Summer Exam
Question 1 (30 points)
The following news item appeared in 2011 WSJ and reflects a dispute involving Walgreen and Express Scripts.
Walgreen Prescribes Rate Change
A Pharmacy-Benefit Manager Resists Paying More for Customer Counseling as Contract
Talks Stall
By T IMO TH Y W . M A RT IN Wall Street Journal Oct 25, 2011.
An arcane pricing dispute threatens to have real-world consequences for millions of Walgreen
Co. customers, who may lose their ability to fill prescriptions there starting in January.
With growth in prescription-drug sales slowing, Walgreen and other major retail pharmacy chains hope to boost revenue by offering new health-care services. In addition to filling prescriptions, they now help patients manage their medications. For example, Walgreen pharmacists advise customers on appropriate doses and try to switch them to cheaper generic alternatives when possible.
As compensation for the additional services, the nation's largest drugstore chain is asking Express Scripts Inc.—a pharmacy benefit manager that administers benefits for insurers and employers—to reimburse it for prescriptions at a higher rate than Express Scripts has offered. Walgreen believes Express Scripts' offer is too low because Walgreen's new services reduce health-care costs for the benefit managers' clients and don't cover the drug chain's costs.
"Our product is not a pill; our product is a health outcome," says Walgreen Chief Executive Greg Wasson.
Express Scripts' response thus far: A pill's a pill, and Walgreen doesn't deserve more money than other pharmacies for telling patients how to take them. If Express Scripts did agree to pay more, Walgreen would become its most expensive pharmacy, raising client costs "for essentially doing the same thing as everyone else," says spokesman Brian Henry.
But if the pharmacy-benefit manager holds firm, Walgreen says it will remove itself from Express Scripts' network by Jan. 1. That would mean the people it covers couldn't get their prescriptions filled at the drug-store chain, a particular problem for residents of Phoenix, Memphis, St. Louis and other markets where Walgreen has little competition from CVS Caremark Corp. or Rite Aid Corp.
Express Scripts' members account for about 90 million of the prescriptions Walgreen fills each year. The company, which will report third-quarter earnings Tuesday, says some of its members have already started switching their prescriptions away from Walgreen.
Walgreen has struck some regional deals recently. Blue Cross & Blue Shield of Kansas City, Mo., will continue to work with the chain next year, though it declined to disclose the length of its contract. Another pact was made with a small Puerto Rican plan earlier this month.
Pharmacy-benefit managers are unlikely to agree to pay for extra services like medical counseling unless their clients demand it, says Dan Mendelson, chief executive of Avalere
Health Inc., a consulting firm for health-care companies. "If the health plan demands it, the PBM
will provide it," he says.
But so far, the "overwhelmingly vast majority" of Express Scripts' biggest clients don't want to pay more and are willing to stop using Walgreen, says a person who is familiar with Express Scripts' thinking.
Express Scripts remains open to doing business with Walgreen if the pharmacy accepts its terms, this person says. But support from its clients is "fortifying" its belief that it shouldn't budge in negotiations. Express Scripts also says its clients' costs would rise if it accepted Walgreen's current offer. Walgreen counters that its advisory services would save Express Scripts members
$180 million a year, or $2 a prescription.
The situation could create problems for the Ysleta Independent School District in El Paso, Texas, which has 6,000 full-time employees. Walgreen is the city's only national drug chain with a
major presence, says Patricia Ayala, a Ysleta spokeswoman. "In El Paso, we don't have other pharmacy chains that are able to provide 24-hour pharmacies," she says. "Everybody just wants to know: How is this going to impact me?"
About 2.5 million seniors may already have been affected. Open enrollment for Medicare Part D plans administered by Express Scripts started Oct. 15, and some plans had to advertise offerings without including Walgreen.
The dispute could hurt both companies. Express Scripts members represent more than 10% of Walgreen's pharmacy business, according to Walgreen, which says it handles about one of every five U.S. prescriptions.
Many analysts think that's optimistic. Standard & Poor's Ratings Service cut its Walgreen outlook recently to negative from stable, citing the potential for lower earnings because of lost Express Scripts revenue.
Express Scripts says its initial financial hit would be minimal. But longer term, analysts say, some current clients could drop Express Scripts for other benefits managers that work with Walgreen.
Big health-care plans and employers believe the two sides will eventually reach an agreement, says David Dross, managed pharmacy practice leader at Mercer, a consulting firm. Still, earlier this month, Walgreen said that the two companies remained "miles apart."
Walgreen embraced its new strategy as 2010 prescription-drug sales grew just 2.3%, the slowest increase since the 1950s, following 15 years of nearly double-digit year-over-year growth, according to health-care research firm IMS Health Inc.
