, none of which are located in IHS's greater service area. The joint venture would be the first proton therapy unit in the region.

The problem with proton therapy is the facility cost; construction of a proton therapy unit could exceed $200 million. As a result, the cost per treatment often exceeds $100,000 per patient—two to three times the cost of traditional radiation therapy. Although state-of- the-art, the facility's massive cyclotron could be supplanted in the future by superconducting synchrocyclotrons, a newer technology that might cost less than half the proposed construction cost. Local insurance companies have also expressed concerns about paying for this service.

IHS has to decide whether it wants to pursue the partnership. By adding proton therapy, it may achieve the differentiation it desires. It might be able to distinguish itself in oncology and regain much of the market volume it has lost to competitors. Nevertheless, there are risks. The large capital cost would need to be financed or taken from IHS's limited capital reserves. NFC also has hinted that it may take its offer to one of IHS's competitors if IHS does not agree to the partnership. Moreover, the local university hospital has established oncology as one of its key competencies and has been seeking tax support to establish a proton therapy research and treatment center.

Questions 1. For IHS, what are the advantages and disadvantages of being the first mover into the

proton therapy market?

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2. How might IHS minimize the risk posed by the joint venture? 3. What additional actions would you propose IHS take to improve its chances for a

successful partnership with NFC? 4. Would you recommend that IHS accept or decline the offer?

Deciding Between Innovative Options A donor gave Major Boston Academic Medical Center (MBAMC) a large bequest to further its mission. Stakeholders were asked to come up with innovative proposals, which were narrowed down to two that were submitted to MBAMC's board. One proposed to use the funds to expand the existing tertiary services into more highly specialized quaternary services that would extend the “boundaries of its clinical excellence.” The other created a unique nursing fellowship that would train nurses to provide services currently given by physicians, but at a much lower cost. After due deliberation the board chose the first option and all the donation was applied toward increasing the sophistication of MBAMC's services (Christensen et al. 2006).

Questions 1. Which proposal was a sustaining and which a disruptive innovation? 2. Why would an organization choose a sustaining innovation over a disruptive

innovation? 3. Read the article the case comes from and discuss the impact disruptive innovation has

on the social structure.

Chapter Assignments

1. Identify an innovation that is in the emerging stage of market development. Write a one- page paper describing how product standards and quality are established. Address how the rate of technological and market change affects the product's potential for success during the emerging stage of market development.

2. How can a middle strategy be successful in healthcare? Write a one-page paper on what a healthcare organization must do to make this strategy successful. What problems might creating this type of strategy in healthcare present?

3. The MedCottage—sometimes called a granny pod or, more properly, an auxiliary dwelling unit (ADU)—is a portable hospital room that can be placed next to a private residence. The units are designed as a substitute for nursing homes and can keep elderly persons out of institutionalized care. The units are equipped with the latest biometric and communications technology, enabling physicians and nurses to monitor the occupant's vital signs directly, be alerted to emergencies, and even change the unit's temperature. ADUs run from $100,000 to $125,000. Read more about this innovation in the November 25, 2012, Washington Post article by Fredrick Kunkle titled “The Ultimate Care Package? ‘Granny Pods’ Help Keep Loved Ones Close.” Write a one-page paper about how ADUs are disruptive innovation as described in this chapter and whether they present a first-

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mover opportunity.

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CHAPTER

GROWTH AND INTEGRATION STRATEGIES 4

Size does matter, but big doesn't. A hospital can be too small. And it can be too big. A hospital that's too small can't generate the proficiencies necessary to consistently deliver high-quality care or the volume necessary to effectively amortize the cost of technology.

On the other hand, a hospital that's too big can become lumbering and ponderous. Organizational coherence, including consistency in care, becomes more difficult to orchestrate. Wayfinding becomes onerous not only for patients but for caregivers as well.

There is a right size for a hospital—somewhere between 100 and 300 beds. Unfortunately, there's not much hope for the too-small hospital beyond government subsidies. The too-big hospital, on the other hand, can break itself up into a collection of smaller, focused hospitals. The big elephant may not be able to dance. But the little one can. Size is a choice.

—Dan Beckham, “How to Make Strategic Planning Work for Your Health Care Organization,” 2016a

Learning Objectives After reading this chapter, you will

understand how organizations use different growth strategies, perceive the advantages and disadvantages of the types of strategic expansion, grasp the strategic concepts of vertical integration, comprehend the issue of transfer pricing and its effect on vertical integration, recognize the difference between ownership and integration and the methods by which integration can be accomplished, know the strategic concepts of horizontal expansion, and be familiar with the concepts of related and unrelated diversification expansion.

rowth and integration are key organizational strategies. Growth can be generated by various means, including mergers and acquisitions, internal expansion, and

networking. Organizations also may expand horizontally into similar products, diversify into new products, or extend vertically to own products and services offered by their suppliers or buyers. Integration is critical to achieving the potential benefits of growth.

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Growth Strategies

Organizations have many motives for growth. It is an attractive prospect because it promises greater economies of scale, augmented reputation, swift entry into markets, achievement of synergies, increased market power, and higher salaries for top management. Expansion often energizes an organization by interjecting new ideas, people, and cultures. Growth can also help reposition an organization to take advantage of new opportunities and changing markets.

As the introduction to the chapter discusses, size can both help and hurt healthcare organizations. Too small may not allow the necessary volume for high quality and costs; too large can create many problems. As stated, size is a choice—a strategic choice.

As exhibit 4.1 shows, growth strategies sometimes go bad. Growth does not guarantee that an organization will realize any of the aforementioned benefits. In fact, if significant synergies, market power, or economies of scale do not materialize, a growth strategy can seriously damage or destroy a firm.

Although an organization can grow in many ways, it usually accomplishes growth through three generally accepted methods:

1. Internal expansion 2. Acquisition or merger 3. Networks and alliances

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Internal Expansion Internal expansion builds on an organization's own capabilities and resources to advance company activities, products, services, and revenues. Internal expansion may include developing new products and services, launching marketing efforts to increase market share, and entering existing products in new markets. As shown in exhibit 4.2, internal expansion is advantageous in many ways. It is less risky than other growth options, and internal funds and efforts can be engaged incrementally. Organizations can preserve—and expand—their culture as they grow. This method also affords managers the greatest control over organizational growth and is generally less disruptive to existing operations. Internal expansion may work well when the product cycle is in the emerging stage and few product leaders exist.

Internal expansion may not be appropriate in all situations, however. Product development and market entry may be slow. If speed to market is critical, internal development may not be the best choice. Internally developed products may take time to acquire a positive market reputation. The organization also risks consumer rejection of its new products.

For example, many healthcare organizations have entered the retail clinic market. Retail clinics generally offer basic medical services for minor illnesses such as influenza, ear

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infections, back pain, sports physicals, or vaccinations and are often located in retail locations, such as drugstores and chain superstores. By 2016, there were about 2,000 such clinics across the United States, hosting more than 6 million visits per year. About half of visits occurred after most doctors’ offices closed (Abelson 2016). Initially, large businesses such as pharmacy chains Rite Aid, Walgreens, and CVS, along with Kroger, Walmart, and Target, developed and staffed their own, in-house clinics. These companies owned about 93 percent of US clinics in 2016. However, more and more these chains are outsourcing the retail clinics to healthcare systems. For example, in 2016, Advocate Health Care took ownership of 56 Chicago-area Walgreens clinics, which allows for better-coordinated care (Hennessy 2016; RAND Corporation 2016).

Acquisition Acquisition can rapidly launch an organization into a market. By purchasing an existing business, an organization adds an established product to its market offerings; similarly, acquiring an existing business's research and development can expedite a product to market. The purchase of an existing organization (or the merger of two organizations) reduces competition by eliminating a market rival and can increase the combined organization's customer volume immediately.

Acquisition also may enable an organization to bypass regulators’ restrictions on market entry. For example, in states that still have certificate of need (CON) laws, healthcare organizations must obtain permission to enter certain markets (the types of markets subject to restriction vary from state to state). In 2016, 37 states had some form of CON program, most restricting entry into the outpatient and long-term care markets. Permission to add new outpatient or long-term care capacity (internal expansion) could take months or years to obtain, and the state agency may deny the application (National Conference of State Legislatures 2017). In this case, acquisition of existing assets may be a better strategy—or the only option.

Nevertheless, acquisition has its drawbacks. Merged organizations sometimes have incompatible cultures and management systems, and this incongruity can inhibit success. One organization's culture may differ dramatically from the other's with regard to decision- making and managerial styles. The transfer of culture from one organization to another is often difficult, especially if the organizations do not have similar core values (Schraeder and Self 2003). A long line of failed acquisitions and mergers has been attributed to such differences.

A look at recent history reveals many examples of failed acquisitions. These include the failed mergers of Google and Motorola, Bank of America and Countrywide, and Kmart and Sears (CB Insights 2016). Culture incompatibility can be the “root cause of any merger's failure or success” (Bradt 2015).

For instance, the well-documented cultural clashes between Daimler and Chrysler ultimately led to operational problems and a $34 billion loss for Daimler when it sold Chrysler to a private equity firm in 2007 (Jacobsen 2012). Likewise, organizations may acquire products too late in the product cycle or find that the acquired product is inferior to that of the market leader. For instance, to enter the cell phone market more quickly, Microsoft

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acquired Nokia for $7.2 billion in 2008. But in 2010, less than two weeks after the official introduction of the new line of smartphones—the Kin One and Kin Two—Microsoft announced it was killing the products (Vance 2010). Then, in 2016, Microsoft sold its phone assets to Foxconn Technology for just $350 million (Kharpal 2016).

Hospitals have found that healthcare mergers are fraught with cultural and managerial problems. Many organizations ignored their differences until after the merger took place: “They devoted so much effort toward whether they could merge, they didn't stop to consider whether they should” (Andrews 2000, 52). Differing organizational personalities or cultures have been seen as a major factor in the failure of many healthcare mergers, as for the Henry Ford Health System and Beaumont Health System proposed merger that fell apart, less than a year after the announcement that they were “ideal partners,” as a result of cultural and business differences (Gelineau 2015).

