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CHAPTER

GROWTH AND INTEGRATION STRATEGIES

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.

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 neces- sary 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

Walston, Stephen L.. Strategic Healthcare Management : Planning and Execution, Health Administration Press, 2018. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/westernkentucky/detail.action?docID=5517312. Created from westernkentucky on 2021-09-17 02:00:16.

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G 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.

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

In July 1998, the Allegheny Health, Education, and Research Foundation (AHERF) filed for bankruptcy, revealing $1.3 billion in debt and 65,000 credi- tors. Up until this time, AHERF’s bankruptcy was the largest nonprofit health- care failure in the United States. A large part of AHERF’s problems arose when it embarked on an ambitious strategy of horizontal and vertical expan- sion. AHERF began as a prosperous 670-bed facility, Allegheny General Hos- pital, in Pittsburgh in the early 1980s. With increasing competition and a new CEO, Sherif Abdelhak, the hospital rapidly expanded to create Pennsylvania’s first statewide integrated delivery system. Between 1986 and 1997, AHERF grew from revenues of $195 million to $2.05 billion and employees from 4,000 to 31,000; where it once had one hospital, it eventually comprised 14. However, by 1998, because of financial irregularities, enormous debt, and general fiscal deterioration, AHERF was forced into bankruptcy.

Some observers have questioned the organization’s growth strategy. Few payers in Pennsylvania appeared to want a statewide system with which to contract. The market share gained by AHERF’s expansion was insufficient to increase its negotiating power. It was also unable to garner synergies and economies of scale through its rapid mergers. Overall, its growth strategy was a miserable failure, as “growing their business seems to have trumped fiscal restraint and responsible investment.”

EXHIBIT 4.1 AHERF

Bankruptcy

Source: Burns et al. (2000).

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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

Internal Expansion Internal expansion builds on an organization’s own capabilities and resources to advance company activities, products, services, and revenues. Internal expan- sion 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

Internal expansion A method of business growth that builds on an organization’s capabilities and resources and may include developing new products and services, launching marketing efforts to increase market share, or introducing existing products into new markets.

Growth Strategy Advantages Disadvantages

Internal • Preserves organizational culture

• More easily funded with internal resources

• Builds on firm’s strengths and reputation

• Incremental growth rate • Generally less exposure to

risk

• Slow growth and develop- ment of new products

• Steep learning curve • May not be able to overcome

established barriers to mar- ket entry

Acquisition/ merger

• Not subject to legal restric- tions (e.g., certificate of need)

• Rapid market entry • May become associated with

the positive reputation of another organization

• Purchasing a competitor reduces competition

• Culture and management structures of acquired orga- nization may be incompat- ible, jeopardizing successful integration

Network/ alliance

• Lowest risk • Potential for rapid market

entry • May obtain critical knowl-

edge and market access

• Least control over outcomes • May easily dissolve • May lose technical and other

key personnel

EXHIBIT 4.2 Advantages and Disadvantages of Different Growth Strategies

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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 organiza- tion 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 infections, back pain, sports physicals, or vac- cinations 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’ restric- tions 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.

Acquisition The purchase (or merger) of an existing organization. Through this method of growth, the acquiring organization gains an established product in the market and may also reduce competition by eliminating one of its competitors.

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Nevertheless, acquisition has its drawbacks. Merged organizations some- times 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 incompat- ibility 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 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

Networks Joint ventures and alliances between established organizations for growth purposes. By forming networks, organizations can enter a market more quickly and with minimal risk.

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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 busi- nesses 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 [AHA] 2017). Health insurance companies also have merged; by 2015, the largest 10 insurance com- panies controlled more than half of the US market (Statista 2017b). Specialist physicians, especially cardiologists and orthopedists, are increasingly consoli- dating 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 expan- sion 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).

Vertical expansion Acquisition of a business that is a source of supplies for the acquiring organization (backward expansion) or that purchases from the acquiring organization (forward expansion).

Horizontal expansion The acquisition or merger of two or more organizations that produce similar products or services.

