Tutorial 2

Case 2: Narayana Hrudayalaya: A Model for Accessible, Affordable Health Care?

Cardiac surgeon Dr. Devi Shetty is on a mission to build 5,000-bed “health cities” across India,
encouraged by the success at his nine-year-old Narayana Hrudayalaya hospital in Bangalore. He
has contained costs by tweaking processes, driving hard bargains and negotiating creative
partnership deals, but faces challenges in replicating that model on a bigger scale. Shetty wants
to make quality health care affordable using cost advantages due to expansion.

Shetty believes his success could lead to a new health care model not only for India but also for
the world. “The first heart surgery was done over a hundred years ago but even today only 8% of
the world’s population can afford heart operations,” Shetty notes. “In India, around 2.5 million
people require heart surgeries every year but all of [the country's doctors] put together perform
only 80,000 to 90,000 surgeries a year…. We clearly need to relook and change the way things are
being done.”

At his Narayana Hrudayalaya Institute of Cardiac Sciences in Bangalore, the 56-year-old Shetty is
doing just that. Patients at his hospital get cardiac care at a cost lower than any other hospital in
the country and at a fraction of what it would cost elsewhere in the world, a
feat accomplished through what Shetty refers to as “process innovation.”

Shetty argues that the health care industry needs more process innovation than product
innovation. The industry “does not need a magic pill or the fastest scanner or a new procedure,”
he states, but instead requires improvements that lower the cost of medical attention and make
it more widely available. Shetty’s premise is not radical; in fact, the doctor describes his way as
“the Walmart approach.” What sets him apart, however, is that he has successfully adapted the
method to a field as complex and costly as cardiac care.

Now Shetty is ready to aim higher. India currently has around 0.7 hospital beds per thousand
people; the key to better aligning those numbers with the population, he states, is creating a chain
of large “health cities” across the country. To set the ball rolling, Shetty spearheaded the creation
of a 1,400-bed cancer and multispecialty hospital — the largest cancer hospital in the country —
at the Bangalore campus. A women and children’s hospital and another for nephrology are also in
the works. In addition, the Bangalore facility — which is set to expand to a total of 5,000 beds over
the next three years — includes a 500-bed orthopedic hospital, an eye hospital,
research facilities and room for about 50 training programs. Over the next five years, Shetty
wants to build similar 5,000-bed health cities across the country.

Shetty has reason to be confident. Over the years, the Bangalore heart hospital he opened in 2001
grew to 1,000 beds; the facility has added advanced technology and doctors there perform some
30 surgeries a day — the highest number of cardiac surgeries done by any hospital in India. Other
hospitals in India, including Escorts, Apollo, Wockhardt and Fortis, perform about half that
number. In addition, Shetty’s staff has the capability to do a large number of different cardiac
procedures. The hospital’s mortality rate of around 2% and hospital-acquired infection rate of 2.8
per 1000 ICU days are comparable to the best hospitals across the world, Shetty asserts.

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Serving the Poor

Cardiac surgeries in the United States can cost up to US$50,000. In India, they typically cost
around US$5,000-US$7,000, depending on the complexities of the procedure and the length of
the patient’s stay at the hospital. At Narayana Hrudayalaya, however, surgeries cost less than
US$3,000, irrespective of the complexity of the procedure or the length of hospitalization. About
45% of Shetty’s patients pay even less. Of these, about 30% are covered under a micro-insurance
plan for health care called Yeshasvini that reimburses Narayana Hrudayalaya at about US$1,200
a surgery. Conceptualized by Shetty and run by an independent trust, Yeshasvini was launched in
2002 in association with the Karnataka state government.

For those who are not part of the insurance plan and can’t afford the hospital’s regular charges,
Shetty offers concessional rates. The discounts depend on patients’ financial capacity and are
funded either by the hospital’s charitable trust, individual donors or by the hospital itself. Almost
15% of the hospital’s patients benefit from these concessions. In addition, Shetty and his team
reach out to patients through a network of rural clinics and via telemedicine facilities. Patients
come to the Bangalore facility from more than 50 countries. Shetty’s instructions to his team are
clear: No one who comes to Narayana Hrudayalaya will be denied treatment due to a lack of
funds.