Networks and Alliances An organization can grow by linking with other established organizations through networks and alliances (e.g., joint ventures). As discussed in depth in chapter 5, these structures enable organizations to enter a market more quickly with minimal risk. However, organizations in these arrangements have less control over their business outcomes, and alliances can be difficult to manage. As a result, problems arise and many of these structures dissolve. Even though 85 percent of business leaders feel alliances are essential or important to their business, failure rates exceed 60 percent (Whitler 2014). Organizations also risk losing important proprietary knowledge. When a network dissolves, Partner A can retain key technological information and perhaps even personnel from Partner B, potentially damaging Partner B's competitive position.

Vertical, Horizontal, and Diversified Expansion

Expansion also can occur vertically, horizontally, and through diversification. The literature often refers to vertical and horizontal expansion as vertical and horizontal integration. While in many cases the acquired organizations are not actually integrated, most of the benefits of these means of expansion accrue only if the organizations’ operations are integrated.

Vertical expansion occurs when an organization acquires a business that is either a source of supplies (backward expansion) or an entity that may purchase from the organization (forward expansion). Thus, the organization buys stages of its industry value chain. For example, a paint manufacturer might own its own retail stores (e.g., Sherwin- Williams) or a hospital might employ physicians or own its own insurance company (e.g., a health maintenance organization [HMO], a preferred-provider organization).

Horizontal expansion occurs when similar organizations merge or are acquired—an organization grows by acquiring or merging with other businesses that offer comparable products. Many hospitals and physician groups have expanded horizontally to form multihospital systems and larger physician groups. In 2016, a total of 3,183 of 4,926 community hospitals belonged to a system (65 percent) (American Hospital Association

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[AHA] 2017). Health insurance companies also have merged; by 2015, the largest 10 insurance companies controlled more than half of the US market (Statista 2017b). Specialist physicians, especially cardiologists and orthopedists, are increasingly consolidating into larger, single-specialty groups (Kash and Tan 2016).

The third method of expansion is diversification, or the acquisition of organizations in different businesses. An organization may diversify into related or unrelated businesses. Related diversification leverages components of an organization's value chain to expand its customer or product base. For example, some of the largest health insurance companies, such as United Health Group, have related diversification into areas such as population health management, health information technology consulting, and pharmacy care services (United Health Group 2016) Unrelated diversification involves acquisition and expansion into markets that have little relationship with an organization's existing products and customers. A hospital acquiring a sports store, mall, or restaurant would be unrelated diversification.

Vertical Expansion and Vertical Integration Vertical integration has long been known as “the combination or coordination of different stages of production” (Walston, Kimberly, and Burns 1996, 83). In healthcare, vertically integrated structures include combinations of hospitals, physicians, insurance companies, nursing homes, durable medical equipment companies, educational programs, and home health care agencies in which one organization's products and services are inputs to or outputs from another organization's products and services. As depicted in exhibit 4.3, vertical integration in healthcare differs somewhat from vertical integration in traditional sectors. In the manufacturing industry, the value chain begins with raw materials, which are formed into components, fashioned into a product by a manufacturer, distributed, and finally sold to an end user. For instance, trees are grown, harvested, and used to make plywood. Distributors sell the plywood to local hardware stores, and then the hardware stores sell the plywood to homeowners. Some companies, such as Weyerhaeuser, grow trees, make wood products, and build homes.

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Healthcare—a service field—does not have clear upstream and downstream product flows. The healthcare consumer—the patient—uses services at different levels of the value chain at different times. Generally, healthcare providers have sought to become vertically integrated by acquiring other types of providers (e.g., hospitals buy physician practices and nursing homes) and insurance companies. Merger with manufacturers of medical supplies and pharmaceuticals is less common.

Common ownership of healthcare's vertically related services promises to provide cost efficiencies through improved internal control and coordination and increased market power. Providers have been encouraged to organize integrated delivery systems—vertical integration of most patient care services into a single organization in order to advance to a population health focus (AHA 2014). Many administrators believe that ownership of services and employment of providers promote goal congruence, standardization of processes, and more efficient decision making, enabling conflict resolution and quick adjustment to market conditions (Luke, Walston, and Plummer 2004).

Many have assumed that these benefits and synergies would emerge on their own, especially from common ownership of hospitals, physicians, and health insurance plans. However, research has demonstrated that the benefits of vertical ownership do not simply materialize—they are achieved only when the organization's vertical components are proactively integrated though appropriate management structures, protocols, processes, and incentives that can be difficult to implement. In fact, rather than create a more efficient structure, vertically integrating hospital and physician practices can lead to higher prices and spending (Baker, Bundorf, and Kessler 2014). Lawton R. Burns and Mark V. Pauly (2002, 132) have noted: “All too often, however, they [vertical-owned healthcare organizations] failed to develop a common, standardized set of activities across the different IDN [integrated delivery network] components to closely link the new structures with the new organizational processes of providing incentives to physicians, managing medical staffs, and developing leadership. Thus, the structural integration was not accompanied by a processual approach to integration. All too often the structural and processual activities were only loosely linked together, with some disregard for day-to-day operations.”

The theory of transaction cost economics articulates a rationale for pursuing vertical integration, suggesting that organizational boundaries are influenced by organizations’ efforts to mitigate the costs of transactions and contractual hazards. All organizations buy and sell resources and services to others. Each exchange has some cost. Transaction costs might include shipping and handling fees; the markup added to a good's price; and the costs of writing, monitoring, and enforcing contracts. Any inefficiencies that arise from the exchange are another form of transaction cost (Joskow 2010). When transaction costs are high, an organization may choose to acquire the supplier or the distributor.

The cost of transactions increases when there are few critical suppliers or buyers and a high frequency of exchange, as well as when information is not freely shared and trust is low. If an organization requires a critical product and there are few sources from which to buy it, the vendor may unreasonably increase the product's price. This opportunistic behavior intensifies when production information is not shared between buyer and seller and the organizations involved in the exchange have little trust in the fairness and honesty of each

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other's behavior. This lack of trust is characteristic of many relationships between major organizations in

healthcare. Hospitals, insurance companies, and physicians have intense and often conflicting exchange relationships. Hospitals need contracts with insurance companies to obtain admissions from physicians. When a health insurer or an HMO controls a large percentage of the local insurance market, it becomes a critical, frequent supplier for a hospital. However, transparent information exchange often does not occur. Insurance companies generally have much better information regarding the healthcare costs and utilization of their customers and commonly do not share it with hospitals. As a result, little trust exists between the parties, and opportunistic behavior becomes the norm. The relationship between Texas Health Resources and Blue Cross Blue Shield of Texas described in exhibit 4.4 illustrates how these factors may lead to bitter negotiations, threats, and potential increased costs to both parties.

Because of perceived high transaction costs, hospitals and insurance companies have acquired ownership of vertically related organizations. Some believe that the most successful vertically integrated healthcare system is Kaiser Permanente. As of September 2016, this not- for-profit organization served more than 10.6 million people, employed more than 18,600 physicians, and owned 38 hospitals across the United States (Kaiser Permanente 2017). Other successful provider ventures that have expanded vertically into HMOs include Carle, Marshfield Clinic, Geisinger, Scott & White, and Mayo Clinic. However, many attempts to expand vertically have been unsuccessful because of low capitalization, medical loss ratios, conflicting capital needs, and lack of actuarial science applications. Rather than lowering

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costs, vertical integration may increase them (Goldsmith et al. 2015). For example, as mentioned in chapter 7, FHP, an HMO, attempted to expand vertically by constructing a hospital in Utah, but the hospital later became economically unsustainable (Jones 1999).

Vertical integration of hospitals and physicians has similarly been a difficult prospect. Many hospital systems have professed a desire for closer alignment with their affiliated physicians to improve quality and lower costs. However, because of conflicting incentives and priorities and a lack of physician leadership, many have failed (Burns 2015).

Transfer Pricing Another factor that causes conflicts in vertically owned structures is transfer pricing—the “price” charged for a transaction of goods or services between two divisions of an organization (Business Dictionary 2017). For example, Company XYZ's manufacturing division obtains raw materials from its supplier division and pays an intracompany price. In a vertically integrated healthcare organization, the organization's insurance unit would pay the organization's hospitals and physicians a price for their services. This disbursement might occur via an actual cash transfer or intracompany credit. Transfer prices should be established to encourage goal congruence across units of a vertically integrated healthcare organization —that is, the organization's insurance unit, hospitals, and physicians should use transfer pricing methods that further the organization's mission, whether it be community benefit or profit maximization. Despite these recommendations, however, experts have long considered transfer pricing to be one of the most difficult management control problems, often creating organizational disruption and conflict (Finkler and Ward 1999).

Transfer pricing is set through one of three common methods, each of which poses potential problems:

1. Cost-based prices: Prices are based on actual fixed and variable costs or just variable costs.

2. Full market prices: Prices are based on actual market prices. 3. Discounted prices: Prices reflect some discount from actual market prices.

As do most businesses, healthcare organizations frequently reward their managers for their units’ operational successes. For instance, if an organization's hospitals and physicians charge the organization's insurance unit cost-based prices, the insurance unit will be pleased; it will enjoy higher profits and in turn can charge its customers lower rates. The organization will reward the manager of the insurance unit for the unit's success.

However, the organization's physicians and hospitals also want rewards for their operational success, so they may resist setting cost-based prices for intraorganization transactions, especially if they can attract patients from outside insurance companies and operate at full or close to full capacity. Prices charged to outside customers are substantially higher than cost-based prices and would markedly increase their profits. If they have capacity constraints (i.e., they are operating at full or almost full capacity), the organization's physicians and hospitals may choose to treat higher-paying outside patients rather than lower- paying system patients.

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On the other hand, if the organization's physicians and hospitals charge the organization's insurance unit full market prices, the insurance unit may be able to find outside hospitals and physicians who charge lower prices and may direct patients to outside providers, even if the organization's providers have unused capacity, such as empty beds. Humana's choice of transfer pricing between its insurance company and hospitals in the 1980s and early 1990s demonstrates one of the major reasons for the eventual divestiture of its hospitals. Humana had set the transfer prices for its owned hospitals higher than the market prices for its competitor hospitals. As a consequence, Humana's insurance company preferred to refer its patients to non-Humana hospitals. (See “The Case of Humana and Vertical Integration” located in the case studies section of this book.)

