The shift from vertical to networked integration - part 1

The trend of the 1990s in health care has been to jump onto the vertical integration bandwagon, epitomized by a rash of mergers and acquisitions in the pursuit of economies of scale and elimination of redundancies. Worshipping at the alter of cost cutting, the focus of first generation vertical integration has been to create delivery systems that contain costs while maintaining quality-all worthy goals.

Not new to other industries

Vertical integration. while relatively new to health care, is a well-traveled route for other industries. Characterized by its monolithic, hierarchical. centralized control systems, vertical integration has typically been the first step in consolidating businesses that have been traditionally fragmented, such as health care. Examples in other industries include:

Steel: Vertical integration began in the steel industry in the late 1800s with ownership of every step of production from the mine to the railroads. to transport the ore to the smelters to the steel production plants. While highly successful for many years, smaller, more decentralized steel producers virtually wiped out the vertical integrators ten years ago.

Autos: General Motors made its name through vertical integration in the 1920s, and Ford not much later. Ford is beginning to "deintegrate now, and Chrysler did it in the 1980s. Ford is far more profitable than General Motors on a car by car basis, and Chrysler even more so--making better cars and more money. However, General Motors has been slower to learn, and paying a very high penalty for the lesson--just barely eking out a profit on autos, while a highly networked competitor such as Chrysler has earned billions.

Computers: IBM succeeded with vertical integration for many years, building to a crescendo in 1989 with $60 billion in sales and 420,000 employees. But IBM got its wings clipped by more agile competitors that were highly networked with strategic alliances focused on providing unique core competencies. After losing billions in the early 90s, IBM has shifted from a command and control vertical integration to a service-based networked integration, shedding employees, and gaining back revenue. Its revenues have increased by $10 billion, profits have skyrocketed, while the workforce was cut by a third.

What's wrong with vertical integration?

The problem is not with integration, per se, it's with the vertical aspects.

It's important to know how our thoughts have shifted about integration. In heavy capital industries (steel, autos, electronics, insurance, and health care), the prevailing ideas have been to control through command systems that were originally designed for the Roman Legions and the Catholic Church. While these worked well in the past, in a fast moving, technologically driven world, these systems have proved to be inefficient.

In health care, doctors tended to have their own command and control systems as small independent practices. When scaled to the size of a hospital, the command and control system worked well until too much government bureaucracy, medical control, proliferating insurance red tape, and technology pushed this paradigm to its limits.

Now, looking to gain efficiencies and economies of scale, many of the large health care acquisitions are attempting to squeeze more and more out of a dying paradigm. While broad-based, first-generation vertical integration-with its attendant command and control systems-will work for the short term (because of the tremendous inefficiencies and overcapacity in the health care system-some claim 50 to 60 percent of all work is non-value added), it is now being shown that there are far more efficient and effective methods of delivering health care.

Deintegration, outsourcing, and networked integration

As health care shifts into this first stage of integration, in industry after industry faced with intense competition, hierarchical vertical integration is being replaced by the next stage of progression: outsourcing core competencies. This process of downsizing and outsourcing is called deintegration (deintegration should not be confused with disintegration, a totally different process). What's more, deintegration is simply a transitional state--it will not be permanent--now being replaced by a more advanced phenomenon: networked integration, sometimes referred to as the virtual organization or the extended enterprise (see figure 1).

Networked integration is far more efficient and powerful as a generator of value to customers, shareholders, and employees. It rethinks the value chain and embraces shared risks and rewards, as well as an alignment of interests through strategic alliances. Networked integration focuses on delivering unique core competencies, supported by enabling competencies that are not indigenous to health care, such as computing, digital imaging, and telecommunications. The result of networked integration has been the achievement of breakthrough strategies that redesign complete delivery processes and value chains.

Value generated by networked integration

As industries have transitioned to the networked structures, the results have shown significant advantage over the slower, more cumbersome vertically integrated competitors:

Autos: General Motors, using the hierarchical vertically-integrated method, takes $5 billion and five years to design a new car, whereas network-integrated competitors, such as Chrysler and Toyota, can design a car for a third of the cost, and in less than half the time.

