CEO SUMMARY: Not since the era of commercial lab consolidation ended has such a significant trend emerged. As the three national labs eliminate service to unprofitable accounts, profound changes will occur to the market for laboratory and pathology services. How quickly this leads to improved pricing for lab testing has yet to be determined.
WITHIN THE LAB INDUSTRY, a fundamental marketplace shift is under way. As described on pages 2-6 of this issue of THE DARK REPORT, the “Three Blood Brothers,” Quest Diagnostics Inc., Laboratory Corporation of America and SmithKline Beecham Clinical Laboratories (SBCL) are taking first steps to purge unprofitable accounts or restructure test pricing.
Each of the three national laboratories is evaluating individual accounts and individual assays for profitability. Their common goal is to eliminate accounts which lose money and restructure lines of testing which fail to recover costs.
In taking this action, the three national laboratories are opening a door to improved profit margins. All commercial and hospital laboratories serving the outreach market will benefit from this situation. The reason is simple.
For ten years it was the national laboratories and their predecessors which dictated pricing levels in virtually every metropolitan market. Armed with huge test volumes and ample war chests, they offered low test prices as a way to further increase specimen volume.
During the last seven years, the national labs played a dominant role in the markets they serve. Thus, changes to their pricing practices will greatly influence local markets. As the national laboratories get serious about improving the profitability of individual accounts, then radical changes to current laboratory pricing practices will result.
“I believe that efforts by the national labs to improve profitability will help stabilize and even increase the price of lab tests in different cities around the United States.”
-Mark H. Smythe
This could be good news for independent regional laboratories and hospital laboratory outreach programs. As the national laboratories seek to improve profit margins on individual accounts, it can be expected that general price levels for diagnostic testing will begin to rise. Increased pricing will benefit all laboratories. However, there is a caveat. Whatever increases occur to test prices will be neither large nor quick.
Managed care also makes the job of the national laboratories tougher. In markets with high managed care penetration, most physicians offices will be using from two to five separate laboratories. Determining service levels and pricing for physician accounts which refer a limited number of specimens becomes more complicated because of these managed care relationships.
Despite such challenges, the three national laboratories will continue their attempts to increase the profit margins of individual accounts. Price stabilization will take several years to work its way through the marketplace. Recent events in California illustrate this. During the previous 18 months, both Unilab and Physicians Clinical Laboratories (PCL) declared their commitment to maintaining adequate pricing. Despite these public pronouncements, competitors tell THE DARK REPORT that both labs recently inked managed care contracts at cap rates under 50¢ PMPM.
As the Unilab and PCL examples demonstrate, commercial laboratory executives must unlearn their habit of marginal cost pricing for new business before price stabilization occurs. It is important for competitors to understand how deeply entrenched such habits are.
During the last ten years, it was the major commercial laboratories which pursued specimen and revenue growth through highly discounted pricing. Whether offering sizable discounts from client bill and patient bill fee schedules, or contracting services at capitated rates, the national laboratories cut test prices to rock bottom levels.
“The popular wisdom among commercial lab executives was that their large regional labs produced testing at such a low cost that they could still earn profits at cutthroat price levels,” stated Bernie Ness, of B.J. Ness Consulting Group in Toledo, Ohio. Ness served as national sales or marketing director for several large laboratories. He currently provides contract sales and marketing management services for hospital laboratory outreach programs.
“The other popular misconception was the impact of incremental specimens on the fixed cost/marginal cost structure of the laboratory,” continued Ness. “These same commercial laboratory executives believed that incremental test volume, priced at marginal cost, would use up excess capacity and drive the average cost per test down.”
“We all bought into that,” said Ness. “As a result, laboratories permitted their sales reps to solicit business at any price necessary to bring tests through the door. Most of the time, the profitability of the individual account was ignored.”
Cytology, Anatomic Pathology Undergoing Profit Scrutiny
Further changes to marketplace pricing will be visible in the areas of cytology and anatomic pathology. As reported last year in THE DARK REPORT (See April 8, 1996), the national laboratories know that cytology is a money-loser.
Pap smears illustrate the problem perfectly. Years ago, commercial labs priced Pap smears at marginal cost in order to get the OB/GYN’s other testing. Today the labs calculate their full cost at about $15, but they average only $7 in reimbursement. With each of the major labs doing 5 million Pap Smears per year, that works out to annual losses of $40 million just on Pap testing. For that reason, the national labs want to either reprice Pap Smears or exit this segment of the business.
The story is similar with anatomic pathology. The national laboratories consider AP specimens as outside their core competency. Much of their existing AP work will be released to other providers in the immediate future. Of the three, SmithKline Beecham Clinical Laboratories seems to be the most aggressive at restructuring their anatomic pathology arrangements.
Destructive Test Pricing
Mark H. Smythe, Principal of Management Mentors in Wilsonville, Oregon, pointed out another factor which contributed to destructive test pricing. “You had a situation where management was willing to fill excess capacity with specimens priced at marginal cost. That was tied into a sales compensation plan which paid the sales reps a commission calculated against net revenue. Therefore, sales reps were paid bonuses to bring in new accounts which lost money for the laboratory! No one in the system had an incentive to monitor the profitability of individual accounts.
“As a result, laboratories ended up with lots of new accounts which actually lost money from day one of service,” explained Smythe. “In those days laboratories showed overall profits of 20% to 35%, so no one cared. That’s changed in the last three years as reimbursement for diagnostic tests decreased.”
Good For Lab Industry
“I think it is a good thing for the laboratory industry that the national labs finally want to emphasize profit per individual account, not the net revenues,” he continued. “This is the first evidence I’ve seen of rational business decisions concerning money-losing client accounts. Every laboratory should want to look at profitability per individual account. The laboratory industry must learn that it is an acceptable business practice to offer testing only at prices that fully cover costs and result in a profit to the laboratory.”
Smythe’s comments are on target. Competitors of the major laboratories will need to adopt similar management programs. The potential gains in operating profit are too great to ignore. In addition, the national laboratories will gain a competitive advantage with this effort if competing laboratories do not respond.
THE DARK REPORT recommends that both independent laboratories and hospital laboratory outreach programs begin with three management initiatives. First, each laboratory should develop accurate “cost per account” and “operating profit per account” measures. This provides the information baseline necessary to evaluate individual accounts.
Learn To Rank Accounts
Second, each laboratory should learn how to rank their client accounts by revenue, operating profit and service costs. As explained on pages 10-14 of this issue, such rankings highlight money-losing accounts and help management make easy decisions about the proper course of action.
Third, each laboratory needs to proactively use the information developed in the first two steps. Like Quest, they should act decisively to restructure money-losing accounts. Although most laboratory managers do not like to give clients “bad” news, implementation is the essential step in this process.
Managing with the goal of increasing operating profit is a new development for the clinical laboratory industry. As it becomes widespread, it will be a major factor in helping clinical laboratories achieve financial stability.