Competition with Existing Customers Another issue with vertical integration is that it foments competition with existing customers. For instance, a typical hospital relies on referrals from multiple insurance companies and physicians, who could be considered its key stakeholders. A hospital's owned insurance company or employed physicians generally account for only a small fraction of its total patient volumes. The major referral entities remain nonowned insurance companies and independent physicians with whom the hospital-owned insurance company and employed physicians compete. This dynamic can cause the nonowned physicians and insurance companies either to seek prices that are lower than the prices of the owned entities or, potentially, to move patients to other hospitals that do not compete with them.

This situation can be especially problematic when an existing insurance company has a most-favored-nation clause in its contracts. This clause guarantees that a nonowned insurance company, often a Blue Cross entity, receives the lowest prices of any contract. The financial arrangement with the owned insurance company sets the floor for the most-favored- nation contract, which can severely damage the competitive ability of the owned entity. As a result of this and other issues, providers claim that this clause imposes an unfair advantage and discourages innovation. Given the US Justice Department's lawsuits against insurers with most-favored-nation agreements, many US states, including Michigan, Indiana, and Connecticut, have prohibited or restricted most-favored-nation clauses, and other actions are pending (Becker 2011; Schencker 2016).

Unmatched Services and Incentives Two additional problems with vertical integration in healthcare are unmatched service areas and incentives. As illustrated in exhibit 4.5, the components of vertically integrated healthcare systems—insurance companies, hospitals, and physicians—attract customers from vastly different markets. Insurance companies compete in expansive markets with large populations, often statewide. General hospitals compete regionally, and primary care physicians compete locally (specialists have wider service areas). To be successful, insurance companies must contract for services across a large population base. In many cases, vertically integrated healthcare systems’ insurance companies have customers in areas where the systems do not own hospitals and employ physicians, making contracting with nonsystem providers necessary. As a result, systems sacrifice many potential economies of scale. In

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these situations, vertical integration tends to increase overhead costs because it adds new administrative functions and required competencies to manage the expanded base of operations. Overall, the clinical competencies required to deliver healthcare are rather distinct from health insurance organizations that focus on network development and risk (Robinson 1999).

Likewise, the incentives of insurance companies and providers differ. An insurance company's profitability increases as its customers’ use of healthcare services decreases. On the other hand, hospitals in the United States are still generally paid on a fee-for-service basis, and they increase their finances through additional admissions. Providers are rewarded by a fee-for-service payment system that promotes intensive use of services and frequent use of technology to increase billings. Scholars have identified this conflict as a major barrier to system integration and the improvement of healthcare delivery (Porter and Kaplan 2016).

Integration of Vertically Owned Structures Many suggestions have been made regarding what needs to be accomplished to integrate vertically structured systems. Ownership is relatively easy to achieve. However, the benefits of ownership cannot be achieved without integration. Ghoshal and Gratton (2002) identify four essential areas of integration:

1. Operational integration: standardization of the technology and infrastructure 2. Intellectual integration: development of a shared knowledge base 3. Social integration: creation of cultural bonds that drive collective performance 4. Emotional integration: establishment of a common identity and purpose

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Integrating all of these aspects can be challenging and take a great deal of time. Given the challenges these four areas present in healthcare, many vertically owned structures have long recognized the difficulty of realizing the promises of vertical integration.

Yet the allure of vertically integrated structures still draws healthcare organizations. At the end of 2010, vertically integrated structures called accountable care organizations (ACOs) were promoted as a means of improving the quality of care and lowering costs. However, although the concept is very appealing, results have not lived up to the hype. Many feel that patients, providers, and payers must work more closely together before ACOs can become successful (Schroeder 2015).

Some believe that only capitation—a system that offers a fixed amount per person—will incentivize organizations to refocus efforts to a population-based system, requiring vertical integration across providers and services to lower total healthcare costs (James and Poulsen 2016). The challenge for healthcare organizations lies in designing the processes, structures, and mix of personnel needed to integrate vertically owned organizations effectively. As Peter P. Budetti and colleagues (2002, 209) state: “Newer approaches emphasize outcomes of care and would hold health systems to a new level of accountability. It is unlikely that either health systems or physicians will be able to meet these challenges without closer integration and cooperation in redesigning how health care is delivered and measured. The new accountability demands could push physicians and health systems closer together but could also pull them farther apart. Physicians are unlikely to cooperate with heightened accountability requirements if health systems cannot provide clinically relevant feedback.”

Recent studies confirm that much still needs to be done to integrate vertically owned health systems. Scholars have reported that physician employment by systems may improve quality through better clinical integration but also increase overall healthcare costs. Hospitals appear to have used employed physicians more often to gain market share in lucrative service line strategies than to lower costs through integration (Baker, Bundorf, and Kessler 2014; O'Malley, Bond, and Berenson 2011). Many predict that healthcare systems will continue to employ more physicians to enlarge and further develop clinically integrated networks to promote population health and value-based models (Jacobs 2016).

Insurance companies also are slowly buying healthcare providers or engaging in cooperative deals and payment models to share risk. Although many predicted health insurance companies would rapidly expand their purchase of physician practices, the progress has been measured. For instance, only a few prominent US health insurance companies have made large acquisitions. In 2010, Humana purchased Concentra, a provider of occupational medicine, urgent care, physical therapy, and wellness services, for $790 million, though its business activities and services did not align with Humana's strategies and core competencies. Concentra was later sold to a specialty hospital chain and a private equity firm for nearly $1.1 billion. Humana still owns 22 primary care centers, mostly in Florida. In 2011, WellPoint, Inc., paid about $800 million to acquire CareMore, a provider of preventive services that is structured to lower costs for patients with chronic diseases. Also in 2011, UnitedHealth Group Inc. bought Monarch HealthCare, an association of 2,300 physicians in a range of specialties. However, by 2016, only about 2 percent of all primary care physicians worked for insurance companies (Herman 2015; Matthews 2011). Exhibit 4.6 describes some

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of the dynamic integration efforts in Pennsylvania.

Virtual Vertical Integration An alternative to vertically owned, integrated systems is virtual vertical integration. Virtual integration can be achieved with contractual, nonowned mechanisms that provide more flexible means of coordinating cost-effective patient care but do not incur the costs of ownership. In the mid-1990s, Richard A. D'Aveni and David A. Ravenscraft (1994, 1196) suggested, “True competitive advantage may be gained by replacing vertical integration [ownership] with vertical relationships.” These interorganizational alliances may rely on a mix of exclusive long-term contracts and operating agreements that align the organizations’ purposes and integrate stages of care.

Most insurance companies take the role of the virtual integrator of healthcare—the intermediary coordinator of care for patients across a spectrum of providers. These entities exist in many forms, as open-panel HMO networks, independent practitioner associations, third-party administrators, or traditional insurance plans.

The integration of hospitals and post-acute care providers has experienced both virtual and ownership vertical integration. Many health systems are integrating with skilled nursing organizations, home health agencies, inpatient rehabilitation facilities, behavioral health, paramedic and ambulance systems, and others through acquisitions or partnerships. Linking

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acute care with post-acute care organizations promises to permit a greater continuum of care, leading to better outcomes. For instance, Granville Health System, located in Oxford, North Carolina, offers a transitional care program that reaches out to post-acute providers. For example, it partners “with a local pharmacy to ensure home medications are delivered to the patient's bedside prior to discharge” (Buell 2017, 15). The system is also collaborating with physician practices with a chronic care management program that will embed the system's nurses in key primary care practices.

Owned systems may be more effective in stable environments, whereas virtual arrangements may perform relatively better in unstable environments (Walston, Kimberly, and Burns 1996). Virtual structures reduce the massive capital expenditures needed to form an owned system. Virtual organizations have greater flexibility and higher capital reserves and preserve the option of investing in critical services as an environment shifts. Chapter 5 discusses alternative forms of alliances, partnerships, and networks.

Many predict that healthcare reform efforts in the United States will bring about the formation of more vertically integrated healthcare systems. By proposing to change the current form of federal reimbursement to some form of capitated payment in 2015, the Affordable Care Act (ACA) encourages the formation of ACOs. Although the actual composition of ACOs may vary, they will comprise vertically organized components, and they will receive payments from and distribute payments to different stages of healthcare provision. The Centers for Medicare & Medicaid Services (CMS) defines ACOs as follows (CMS 2017a): “Accountable Care Organizations (ACOs) are groups of doctors, hospitals, and other health care providers, who come together voluntarily to give coordinated high quality care to the Medicare patients they serve. Coordinated care helps ensure that patients, especially the chronically ill, get the right care at the right time, with the goal of avoiding unnecessary duplication of services and preventing medical errors. When an ACO succeeds in both delivering high-quality care and spending health care dollars more wisely, it will share in the savings it achieves for the Medicare program.”

Although Congress may repeal the ACA, pressures to expand access to healthcare while controlling costs will encourage a shift toward structures similar to ACOs. Such structures may contain costs by establishing vertically integrated relationships with the intent to lower costs and improve quality. These goals may be accomplished by either ownership or virtual relationships.

Horizontal Expansion Horizontal expansion involves the merger of two or more organizations that produce the same product or service. Significant horizontal expansion has occurred in healthcare since the 1970s. Physician practices have merged to form group practices, insurance companies have expanded to have national presences, and hospitals have merged to create multihospital systems.

Throughout most of the last century, a majority of US physicians practiced alone or in small group practices. This situation began to change significantly in the 1980s and 1990s. In 1983, 60 percent of physicians worked in group practices (Burns 2000). By 2016, only 17 percent of physicians were in solo practices and one-third operated independent practices.

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Group practices and physician employment have been the fastest-growing segments in healthcare, prompted by the move toward a population health–management model and ACOs or other integrated systems. Some observers have suggested that the shift is motivated primarily by the need to gain negotiating leverage with health insurance plans, lower costs, and spread financial risk under capitated arrangements (Berry 2011; Boukus, Cassil, and O'Malley 2009; Casalino, Pham, and Bazzoli 2004; Physicians Foundation 2016).

