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CHAPTER

45

BUSINESS MODELS AND COMMON STRATEGIES

Learning Objectives

After reading this chapter, you will

• understand the concept and use of business models; • be able to describe how business models vary in healthcare and how

business models may provide a competitive advantage; • comprehend generic strategies and their application to healthcare; • be familiar with strategies for differentiation in healthcare, including

focused factories; and • recognize the advantages and disadvantages of first-mover strategy.

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

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

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

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

C o p y r i g h t 2 0 1 8 . H e a l t h A d m i n i s t r a t i o n P r e s s .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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Strategic Healthcare Management46

Organizations, even direct competitors, may form and pursue strategies in vastly different ways. This chapter discusses how organizations pro- duce value for customers and how their structure, processes, and strate-

gies influence their success. As discussed in chapter 6, success is relative to the values, mission, and vision of an organization. For for-profit organizations, sustained profits may signify competitive advantage and success. Not-for-profit organizations, however, may recognize other achievements as success. There- fore, the desired business outcome must dictate the business model of an organization.

Business Models

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

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

New business models do not guarantee success and are often fraught with peril. For example, the US government has encouraged new organizations to experiment with distinct business models. Some experiments, like the Pioneer

Business model The underlying structure of an organization; the means through which an organization creates and delivers value to its customers and earns revenues.

Isomorphic The tendency of organizations in a market to become similar in form and structure, offer similar products, and adopt similar practices over time.

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Chapter 3: Business Models and Common Strategies 47

Accountable Care Organization (ACO) Model program, created accountable care organizations that would provide savings (see exhibit 3.1). However, while many healthcare organizations initially welcomed the new approaches, most seemingly failed and abandoned the program.

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

Customer Value Organizations seek to produce what customers value. This perceived value consists of a range of products and services, a degree of customization, ease of availability and access, and the trade-off between cost and quality. Dissimi- lar business models may provide a different type of value to customers (e.g., Amazon vs. Walmart). Customers have differing desires and needs. Some may value ease of access and availability, others want low cost, yet others seek high quality. An innovative business model aims to address the needs and desires of

In December 2011, the Centers for Medicare & Medicaid Services (CMS) signed agreements with 32 organizations to participate in its Pioneer ACO Model. According to CMS, the model was “designed for health care organi- zations and providers that are already experienced in coordinating care for patients across care settings. It will allow these provider groups to move more rapidly from a shared savings payment model to a population-based payment model on a track consistent with, but separate from, the Medicare Shared Savings Program. And it is designed to work in coordination with private payers by aligning provider incentives, which will improve quality and health outcomes for patients across the ACO, and achieve cost savings for Medicare, employers and patients.”

Moving to a new business model remains challenging. Five years later, only 9 of the 32 continued with the model program. The inability to accrue savings and increasing financial risk, coupled with the model’s strategic, operational, and information technology challenges, were huge departures from these organizations’ original business models, and few could success- fully adapt. ACOs are much more complex and require significantly greater cooperation and coordination among healthcare facilities and professionals. CMS also required the health systems to track too many quality metrics, and organizations also found it difficult to attract and retain patients.

EXHIBIT 3.1 The Challenge of Business Model Change: ACOs

Source: CMS (2017a), Advisory Board (2014), Evans (2015), Leventhal (2015).

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Strategic Healthcare Management48

all consumers or just a segment. The value provided by successful organizations reflects their mission and vision and differentiates them from competitors.

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

• What value is provided to the customer segments served? • What customer problems does the organization’s product or service

solve? • What customer needs does the product or service satisfy? What needs

are not satisfied? • Does the value created by the organization support its mission and

vision? • How does this value distinguish the organization from competitors?

Inputs The type and mix of resources organizations use to provide a product or ser- vice make up the inputs component of the business model. Resources include personnel, materials, and equipment. Organizations choose a mix of automated equipment and personal interaction and select types and quantities of materi- als and supplies according to the value they wish to deliver. Some businesses choose to hire personnel to answer phones and greet customers, while others automate customer interactions. Other inputs include organizational core competencies—a critical source of competitive advantage—and strategic assets, such as facilities, equipment, location, patents, networks, and partnerships. For

Customer value The perceived benefits of a product or service. Consumers may find value in many aspects of products and services, including range and type, degree of customization, ease of availability and access, and the trade-off between quality and cost.

Inputs The combination, type, and mix of resources an organization uses to provide a product or service, such as personnel; materials; and strategic assets such as facilities, equipment, location, patents, networks, and partnerships.

Value to Customers

Revenue Generation What financial mechanism is used to generate revenues to sustain the provision of the product or service?

Processes

Inputs What inputs distinguish the organization in terms of the combination of resources it uses to produce the product or service?

What value is created for customers in terms of product quality, cost, or access and availability?

What processes are used to create and provide the product or service?

EXHIBIT 3.2 The Four

Components of Business

Models

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Chapter 3: Business Models and Common Strategies 49

instance, many hospitals have begun using hospitalists and intensivists as an input. An organization may change its inputs over time; for example, innova- tions in technology often trigger a change of inputs.

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

• What key inputs directly contribute to the value of the product or service?

• Are any inputs inconsequential? Could the organization lower costs or increase value if it changed any of its inputs?

• Are there new technologies that the organization should consider adding as new inputs?

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

The following questions can be used to examine processes:

• How do the organization’s processes differ from those of its competitors?

