Cognizant 20-20 Insights

A Playbook for Contending with the Medical Devices Excise Tax

Research shows that few device makers have offset the excise tax they began paying in January 2013; heres how to reduce costs in targeted areas of SG&A in order to maintain profit margins.
Executive Summary
By now, you have probably read that in March 2013, the U.S. Senate voted 79-20 to repeal the new excise tax on gross sales of medical devices, which includes everything from CT scans and replacement knees to tongue depressors. While the move appears encouraging for device manufacturers, theres a catch: For the repeal to go through, lawmakers must identify an alternative tax source to replace the $29 billion the excise tax is expected to generate over 10 years.1 Sound futile? Exactly. Given that the tax is likely here to stay, how have medical device makers reduced their costs to compensate for the 2.3% duty they began paying on January 1? A review of manufacturers SEC 10-K filings reveals that they havent. To avoid margin erosion, however, the offsetting cost reductions must happen soon. An objective, disciplined approach to SG&A cost reduction can help manufacturers meet the margin squeeze and result in healthier businesses. recovery have caused prospective patients to defer elective medical procedures such as knee and hip replacements. Moreover, because the manufacturers typically draw from an older demographic already covered by Medicare, they expect minimal new business from the Affordable Care Acts pool of newly insured patients. Unlike other excise taxes such as the gasoline tax that funnels funds to road repairs the device makers tax has no mitigating industry benefit. Estimating the excise taxs effect on companies is complex. For one thing, the tax applies only to U.S. sales. For another, it excludes associated services, such as education and consulting. As a result, calculating the taxs impact on individual organizations depends on the companys geographic revenue mix, as well as the mix of device and services revenues. Major device manufacturers generate roughly 46% of their revenues outside the U.S. (see Figure 1). Least affected by the excise tax are those companies with large non-U.S. revenues and lucrative services revenues. For example, Becton Dickinson and St. Jude Medical earn less than half of their revenues from the U.S. On the other

How the Tax Affects the Medical Devices Industry

The tax comes at a difficult time for the industry. High unemployment and the economys uncertain

cognizant 20-20 insights | june 2013

hand, Stryker and C. R. Bard earn approximately two-thirds of their revenue in the U.S., making them more vulnerable to the taxs impact.2 Equipment titan Thermo Fisher Scientific predicts little impact on its business because the majority of its sales are laboratory devices, which are not subject to the tax. The company estimates its exposure to result in a tax of only $20 million to $25 million.3 Breaking out revenues of devices vs. services adds an administrative burden to pricing and accounting activities, and theres no doubt it will impact the way companies write future pricing agreements. Bundled pricing of products and services is likely to change. It should be noted that the tax burden is especially high for startup companies. Because the tax applies to total device sales rather than profits, young organizations with nascent profits pay disproportionate shares of their profits toward the tax. In addition, startups tend to earn a higher percentage of revenues from U.S. domestic sales and typically earn less service revenue. The result is that the new tax may lead to increased industry consolidation and discourage the innovation and creativity that is often the hallmark of young businesses.

some steps to offset the tax, such as aggressively pursuing new business outside the U.S. From 2009 to 2012, the industry grew non-U.S. revenues from 41.5% to 45.5% of total revenues a surprisingly large and rapid shift in such a short timeframe (see Figure 2, next page). In addition, empirical evidence shows device makers putting the brakes on hiring. According to a review of corporate 10-K filings, total employment among the largest device manufacturers reached 183,298 in 2009, the year before the Affordable Care Act was signed into law. By 2012, the companies employment had risen by 6.9% to 195,965. Revenues grew an even healthier 12.3% (see Figure 3, next page). Revenue growth that outpaces hiring should result in productivity gains that appear in improved SG&A as a percentage of sales. Yet among medical device makers, SG&A as a percentage of revenues has worsened (see Figure 4, page 4). The industrys decline in SG&A performance between 2009 and 2012 may in part reflect the expansion overseas. It also suggests that the productivity gains are showing up elsewhere in the corporation, most likely in manufacturing. Device makers sagging SG&A cost efficiency also clearly indicates that the industrys expansion through mergers and acquisitions has produced multiple redundant back-office functions that are decentralized, nonstandardized and fragmented. Despite the abundant M&A activity, we dont see the SG&A efficiency gains that would indicate