Likewise, healthcare insurance companies have rapidly expanded to become large, horizontal entities. Many of these mergers resulted from acquisitions made by former regionally based Blue Cross plans. By 2012, WellPoint posted $60.7 billion in revenues and profits of $3.6 billion (Anthem 2013). Originally a Blue Cross plan in California that converted to for-profit status, WellPoint expanded by frequent mergers and now operates in 14 states (Anthem 2017). Other Blue Cross plans have maintained their not-for-profit status but also have rapidly expanded. One example is the Health Care Service Corporation, the former Blue Cross plan in Illinois, which has grown to include Texas, Oklahoma, and New Mexico (Benko 2007).

By 2015, the health insurance market was dominated by five huge national companies— United Healthcare, Anthem, Aetna, Humana, and Cigna. The number of major competitors was proposed to drop to three when, in 2015, Aetna and Humana announced their intent to merge; shortly thereafter Anthem and Cigna agreed to do the same.

Concerns arose because of the market power of the proposed mergers. For example, if the merger had occurred, Humana and Aetna would have controlled 43 percent of the Florida Medicare Advantage market. Given these concerns, the US Department of Justice has sued to block the mergers. As a result, Aetna and Humana called theirs off in early 2017. In mid- 2017, Anthem appealed to the US Supreme Court to overturn the rejection (Garcia 2016; Hersher 2017; Laszewski 2015; Radelat 2017).

Since the 1970s, hospitals also have merged to form broader horizontal systems. As mentioned before, by 2016 about two-thirds of US hospitals belonged to a health system (AHA 2017). For-profit and religious systems have become the largest healthcare systems in the US. The ten largest nongovernmental hospital systems in 2015 include

1. Hospital Corporation of America (HCA), a for-profit system with $39.7 billion in revenue;

2. Community Health Systems, a for-profit system with $19.4 billion in revenue; 3. Ascension Health, a Catholic-owned system with $18.8 billion in revenue; 4. Tenet Healthcare Corporation, a for-profit system with $18.6 billion in revenue; 5. Catholic Health Initiatives, a Catholic-owned system with $13.3 billion in revenue; 6. Trinity Health, a Catholic-owned system with $12.5 billion in revenue; 7. Providence Health & Services, a Catholic-owned system with $11.8 billion in revenue; 8. Dignity Health, formally Catholic Healthcare West, with $11.4 billion in revenue; 9. University of California Health system, a governmental system with $10 billion in

revenue; and 10. Sutter Health, a not-for-profit system with $9.6 billion in revenue (Modern Healthcare

2016).

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Like vertical expansion, horizontal expansion has the potential to yield benefits if horizontal integration occurs. As shown in exhibit 4.7, the rationale given by healthcare organizations for horizontal mergers highlights possible economies of scale or cost efficiencies and improved access or expansion of the delivery network (Burns and Pauly 2002). However, greater market power and the ability to negotiate better payments are also primary reasons for horizontal expansion (Weil 2010).

Horizontal integration has the potential to reduce costs by eliminating duplicative equipment and services. Healthcare organizations can also reduce administrative and purchasing costs by spreading fixed expenses over a larger volume of business. For example, horizontally expanded healthcare insurance companies may spread administrative overhead, such as product development, finance, quality management, information systems, and utilization management, across a larger number of enrollees to achieve lower costs per enrollee. Organizations can also share marketing costs, spreading them across a larger customer base—especially for regional and local mergers. In addition, many horizontal systems apply organizational competencies obtained in one market to others to attain economies of learning (Robinson 1999).

However, achieving the promised savings can be very difficult. Many horizontal mergers have struggled to achieve their anticipated efficiencies (Evans 2016). In fact, rather than lowering prices through efficiency, mergers can concentrate an organization's power to increase prices in local markets, as mentioned in chapter 2. With the exception of some for- profit hospital systems, consolidation and horizontal expansion have occurred mostly in local markets. When such mergers are proposed, they may be subject to review by the US Department of Justice and Federal Trade Commission (FTC) to ensure they do not affect consumers negatively. For instance, in 2013, the FTC challenged the merger of Capella Healthcare and Mercy Hot Springs, claiming the merger would injure competition and increase prices. The systems withdrew their proposal (Miles 2016).

A number of studies indicate that completed hospital consolidations do increase market power and enable facilities to raise inpatient prices, especially if the consolidated hospitals were in contiguous markets (Capps and Dranove 2004; Evans 2015; Vogt and Town 2006; Weil 2010). On the other hand, research also suggests that many horizontal mergers and consolidations do not achieve their predicted efficiencies and cost savings (Burns and Pauly 2002; Evans 2016; Weil 2010). As described in exhibit 4.8, legislators commonly believe that, in most cases, horizontal consolidation in healthcare only occasions higher prices.

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The concentration and dispersion of horizontal expansion strategies tend to differ by organizational purpose or mission. As illustrated in exhibit 4.9, horizontal systems can be widely dispersed or highly concentrated. Healthcare generally is a local business, and the benefits of horizontal integration become more difficult to achieve when the distances between facilities are large. For-profit organizations initially expanded into states whose laws facilitated higher profits through less regulation and lower wages (e.g., no or weak CON laws and limited or no unionization), creating horizontal companies across the United States. Catholic hospitals, whose missions generally focus on serving the disadvantaged, expanded into poor areas across the United States. In contrast, most not-for-profit hospitals, whose missions emphasize caring for the health of a local or regional population, expand into adjoining markets. For-profit have tended to be dispersed, while not-for-profit hospital systems usually are concentrated in one region. For example, HCA operates 168 hospitals in 20 states, while Texas Health Resources has 24 hospitals, mostly in North Texas. HCA has fewer than 10 hospitals in 16 of the 20 states (HCA 2016). Exhibit 4.9 illustrates dispersed and concentrated systems.

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Evidence suggests that for-profit organizations have recognized the difficulty of achieving horizontal integration across a widely dispersed system. For instance, HCA has begun to cluster its hospitals in regions to achieve greater efficiencies and better integrate its facilities (Barkholz 2016). TriStar Health System, one of these regional groups, includes 13 hospitals, 57 medical group offices, 10 urgent care centers, and 1,600 physicians in middle Tennessee and southern Kentucky. (TriStar Health 2017):

What's the advantage of being part of Tristar Health System? Across the country, there is a continuing increase in the cost and complexity associated with healthcare delivery. The benefits of a number of hospitals and medical centers working together, sharing the best practices in quality care and focusing on reducing costs, far outweigh the costs of working alone or independently.

Is Tristar a part of HCA? HCA is a national healthcare system, and its markets have their own identity separate from the corporate office. We are one of their markets. This is not a break from HCA, but merely an opportunity to position ourselves across Tennessee and Southern Kentucky as a comprehensive healthcare delivery system. Through shared strengths, knowledge, resources and support we are the most comprehensive healthcare system in the entire region. This reinforces the company's strategy and strengthens individual decision making.

Mergers and expansion are expected to continue. Merger talks began in late 2016 with Dignity Health and Catholic Health Initiatives. If consummated, the merger will create the US's largest not-for-profit hospital company, with combined revenues of $27.6 billion. In addition, Ardent Health and LHP Hospital Group, both for-profit companies, announced their proposed merger, which occurred in 2017 and created the second-largest privately owned system in the Unites States, comprising 19 hospitals in six states and producing $3 billion in revenues (Livingston 2016; Rege 2017; Taylor 2016).

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Diversified Expansion Another expansion strategy is to diversify into other types of business. Diversification may be related or unrelated. Related diversification occurs when an organization (1) enters a different business that uses similar technologies (sometimes called concentric diversification) or (2) adds new products or services to its current offerings (also called horizontal diversification). For example, a manufacturer of pharmaceuticals for humans might diversify into veterinary drugs. This approach uses the company's existing technologies and opens up a new customer base. Pharmaceutical companies also might diversify into new products for their existing customers—for example, by offering diagnostic equipment and nutritional supplements.

Related diversification engages new business activities—such as manufacturing, marketing, and technological development—in one or more components of an organization's value chain (Hitt, Ireland, and Hoskisson 2016). This strategy seeks to leverage an organization's assets and expand its markets or products to achieve greater competitive advantage. Related diversification also pursues economies of scale by combining manufacturing, distribution, advertising, and other costs.

Related diversification generally poses fewer risks than those presented by unrelated diversification because the expansion involves comparatively similar businesses of which their leaders may have relevant knowledge. Related diversification allows the potential for transference of core competencies and increased market power. For instance, hospitals have expanded into providing dental care for the disabled, drug detoxification and counseling, bariatric weight loss surgery, sleep disorder clinics, long-term care, and health promotion (Eastaugh 2014). These diversification efforts are relatively similar to providing hospital care, and hospital managers’ knowledge and competencies may be transferable to these areas.

Unrelated diversification (also called conglomerate or lateral diversification) occurs when an organization adds new products or services that have little or no overlap with its current products and assets. Some of the most famous companies in the world practice unrelated diversification. The Walt Disney Company, General Electric (GE), Kraft Foods, and Phillip Morris all are conglomerates that own dissimilar products and services. For example, Disney owns movies, parks and resorts, and consumer products, while GE offers financial services, energy, industrial manufacturing, and healthcare products and consulting services.

Unrelated diversification has been the role of venture capitalists, such as Bain Capital, a prominent venture capital fund. For example, Bain Capital and Kohlherg Kravis Roberts & Company (KKR) invested about $1.2 billion and assisted in the 2006 buyout of the hospital chain HCA. At that time, HCA was a publicly traded healthcare company. The buyout enabled the company to become privately owned. Bain and KKR partners served on the HCA board of trustees, and after five years of restructuring, the company was taken public again and the private equity firms recouped about three and a half times their investment (Creswell and Abelson 2012b).

Likewise, the acquisition of Surgical Care for $2.3 billion by UnitedHealth Group Inc., one of the largest health insurance companies in the United States, could be considered an unrelated diversification, even though both are in healthcare. UnitedHealth will pare the

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acquisition to its urgent care business and place the company in the outpatient surgical business (Tracer 2017).

An organization may gain a number of benefits by expanding through diversification. Some organizations seek to acquire poorly run companies and restructure them to improve their efficiencies and increase their resultant value. These improvements may be achieved by transferring management talent or sharing assets and competencies. On the other hand, diversification expansion also has the potential to impose additional costs on an organization and depress its profitability. Both related and unrelated diversification can increase the levels of management and control structures required to administer an organization. As an organization's businesses increase in number, the difficulty and bureaucratic costs of running them also increase. Although success often appears easier to achieve via related diversification than by unrelated diversification, both pose similar challenges, and organizations that become extensively diversified tend to be less successful (Hitt, Ireland, and Hoskisson 2016).