Retailing: Similar results prevail in other industries. In retailing, network-integrated companies such as WalMart or the many retail franchises (i.e., McDonald's, Radio Shack, etc.) are growing at a galloping rate, while their more traditionally vertically integrated and deintegrated competitors, such as Sears and K-Mart, can't keep pace.

Insurance: Comparable results have been achieved by shifting from a bureaucratic command and control hierarchy to a networked integration structure, with a 30 percent reduction in non-value added work, boosting profits and customer satisfaction by a similar amount.

The difficulty is "control"

Vertically integrated hierarchies have become overburdened with too much control. GM's Oldsmobile General Manager John Rock stated the difficulty in shifting from such a system to a team-oriented organization when he said: "We still are working to change the attitude of many middle managers....many of them are from the old command and control school," who are unwilling to give up their traditional areas of power within the corporation.

Cost squeezing is the usual tactic of the command-and-control, vertically-integrated corporation. The classic example is General Motor's former chief of procurement, who was notable for squeezing his vendors unmercifully. While credited with saving $2 billion in supplier costs, his actions so fouled up the supply chain in the new Cavalier plant that it cost GM more than $2 billion in lost revenues because of delivery delays, poor quality, and inabilities of the new suppliers to produce components necessary to run the operations.

Vertical behemoths operate at a higher-cost level than the more streamlined networked organizations. In the mega-acquisition of HCA by Columbia Healthcare, the goal is to cut out more than $100 million in operating costs by slicing out duplicative administration, facilities, and services. However, this will take a lot of squeezing. For example, the cost structure of an HCA hospital in Atlanta necessitated charges that were 41 percent above the national average.[1]

Justification of capital investment

Through massive acquisitions, first generation vertical integration carries along a heavy burden of capital expenses, which require mammoth cost cutting to feed investors hungry for their returns. In a race to cut costs, the verticals engage in squeezing vendors harder and harder, thereby commoditizing the supply base. When one considers that the "vendors" are now doctors, it is easy to understand the physician's general dissatisfaction with the state of the industry. Capital investment causes justification of itself, not reform, re-engineering, or regeneration.

In a further effort to control costs, vertically integrated bureaucracies are also noted for excessive reporting systems. The emphasis by health care to engage in external utilization review (UR) is an effort to wring out excesses in the system. But it hasn't produced much benefit to the overall system, adding significant extra time to primary care provider's already pressured schedules and adding millions in costs to maintain the control systems in place.[2] When the draconian controls do not cut costs sufficiently, the natural reactions are to put in more controls, send in the auditing team, and tighten the reins.

The trend toward deintegration is already evident. Kaiser Permanente, a vertically integrated organization, is growing at only six percent annually. Others verticals, such as HCA/Columbia, can maintain high growth rates only through acquisition. Contrast this with the 20 to 30 percent growth rates of deintegrated competitors such as United Healthcare Corpration and PacifiCare.

Dying paradigm

The fundamental problem is that the health care system is misaligned: Doctors, hospitals. insurers, and patients are not pulling in the same direction. Vertical integration fails to solve the basic problem: Purchasers want to pay less, and providers have excess capacity to provide more. Once the redundancies and overcapacities are driven out of health care, there is nowhere to go except squeeze vendors, insurers, and customers. Organizations in this situation fail to heed the signs of a dying paradigm:

When great intentions yield mediocre results, when the tried-and-true ceases to work, when ever attempt to fix things is met with frustration and failure.... then perhaps the design has reached its limits, and the paradigm is ready to shift. Opportunity is present: creative vision is called for, and bold action in new dimensions is the nature of things....--Robert Porter Lynch

Making the shift to networked integration

While health care is experiencing the next wave of deintegration with a realignment of risks based on capitation, it is only a transitionary step to what lies beyond--the more synergistic, systems-oriented, networked integration. We need to create a system that is market driven, medically directed, patient-centered, payer friendly, simple to operate, interconnected, cross functionally delivered, and aligned for the same "win."