To ensure the viability of the project, Shetty has devised a hybrid pricing model. Apart from the
regular package of US$3,000 a surgery, he also offers semiprivate and private rooms for those who
want and can afford better personal amenities. The medical facilities stay the same for every
patient. The upgraded rooms, which comprise around 20% of the total available at the hospital,
are priced at US$4,000-US$5,000 and “offset the losses incurred from treating the poor,” Shetty
notes.

The managing team at Narayana Hrudayalaya follows the unique accounting practice of studying
the profit and loss account on a daily basis. “By monitoring the average realization per surgery and
our profitability on a daily basis, we are able to assess how much concession we can afford to give
the following day without adversely impacting our profitability,” states Sreenath Reddy, the
hospital’s chief financial officer. Reddy expects revenues of US$80 million for the year ending
March 2010 and to generate US$200 million annually over the next two years. The hospital has
been profitable from the first year. Shishir Jain, executive director at JP Morgan believes Shetty has
shown that “it is possible to fulfil a great social need without compromising on the profitability.”

Innovations in Operations

One of Shetty's first innovations when he set up Narayana Hrudayalaya was the way in
which doctors are compensated. Typically, cardiac surgeons are paid per surgery, and their
costs constitute a significant proportion of a hospital’s total expenses. Shetty invited his staff
physicians to work for fixed salaries; he did not pay them less than what they would have normally
taken home at the end of the month. He required doctors to perform more surgeries, bringing
down the cost per procedure. This approach continues to be one of the core savings areas at
Narayana Hrudayalaya.

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In addition, Shetty’s father-in-law — who was in the construction business — built the first
hospital for him, keeping costs to the minimum. Shetty claims he passed on those savings to
patients. Construction costs at his hospitals are still less than half of that for others, he says. “The
way we design the hospitals and our close monitoring of our projects help us to keep a very tight
control of our construction costs,” notes Shetty’s son Viren, an engineer and director at the
hospital.

In the initial days of Narayana Hrudayalaya, patients came because of Shetty’s skill and his
reputation. The cost savings he offered started attracting customers in greater numbers. Apart
from the surgeries, the Bangalore campus treats about 2,500 people daily in its out-patient
department. The increasing volumes in turn have helped lower costs in many ways, staff says.
Instead of buying surgical gloves in India, for example, Narayana Hrudayalaya saves about 40%
by importing them in container loads from Malaysia. The hospital has moved to digital X-ray
technology, saving on the recurring cost of film. Most hospitals use their CT scanners, MRI
(magnetic resonance imaging) and other machines for only eight hours a day, but
Narayana Hrudayalaya uses them for 14 hours and offers these tests to the patients at lower rates
in the late evenings. As volumes increase, per unit costs naturally come down.

For procedures like blood gas analysis, Shetty’s team convinced the equipment vendor that,
instead of selling the machine to the hospital, he could simply park it there and make his money
by selling the chemical reagents required for the test. The hospital saves on the cost of the
machines while the vendor also profits. For the past six months, another vendor has parked his
catheterization laboratory equipment at the hospital free of charge.

The high patient volumes help Shetty drive a hard bargain with vendors when negotiating prices
for everything from basic supplies to sophisticated medical equipment. The new cancer hospital,
for example, purchased two linear accelerators (for producing X-rays) that typically cost US$6.4
million each for the price of one machine. The cost of the machines was spread out, interest-free,
over seven years. “Given [the hospital's] volumes and Shetty’s own credibility, every negotiation is
as tough as it can be. He certainly gets his pound of flesh,” notes V. Raja, president and CEO of
GE Healthcare South Asia.