Diversified organizations more often succeed when they maintain a common business model across their corporations. As discussed in chapter 3, business models are the core operational structures of organizations, encompassing their processes, inputs, revenues, and value to customers. For example, Britain's Virgin Group owns a wide array of products and services, including records, airlines, trains, cinemas, and finance, yet the company's business model is common across all of its units. Virgin's approach to all of its products and services is “low cost, flair, strong reliance on its brand and an appeal to younger customers” (Yip and Johnson 2007).

To diversify successfully, the central organization must recognize that its distinct services may require diverse technological, managerial, and cultural competencies to operate and that it may need to give each service sufficient autonomy to meet local needs. Although provided decades ago, the advice of Shortell, Morrison, and Hughes (1989, 485) is applicable today: “You cannot manage this kind of activity [a primary care center] as you do the hospital's radiology department…. The needs are different—different markets, different kinds of staff, different technologies. We found that they didn't even want to use our purchasing system because they [the primary care center] felt they could build good will by purchasing from a local vendor.”

Chapter Summary

Organizations may position themselves through growth and integration. Growth may occur through mergers, acquisitions, internal growth, and networks and alliances. Each growth option presents unique challenges and opportunities for organizations seeking to become more efficient and gain market power. Internal expansion preserves organizational culture but can take much longer. Acquisition facilitates more rapid market entry, but culture and existing organizational structures may impede integration. Networks and alliances may also enable rapid entry, but organizations may have difficulty sustaining them and obtaining the value they desire from these arrangements.

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Firm expansion can occur vertically, horizontally, and through diversification. Vertical expansion occurs when an organization acquires one or more of its suppliers (i.e., backward expansion) or companies to which it sells its products (i.e., forward expansion). Vertical integration promises increased cost efficiencies through greater internal control and coordination and market power. Organizations often have difficulty integrating vertical structures, although some organizations—such as Kaiser Permanente—have done so successfully. The ability to structure transfer pricing properly affects the success of vertically integrated organizations.

Ownership does not equate to integration. To achieve many of the benefits of expansion, an organization must integrate its functions. An organization's operations, knowledge, social interactions, and culture should all be integrated. Many organizations find this endeavor difficult, and studies demonstrate that the promises of integration often are not realized. However, these difficulties have not discouraged healthcare organizations from pursuing both vertical and horizontal expansion strategies.

Horizontal expansion is the merger of organizations that produce the same product or provide the same service. Healthcare organizations continue to grow larger through horizontal expansion. Like vertical integration, horizontal integration promises greater cost efficiencies and market power, but many organizations struggle to realize these benefits. Research suggests that mergers often do not achieve efficiencies but do enable organizations to raise prices. To guard against excessive market power, the federal government—through the Federal Trade Commission and state agencies—regulates merger activity.

Diversification expansion includes related diversification (entering a business that uses similar technologies or adds distinct products to an organization's offerings) and unrelated diversification (adding products that have little or no overlap with an organization's current products and assets). Organizations using the latter strategy are also known as conglomerates.

Chapter Questions

1. Why do organizations repeatedly use growth as a key strategy? 2. What are the benefits and challenges of growing through internal expansion?

Acquisition? Networks and alliances? 3. What are the main differences between upstream and downstream vertical structures in a

manufacturing organization and those in a healthcare organization? 4. How do transaction costs influence the need for vertical integration? 5. What is transfer pricing, and how might it affect an organization's ability to achieve

vertical integration? 6. Other than transfer pricing, what are potential barriers and challenges to successful

vertical integration? 7. What is virtual vertical integration? How might this strategy lower healthcare costs and

improve quality? 8. The promises of horizontal integration include improved efficiencies and greater market

power. Which of these benefits is most easily achieved? Why?

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9. In your opinion, would horizontal expansion across a large geographic area or concentrated expansion more effectively increase an organization's market power and improve its efficiencies? Why?

10. Which existing assets of an organization does related diversification leverage? 11. Why would an organization seeking to expand through diversification succeed more often

by entering similar businesses? 12. What are the major challenges of unrelated diversification expansion? Identify some

healthcare conglomerates.

Chapter Cases

Case Studies 1. Read “The Case of Humana and Vertical Integration” in the case studies section at the

end of this book. How does the history of Humana demonstrate both vertical and horizontal integration? What problems did Humana encounter? What could Humana have done to prevent some of these problems?

2. Read “The Battle in Boise” in the case studies section at the end of this book, and answer the questions that follow the case.

Deciding on Where to Focus Sarah was appointed the director of development for Carston Healthcare System two years ago. She has recently been assigned the management of Carston's merger with a smaller system in an adjacent state. Their combined system will include 19 hospitals, 5 of them critical-access, generating revenues of $12.2 billion. The system also include 15 nursing homes, 3 home health agencies, 55 physician clinics, and 23 outpatient or urgent care centers. They have a joint venture health plan with a local Blue Cross company that has been moderately successful.

Leaders anticipate some rough spots during integration but want most of the critical problems resolved and strategies decided within the next six months. The CEOs indicate a willingness to approve consolidation of numerous corporate functions and overlapping services (e.g., duplication of obstetrics in two cities).

Leaders from both systems sold the merger to their communities based on projected savings of at least 10 percent and a commitment not to raise rates for two years. Sarah has been charged with finding the savings and recommending changes to meet the promised objectives. She is working diligently to achieve this but has found the task daunting. To help herself and her colleagues understand the challenge, she has provided the following cost drivers:

1. Labor costs: 35 percent 2. Prescription drugs: 5 percent 3. Professional fees: 5 percent 4. Professional liability insurance: 2 percent

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5. Rising demand of care: 34 percent a. Population growth: 15 percent b. Use rate increases: 19 percent

6. Increased hospital intensity: 2 percent 7. All other: 17 percent

Sarah notes that the merger provides greater opportunities for savings in some of these categories than others. She needs to decide which she should focus on and what strategies might best help reduce costs in these selected areas.

Questions 1. Which of these areas would be affected (both positively and negatively) by horizontal

integration? Vertical integration? 2. Which areas should Sarah concentrate on? Why? 3. What types of strategies may reduce costs for the new combined system? Why?

Chapter Assignments

1. Research one large healthcare system, and note its core business and any diversified organizations. Is the system practicing related or unrelated diversification? How does this strategy reflect its mission and vision?

2. Read the 2002 article “Integrated Delivery Networks: A Detour on the Road to Integrated Care?” by Lawton R. Burns and Mark V. Pauly in Health Affairs, volume 21, issue 4, pages 128–43. What are the authors’ findings and recommendations regarding vertical integration in healthcare?

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CHAPTER

STRATEGIC ALLIANCES 5 Join the Premier Alliance Today you have a greater need than ever to lower costs, improve outcomes and assume more risk, knowing that pressures have only increased with healthcare reform provisions. As a member of Premier, you'll be prepared for the future of healthcare and will actually help transform it. Our members come in all shapes and sizes. The Premier alliance could be a good fit for you too.

You'd be in good company with approximately:

3,750 U.S. hospitals more than 130,000 other provider organizations

Plus, our supplier partners are critical to the success of our alliance. Approximately 1,100 suppliers are part of our alliance, with 2,000 contracts, helping our members reduce costs and improve quality of care.

Through the collaborative power of the alliance, you will:

Improve outcomes and lower costs Reveal key opportunities for improvement Join the ranks of top performers in the nation Share in the latest clinical best practices, cost reduction strategies, safety measures and more Influence policy that shapes the future of healthcare

It's easy to join. Whether you want to lower your supply spend by participating in our group purchasing organization, increase your quality and safety with our healthcare informatics solutions, or improve care delivery by joining one of our collaboratives, we welcome you!

And all members get access to our state-of-the-art technology platform, PremierConnect®—connecting you with actionable information, knowledge and communities of your peers across the country.

Bottom line: If you want to join a group of passionate, forward-thinking healthcare organizations that are committed to transforming healthcare, we welcome you!

—Premier, “Who It Benefits,” 2017

Learning Objectives

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After reading this chapter, you will

understand why strategic alliances are more frequently used in healthcare than in other fields, be aware of the pitfalls alliances may encounter as well as their potential benefits, be able to distinguish the different forms of strategic alliance, comprehend how organizational mission should relate to alliance structure, and recognize alliance structures that appear to work in healthcare and those that have been problematic.

s discussed in chapter 4, healthcare organizations are using increasingly diverse interorganizational strategies to better fulfill their missions and expand their

capabilities, ranging from loose alliances, partnerships, joint ventures, networks, consortia, and trade associations to interlocking directorates referred to as virtual organizations (Luke, Walston, and Plummer 2004). Strategic alliances have also been called “quasi firms” and “hybrid arrangements” (Kaluzny, Zuckerman, and Ricketts 2002).

Strategic alliances may be defined as “a mutually beneficial long-term formal relationship formed between two or more parties to pursue a set of agreed upon goals or to meet a critical business need while remaining independent organizations” (McSweeney-Feld, Discenza, and DeFeis 2010, 13). Thus, strategic alliances establish interorganizational linkages to help member organizations achieve their missions and strategic objectives.

Relative to acquisitions, alliances are “cooperative, negotiated, and not so risky” (Dyer, Kale, and Singh 2004, 110). As the invitation from Premier in the introduction of this chapter suggests, organizations establish strategic alliances to gain joint competitive and collaborative advantage and share each other's resources and capabilities. As environmental demands change, new resources and skills may become critically important. As suggested by prominent strategy authors, “Strategic alliances are an important source of resources, learning, and thereby competitive advantage…few firms have all the resources needed to compete effectively in the current dynamic landscape” (Ireland, Hitt, and Vaidyanath 2002, 413). Organizations across the world continue to engage in numerous strategic alliances. A 2016 survey by PricewaterhouseCoopers, a prominent international consulting firm, found that almost half of global CEOs and two-thirds of healthcare company CEOs planned to make a strategic alliance in the following year (PricewaterhouseCoopers 2016).