Vertical integration Assimilation of the vertical components of an organization through greater internal control and coordination.

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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 orga- nization’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 fi nally 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 compa- nies, such as Weyerhaeuser, grow trees, make wood products, and build homes.

Healthcare—a service fi eld—does not have clear upstream and down- stream product fl ows. 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 effi ciencies through improved internal control and coordination and increased market power. Providers have been encouraged to organize inte- grated 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 effi cient decision making, enabling confl ict resolution and quick adjustment to market conditions (Luke, Walston, and Plummer 2004).

V er

ti ca

l I n

te g

ra ti

o n

Healthcare Vertical Integration

Health promotion Long-term care Retail clinics Ambulatory care Home health care Primary care Specialty physician care Hospital care Health insurance Medical suppliers Raw materials

Traditional Vertical Integration

End user

Retail sales

Distributor

Manufacturer

Component maker

Raw materials

Upstream

Downstream

EXHIBIT 4.3 Contrasting Traditional and Healthcare Vertical Integration

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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 appro- priate 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 provid- ing 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 pursu- ing 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 orga- nizations involved in the exchange have little trust in the fairness and honesty of each 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,

Transaction cost economics A theory that suggests that organizational boundaries influence organizations’ efforts to mitigate the costs of the transactions and contractual hazards incurred by buying and selling assets and services.

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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 actu- arial science applications. Rather than lowering 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 diffi- cult prospect. Many hospital systems have professed a desire for closer alignment with their affiliated physicians to improve quality and lower costs. However,

Blue Cross Blue Shield of Texas (BCBSTX), the largest insurance provider in Texas, threatened to terminate its contract with Texas Health Resources, one of the state’s largest hospital systems, on December 31, 2016. In early December, negotiations had acrimoniously ended. Texas Health Resources CEO Barclay Berdan stated that BCBSTX’s “continued delays place patients, their employers, and their physicians in the middle of this and may ulti- mately and significantly disrupt care.”

Texas Health Resources had asked for a 4 percent increase in rates in the contract extension. BCBSTX offered 2 percent, which Texas Health Resources rejected. The insurer noted that the difference could potentially cost it $57 million, an increase that it deemed “unacceptable.” BCBSTX added, “Texas Health rejected our proposed extension and countered by proposing new short-term contracts with egregious rate increases that would cause our members to bear the burden of additional unnecessary and unwar- ranted costs with no guarantee of better health outcomes.” As the “defender for low cost care in Texas,” BCBSTX felt it necessary to reject Texas Health Resources’ demand.

In response, a Texas Health Resources spokesperson said that any numbers that BCBSTX provided “should be taken with a truckload of salt” and that “any figures BCBSTX uses is [sic] an effort to grab headlines.”

EXHIBIT 4.4 Blue Cross Blue Shield May Drop Texas Health from Its Network

Source: Hoye (2016).

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because of conflicting incentives and priorities and a lack of physician leader- ship, 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 inte- grated 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 maximiza- tion. 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 out- side 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.

Transfer pricing The price charged for intraorganization trade (i.e., the sale or transfer of goods and services within an organization).

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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 insur- ance 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 guar- antees 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 advan- tage 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 (spe- cialists have wider service areas). To be successful, insurance companies must

Most-favored- nation clause A clause in a contract between a provider and an insurance company that guarantees that the provider will charge the insurance company prices that are lower than the prices the provider charges all other insurance companies it does business with.

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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 con- tracting with nonsystem providers necessary. As a result, systems sacrifice many potential economies of scale. In 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 insur- ance 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 inte- gration 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:

Insurance market—statewide

Hospital market— regional

Physician market—

local Physician

market—local Physician

market—local

EXHIBIT 4.5 Differences in Service Areas for Vertically

Integrated Healthcare

Systems’ Components

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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

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 orga- nizations. 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 account- ability 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 clini- cally relevant feedback.”