Attempts to Offset the Tax

Data shows that in the three years between the Affordable Care Acts enactment and the date the tax went into effect, device makers have taken

Medical Device Makers Non-U.S. Revenues

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Non-U.S. Revenues % U.S. Revenues %

Be

ct

on T

o er rm sh he Fi

St

.J

de

c on fic ni st nti ro t Bo cie ed S M

Zi

er St

ry

r ke C.

R.

d ar

Source: Company 10-K filings Figure 1

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Medical Device Makers Business Expansion Outside the U.S.

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

41.5%

45.5%

58.5%

54.5%

Non-U.S. Revenues % U.S. Revenues %

2009 2012

Source: Company 10-K filings Figure 2

companies integrating their combined systems and wringing out the inefficiencies. These nonoptimized SG&A costs are an obvious target for offsetting the excise tax.

costs. But the data shows companies have not yet begun to do so. To carry out the reductions, manufacturers may need to reduce their research and development investments and take a fresh look at marginally profitable product lines; however, SG&A is the obvious target. The goal should be a 50% reduction in costs for activities such as payroll, general HR support, general accounting, accounts receivables processing, accounts payables processing, fixed assets accounting and support of redundant IT applications. The industry needs to assess and benchmark its SG&A functions, document the landscape people, processes, systems and costs and

What Device Makers Need to Do

From all appearances, the excise tax is here to stay, but company options are limited. Few can pass along the tax costs as price increases. Most medical product lines are sold in highly competitive markets that preclude marking up prices to offset the increased tax. As a result, organizations face one of two choices: decrease margins or reduce costs. Given Wall Streets penchant for punishing companies with falling margins, the obvious approach is to cut

Medical Device Makers Employment Levels

Number of Employees Up 6.9% 41.5% 2009 Revenues 60,000 40,000 20,000 0 2009 2012 58.5% Up 12.3% 54.5% 45.5% 2012
Zimmer C.R. Bard St. Jude Stryker Boston Scientific Becton Thermo Fisher Medtronic Zimmer C.R. Bard St. Jude Stryker Boston Scientific Becton Thermo Fisher Medtronic

200,000 150,000 100,000 50,000 0

Source: Company 10-K filings Figure 3

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Rising SG&A Costs

2009
Zimmer Stryker Boston Scientific Medtronic St. Jude C.R. Bard Thermo Fisher Boston Total
(percent of revenues) Figure 4

2012
40% 40% 35% 35% 34% 29% 27% 25% 33%

42% 37% 32% 35% 36% 27% 26% 24% 32%

With limited options, companies need to take an objective and disciplined approach to SG&A cost reduction that meets the margin squeeze and results in healthier businesses. Although SG&A is the target, lets be clear: we recommend not cutting sales but focusing on the general and administrative expenses that fall within SG&A, such as human resources, finance and procurement. In general, HR is not a primary target for cost reduction because it is more of a people function that companies need to maintain at least partially in the field. As such, this function does not always lend itself as well to centralization and automation. Finance, however, is an important target for cost reduction. Approximately 60% of companies finance and accounting headcount is related to transaction processing. As such, companies can generate significant savings by wringing inefficiencies out of finance transaction processes such as accounts payables, accounts receivables, fixed assets, general accounting and the payroll process whether managed by HR or finance and typically with little impact to the customer. Procurement, too, is a major part of a companys cost structure, and any savings from more effective procurement go straight to the bottom line. The key in procurement is not to reduce headcount but to make people more effective. Strategic sourcing is a critical exercise through which organizations analyze spending, rationalize vendors, re-bid contracts and centralize master data maintenance, both vendor and item masters. A disciplined approach is essential to identifying costs that can be reduced. Start by assessing and benchmarking functions. What systems are used? How automated are they? To what degree has outsourcing been used? Are best practices being utilized? Once your organization has assessed and documented the operational landscape, it can begin making the strategic choice of which functions to retain and which are candidates for automation and outsourcing. With the development and implementation of a transformation roadmap, your organization can make the adjustments to offset the excise tax and emerge a stronger, more efficient business.