Strategic alliances differ from coalitions and professional and trade associations by their partner selectivity. Strategic alliance partners should bring complementary resources, skills, and personnel, while coalitions and associations often encourage as many organizations or parties in an industry or profession as possible to join (Judge and Ryman 2001).

Potential Benefits of Strategic Alliances

Today there are many reasons that companies form alliances. Exhibit 5.1 illustrates traditional reasons for alliance creation, as well as new drivers. Note that most benefits involve access to a resource or market, plus sharing the risk of a strategic effort.

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However, alliances often do not produce immediate, tangible benefits. Their outcomes are perceivable only over the long term and may be intangible. Because of this lag of benefits, organizations must consider opportunity costs when assessing the value of an alliance. Participants in an alliance must weigh the costs and risks of membership against alternative strategies and not just consider potential return on investment. Value emerges when organizations couple their resources with those of others and all participants benefit over time.

The benefits of strategic alliances can be seen in some recent ventures. For example, General Motors (GM) recently entered into an alliance with the car-share company Lyft, investing $500 million. GM benefits by becoming the preferred provider of vehicles to Lyft drivers and by promoting its electric car, the Chevy Bolt; it also gains a seat on Lyft's board. Moreover, GM has positioned itself to strengthen Maven, its personal mobility car-sharing service launched in January 2016, through the development of a network of on-demand autonomous vehicles in the United States. GM plans to help Lyft grow and position itself as a leader in self-driving cars (Welch and Newcomer 2016).

Organizations often need to cooperate with other organizations that have profoundly different missions, cultures, and strategic intents. Such differences commonly arise in healthcare. As shown in exhibit 5.2, the alignment or misalignment of missions and cultures highly affects the success of mergers and strategic alliances. Clearly, organizations that have aligned missions and cultures find cooperation and coordination much easier, and mergers and strategic alliances among organizations with conflicting missions are more likely to fail. For example, mergers and alliances among Catholic healthcare providers are more likely to be successful because they share similar missions and cultures. Nonetheless, strategic alliances in lieu of ownership can buffer organizations that have significantly different cultures—they may separate cultures enough to allow goals to be met.

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Sadly, most alliances fail. Prashant Kale and Harbir Singh (2009) suggest that between 30 and 70 percent of alliances fail to meet the goals of the alliance and do not deliver the anticipated operational or strategic benefits. Others suggest that the rate of failure could be as high as 80 percent (Zajac, D'Aunno, and Burns 2012). In many cases, members withdraw and join competing alliances. Nevertheless, strategic alliances in all industries continue to grow by 25 percent annually, and many consider them to be a significantly better option than traditional ownership (Judge and Ryman 2001).

Organizations also form strategic alliances in times of heightened environmental uncertainty. As discussed in chapter 1, environmental uncertainty significantly affects an organization's strategies. As uncertainty increases, so does risk. In an environment of sustained uncertainty and change, entry barriers deteriorate and new knowledge and technologies are required for success. Rather than purchase assets and commit significant funds, organizations seek less costly opportunities to place smaller bets through alliances. Although alliances create interdependencies, members retain substantial independence and autonomy, much more so than do organizations in owned vertical and horizontal structures. Fewer interdependencies and less investment give organizations more flexibility during high environmental uncertainty, and they can easily withdraw from alliances if they bet incorrectly.

Healthcare organizations have long experienced heightened environmental uncertainty and have engaged in strategic alliances to address their insecurities and competitive risks. Not-for-profit hospitals formed many of the first strategic alliances in healthcare in response to the emerging threat of for-profit systems (Zuckerman and Kaluzny 1991). Following early experimentation, the formation of strategic alliances exploded during the 1990s, and by 1997 more than two-thirds of healthcare organizations were involved in one or more strategic alliances (Judge and Ryman 2001). Some research suggests that organizations’ interest in alliances declined somewhat following this explosion. In 1996, 33 percent of hospitals participated in a physician–hospital organization (PHO), but this percentage decreased to 26 percent by 2000 (Burns and Pauly 2002). Nevertheless, many of today's successful managed care organizations operate and share risk in alliances. Past sector leaders, such as Oxford Health Plans, PacifiCare, and US Healthcare, traditionally did not hire their

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physicians but ran virtual networks (Morrison 1998). Many organizations perceive virtual networks as a way to position themselves strategically for the future (Bolch 2012; Carlson 2012).

Healthcare organizations are finding that alliances and partnerships can greatly assist in moving toward patient centered services and preparing a transition toward a population health model. Partnering quickly expands the data undergirding diverse population health programs that may come from affiliations with “community health centers, school districts, local public health departments, chambers of commerce, and faith organizations.” For instance, alliances with school districts could make “physical exams, screenings, and diagnosis and treatment” more available to pediatric populations, which would reduce the use of more expensive health services (Lasser 2016).

Similar to all interorganizational structures, the outcomes of strategic alliances may be positive or negative. On the positive side, strategic alliances encourage cooperation, trust, commitment, and shared risk among participating organizations. They address organizational inertia by creating novel relationships and engendering new knowledge and practices. Unlike organizations in horizontal and vertical mergers, alliance members retain their autonomy and independence and have greater strategic flexibility.

On the negative side, strategic alliances can divert an organization from its mission. As discussed earlier, alignment of participating organizations’ missions is critical to the success of the alliance. If an alliance focuses on something outside or even tangential to its members’ core missions, members will accrue few real benefits and may become sidetracked. Relative to ownership, alliances are much more difficult to establish and unity of purpose and organizational cohesion are more difficult to maintain. Furthermore, setting up such structures can be costly and time consuming. Strategic alliances often demand top leaders’ time and involve significant legal fees. If handled improperly, participation in strategic alliances can create antitrust problems. Organizations should be certain that their agreements meet legal conditions in order to avoid collusion (Zajac, D'Aunno, and Burns 2012).

Alliances may be a better option than ownership if the key assets involved in the collaboration are softer in nature—for example, human resources and knowledge. Research has shown that key personnel often depart following mergers, taking key company knowledge with them. Key personnel may be more likely to remain with organizations that participate in alliances, particularly equity alliances (DePamphilis 2014; Dyer, Kale, and Singh 2004).

As shown in exhibit 5.3, strategic alliances in healthcare take many forms. Manufacturers of healthcare goods have entered into numerous alliances with other manufacturers to spur research, development, and commercialization of their products. Pharmaceutical and biotechnology companies have entered strategic alliances to accelerate drug discovery and time to market. When valuing stock, market analysts recognize organizations participating in strong alliances.

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One past example of a highly successful strategic alliance between two pharmaceutical companies was the pairing of Pfizer and Warner-Lambert to develop and market Lipitor, a cholesterol-reducing drug. The market was saturated with four similar drugs, and Warner- Lambert—the developer of Lipitor—did not have the marketing abilities and access to the distribution channels the company needed to quickly break in. The first six months of a drug launch generally make or break sales, so timing was critical. The patent for Merck's cholesterol drug was set to expire in 2001, leaving only a narrow window of time before a lower-priced generic drug would enter the market. Pfizer, one of the few large pharmaceutical companies without a cholesterol-fighting drug, was interested in Warner- Lambert's proposal. Pfizer agreed to pay Warner-Lambert $205 million and other milestone payments and to split marketing and clinical trial costs. In return, Pfizer would receive about half of all net sales. Together, the companies fielded an army of more than 2,200 sales representatives to sell Lipitor during its launch in the United States and distribute 7.3 million samples of the drug to physicians. The strategic alliance was extremely successful. In its first year, Lipitor sales totaled $1 billion, and the drug went on to become the market leader among cholesterol-fighting drugs (University of Michigan Business School 1999).

Examples of Healthcare Alliances

The following section provides four healthcare alliances. The first involves United Healthcare, a large for-profit insurance company allying with a large not-for-profit integrated provider system. The second includes two major healthcare providers, a multinational for- profit system and a regional not-for-profit academic medical center in Connecticut. The third is an alliance between a religious provider, St. Dominic, and a retailer, Walmart, formed to deliver primary healthcare in Walmart stores. The last is an alliance between a large regional provider and a small rural facility.

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For-profit Insurer and Not-for-profit Provider United Healthcare, the largest for-profit US healthcare insurance company, teamed with the largest integrated system in New York, the North Shore-LIJ Health System (now known as Northwell Health). North Shore-LIJ comprises 21 hospitals, along with rehabilitation and skilled nursing facilities, a home care network, 9,000 physicians, a hospice network, and progressive care centers offering a range of outpatient services.

The alliance introduces a new suite of tiered health benefit plans that include accountable care concepts built around physicians and hospitals affiliated with the North Shore-LIJ Health System. UnitedHealthcare began offering the health plans to Nassau, Suffolk, and Queens Counties employers for January 1, 2013, enrollment. The new health plan suite, called UnitedHealthcare North Shore-LIJ Advantage Plans, is part of UnitedHealthcare's ongoing emphasis on increased collaboration, outcome-based payment, and new benefit designs that are transforming how healthcare is paid for and delivered.

“UnitedHealthcare and North Shore-LIJ are working together to improve the local delivery of care and lower costs for our customers,” said Bill Golden, the CEO of UnitedHealthcare Employer and Individual of New York. “Thanks to North Shore-LIJ's leadership and willingness to innovate with us, new benefit designs like the Advantage Plans will help enhance the quality and cost efficiency of care provided through a focused, easy-to- access provider network” (Business Wire 2012b).

As part of the collaboration with UnitedHealthcare, the North Shore-LIJ Health System has the opportunity to earn financial incentives based on quality health outcomes and medical cost reductions in both office and hospital settings among fully insured individuals enrolled in the United Healthcare North Shore-LIJ Advantage plans (Business Wire 2012b).

For-profit Provider and Not-for-profit Provider Tenet Health, a large multinational healthcare provider with 83 US hospitals, has allied with Yale New Haven Health System—the largest healthcare system in Connecticut—to build new clinical networks in the Northeast. The two systems’ alliance may be unlikely; Yale New Haven Health is a respected regional academic medical center, while Tenet is a for-profit hospital system with national and international operations. The systems state that the alliance members complement each other—Yale New Haven Health provides clinical expertise, while Tenet brings its financial strength to help fund potential acquisitions. The relationship allows Tenet to enter the clinical network market (for-profit organizations are not legally allowed to develop clinical networks in Connecticut).