Recent studies confirm that much still needs to be done to integrate vertically owned health systems. Scholars have reported that physician employ- ment 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

Accountable care organization (ACO) A payment and healthcare delivery model in which a group of healthcare providers work together to coordinate a patient’s care, improve quality, and reduce costs.

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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 of the dynamic integration efforts in Pennsylvania.

Virtual Vertical Integration An alternative to vertically owned, integrated systems is virtual vertical integra- tion. Virtual integration can be achieved with contractual, nonowned mecha- nisms 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 competi- tive 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 health- care—the intermediary coordinator of care for patients across a spectrum of provid- ers. 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 experi- enced 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 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 provid- ers. For example, it partners “with a local pharmacy to ensure home medications

Virtual integration Coordination of intraorganization processes, flows, and outcomes through contractual, nonowned mechanisms.

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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 manage- ment 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.

Highmark was created in 1996 by the merger of two of Pennsylvania’s Blue Cross companies. Centered in Pittsburgh, it had become one of the largest health insurers in the United States by 2010, covering almost five million members and posting revenues of $14.6 billion. Highmark dominated the health insurance market in western Pennsylvania, controlling 65 percent.

Highmark dealt with all providers in its area but was having increasing difficulty negotiating with the dominant provider, UPMC, a vertically inte- grated, ten-hospital system with its own health plan. UPMC, which generated $8 billion in revenues in 2010 and provided services to about 34 percent of patients in western Pennsylvania, was using its market power to demand higher payments from Highmark.

In a surprising strategic move, Highmark broke off negotiations with UPMC in June 2011 and announced an agreement to acquire West Penn Allegheny, the second-largest health system in western Pennsylvania, mak- ing it one of the few insurers to purchase a healthcare system. West Penn reported $1.6 billion in revenues in 2010 but had suffered losses for a num- ber of years. With this strategic vertical integration, Highmark believed it would be able to compete directly in all stages with UPMC.

As a result of the pending merger, UPMC announced that it was work- ing to enhance and expand its contracts with other insurers, including Aetna, Cigna, HealthAmerica, and UnitedHealthcare, and proposing to offer more choice and competition in health insurance in a market long dominated by Highmark.

After more than a year of extensive negotiations and turmoil, High- mark and West Penn announced in January 2013 that the merger would take place. In the meantime, the acrimony between Highmark and UPMC esca- lated to such an extent that the governor of Pennsylvania had to intercede to encourage the feuding groups to find a compromise. The agreement they eventually reached extended through 2014. UPMC announced that it looked forward to competing with Highmark’s new integrated system but would not renew or extend the contract with Highmark on expiration. These two domi- nant, vertically integrated systems appear to be changing the nature and degree of competition in western Pennsylvania’s healthcare market.

Sources: Evans (2013), Herman (2013), Langley et al. (2012), Lee (2011).

EXHIBIT 4.6 Continued Attempts at Vertical Integration in Pennsylvania: The Proposed Merger of Highmark and West Penn Allegheny Health System

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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. Coor- dinated 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 prac- ticed alone or in small group practices. This situation began to change signifi- cantly 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. Group practices and physician employment have been the fastest-growing segments in health- care, 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

Affordable Care Act (ACA) A law passed by the federal government in 2010 that sought to decrease the number of uninsured to improve health outcomes and streamline the delivery of healthcare.

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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 horizon- tal 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 nongovern- mental 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 manage- ment, 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

Economies of Scale Market Power Access

• Merged/consolidated services

• Lower administrative costs per consumer

• Shared marketing costs

• Ability to charge higher prices

• Greater utilization • Easier entry to system • Increased customer

use across markets

EXHIBIT 4.7 Theoretical Benefits of Horizontal

Integration

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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 occa- sions higher prices.

Representative Wally Herger, Republican from California and subcommittee chair, called the meeting to order. He then made the statement excerpted in the following section.

Today we’re going to hear from a panel of witnesses regarding consolidation

in the health care industry.

Consolidation among hospitals, doctors, and insurance plans has

occurred for some time. I recognize that, at least in theory, consolidation can

lead to greater efficiencies and improved outcomes. Unfortunately, research

has shown that higher prices are more often the result.

