Carilion Clinic

Case History/Background

Nestled in the Commonwealth of Virginia between Salem and Vinton is the city of Roanoke, whose population was approximately 98,000 in 2010. The metropolitan area population was about 309,000. Bisected by the Roanoke River and circled by the Blue Ridge Mountain Parkway, Roanoke is the commercial and cultural hub of western Virginia and southern West Virginia.

The community that became Roanoke was established in 1852. Early economic development of Roanoke resulted from its importance as the junction point for the Shenandoah Valley Railroad and the Norfolk and Western Railway. These railroads were essential for transporting coal from western Virginia and West Virginia. Roanoke’s service area includes a regional report, shopping malls, a regional hub for United Parcel Service, and manufacturing plants for General Electric, Yokohama tires, and Dynax, a maker of friction-based automobile parts.

Carilion Clinic

Carilion Clinic employs almost 12% of Roanoke’s population. The clinic includes 9 freestanding hospitals, 7 urgent care centers, and 220 (and increasing) practice centers, and it employs over 650 physicians in more than 70 specialties. The clinic has 1,026 licensed beds, not including 60 neonatal intensive care unit beds. The clinic had 48,659 admissions in fiscal year 2014-15.

The clinic’s joint ventures and related companies include the following:

Carilion Clinic Physicians, LLC (real estate holding company)

Carilion Emergency Services, Inc.

Carilion Behavioral Health, Inc.

In March 2010, the same month and year the Affordable Care Act became law, the clinic was ordered by the Federal Trade Commission to divest itself of an outpatient surgical center and an imaging center. Both had been acquired as it sought to re-create “The Mayo Clinic” medical delivery model.

Led by Edward G. Murphy, M.D., from 1998 to 2011, Carilion Health System became Carilion Clinic, a vertically integrated health-care system. During Murphy’s tenure the system expanded to include graduate and undergraduate medical education programs, a school of medicine (through a partnership with Virginia Polytechnic Institute and State University Virginia Tech), and, perhaps most impressively, Carilion established an accountable care organization in partnership with Aetna insurance company.

Dr. Murphy’s total compensation was almost $2.3 million in 2007. Nancy Agee, the clinic’s chief operating officer at the time, earned the next highest salary of about $800,000. When Murphy resigned in 2011, Ms. Agee was promoted to president and CEO. In fiscal 2014, Carilion Clinic net revenue was $1.5 million. Agee’s salary was $1.9 million.

CONTROVERSY IN ROANOKE

Despite its philanthropic mission and positive effect on Roanoke, Carilion Clinic has not always enjoyed a good relationship with its community.

   In May 1988, the U.S. Justice Department’s Antitrust Division sought to prevent the merger of Roanoke’s two hospitals: Memorial Roanoke Hospital and Community Hospital of Roanoke Valley. The lawsuit sought to block the merger because of the monopoly it alleged would result. Less than one year after the suit was filed, the Fourth Circuit U.S. Court of Appeals found for defendants Memorial Roanoke Hospital and Community Hospital of Roanoke Valley.

   The merger between defendant hospitals would not constitute an unreasonable restraint of trade under the Sherman Act $1. The merger would strengthen the competition between the hospitals in the area because defendant hospitals could offer more competitive prices and services.

In the two appeals that followed, courts found for defendant hospitals, which then merged and were named Carilion Health System. The decision provided legal basis for what is now the Carilion Clinic.

IN A MARKET: WHAT CONSTITUTES A MONOPOLY?

A monopoly occurs when one or more persons or a company dominate an economic market. This market domination results in the potential to exploit or suppresses those in the market or those trying to enter it (supplier, provider, or consumer).

   During the 19th century, the U.S. government began prosecuting monopolies under the common law as “market interference offenses” to block suppliers from raising prices. At the time, companies sometimes sought to but all supplies of a certain material or product in an area, a practice known as “cornering the market”.

   In 1887, Congress passed the Interstate Commerce Act in response to railway companies’ monopolistic practices in small, local markets. This legislation protected small farmers who were being charged excessive rates to transport their products. Congress addressed monopolistic practices further by passing the Sherman Antitrust Act of 1890, which limited anticompetitive practices of businesses. The act blocked transfer of stock shares to trustees in exchange for a certificate entitling them to some of the earnings. The Sherman Act was the basis for the Clayton Antitrust Act of 1914, the Federal Trade Commission Act of 1914, and the Robinson-Patman Act of 1936, which replaced the Clayton Act.

   Antitrust or competition laws address three main issues:

Prohibit agreements or practices that restrict free trade and competition among business entities.

Ban abusive behavior by a firm dominating a marker, or anticompetitive practices that tend to lead to such a dominant position.