Testing an Untested Model

Shetty’s model of 5,000-bed health cities has its share of risks and challenges. It remains to be
seen if the doctor can replicate his success in volume-based cardiac care across specialties and
cities. Observers say to succeed, Shetty needs to build organisational and management
bandwidth; create teams of medical professionals that share his vision and are willing to work
hard; put in place robust processes, and raise the required funding.

Amit Varma, president healthcare at Religare Enterprises, a financial services group and director
of critical care medicine at the Fortis Escorts group of hospitals, raises another concern. Varma
was part of Shetty’s team at Manipal Hospital and at Narayana Hrudayalaya. “The intention is
absolutely right but there is a base cost to any procedure and you can bring that down only to a
certain level,” he notes. “There is a tipping point beyond which the volume that you do will have an
adverse impact on the quality. What that tipping point is remains to be seen.”

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Mazumdar-Shaw of Biocon, who owns a stake in Shetty’s company, says the doctor brings a
missionary work ethic to his efforts and has attracted a talented and committed team of doctors,
nurses, paramedics and professionals. She credits Narayana Hrudayalaya with consistently
focusing on training and developing specialized skills. “I have no doubt that
Narayana Hrudayalaya is scalable in India and Shetty’s concept of 5,000-bed health cities is the
way to go. India’s medical talent pool is vast and can certainly sustain this growth.”

Wharton University of Pennsylvania. (2010, July 1). Narayana Hrudayalaya: A Model for
Accessible, Affordable Health Care? Retrieved from Wharton University of Pennsylvania

Video: [Link]

View the related video on your mobile by scanning the QR Code (6 ½ minutes long)

Questions

1. Provide a reason as to why the Bangalore heart hospital provides heart surgeries at
a substantially lower cost. What is the economic term for Shetty's premise (what he refers
to as the Walmart approach)?

2. Narayana Hrudayalaya (NH) plans to open 5000-bed “health cities.” Does he, with this
expansion, hope to benefit from economies of scale, economies of scope, or both?
Explain your answer.

3. Name a barrier to exploiting economies of scale in India’s healthcare. How does

4. Would the Narayana Hrudayalaya (NH) model work to provide affordable healthcare in the
Netherlands? Explain why or why not.

5. How could this healthcare model be adapted in different countries with similar healthcare
issues? And what international partnerships could support Narayana's global expansion?

Narayana Hrudayalaya (NH) considers opening a new heart hospital in the neighbouring country
of Nepal. A larger hospital can treat several patients simultaneously at low per-patient costs.
However, fixed cost associated with constructing a larger hospital is higher. In addition, it is more
costly to operate and maintain a larger hospital per day. The construction of a larger hospital does
not guarantee that patients will enrol. This is expressed by an occupancy factor,
which indicates the percentage of hospital beds that are filled.

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Item Small hospital Large hospital
Hospital construction costs € 30,000,000 € 113,000,000
Hospital maintenance costs per day € 7,000 € 9,100
Hospital bed occupancy factor 88% x%
# Hospital beds 115 320
# Days of operation over lifetime 4000 (~11 years) 5000 (14 years)
Price per Heart Surgery € 1,975 € 1,750
Duration of stay per Heart Surgery 5 days 5 days

6. How much should the hospital bed occupancy factor of the large hospital be before
switching from constructing a small to a large hospital becomes profitable?
7. Shetty’s strategy of paying physicians does not only have beneficial consequences.
Describe the potential problem(s) with his new approach.
8. Describe three examples of innovations that help NH to achieve and sustain economies
of scale.
9. Below you see the average cost curve after the realization of all NH's innovations.
a) Draw another cost curve in the figure that represents the period before NH’s
innovations were realized.
b) Mark the places where the “efficient scale of output” should be in the two cost
curves.
c) Describe what the efficient scale of output is.
d) Explain why the efficient scale of output is important for NH.

