Background
Dr. Eileen OâToole bought the assets of the old âOK CareHospitalâ in 2010 believing the former company had gone out ofbusiness because of poor management rather then issues relating tomarket demand. The new âExtra Care Hospitalâ was a 24/7 emergencyhospital and the only one in the County. The closest direct rivalwas over 45 minutes in any direction. With many 80 hour weeks andthe help of friends, the new Extra Care Hospital was building astrong reputation in the community helping to overcome some of thenegative impact of one of the worst recessions in US history.
Dr. OâToole immediately faced an unexpected issue of equipmentmaintenance/failure. While the new company had bought all theassets of the former company, this did not include the warranties,guaranties and service agreements that the former company hadreceived when the equipment was originally purchased.
Almost all clients/patients require blood work in earlydiagnosis and treatment. To perform these tests the company owned athree year old âItechâ Blood Analyzer that had recently begunacting up. It had been down for two days and the less sophisticatedback-up machine was showing signs of failure. If a new machine wasnot acquired or the current one repaired, the hospital would beunable to perform basic diagnoses.
Blood Analyzer Situation
When Dr. OâToole called Itech to have the machine repaired, shelearned that there was neither a service agreement nor a warranty.Furthermore, the software on her machines was out of date.
Before signing and paying for a new service agreement, Dr.OâToole decided to contact other equipment distributors about theirmachines. Dr. OâToole contacted a competitor, âHesterâ, andinquired about what kind of deal Hester could offer on a newmachine. The next day, a âsampleâ Hester DC-70 blood analyzerarrived for Extra Care to use while their Itech machine wasdown.
The hospital staff were trained the same day and were excitedlytalking about the new Hester machine when Dr. OâToole came in laterthat day.
Razors and Blades
In the medical / healthcare industry many procedures requirespecial equipment and âconsumablesâ that would only fit specificmachines. For example, a Hester blood analyzer required specificcartridges that uniquely fit its machine and contained specialchemical formulas that in conjunction with the analyzer actuallyperformed the various tests on the blood sample. Itech sold adifferent cartridge that only fit its analyzers. Thus the inventoryof âpanelsâ or cartridges that Extra Care possessed only workedwith Itech machines. Needless to say, both Itech and Hester madesubstantial profits on their consumable business. Once theirmachine was purchased, the customer had no choice on their vendorfor the related consumables. Much like once you buy a particularrazor you could only buy blades from the same company.
Many industries use this âRazor and bladeâ or ârecurringrevenueâ business model. For example, Ink Jet printers are oftenpractically given away so as to build the demand for the highlyprofitable ink cartridges.
Hesterâs Blood Analyzer cartridges were less expensive then wereItechâs, as the volume of usage grows with the business, the gap inoperating cost of the two machines grows as well.
Itech Estimated Costs
Cost to purchase: $ 25,999 (in year 8)
Life Expectancy: 10 years
Annual Service Agreement: $1,300
Cost of Annual Calibration (varies with use): $400 (currentyear)
Estimated cost of consumables (varies with volume/usage):$15,114 (Year 1)
Cost to install new linking software: $500 (waved)
One time credits/discount awarded for other Itech consumables:$2,000
Extra-Care Hospital currently earns $50,000/yr in Blood AnalysisRevenue
Hester Estimated Costs
Cost to purchase: $ 16,694 (the price after the 20% discount
Life Expectancy: 10 years ï¡ Annual Service Agreement: $750
Cost of Annual Calibration (varies with use): $175 (currentyear)
Estimated cost of consumables (varies with volume/usage):$13,434 (current year)
Cost to install new linking software: feature not available
Extra-Care Hospital currently earns $50,000/yr in Blood AnalysisRevenue
The Alternatives
Option 1 â Stay with Itech 3 year old machine: Itech will giveExtra Care a one time $2000 of credits for the purchase ofconsumables over the next 2 years and will provide two newservices: (1) integration into the companyâs hospital managementsoftware to automatically link blood tests with client records andinvoices thus eliminating the need for staff to enter the chargesthemselves, and (2) a link to Itech laboratories allowing automatedsoftware updates and Itech lab results to be downloaded to companyrecords. Additionally, Itech will bring the current Extra Caremachine up to current specs or replace it with one that is. Theblood analyzer needs to be calibrated at a frequency related tousage. High use requires more frequent calibration. Itech willreduce the price of the chemicals needed for the calibrationprocess.
Option 2 â Purchase the Hester DC-70 ï¡ Hester has reduced thepurchase price by over 20%. Hesterâs machine has a lowercost of calibration. Hesterâs machine uses lower costconsumables.
Extra Care Hospital growth is expected to grow at about 10-15%per year with a direct 10-15% growth in blood tests.
Questions
1. Dr. OâToole wonders if she should take this opportunity toswitch from the current 3 year old Itech blood analyzer to the newHester DC-70. What would be the financial implications over thenext 10 years?
2. Also, she wonders what the operational considerations mightbe with regards to staff training, dependability, etc.
3. Dr. OâToole read recently that, on average, hospital staffforgets to bill for about 15-20% of the services provided. If herstaff was similar to the industry norm then would the Itechsoftware link to the Extra Care Hospital management software leadto an increase in revenue? If so, how would that 15-20% increaseaffect her decision?
4. Dr. OâToole wonders what other factors should be included inher analysis?
Financial Assumptions
10 year analysis period
Cost of capital (discount rate): Low risk investments: 10%Medium risk investments: 15% New ventures other high risk: 25%
Replace Itech in year 8 for $25,999
Hester machines last for 10 years
No impact for inflation, work in constant dollars
Cost of calibration and consumables increase with revenueincreases.