A similar strategic alliance previously occurred in North Carolina, where Duke University Health System and LifePoint—a for-profit group of 60 facilities in 20 states— formed a joint venture (Diamond 2014).

Religious Provider–Retailer On November 8, 2010, St. Dominic Hospital in Jackson, Mississippi, opened a primary care clinic at the Walmart in the neighboring town of Pearl through a strategic arrangement. “The Clinic” encourages walk-in visits, and referrals for additional care are made to St. Dominic's providers. The Clinic also is connected to St. Dominic's electronic health record system.

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Kevin Flynn, vice president of network administration for St. Dominic, stated, “Our mission is to serve the community, and the Walmart Pearl location is one more way we can fulfill that mission” (Chandler 2010, 4).

“Walmart is dedicated to serving our customers and our communities, and this type of clinic helps expand their access to quality healthcare,” said Bruce Shepard, Walmart's director of healthcare innovations (at the time). “St. Dominic is a well-known and respected healthcare provider in this area, so our customers will receive quality care from people they know and trust” (Chandler 2010, 4). As of 2013, 118 clinics operate in Walmart store locations in 22 states through alliances with independent healthcare providers (Walmart 2017).

Urban Provider–Rural Provider Formed in 2012, a strategic alliance between PMH Medical Center in Prosser, Washington, and Kadlec Regional Medical Center in nearby Richland made medical specialists available in Prosser. The alliance enables PMH to use Kadlec's new electronic medical record system, facilitating referrals and patient care. Prior to the alliance, Julie Peterson, PMH's CEO, stated, “This is not an acquisition, a merger or some kind of takeover. We will remain a public hospital district with an elected board.” PMH Medical Center is a small community hospital with 62 licensed beds. Kadlec Regional Medical Center, a 215-bed facility, is located approximately 30 miles from PMH (Von Lunen 2011).

Interdependencies and Strategic Alliances

The type and extent of organizations’ resources also influence their decision to form an alliance rather than expand through ownership. Organizations combine resources in different ways to achieve desired outcomes. These combinations create resource interdependence. As shown in exhibit 5.4, the degree of organizations’ interdependence depends on whether they have a pooled, sequential, or reciprocal relationship. Pooled interdependence exists when organizations’ resources are modular in nature—that is, the organizations share limited common assets, and management of those resources needs little coordination (Thompson 1967). For example, a group of primary care clinics might have pooled interdependence. The clinics can function independently and share only resources that benefit all of them, such as billing and information systems.

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In a relationship of sequential interdependence, one organization produces a product and hands it off to the other. This type of interdependence is greater than pooled interdependence. Increased coordination is required to ensure that the transferred products meet both parties’ requirements. Drug discovery and the governmental approval process are an example of sequential interdependence. A pharmaceutical company can fully focus on discovery and then hand its discoveries to another organization for approval. As a result, companies can conduct clinical trials more efficiently and bring drugs to market more quickly.

Reciprocal interdependence involves multiple interactions and integration of participants’ knowledge. For example, the physicians and other healthcare professionals who deliver medical care in an intensive care unit have reciprocal interdependence. In a hospital, physicians, nurses, respiratory therapists, dietitians, and others are mutually dependent, continuously interacting and transferring knowledge among one another to adjust patient treatment. Coordination is much more complex and difficult.

Another factor influencing organizations’ decision to participate in an alliance is the nature of the resources among them. This factor is more important when excess capacity exists. If organizations seek to combine hard resources, such as factories, hospitals, and other costly assets that produce products and services, a merger or an acquisition may be best. Such assets are easier to price than knowledge-related resources, and if combined, managers may substantially eliminate excess capacity.

Although many alliances fail, some have been successful for a number of years. One enduring example is Centura Health System, headquartered in Colorado. In 1996, two faith- based groups—Adventist Health System (sponsored by the Seventh-Day Adventist Church) and Catholic Health Initiatives (sponsored by the Catholic Church)—joined forces as a not- for-profit healthcare network to manage and strengthen their hospitals and services in Colorado and Western Kansas. The system—composed of 17 acute care hospitals, 14 ambulatory surgery centers, senior communities, diagnostic imaging centers, home health care services, hospice services, and physician clinics—serves more than a million outpatients

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annually (Centura Health 2016). The religious groups’ common mission is to “extend the healing ministry of Christ by caring for those who are ill and by nurturing the health of the people in our communities” (Centura Health 2016). The two sponsoring organizations continue to coordinate their assets and skills to leverage their combined position in the Colorado and Kansas healthcare markets.

Given the continued uncertainty regarding market and governmental reform in healthcare, the role of strategic alliances probably will continue to grow. This shift has been especially been true in the development of accountable care organizations (ACOs) and the push toward a population health focus. For example, in 2014, six Wisconsin health systems, which in total provide care to about 90 percent of their state, created a nonequity strategic partnership to develop a low-cost, high-quality ACO. Patient data will be shared among partner organizations to facilitate and streamline patient care (Herman 2014).

Types of Alliances

Alliances can be categorized by the degree of control and equity that members have in the arrangement. Exhibit 5.5 shows where different types of alliances lie on the control–equity continuum. Learning and purchasing alliances, such as professional associations and group purchasing organizations (GPOs), generally involve little capital investment (often just participation fees), and members have minimal control over the direction and activities of the alliance. On the other end of the continuum, joint ventures involve shared ownership and investments, and members have greater control.

Strategic alliances and participants’ relationships change over time. As alliances mature, their purposes and value may change. For example, many of today's large GPOs originated to benefit a select group of providers and required large capital contributions from their founding organizations. As the GPOs grew and matured, their memberships greatly expanded and the influence and money required to participate decreased.

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For example, a strategic alliance between Roche Diagnostics, an international diagnostics testing firm, and Cedars-Sinai Medical Center, a large healthcare provider in Los Angeles, is an example of a low-equity, low-control relationship. The organizations share knowledge and the results of molecular diagnostics testing with intent to “collaborate and capitalize on scientific knowledge in molecular testing and, in turn, accelerate the advancement of new test methods and technology” (Roche Diagnostics 2011). Except for their personnel and knowledge, the parties contribute little capital, and the effort depends on cooperation and trust. Neither party can dictate or control the joint work.

Large pharmaceutical companies, such as Eli Lilly, have used alliances effectively to foster research and development. In this way, it can draw on a wide range of external resources. Its cooperative agreements with universities, hospitals, and other drug companies allow much greater flexibility and also speed drugs to market (see chapter 3). A few drug firms, such as Shire Pharmaceuticals, have gone so far as to outsource such functions as discovery, medical monitoring, data management, statistics, and medical writing via alliance- type contracts (Garguilo 2016).

Some have categorized strategic alliances according to membership size, governance structure, and whether they pool or trade resources (Zajac, D'Aunno, and Burns 2012). By nature, low-control, low-equity strategic alliances often have large memberships. GPOs, more fully described in chapter 7, have thousands of members. For example, Novation, established in 1998 with the merger of the VHA and UHC purchasing programs, had 5,200 health system members and 118,000 non-acute health system affiliates from which members purchased more than $50 billion goods and products in 2015 (Dietsche 2015). This GPO continues to grow with the acquisition of MedAssets in 2015 and a change of name to Vizient (Rubenfire 2015).

Although size diminishes each member's control, it can create significantly more overall power and synergies. Healthcare GPOs can demand large price and delivery concessions from suppliers as a result of their size. Larger coalitions can also wield more clout when dealing with governmental agencies, regulations, and legislation (Walston and Khaliq 2012).

An alliance's governance structure often is proportional to the size and equity position of the alliance. Large alliances tend to have larger governance boards. Vizient's board of directors, for example, consists of 22 members from its supporting organizations (Vizient 2017). Joint ventures, which involve two or three participants, often have much smaller boards or operating entities consisting of executives from the sponsoring organizations.

Alliances, moreover, can be distinguished by the type of resources members bring together. In some alliances, members pool similar resources, while in others, members contribute distinct but complementary resources. For example, GPOs pool resources to enable healthcare providers to buy supplies jointly at a discount, while Tenet Health and Yale New Haven each contributes a different resource—Tenet Health shares capital resources; and Yale New Haven provides clinical expertise and reputation.

Exhibit 5.6 illustrates the three types of alliances discussed in this chapter: the pooled- service alliance, the joint-venture alliance, and the network outsource alliance. A pooled- service alliance combines resources from a relatively large number of members. The alliance leverages the resources to benefit its members. Member organizations often contract with the

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alliance for services. Again, GPOs, which combine members’ purchase volumes to engender greater price concessions from suppliers, are an example of a pooled-service alliance.

A joint-venture alliance is similar to a pooled-service alliance in that participants pool resources but differs in that it generally has fewer members, and members have a direct ownership position and greater directional authority. Many medical services organizations began as joint ventures between a hospital and its associated medical staffs. All parties contribute capital and jointly hold equity in a company that can furnish needed administrative services to its members.

A network outsource alliance revolves around a core organization that contracts out critical products and services. The core organization facilitates activities through an initial capital infusion, licensure, or some other means. The strategic alliances that large pharmaceutical companies have created with universities, biopharmaceutical companies, and other organizations are fashioned on this model.

Management of Alliances

As stated earlier in this chapter, the majority of strategic alliances fail to achieve their objectives, often as a result of poor preparation and management. An alliance's governance

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function relies on consensus among member organizations. However, unanticipated conflicts almost always arise and make consensual governance exceptionally difficult.

Before a strategic alliance is established, a statement of the agreement's purpose or mission must be in place. Too often this critical factor has not been addressed. “The lack of an articulated mission statement is often cited as the root of many failures in organizational strategy. The same is equally if not more true for strategic alliances” (Zajac, D'Aunno, and Burns 2012, 327). Many alliances have collapsed because of a lack of well-understood objectives and expectations. To be successful, a strategic alliance must have a mission that delineates the reasons for the collaboration.

As discussed in chapter 6, if its purposes are ill-defined, a strategic alliance can quickly become a liability for all parties involved. Some, such as previously popular PHOs, have had a history of ambiguous motives. Hospitals can bring various motivations to the alliance; they may be seeking to increase their revenues by attracting physician outpatient markets, grow their market power to negotiate better managed care contracts, or improve physician loyalty. On the other side, physicians’ motives may contradict their hospital partner's purposes; physicians may desire capital, technology, greater control, and higher incomes. It is no wonder that studies on PHO efforts have demonstrated few significant economic benefits.