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Case 3: Zara Part I: Spain’s Zara – Floating on air

A mixture of vertical integration and street smarts has transformed a small Spanish clothing chain
into a global success

Most fashion retailers discreetly tuck their price tags inside their garments. Not Zara. Its sales
tickets are big and colourful, emblazoned with the flags of a dozen countries, each accompanied
by a local-currency price that is the same for that item around the world, from Madrid to Riyadh
to Tokyo. In an industry traditionally geared to local tastes, this United Nations approach
exemplifies the centralization and integration that have turned Zara into the world's fastest-
growing retailer. Over the past five years, the number of its stores has risen from 180, mainly
in Spain, to 450 in 30 countries. Revenues have grown by an average of 27% a year since 1998.

At the heart of Zara's success is a vertically integrated business model spanning design, just-in-
time production, marketing and sales. Unlike other international clothing chains, such as
Hennes & Mauritz (H&M) and Gap, Zara makes more than half of its clothes in-house, rather than
relying on a network of disparate and often slow-moving suppliers. This gives the group more
flexibility than its rivals, who must respond to fickle fashion trends. “Vertical integration has gone
out of fashion in the consumer economy,” says Richard Hyman of Verdict, a retail consultancy in
London. “Zara is a spectacular exception to the rule.”

Starting with basic fabric dyeing, almost all Zara's clothes take shape in a design-and-
manufacturing centre in La Coruna, with most of the sewing done by seamstresses from 400 local
co-operatives. Designers talk daily to store managers, to discover which items are most in
demand. Supported by real-time sales data, they then feed repeat orders and fresh designs into
the manufacturing plant. This, in turn, ships the desired items directly to the stores twice a
week, eliminating the need for warehouses and keeping inventories low.

The result is that Zara can make a new line from start to finish in three weeks, against an industry
average of nine months. It produces 10,000 new designs each year; none stays in the stores for
over a month. Jose Maria Castellano Rios, the firm's chief executive, who rather
prosaically compares the shelf life of a new frock to that of a tub of yoghurt, says constant
refreshment of the store offering creates a sense of excitement that attracts new shoppers and
ensures that old ones return.

Moreover, Zara's business model makes it highly price-competitive, allowing it to offer mid-
market chic at downmarket prices. And it protects against slip-ups, too. Whereas most retailers
have committed 60% of their production at the start of a season, the figure at Zara is 15%, so it is
easier to dump a range that turns out to be unpopular—and Mr Castellano admits that Zara, like
everybody else, makes mistakes.

Zara Part II: Clothes retailing – The dedicated followers of fast fashion

Spain’s most successful fashion retailer, Inditex, has two ambitious local rivals snapping at its
heels

On high streets and in shopping centres across the globe, Spain’s most successful clothing
retailer, Inditex—best known for its Zara outlets—does battle daily against such other
multinational fast-fashion giants as Hennes & Mauritz of Sweden, Uniqlo of Japan and Gap of the
United States. But it also faces rising competition, at home and abroad, from two Spanish
rivals, Mango and Desigual.

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The larger of the two contenders, Mango is still fairly small: its turnover of €1.9 billion ($2.6 billion)
last year was less than one-fifth that of Inditex’s Zara branches. But Mango already has more
outlets than Zara, and is in more countries (107) than Inditex as a whole (88). Mango plans to open
lots more branches and increase its turnover to €5 billion by 2017.

Desigual is smaller still. It had sales of €828m last year, four-fifths of them outside Spain, and has
outlets in 109 countries. It has expanded tenfold since 2007. Its heady growth has attracted the
attention of Eurazeo, a French private-equity firm, which in March bought a 10% stake. This valued
Desigual at €2.9 billion; Inditex’s current stock market valuation is €70 billion.

Whereas its two younger rivals follow a more conventional fashion-retail model of changing their
collections two to four times a year, Inditex constantly churns out new designs, to encourage
consumers to return to its shops frequently. Inditex has about half of its clothes stitched together
in Spain or nearby countries, so it can react fast to changing trends. This costs more but helps
avoid fashion misses and markdowns. The other two, again following the industry’s conventions,
have largely outsourced production to Asia, though Desigual is also starting to stitch more
clothes in Europe to get them into the shops faster.