No increases to cost of annual service contract
Background
Dr. Eileen OâToole bought the assets of the old âOK CareHospitalâ in 2010 believing the former company had gone out ofbusiness because of poor management rather then issues relating tomarket demand. The new âExtra Care Hospitalâ was a 24/7 emergencyhospital and the only one in the County. The closest direct rivalwas over 45 minutes in any direction. With many 80 hour weeks andthe help of friends, the new Extra Care Hospital was building astrong reputation in the community helping to overcome some of thenegative impact of one of the worst recessions in US history.
Dr. OâToole immediately faced an unexpected issue of equipmentmaintenance/failure. While the new company had bought all theassets of the former company, this did not include the warranties,guaranties and service agreements that the former company hadreceived when the equipment was originally purchased.
Almost all clients/patients require blood work in earlydiagnosis and treatment. To perform these tests the company owned athree year old âItechâ Blood Analyzer that had recently begunacting up. It had been down for two days and the less sophisticatedback-up machine was showing signs of failure. If a new machine wasnot acquired or the current one repaired, the hospital would beunable to perform basic diagnoses.
Blood Analyzer Situation
When Dr. OâToole called Itech to have the machine repaired, shelearned that there was neither a service agreement nor a warranty.Furthermore, the software on her machines was out of date.
Before signing and paying for a new service agreement, Dr.OâToole decided to contact other equipment distributors about theirmachines. Dr. OâToole contacted a competitor, âHesterâ, andinquired about what kind of deal Hester could offer on a newmachine. The next day, a âsampleâ Hester DC-70 blood analyzerarrived for Extra Care to use while their Itech machine wasdown.
The hospital staff were trained the same day and were excitedlytalking about the new Hester machine when Dr. OâToole came in laterthat day.
Razors and Blades
In the medical / healthcare industry many procedures requirespecial equipment and âconsumablesâ that would only fit specificmachines. For example, a Hester blood analyzer required specificcartridges that uniquely fit its machine and contained specialchemical formulas that in conjunction with the analyzer actuallyperformed the various tests on the blood sample. Itech sold adifferent cartridge that only fit its analyzers. Thus the inventoryof âpanelsâ or cartridges that Extra Care possessed only workedwith Itech machines. Needless to say, both Itech and Hester madesubstantial profits on their consumable business. Once theirmachine was purchased, the customer had no choice on their vendorfor the related consumables. Much like once you buy a particularrazor you could only buy blades from the same company.
Many industries use this âRazor and bladeâ or ârecurringrevenueâ business model. For example, Ink Jet printers are oftenpractically given away so as to build the demand for the highlyprofitable ink cartridges.
Hesterâs Blood Analyzer cartridges were less expensive then wereItechâs, as the volume of usage grows with the business, the gap inoperating cost of the two machines grows as well.
Itech Estimated Costs
Cost to purchase: $ 25,999 (in year 8)
Life Expectancy: 10 years
Annual Service Agreement: $1,300
Cost of Annual Calibration (varies with use): $400 (currentyear)
Estimated cost of consumables (varies with volume/usage):$15,114 (Year 1)
Cost to install new linking software: $500 (waved)
One time credits/discount awarded for other Itech consumables:$2,000
Extra-Care Hospital currently earns $50,000/yr in Blood AnalysisRevenue
Hester Estimated Costs
Cost to purchase: $ 16,694 (the price after the 20% discount
Life Expectancy: 10 years ï¡ Annual Service Agreement: $750
Cost of Annual Calibration (varies with use): $175 (currentyear)
Estimated cost of consumables (varies with volume/usage):$13,434 (current year)
Cost to install new linking software: feature not available
Extra-Care Hospital currently earns $50,000/yr in Blood AnalysisRevenue
The Alternatives
Option 1 â Stay with Itech 3 year old machine: Itech will giveExtra Care a one time $2000 of credits for the purchase ofconsumables over the next 2 years and will provide two newservices: (1) integration into the companyâs hospital managementsoftware to automatically link blood tests with client records andinvoices thus eliminating the need for staff to enter the chargesthemselves, and (2) a link to Itech laboratories allowing automatedsoftware updates and Itech lab results to be downloaded to companyrecords. Additionally, Itech will bring the current Extra Caremachine up to current specs or replace it with one that is. Theblood analyzer needs to be calibrated at a frequency related tousage. High use requires more frequent calibration. Itech willreduce the price of the chemicals needed for the calibrationprocess.
Option 2 â Purchase the Hester DC-70 ï¡ Hester has reduced thepurchase price by over 20%. Hesterâs machine has a lowercost of calibration. Hesterâs machine uses lower costconsumables.
Extra Care Hospital growth is expected to grow at about 10-15%per year with a direct 10-15% growth in blood tests.
Questions
1. Dr. OâToole wonders if she should take this opportunity toswitch from the current 3 year old Itech blood analyzer to the newHester DC-70. What would be the financial implications over thenext 10 years?
2. Also, she wonders what the operational considerations mightbe with regards to staff training, dependability, etc.
3. Dr. OâToole read recently that, on average, hospital staffforgets to bill for about 15-20% of the services provided. If herstaff was similar to the industry norm then would the Itechsoftware link to the Extra Care Hospital management software leadto an increase in revenue? If so, how would that 15-20% increaseaffect her decision?
4. Dr. OâToole wonders what other factors should be included inher analysis?
Financial Assumptions
10 year analysis period
Cost of capital (discount rate): Low risk investments: 10%Medium risk investments: 15% New ventures other high risk: 25%
Replace Itech in year 8 for $25,999
Hester machines last for 10 years
No impact for inflation, work in constant dollars
Cost of calibration and consumables increase with revenueincreases.
No increases to cost of annual service contract