Consolidation allows providers to command higher private insurance

payment rates. As one official at an Ohio hospital that is seeking to merge

with another hospital stated in an internal document obtained by the Federal

Trade Commission, such a partnership would allow them to, quote, “Stick it to

employers; that is, to continue forcing high rates on employers and insurance

companies,” close quote. Research has repeatedly shown that after hospitals

merge, the prices they charge to those with private health insurance increase

significantly. Unfortunately, research has not shown that such consolidation

leads to greater efficiencies or improved quality.

In my own state, a 2010 report conducted by the Sacramento Bee con-

cluded that one California hospital system’s large market share has allowed

them to obtain reimbursement rates with markups more than double what it

costs them to provide services.

Consolidation also enables providers to receive higher Medicare reim-

bursements by simply changing their designation on paper. While this increases

provider revenue, it results in higher cost for beneficiaries and an increased

burden on taxpayers with no discernible community benefit.

When hospitals purchase physician groups, hospitals are able to further

increase revenue by controlling referral patterns and creating a situation in which

they could pressure their physicians to perform more procedures. Similarly,

insurance plan consolidation leaves consumers with fewer coverage options

and providers with fewer carriers paying claims.

Source: Subcommittee on Health of the Committee on Ways and Means, US House of Representa- tives (2012).

EXHIBIT 4.8 Minutes from Hearing on Healthcare Consolidation Before Subcommittee on Health of US House Committee on Ways and Means, September 9, 2011

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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 benefi ts of horizontal integration become more diffi cult to achieve when the distances between facilities are large. For- profi t organizations initially expanded into states whose laws facilitated higher profi ts 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-profi t hospitals, whose missions emphasize caring for the health of a local or regional population, expand into adjoining markets. For-profi t have tended to be dispersed, while not-for-profi t 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.

Evidence suggests that for-profi t organizations have recognized the dif- fi culty of achieving horizontal integration across a widely dispersed system. For instance, HCA has begun to cluster its hospitals in regions to achieve greater effi ciencies and better integrate its facilities (Barkholz 2016). TriStar Health System, one of these regional groups, includes 13 hospitals, 57 medical group

Dispersed system

Concentrated system

EXHIBIT 4.9 Dispersed

Versus Concentrated

Health Systems

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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 asso-

ciated 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 sys-

tem 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).

Diversified Expansion Another expansion strategy is to diversify into other types of business. Diver- sification 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 manu- facturing, marketing, and technological development—in one or more com- ponents of an organization’s value chain (Hitt, Ireland, and Hoskisson 2016). This strategy seeks to leverage an organization’s assets and expand its markets

Diversification Strategic expansion into different businesses.

Related diversification Expansion into a different business that uses similar technologies (also called concentric diversification) or adds new products or services to an organization’s existing offerings (also called horizontal diversification).

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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 simi- lar 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 provid- ing 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 provid- ing hospital care, and hospital managers’ knowledge and competencies may be transferable to these areas.

Unrelated diversification (also called conglomerate or lateral diver- sification) 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, Dis- ney 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 United- Health 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 acquisition to its urgent care busi- ness 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

Unrelated (conglomerate or lateral) diversification The addition of new products or services that have little or no overlap with an organization’s current products or services and assets.

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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 bureau- cratic 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, encom- passing 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, differ- ent 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 orga- nizational 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.

Firm expansion can occur vertically, horizontally, and through diversifi- cation. Vertical expansion occurs when an organization acquires one or more of its suppliers (i.e., backward expansion) or companies to which it sells its

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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 orga- nization’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, horizon- tal 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 busi- ness 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?

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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?

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 com- bined system will include 19 hospitals, 5 of them critical-access, generat- ing 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

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S t r a t e g i c H e a l t h c a r e M a n a g e m e n t102

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?

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 recom- mending changes to meet the promised objectives. She is working diligently to achieve this but has found the task daunting. To help herself and her col- leagues 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 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 sav- ings 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?

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