• Which processes add value, and which do not? • Could processes be redesigned to eliminate unneeded steps? • Do processes unnecessarily delay final outputs? • Can processes be automated? • Is there new technology that could streamline existing processes?

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

Process A series of steps that transforms inputs into products or services (outputs). Processes usually are established to organize functions and interface with external entities.

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Strategic Healthcare Management50

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

• In what ways does the organization generate revenues? • If the organization generates revenues in multiple ways, which are the

most important? Which will be the most important in the future? • Could new technology significantly affect the ways the organization

generates revenues? • Does the organization generate enough revenues to achieve its mission?

If not, what needs to occur?

Business Model Innovation and Adaptation

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

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

Nonetheless, business models must change when the external environ- ment substantially shifts and organizations must seek different ways to compete and survive. For example, most consider the traditional pharmaceutical business model unsustainable. It consists of large, vertically integrated organizations with large sales forces promoting drugs created from small-molecule compounds (Miller 2008; Tyson 2015). As detailed in exhibit 3.3, experts predict that by 2020, the business model of successful pharmaceutical companies will evolve

Profitability The degree to which the revenues generated by a product or service exceed the costs of producing that product or service.

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Chapter 3: Business Models and Common Strategies 51

into a collaborative network of firms that help manage patient outcomes through a so-called medicine-plus approach.

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

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

Chorus is a small group of experienced drug developers focused on establishing

clinical proof-of-concept (PoC) as quickly and inexpensively as possible. Chorus

designs and manages drug development plans on new chemical entities. . . .

Component Traditional Pharmaceutical

Business Model Suggested 2020

Pharmaceutical Business Model

Value Vendor of medicines to physi- cians and patients

Managing patient outcomes through pharmaceuticals

Inputs Large, vertically integrated organizations, including research, clinical trials, marketing, and manufacturing based in Western countries

Nonownership agreements with universities, hospitals, technol- ogy providers, and organizations offering such services as compli- ance programs, stress manage- ment, nutrition, physiotherapy, exercise, and health screenings; more research to migrate to Asia

Processes Discovery of small-molecule compounds, few of which are approved for sale; sales direct to primary care physicians and patients focused on primary care

Collaboration with many firms to provide offerings of medicine-plus packages; sale through insurance and regulated mechanisms

Profits Profits generated for and by individual organizations; most profits obtained from sale of blockbuster drugs to pharma- cies and physicians

Profits generated by joint com- pany efforts to achieve health outcomes from sales through governmental payers, which will determine which medicines are prescribed

Source: Data from PricewaterhouseCoopers (2009).

EXHIBIT 3.3 The Changing Pharmaceutical Business Model

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Strategic Healthcare Management52

The Chorus approach alters the balance of risk across the portfolio and

enables clinical study of many more candidates at a fraction of the time and cost

typically associated with traditional drug development. . . .

Chorus teamed up with an external IT solutions partner to develop a cus-

tom, web-based enterprise management system called Voice. Voice enables small,

virtual, global drug development teams to securely collaborate on all aspects of a

project—including broad planning, detailed implementation, document develop-

ment and approvals—and provides administrative solutions to numerous internal

portfolio challenges. . . .

The Chorus business model is built on the foundation of flexible outsource

staffing through TPPs [third-party providers], offsetting fixed internal costs. Tactical

outsourcing such as staff augmentation, functional outsourcing, and full-service

outsourcing is an increasingly common method used by most pharmaceutical and

biotech companies to reduce R&D fixed costs. Rather than dealing with inefficient

outsource models, such as relying on a small exclusive group of providers, Chorus

recognizes the need to leverage a wider group of external global implementation

expertise to deliver multifaceted services. This external network provides Chorus

with the flexibility to match each project’s unique needs and strategic integration

requirements to a wider array of global and niche TPPs. To support this more inclusive

model, Chorus developed and maintains a large and growing network of providers to

support each function. The Chorus external network continues to grow and currently

consists of more than 200 global providers.

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

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

US Healthcare Business Model

As illustrated in exhibit 3.4, healthcare in the United States conventionally has offered fragmented treatment of illness focused on acute care at the expense of primary and preventive care (Marvasti and Stafford 2012; Shih et al. 2008). Physicians and hospitals have been primarily engaged in curing disease on an

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Chapter 3: Business Models and Common Strategies 53

individual basis. Little coordination has occurred among healthcare providers, instigating the delivery of duplicate services and driving up costs. American hospitals have become some of the most costly structures ever built and, as the hubs of healthcare provision, have promoted high-cost acute care medicine (Perkins 2010). Yet duplication and the high cost structure have increased hospitals’ profits (Trinh, Begun, and Luke 2008). Insurance companies have taken the role of middleman, receiving monies from businesses and negotiating contracts with providers for healthcare services. The more services providers deliver, the more money they make.

From a public and consumer perspective, this business model has not produced consistent value. Despite spending more than double per capita on healthcare than any other system in the world, the US healthcare system per- forms relatively poorly in terms of mortality and morbidity outcomes. Despite the high spending, Americans had relatively poor health outcomes, with shorter life expectancy and more chronic disease. Consistently, the US healthcare

Component Traditional Healthcare

Business Model Changing Healthcare

Business Model

Value Treatment of acute care problems; focus on curative outcomes

Improving population health; focus on preventive medicine and reduction of disease

Inputs Fragmented system in which many different providers often compete with each other; sepa- rate ownership of physicians, insurance companies, and hospitals

Greater integration and com- munication among delivery systems focused on the health of a population; information systems needed to capture and manage key data

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