Medical Device Link.

Originally Published MX November/December 2003

ADVERTISING, DISTRIBUTION, & SALES

It is important to know whether customers are sticking to purchasing commitments, for bottom-line and other reasons.

Zack Rinat and Jamie Schein

A recent survey of medical device industry companies with annual revenues of $100 million or more revealed that the greatest challenge to executing a revenue strategy well was achieving customer contract compliance (see sidebar, page 55).¹ The survey focused on revenue execution business processes—the techniques by which companies realize revenues from completed sales. It found that medical device companies are leaving millions of dollars on the table each year as a result of failing to manage contract compliance closely.

Contract compliance is a key element of revenue execution, having an immense impact on both the revenue stream and company profitability. It presents a clear area of opportunity for improvement through more rigorous management. This is especially important for medtech manufacturers because companies in this sector derive a large percentage of their revenue (some 80% of U.S. sales) from long-term contracts negotiated with customers either directly or through group purchasing organizations (GPOs). The contracts are extremely complex, often involving purchase commitments, incentive programs, and administrative fees to be paid to GPOs. This makes compliance tracking very difficult.

Figure 1. Revenue execution cycle. (click to enlarge)

In fact, survey respondents on average verified only 57% of contracts for compliance against negotiated terms. The effects of failing to manage contract compliance are broad. Companies that fail to perform compliance monitoring in this area may find themselves inadvertently deviating from the business strategies they have defined for themselves. By not holding customers to their contractual obligations, these companies can miss their target profitability and open themselves to audit exposure and legal risk.

This article explores ways that companies can tighten management of contract compliance. It discusses business processes affected by compliance monitoring, along with information systems that are available to support those functions. Focus is restricted to compliance in the context of the revenue execution cycle (see Figure 1).

Revenue Execution

The revenue execution cycle involves the device manufacturer's marketing, sales, and finance functions and, peripherally, its legal department. It comprises business processes that:

• Establish the company's pricing strategies.
• Execute pricing strategies through the generation of customer offers and sales negotiations.
• Capture terms of those negotiations in contracts.
• Fulfill the terms of contracts throughout their life cycle (for example, by applying accurate prices to orders, calculating and paying incentives such as rebates and GPO administrative fees, and effectuating annual price increases on the appropriate dates).
• Measure and analyze customers' performance against the terms of their negotiated contracts.

Figure 2. Respondents to the revenue strategy survey revealed that the approval cycle for medtech contracts is generally lengthy, averaging 33 days. Companies devote an average of 12 days of this total to obtaining internal approvals. The best-practice totals were determined by averaging the top 10% of respondents. Source: Model N Inc. (South San Francisco, CA). (click to enlarge)

Within revenue execution, there are three types of compliance. Order compliance is achieved when correct negotiated terms and prices appear on each order placed on behalf of or by a customer. The U.S. government expects compliance with the requirements of the Federal Supply Schedule (FSS), including best-price and basis-of-award tracking. The third type is customer contract compliance, the focus of this discussion.

The Importance of Contract Compliance

Tracking and managing customer compliance is the way to bring revenue execution into line with corporate revenue strategy. Negotiations with a customer may result in that customer committing itself to buy a volume of product on terms that suit the manufacturer's profitability targets (see Figure 2). However, these targets can be met only if the terms are carried out as specified—that is, if the customer fulfills its purchase commitments so that any awarded discounts and promotions are justified. Respondents to the survey collectively believe that more than one-third of all contracts (36%) are out of compliance (see Table I).

To ensure that both customer and manufacturer are carrying out the deals as they were structured, a company analyst in the finance or contract operations department should monitor actual sales operations under these contracts. Contract compliance should be monitored continually, and action taken when the analysis uncovers some deviation from commitments. Through such monitoring, a medtech manufacturer can separate profitable from unprofitable customers (see sidebar).

To minimize its financial risk, and to increase satisfaction with contractual arrangements, a device company can implement several measures. It can employ compliance forecasting to suggest additional purchases for customers falling short of their commitment toward compliance, or to recommend adjustments in pricing and incentive tiers in accordance with forecast sales.

Compliance analysis also allows the company to adjust its customers' commitment levels, along with the associated pricing structure, in order to help customers maintain compliance as planned. Finally, the manufacturer can analyze customer profitability, using the information gained from the analysis to adjust global pricing and incentive strategies.