develop plans to reduce costs through standardization, systems rationalization, increased automation, shared services and outsourcing (see Figure 5).

Looking Forward
The time for device makers to act is rapidly running out. The effect of the new tax is already rippling through 2013 earnings. Integra Life Sciences and Cytomedix are among the device makers that cited the excise tax as a factor in their decreased margins in the first quarter of 2013.4,5 Engineering giant Smiths Group is mulling plans to sell its medical division, citing a 10% decline in operating profits that it attributes to factors that include the new tax.6

Cost Reduction Levers

Te c
gy olo hn
Peo ple
Tool Organizational enhancement structure redesign technology New Rightsizing Workflow tool Offshoring redesign Process Lean Standardization Benchmarking Best practices

P r o c es s e s

Figure 5

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Footnotes
1

Description of H.R. 436, The Protect Medical Innovation Act of 2011, Joint Committee on Taxation, Publication JCX-45-12, May 29, 2012. U.S. Securities And Exchange Commission, Form 10-K. Ibid. Disappointing 1Q Earnings for IART, Zacks Equity Research, May 10, 2013. Cytomedixs CEO Discusses Q1 2013 Results - Earnings Call Transcript, SeekingAlpha, May 10, 2013. Smiths in Talks Over Medical Sale, Midland News Express & Star, May 31, 2013.

2 3 4 5 6

About the Authors

Paul Nowacki, CFA, is Leader of Finance & Accounting, Transformation Consulting, within Cognizants Business Process Services Group. In this role, Paul oversees all F&A consulting activities. He also serves as a thought leader in F&A and helps identify market trends and shape new Cognizant offerings. He is a frequent conference and webinar speaker and author of numerous articles and whitepapers on various finance and accounting topics. By combining his industry experience in IT and finance leadership roles with a background in transformational consulting, Paul looks holistically at finance and accounting organizations and blends process and systems with organizational design perspectives. He has a B.S. in quantitative business analysis and an M.B.A. with a concentration in operations research. Paul also holds the Chartered Financial Analyst professional designation. He can be reached at Paul.Nowacki@cognizant.com. Moses Mallela, CPA, is a Principal Consultant within the Finance and Accounting Practice of Cognizants Business Process Services Group. In this role, Moses engages with clients on strategic assessments and identifying opportunities for value creation. Moses has extensive experience in offshore service delivery and has led global consolidation and standardization of F&A processes across multiple countries and languages into offshore and near-shore delivery centers. He holds a masters degree in commerce and is a gold medalist from Osmania University, Hyderabad, India. He also holds the Cost and Management Accounting professional designation. He can be reached at Moses.Mallela@cognizant.com.

About Cognizant
Cognizant (NASDAQ: CTSH) is a leading provider of information technology, consulting, and business process outsourcing services, dedicated to helping the worlds leading companies build stronger businesses. Headquartered in Teaneck, New Jersey (U.S.), Cognizant combines a passion for client satisfaction, technology innovation, deep industry and business process expertise, and a global, collaborative workforce that embodies the future of work. With over 50 delivery centers worldwide and approximately 162,700 employees as of March 31, 2013, Cognizant is a member of the NASDAQ-100, the S&P 500, the Forbes Global 2000, and the Fortune 500 and is ranked among the top performing and fastest growing companies in the world. Visit us online at www.cognizant.com or follow us on Twitter: Cognizant.

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