Despite the worst economic recession in the last 70 years, healthcare expenditures continue to rise. A well-publicized report by the U.S. Census bureau in 2007 pegged U.S. healthcare expenditures at $2.2 trillion, while the debate within Congress has produced estimates of $2.5 trillion for 2009. This estimate represents an increase of 13.6% over the last two years, while the rest of the economy has been in a recession.
This robust sector of the economy continues to demand medical devices and equipment. Traditionally, medical equipment OEMs have been in an arms race to outdo each other in features and performance to gain a greater share of this expanding market. To remain at the forefront, medical equipment OEMs traditionally have been vertically integrated, seeking competitive advantages in engineering disciplines as diverse as materials science, ASIC development, hardware, software, and systems engineering. Only the largest of companies can muster the R&D budgets to invest across each of these areas. Indeed, four companies have dominated the medical equipment market—GE, Siemens, Philips, and Toshiba.
A FOCUS ON VALUE
Recent policy changes within Medicare and the ongoing debate on healthcare reform in Congress have served to shift the emphasis for medical equipment from performance to value. Evidence of this shift was first seen in the 2005 Medicare Deficit Reduction Act, which cut reimbursements for medical imaging procedures to hospitals and even clinics with their lower operating costs. The ongoing debate on healthcare reform in Congress has now shown a white-hot spotlight on the issue. The Obama administration has sought to reduce Medicare payments to healthcare providers by $200 billion per year.
Resulting effects were seen at the recent Radiological Society of North America (RSNA) exhibition in Chicago at the end of November 2009. For example, there was much emphasis on the value-priced 64-slice computed tomography (CT) machines, compared to the previous year, which saw introductions of bigger, more expensive 256- and 320-slice machines. Additionally, more cost-effective portable ultrasound systems are becoming highly desired, especially for small clinics in rural areas and for developing countries.
While this focus on value may be a recent development in the U.S. healthcare system, it always has been a fundamental tenet of socialized healthcare systems in Europe and Japan. Of course, nowhere is the focus on cost more important than in developing countries, which represent more than half of the world’s population.
This value-driven focus has caused a plateau in the performance requirements for medical equipment. Once equipment reaches this performance plateau, incremental improvements in performance no longer result in a price premium for which the customer is willing to pay. In China, for instance, certification testing for ultrasound machines involves scanning a wire phantom, a block of gel with wires as well as empty pockets, to simulate cysts. All a machine needs to do is resolve a certain number of wires at a certain depth to be qualified. With a single centralized public healthcare system, once this performance requirement is met, pricing competition becomes fierce for domestic suppliers.
THE SYSTEMS INTEGRATION MODEL
As the performance requirements within an industry plateau, the vertical integration model by OEMs becomes unsustainable, as continued investment in esoteric features fails to provide any return. Instead, OEMs begin to rationalize their R&D expenditures focusing on those features that truly are core to the company’s competitive advantage. Most typically, these will be in the form of algorithms and software. Subsystems and components that aren’t part of the core are outsourced to merchant suppliers. Once a market reaches this performance plateau, the OEMs shift from a vertical integration model to more of a systems integration model.
Together with the shift from a vertical integration model to a systems integration model, this plateau of the performance requirements lowers the barriers to entry for new medical equipment OEMs. As more of the system bill-of-materials becomes available from merchant suppliers, the upfront development cost for new OEMs decreases. As more OEMs enter the market, the supplier base further fragments, causing a further iteration of R&D rationalization by the OEMs.
This shift to the systems integration model and the fragmentation of the OEMs creates opportunities for merchant suppliers at all levels in the value chain. Now, only merchant suppliers can justify the development costs of next-generation semiconductors and subsystems by amortizing this cost across multiple OEMs. As the knowledge base within the industry spreads across a wider set of OEMs, the definition of new products lends itself to standard product management functions, rather than a black art closely held within a narrow group of OEMs. While esoteric features will certainly remain for premium systems, merchant suppliers can easily understand the performance requirements for the mainstream of the market and design them into their next products.
As an example, we can contrast the state of the ultrasound industry ten years ago versus today. An ultrasound machine consists of a probe, an analog front-end board, and an image processing subsystem. Ten years ago, probe manufacture required specialized processes and calibration, whereas today most probes can be manufactured by contract in China. The image processing subsystems of ten years ago required customized backplanes and image processing hardware, whereas today these functions are performed on standard PCI Express Intel CPUs and GPUs.
Nowhere has this shift been more apparent than in analog front-end ultrasound machines. The sea of discrete and custom analog devices and digital ASICs has now been replaced by merchant analog semiconductors with highly integrated analog semiconductors with eight or 16 channels on a single device. Also, FPGAs have replaced custom digital ASICs for beamforming. Eliminating the high nonrecurring-engineering (NRE) costs of custom analog and digital ASICs has significantly reduced the barriers to entry in the OEM market, allowing the number of OEMs to increase from just a handful to close to a hundred.
WHAT’S NEXT?
The current economic climate is accelerating the shift from vertical integration to system integration. Even the largest OEMs must now rationalize R&D expenditures in a series of make/buy decisions for each system component. OEMs will choose to make products that align with their core competencies. System components that aren’t core will be outsourced to merchant suppliers. While some of the top-tier OEMs have announced layoffs, these positions are shifting to semiconductor, software, and hardware subsystem manufacturers as well as new OEMs.