Unfortunately, medtech companies find compliance monitoring a daunting task. Of those responding to the survey, 71% see contract compliance management as a difficult challenge, and 89% rate it a challenge of at least medium difficulty (see Table II). Thus, many companies forgo compliance monitoring completely or else restrict analysis to a relatively small portion of the customers they have under contract. Again, the survey average showed 57% of contracts monitored for compliance. Compliance with contracts that are tracked is generally checked infrequently—quarterly at best, but for some only once a year or at the time of renewal.

Lost revenue is not the only concern. Companies that do business with the government risk exposure to government audits focusing on pricing practices and FSS compliance. Even when a customer's contract complies with FSS pricing as negotiated, if the customer is in fact out of compliance with those terms, then the manufacturer may be effectively—however inadvertently—offering better prices to that customer than to the government. It is prudent for companies to set up business processes to avoid such exposure in this era of intense regulatory scrutiny.

The Challenge of Complexity

Given the complexity of compliance management, it is not surprising that medtech companies find it challenging. Proper compliance management involves tracking all commitments made by customers up front during the sales contract negotiations against the circumstances of actual sales made over the life of the contract. Commitments may be clear but nevertheless involve numerous potentially confusing conditions and incentives (see sidebar).

The effort required of analysts monitoring compliance increases with the number of customers under contract, the number of stock-keeping units (SKUs) covered by contracts, and the complexity of commitments and incentive programs. Companies that sell through both direct and indirect channels have an even greater burden, because distributor-reported sales data are not readily accessible and often must be cleansed before they can be interpreted.

Complicated customer commitments and incentive programs, more than anything else, make tracking compliance difficult. Recording and tracking commitments is never easy, but the complexity grows exponentially as companies respond to intensified competition and attempt to minimize price erosion.

Consider a scenario that any medtech manufacturer might find familiar. A customer makes a variety of purchase commitments to a vendor in exchange for better pricing and other incentives, such as rebates. The commitments involve several of the manufacturer's business units. As time passes, the customer falls short of fulfilling some of its commitments while exceeding others.

The manufacturer should be able to track a customer's performance with respect to commitments; however, often it does not know whether the customer is surpassing or failing to meet its contract performance goals. Assessing the state of compliance should be simple: an analyst matches sales data for the customer against contractual commitments, judges whether the customer is likely to fall short of meeting those commitments, and, if believing it will, alerts the account manager who then works with the customer to guide it toward compliance.

That is the theory. In reality, analysts find it difficult to collect the data necessary for analyzing compliance and to complete the assessment as just outlined. Customer purchase commitments are recorded in contracts that may be filed away or scanned into an electronic repository; in neither case are the data easy to access. The actual customer sales data are captured by the enterprise resource planning (ERP) system. Purchase commitments may comprise products offered by several of the manufacturer's business units. Even if each unit tracks compliance carefully, their separateness makes it difficult to compile a picture of the customer's overall adherence to the complete set of terms laid out in the contract.

The Challenge to Improve

Clearly, the way to begin to improve a business process is to examine the process in the light of the various roles played by participants in it. Members of the company's marketing, finance, sales, sales operations, and contract operations organizations should understand the significance of compliance monitoring and management. They should know what to monitor. They should understand how monitoring is performed and where to find the information that they need to do so.

Individuals in medtech organizations commonly do understand the importance of monitoring compliance and have set goals to, say, analyze a certain percentage of all contracts within a quarter or a year. They also have a plan for action if they should discover a customer out of compliance—typically, to notify the account representative. However, those analysts are also commonly overwhelmed by the effort required to achieve 100% coverage of contracts.

Contract administrators and financial analysts thus often turn to information technology tools for help in performing compliance monitoring. The natural first step is for individual analysts to set up personal productivity tools such as spreadsheets and databases on their own. Such tools are widely, though inconsistently, in use. Yet even so, some companies reach a point at which they start to give up compliance monitoring. They find that they have the resources only to assess each contract occasionally, or else they are compelled by their limitations to abandon monitoring some of their contracts altogether.

Compliance Management Technology

Resource-constrained companies are finding that it makes sense to invest in a more robust information system to track contract compliance. Before making such an investment, however, a prudent company measures the expected benefits of having the information system against its cost.