Achieving this goal will require overcoming a number of shibboleths. Fear of losing control, creating accountability, overhauling the entire value chain, and redesigning the system of incentives are daunting tasks to many. However, as evidenced by Mullikin Medical Centers and Cascade Healthcare Alliance, this shift is very possible, and can produce outstanding results: They have redesigned the value chain, sought out locations near the customers, become owned and directed by physicians, and accepted risk bearing as a mechanism to control costs.

At the core of the shift, however, will be a clear transition away from a hospital-centered delivery system. Our heavy capital investments in hospitals create an "edifice" complex that keeps us trapped in the old paradigm.

Much of the difficulty in making the shift also lies in our lack of understanding of what networked integration means. First, what networked integration is not: It is not hierarchical, not unilateral, not fragmented, not component focused, nor is it centrally owned and controlled (see figure 2).

In a network, each "partner" aligns on a common value proposition, shares risks and rewards, and aims not at satisfying an intermediate customer (e.g. laboratory satisfying physician) but at looking through the value chain to the ultimate customer--the patient-and flexibly teaming with other specialists to deliver the most potent, curative-preventative mix of desired products, services, and systems in the right order, fast, and as inexpensively as possible.

Health care management will be challenged to shift its thinking dramatically. When top management in a vertically oriented company looks at the networked organization. it seems chaotic or political, with no one in control. While this is not the case, the feeling of loss of command and control causes an uneasiness that holds back many executives and physicians from making the move. In contrast, the networked organization is led by a more coordinative, strategic, and visionary form of leadership that represents coaching more than leading an army in combat.

What is needed to be successful?

As the networked delivery system emerges in health care, it will have a number of characteristics that give its cooperative nature a powerful competitive edge:

* Strategic vision and value propositions, which create real breakthroughs in performance by all participants in the network.

* Value chain redesign, which eliminates non-value added work, outsources non-core competencies, and creates alliances for non-specialized core processes (see figure 3).

* Flexibility to shift with changing needs without oppressive hierarchies and vertical structures.

* Services provided by cross-functional teams (nurses and physicians first, then joined by professionals from nutrition, mental health, physical therapy, etc.) addressing root systemic causes of ill health and aiming at wellness.

* Enabling architectures for information, organization, and human resources, which encourage paperless record-keeping, team coordination, and multi-skilled care providers focused on team performance.

* System-wide reward structures that give all the participants-medical professionals, payers, and patients--incentives to work together to focus on wellness not illness. Similarly, sharing of risk by each of the parties is equally important to make sure everyone has some "skin in the game."

* Shared decision-making and control, which comes from the realization that extraordinary value can be created not by unilateral control or by giving up control, but by enjoined and aligned control.

While capitation has invoked a shift from vertical integration to deintegration, the endgame is not capitation but rather a further stage of networked integration with a true alignment of interests across the spectrum from client through provider to payer.

Enterprise transformation is an essential health care priority. Designing the networked organization begins with a total reassessment of how value will be created in the health care enterprise and a commitment to achieve real breakthroughs in performance.

Referenees

[1.] Sommers, Paul A. "Preparing for 2000 and Beyond Through Physician Group, Hospital, and Health Plan Integration," Group Practice Journal, November/December 1994, pages 38-43. [2.] Goldstein, Douglas E. Alliances: Strategies for Building Integrated Delivery Systems, Aspen Publishers, 1995.

Robert Porter Lynch is President of The Warren Company is Providence, Rhode Island. He can be reached at 401/273-0100. Iain Somerville is Founder and Managing Partner of Andersen Consulting's worldwide Organization Strategy Practice in New York City. He can be reached at 212/708-4246. The authors would like to acknowledge James Hudak, of Andersen Consulting, and Stephen Gomes, of The Warren Company, for their assistance.

COPYRIGHT 1996 American College of Physician Executives
COPYRIGHT 2004 Gale Group