Mr. Wasson, who became CEO in 2009, once ran a Walgreen division that worked with hospitals, managed-care partners and insurers. He says that role taught him the high demand for health care outside doctor's offices and the need to cut costs.
He says the extent to which Walgreen could expand into medical services is "unlimited." The only risk, he says, "is not moving fast enough."
Required:
1. Is the service Walgreen is offering a value added service? Why or why not? (10 points)
2. Considering the business model, why do you think Walgreen is unable to convince Express Script to pay a higher reimbursement rate? (10 points)
3. How would you advise Walgreen to formulate a strategy to market this service to capture its value? (10 points)
<Type your answer here. Add space as needed>
Question 2 (30 points)
Matshushita Corporation has a wide range of products ranging from computer chips to consumer electronics products under the brand name of Panasonic. It has a decentralized system where individual managers are responsible for each product division. In their product cost system, Matshushita uses one overhead cost pool that is allocated to products based on the direct labor hours. A recently hired accountant noticed the product diversity and manufacturing complexities and concluded that a labor rate based cost system would create severe under and over costing thereby distorting the product cost information. After several futile attempts to convince lower level management, he was encouraged to speak to the Chairman of the company. The Chairman patiently listened to the merits of activity based costing and the strategic advantages that will come with it for Matshushita. At the end of the presentation, he sighed; “Ah, you don’t understand”, he said gently, “our long term strategy is to create a completely automated factory that is crucial for our success. I think our cost system is quite consistent with that strategy”.
(Background: The Chairman of Matshushita is a very well educated person and knows all about different cost systems)
Required:
1. Examine the adequacy of the existing labor based overhead allocation system for creating a completely automated factory as the Chairman claims. (10 points)
(Note: Keep in mind the Chairman’s objectives)
2. Why do you think the Chairman wishes to adopt this implementation strategy? Is there a downside to the implementation strategy? (10 points)
3. If you are the accountant, how would you proceed with the conversation? (10 points)
<Type your answer here. Add space as needed >
Question 3 (50 points)
Technometrics, Inc., a large producer of electronic components, is having some problems with the manufacturing process for a particular component. The profit contribution of this component is $40 per unit. Under the contract the company has with its customers, Technometrics’ warranty requires them to pay a shipping charge of $20 per defective part which they repair for $30 each and ships for another $20. Further they pay a compensation for delay in the customer’s business which works out to about $80 for each component that the customer finds to be defective. However, before shipping the components to customers, Technometrics could choose to spend
an additional $30 per component to rework any components thought to be defective (regardless
of whether the part is really defective). The reworked components can be sold at the regular price and will definitely not be defective in the customers' applications. Unfortunately, Technometrics cannot tell ahead of time, which components will fail to work in their customers' applications.
The following payoff table shows Technometrics' net cash flow per component.
Figure 1 Payoff Table
Component Technometrics' Choice
Condition Ship as is Rework first
Good +$40 +$10
Defective -$20 +$10
Required:
1. Is Technometric correct in summarizing their information? ( 10 points)
2. If Technomterics believes that their process is likely to generate good parts with a probability of 90% what should they do? Ship as is or rework? ( 10 points)
3. How much should Technometrics be willing to pay for a test that could evaluate the condition of the component before making the decision to ship as is or rework first? After passing this test, the component will not fail at the customers. (10 points).
4. Mr Shaw, an engineer in Technometrics has limited faith in the tests and believes that the probability of detecting the defect correctly is only 80% from the test, and there is a 20% chance of misclassification of defective part as correct part. He does not to buy such an incorrect test. What will you advice? How much will you play for it, if any? (20 points)
Question 4 (40 points)
Wixon Widgets has two decentralized divisions which make two different types of widgets; Premier and Popular. Because of increasing demand, each manager has been lobbying to the Headquarters for purchasing an automatic programming machine that would mechanize part of their operations. Unfortunately, these machines have huge capacity and none of the divisions of Wixon seem to have enough demand to justify purchase of these machines. The managers and the Headquarters have agreed to purchase these machines on a cost sharing agreement. At
present they are considering four different options. The incremental contributions of Premier and Popular divisions for each of the four machines and the respective cost of the machines are as follows:
Cost of Machine Popular’s Contribution Premier’s Contribution
Machine 1 100,000 55,000 75,000
Machine 2 100,000 55,000 55,000
Machine 3 120,000 75,000 85,000
Machine 4 200,000 110,000 110,000
Required
1. Which machine should the company buy, if any? (10 points)
2. How would the controller implement a decentralized decision mechanism to induce the optimal decision in a decentralized manner? Explain and verify your answer in detail. (20 Points)
3. Is this allocation fair? Why or why not? (10 points)
<Type your answers here. Add space if needed>