All parties need to understand the goals of the alliance, and their actions should reflect those aims. New alliances have been found to have rather “broadly stated goals that do not necessarily coincide with their activities” (Zajac, D'Aunno, and Burns 2012, 333). Specific goals are easier to establish when an alliance includes only a few members. A narrow set of goals tends to appeal to select, homogeneous parties with common interests. Broader goals make the management and direction of an alliance more uncertain but can draw a wider range of participants. Shared expectations facilitate commitment and success.

Alliances must have a management structure that has the authority, responsibility, and resources to accomplish the goals that members have set. Uniquely, strategic alliances “involve two or more leaders who have relatively expansive power [in their own organization]…but relatively constrained power and authority over a strategic alliance” (Judge and Ryman 2001, 73). Top leaders often struggle with the ambiguous alliance governance structure because they are accustomed to exercising a high degree of control in their organizations. Those that succeed realize this difference and adjust to the cooperative nature of an alliance. Cooperation means sharing commitments, not controlling them. As suggested by Ohmae (1989), “Good partnerships, like good marriages, don't work on the basis of ownership or control. It takes effort and commitment and enthusiasm…. You cannot own a successful partner any more than you can own a husband or wife.” Cooperation drives success. Attempts to control bring failure.

A lack of sustained commitment and compromise among partners also disposes an alliance to failure. In many cases, members fully engage in an alliance initially, but over time their enthusiasm wanes and they tacitly withdraw their support. Top executives commonly set up alliances but limit their interaction to indirect activities once the agreements are in place.

Participants are more likely to remain engaged if they perceive they are benefitting from the alliance. Milestones (key performance indicators) should be set and achieved. Alliances’ goals in healthcare need to address what constitutes critical, contemporary value for alliance

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participants. Key stakeholders, such as board members and physicians, need to buy into the alliance. Outcomes such as improved quality, lower costs, and increased access should be identified, tracked, and evaluated. Healthcare alliances that have not addressed these important outcomes increasingly fail (Hoffman 2014).

Trust is a critical element of interorganizational relationships. As discussed in chapter 4, lack of trust encourages opportunistic behavior and conflict among the parties involved. Strategic alliances are fragile and can quickly be destroyed if participants distrust each other. Trust develops if values and goals are explicit and shared, processes are transparent, and outcomes are achieved. Sadly, trust does not emerge on its own. As stated by Judge and Ryman (2001, 75), “Trust is an essential glue that holds strategic alliances together, but it is very difficult to develop and maintain in the healthcare industry.” If relationships and trust break down, alliances will almost always end. Building strong relationships and trust can be the only things that can sustain an alliance, especially when conflict arises (Steinhilber 2008).

Conflict ensues even in the best of circumstances, however, and one way of promoting trust is to establish conflict resolution mechanisms. Many alliances fail to do so. Pharmaceutical companies report that almost 70 percent of their alliances failed because the members ignored festering problems that early conflict resolution might have corrected. Only 40 percent had an internal alliance management group responsible for resolving conflict and maintaining lines of communication between partners (PR Newswire 2006). The more successful pharmaceutical strategic alliances employ project managers, who “proactively identify conflict and facilitate resolution” (Eager 2010).

The fragmented yet dependent nature of the healthcare field makes conflict resolution exceptionally important. Top executives often are rewarded for decisive decision making and not for collaborative behavior, and only through continuous cooperation can alliances be successfully managed and trust built. Uncoordinated priorities and uncooperative behavior can quickly lead to poor outcomes. Collaboration results when all partners consider both their own and others’ benefits. When the benefits of others are ignored, cooperation diminishes and the strategic alliance can easily fail. Scholars have found that win–win collaborations that lead to shared decision-making processes and build trust are essential to alliances’ success (Judge and Ryman 2001).

Collaboration can be difficult to achieve in healthcare, especially among providers and managed care (insurance) companies, whose incentives, backgrounds, and perspectives greatly differ. Problems include “high levels of naiveté and mistrust between hospitals, doctors and health plans. Partners speak different workplace languages, view health care through different lenses, and typically have given little thought to wider perspectives” (Bilchik 1997).

Another factor is personnel's commitment to the alliance. Commitment can be formed by dedicating capable managers exclusively to the alliance effort (Zajac, D'Aunno, and Burns 2012). Because much of the commitment comes from the personal relationships between top executives, the turnover rate of CEOs and other key leaders can directly affect the alliance. Although turnover is unavoidable, succession planning should be part of an alliance's strategic thinking. Alliances that do not plan for turnover may fail when an executive departs.

Leaders of alliances cannot mandate commitment and compliance. Direct control

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conflicts with the goals of an alliance, and leaders face the difficult task of seeking commitment through a loosely coupled structure. Some organizations, including GPOs, encourage commitment by tiering their prices on the basis of members’ level of commitment. Alliance members that purchase all of a contracted product (e.g., all of their orthopedic products) through the GPO receive larger discounts than do those that buy only a portion.

As strategic alliances mature and environmental conditions change, alliances may need to reassess their structure and purpose. Partners need to recognize the changes and be willing to reexamine fundamental features such as membership, geographic presence, and desired outcomes. Alliances that make such alterations are more likely to survive over time.

Some organizations use alliances to reduce the risks of acquisition and intend many of their alliances to mature to ownership. Technology firms, such as Cisco, use alliances extensively in highly uncertain environments and then seek to acquire their partners when their joint products become more established. As of 2004, almost 25 percent of Cisco's acquisitions had begun as strategic alliances (Dyer, Kale, and Singh 2004).

Chapter Summary

Organizations create alliances with other industry players to fulfill their missions and strategic objectives more fully. During environmental uncertainty, alliances enable organizations to share the risk of developing and exploring new products, gain market power, and learn new skills. Many alliances fail because of a lack of commitment among members, misunderstandings of the alliance's purpose, and a deficit of leadership and resources. Successful alliances work diligently to develop trust, commitment, and cooperation; resolve conflict; and achieve explicit outcomes that return value to their members.

The role of strategic alliances in healthcare will continue to increase. Pooled-service alliances have been successful at negotiating lower supply and capital prices. Numerous pharmaceutical companies are forming network outsource alliances, and many predict that this strategy will be the future of drug development. Different alliances require different approaches. Some involve significant capital investment, while members in other alliances simply share data and knowledge. Regardless of approach, the success of all alliances depends on dedicated effort and cooperation.

Chapter Questions

1. How might alliances be less risky than ownership? 2. When should an organization consider an alliance rather than ownership? 3. What major benefits do alliances seek? 4. What major factors can cause an alliance to fail? What components are key to an

alliance's success? 5. Which type of alliance might work best for a not-for-profit organization? For a for-profit

organization? Why?

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6. How does the use of alliances for research and development help drug companies improve their efficiencies?

7. How does interdependence determine the type of alliance organizations should form? 8. Why does members’ degree of control often correlate closely with their degree of equity

in an alliance? 9. How can trust affect the success of an alliance? Why is trust more important in an

alliance than in a solely owned firm? 10. What can occur as an alliance matures? Why? 11. What are the trade-offs of having a larger versus a smaller alliance membership? When

would a smaller number of participants be preferable?

Chapter Cases

Case Studies Read and discuss one of the following cases: “Response to St. Kilda's ACO Offer,” “Build a New Service Because of a Large Donation?”, or “Dissolving a Long-Standing Affiliation and Moving On” in the case studies section at the end of the book. Answer the questions at the end of the case.

Read “An Orthopedic Group Decides to Construct a Specialty Hospital” in the case studies section at the end of this book. How could the other hospitals in the area have used the concepts of alliances to prevent the construction of an independent orthopedic hospital?

A New Clinically Integrated Network Jackie serves as the vice president for network development for a large, midwestern healthcare system. She has worked with many rural and semirural hospitals to improve efficiency by offering shared services, consulting, and purchasing. She also develops in- house hospital management abilities, and her system currently provides contracted management services for three rural hospitals.

As part of her network development, she invites 15–20 rural and semirural hospitals quarterly to a network dinner and brainstorming session. Generally, 8–10 attend, but the information and suggestions they made were always helpful.

In an earlier meeting, most of the attendees wanted Jackie to explore the possibility of setting up a clinically integrated network (CIN) that could encompass the smaller, networked hospitals. Her hospital had been working on establishing aspects of a CIN within its own system, and she knew that it had spent many years and significant resources on the project. However, given the interest expressed by the attendees, she agreed to present more information at the next meeting.

When the next quarter arrived, Jackie presented how CINs work and what their desired outcomes are. CINs seek to improve patient care while reducing costs and existing redundancies. These networks should develop a team of primary care and specialty physicians to work together to streamline their care delivery model. CINs also allow both

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employed and affiliated physicians to partner and negotiate with insurers for contracts. Generally, a CIN should do the following:

Establish a network of providers that enhances coordination of care. Create a partnership model with hospitals and their employed and independent physicians. Define roles for physician leadership. Clearly establish performance improvement initiatives to provide demonstrated value. Provide a structure for joint contracting to support care redesign and performance improvement initiatives. Negotiate with businesses and insurers for risk-based contracts. Implement consistent clinical protocols across the network to achieve patient care. Collectively own a reporting system.

Health systems have used many structures to implement CINs. Jackie presented various options that would work best in different circumstances. These ranged from a joint venture to a pooled-service alliance to a network outsource alliance.

During the subsequent discussion, almost all attendees concurred that they would like to pursue this together. They felt that critical aspects included involving their physicians, improving patient care, lowering costs, and providing a mechanism to negotiate joint contracts.

Questions 1. Given what the leaders want to accomplish, what structure would you suggest? Why? 2. What are the advantages and disadvantages of using each of the three structures to

establish a CIN? 3. What other structures could they use?

Chapter Assignments

1. Select a GPO. Identify its locations, services, facilities, and sites, and determine the criteria for membership.

2. Search the Internet for strategic alliances. Find one example of each of the three types shown in exhibit 5.6. In a one-page paper, identify the strengths and potential weaknesses of each alliance.

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