Return on Investment The cost of failing to track and manage compliance is significant, and it can be calculated, or at least estimated. The survey of medical device companies indicates that industry firms overall may trace 80% of their revenue to contractual customers. Respondents believe that 36% of their customers under contract are out of compliance with negotiated terms. It could reasonably be assumed that noncompliant customers are 10–20% below their committed purchase levels and that, by taking corrective action with these customers, the manufacturer should be able to recapture 10–20% of this committed, but uncollected, revenue. Under these assumptions, for every billion dollars in revenue a company generates, it leaves between $1.6 million and $6.4 million on the table. This back-of-the-envelope estimate may provide an indication of whether it is worth an in-depth internal audit to quantify more accurately the opportunity cost of a company's maintaining its current state of operations.

The investment in enterprise-class software costs a company anywhere from the low six figures into seven figures. The cost of a software solution for contract compliance management is based on the following variables:

• The number and type of contracts that will be managed within the system.
• The number and complexity of incentive programs.
• The level of customization required to adapt the system to company-specific business practices.
• The degree to which the revenue execution software will be integrated into existing information systems, such as a data warehouse or ERP system.

Even with a demonstrated return on investment, companies may choose to implement an information management solution in phases in order to spread the cost of the investment. They may first address a single area of need, such as contract development and approval, including the setup of pricing, commitments, incentives, and fees, waiting until they see benefits from phase one before adding more capabilities. In this case, once contract development and approval has been implemented and customer commitment data are being captured, the company might next phase in compliance management and begin monitoring customer purchasing performance against contractual commitments.

An Enterprisewide Solution. A company considering an enterprise-class information system to support contract compliance management should look for a system able to:

• Model the terms of each customer relationship, capturing customer commitment levels, the unit of measure (dollars spent, units of product purchased, or share of business guaranteed to the seller), pricing structures (such as tiered pricing), and incentive programs offered.
• Report customer performance against commitments automatically, on a daily, weekly, monthly, quarterly, or annual basis.
• View customer compliance at different levels: at the individual line-item commitment level for each contract, at the overall contract level, at the customer level should the customer have multiple contracts in place, or aggregated along the manufacturer's business structure to understand compliance by business unit.
• Set and manage adjustable compliance tolerance thresholds for motivating high-performance customers.
• Report compliance with group and integrated delivery network (IDN) contracts at both the individual member level and the aggregate parent level.
• Automatically notify the account manager should a projection of the customer's rate of purchases suggest that it will not meet the commitment levels for the contract.
• Prioritize customers by level of compliance.
• Identify customers who surpass commitment levels, so that the company may invest in those relationships.

In addition to providing information that enables accounts to be managed to higher revenue and profitability levels, effective contract compliance management provides insight into a complicated business process and gives it transparency. The Sarbanes-Oxley Act pertaining to corporate governance and accounting reform, and the generally increased emphasis on documenting business processes, may, however, persuade companies that improved monitoring of contract compliance is necessary regardless of the positive revenue implications.²

Conclusion

The management of contract compliance is an important and challenging element of a medtech company's business. Current needs may require only that the company track compliance with contractual commitments more diligently and regularly. Or, they may require only that analysts use spreadsheets and personal tracking tools to maintain regular compliance monitoring on an individual level. But as pricing structures and incentive programs become more complicated, the company may need to enlarge its investment in compliance management.

Any company that has established rigorous requirements for regular compliance monitoring and has exhausted the benefits that personal productivity tools offer may discover that the time has come to invest in an enterprise-class information system. The manufacturer should weigh the cost of investing in an enterprise application against likely recoverable revenue and against the risk exposure of failing otherwise to track contract compliance accurately and completely.

A system capable of automating and delivering compliance information and analysis will free analysts from the tedious process of manual information gathering and matching activities. It can eliminate exposure to government compliance risk. More important, it will provide the company's marketing, sales, and finance departments with the analytical support necessary for refining and managing price structures and incentive programs, for making maintenance of customer relationships more profitable, and for investing in the most profit-conducive customers. In turn, these efforts can increase the overall company revenue and profitability derived from contract-driven sales.

References

1. Medical/Surgical & Medical Device Industry Benchmark Survey Results (South San Francisco, CA: Model N Inc., 2003).

2. Sarbanes-Oxley Act of 2002, P.L. 107-204 (July 30, 2002).

Zack Rinat is CEO and Jamie Schein is chief marketing officer at Model N Inc. (South San Francisco, CA) a provider of software solutions for revenue execution.

Copyright ©2003 MX