Inditex has been able to do without advertising, relying on good store locations in big cities to
attract custom. Desigual, in its rush to catch up, has created a buzz with controversial
advertisements (such as a television spot in which a young woman, wishing to get pregnant, puts
pinholes in her partner’s condoms) and quirky promotions such as offering free clothes to
shoppers who arrive in their underwear. Desigual promotes itself as a “lifestyle” brand, more like
Nike than Zara. Its bold prints and carefree, Mediterranean vibe are almost as popular in France
as they are in Spain, says its chief executive.

Though Desigual has outlets all over the world, around nine-tenths of its sales are still in Europe,
so it is unclear how far its vibe can travel. It has closed its shops in China to concentrate on other
Asian markets, such as Japan. Inditex, in contrast, has more than 450 shops in China.

Mr Jadraque, seeing how crowded the budget end of fast fashion is getting, is targeting a slightly
fancier segment of the market: in Spain Desigual’s T-shirts start at €29 compared with around €13
at Zara and €10 at Mango. It sells its clothes through a variety of channels, such as wholesalers
and department stores, and it has extended its brand into shoes, sportswear and cosmetics. Last
year its margin (on earnings before interest, tax, amortization and depreciation) was 29%, higher
than Inditex’s and double that of Mango.

Europe’s recession hit Mango harder than its rivals. In 2011 it had to cut its prices and reinvent
itself, ditching glitzier clothes to focus more on casual basics, says its chief executive, Enric Casi.
Last year sales grew 9%, outpacing Inditex’s. So far, Mango’s shops have been relatively small,
and aimed at young women. Emulating Inditex, it is now opening bigger ones that stock men’s and
children’s clothes, sportswear and underwear, as well as a separate chain called Violeta by
Mango, for women with fuller figures. All this means heavy spending on logistics, says Mr Casi,
and less reliance on franchised outlets for growth. Even if all goes to plan, it will take almost
a decade to get to where Zara’s sales are now. Nevertheless, having two such ambitious rivals on
its doorstep will surely keep Inditex on its toes.

The Economist. (2001, May 17). Spain’s Zara - Floating on air. The Economist.

The Economist. (2014, July 5). Clothes retailing - The dedicated followers of fast
fashion. The Economist.

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Questions:

1. The case mentions how vertical integration has gone out of style in fashion. What could
be a reason for this shift towards outsourcing?
2. Zara, compared to its competitors, is considered a vertically integrated firm. Why do you
think Zara follows this strategy? And how does Zara benefit from this strategy compared
to its competitors?
3. How do ‘vertical integration’ and ‘make or buy decisions’ relate to each other?
4. Consider the statement “tapered integration is a mixture of vertical integration and market
exchange”. Based on the case, does Zara use tapered integration? Why would they do
this?
5. Explain why Zara would not fully depend on contracts with external suppliers. Use the
term asymmetric information in your answer.
6. Why does Zara outsource 100% of their sewing activities anyway?
7. Ch 3 explains several types of “coordination fit”. Which of them are the most essential for
a company like Zara?

8. Ch 2 explains the concept of complementarities and strategic fit. Analyze the strategic fit
at Zara. Is the organisation of activities consistent with the firms’ strategic mission?

9. How can cultural diversity shape Zara's fast fashion cycle in global markets? And what are
the benefits of maintaining a multinational design team?

10. Consider Porter’s five forces model. How can Mango and Desigual erode Zara’s profits?
11. H&M, one of Zara’s competitors, buys clothes from more than 900 firms. On the contrary,
almost all Zara’s clothes take shape in a design-and-manufacturing center in La Coruna.
a) Explain H&M’s decision of using the market by mentioning two possible benefits of
‘buying’. b) Explain Zara’s decision of not using the market by mentioning two possible
costs of ‘buying’.