Supervise the mergers and acquisitions of large corporations, including some joint ventures.

The Herfindahl-Hirschman Index (HHI)helps implement these laws by providing a mathematical method to determine market “density”, or the concentration of the market. Antitrust laws and methods of calculating market density, such as HHI, are imperfect and can leave gaps that may be exploited.

   Since its establishment, the mission of the Federal Trade Commission has remained largely unchanged. Laws affecting private enterprise and government agencies have not. It is possible this mal juxtaposition underlies many of the difficulties in the healthcare industry.

VERTICAL INTEGRATION: THE MAYO CLINIC MODEL

The Mayo Clinic is the leading example of vertical integration in the delivery of healthcare in the United States. Founded in Rochester, Minnesota, in 1863, the Mayo Clinic began as the medical practice of William Worrall Mayo and his two sons, who were also physicians. It grew to include a comprehensive array of specialties. Mayo developed different levels of care across the health services continuum. The result was a vertically integrated health system. Mayo physicians are salaried at market levels, and they control the management structure.

   Mayo Clinic is headquartered in Rochester, Minnesota; it has satellite clinics elsewhere in the United States. In addition, Mayo and various medical centers worldwide have consulting and referral relationships. Mayo provides excellence and dedication in delivery of services with a constant, and self-admittedly stubborn, commitment to core values, which include that the needs of the patient come first, the integration of teamwork, efficiency, and mission over profit.

   Mayo has been long recognized for high performance, research and innovation. It has ranked at or near the top of “Honor Roll” hospitals through the history of U.S. News and World Report’s best-hospital rankings. In 2015 - 2016, Mayo clinic had more number one rankings than any U.S. hospital or system. Eight specialties ranked number one: diabetes and endocrinology, gastroenterology and gastrointestinal surgery, geriatrics, gynecology, nephrology, neurology and neurosurgery, pulmonology, and urology.

FORESHADOWING A MAYO CLINIC CLONE

Even before Murphy took the helm in 2001, Carilion Health System actions had stirred significant, but manageable, controversy in the community. Much of the controversy resulted from the antitrust case in 1988. After the court ruled that the merger did not violate federal law because it posted no threat of monopoly, the hospital continued its previous work in the community.

   After becoming CEO, Murphy began to vertically integrate the Carilion Health System. His formal plan was presented in fall 2006. Part of evolving to a Mayo-style organization included acquiring physician practices in the community; some were closed after acquisition.

WHO IS EDWARD G. MURPHY, M.D.?

Edward. G. Murphy earned his BS from the University of Albany, New York, and his medical degree (with honors) from Harvard University Medical School. Although he never practiced medicine. Murphy was a clinical professor at the University of Albany School of Public Health and an adjunct assistant professor at Rensselaer Polytechnic Institute School of Management. Before leaving New York state he was also a member of the New York State Hospital Review and Planning Council, and he served on its executive committee as the vice chair of the fiscal policy council.

   From 1989 to 1991, Murphy served as the vice president of clinical services at Leonard Hospital, a 143-bed facility north of Albany, New York. In 1991, he was promoted to president and CEO of Leonard Hospital until it merged with St. Mary Hospital fo form Seton Health system in 1994. Murphy became president and CEO of that new health system and stayed with Seton until 1998, when he relocated to Roanoke to head Carilion Health System.

   During his tenure at Carilion Clinic, Murphy managed the growth of that two-hospital health system into a vertically integrated model of healthcare delivery anchored by a 500-physician specialty group practice that included nine not-for-profit hospitals, undergraduate medical programs, an array of tertiary referral services, and a multistate laboratory service. In 2007, Murphy announced plans for the Virginia Tech Carilion School of Medicine, which opened in 2010. In 2010, Murphy was paid $2.27 million ($1.37 million in salary and $900,000 in benefits).

Murphy’s other roles in the Roanoke community included memberships on the boards of Healthcare Professionals Insurance Company and Trust; Luna Innovations, Inc; and Hometown Bank. He is past chair of the Art Museum of Western Virginia. He also served in an influential position with the council on Virginia’s Future, which works to frame the growth and progress of the state, including businesses, people, and the health of the population.

   Murphy left Carilion to become chairman of Sound Physicians, a national provider of Intensivist and hospitalist services. In 2012, he became the operating officer of Radius Ventures, a venture capital firm that invests in health-related companies.

VERTICAL INTEGRATION: BECOMING A “CLINIC”

Murphy was always clear about his plans for Carilion Health System. In an August 2006 interview, “Right now...our core business is hospital services. In the new model, the core business will be physician services; the hospital will become ancillary. In a 2007 interview for Health Leaders Magazine, Murphy explained, “I’ve been enamored of this model of healthcare delivery for a long time.”

   In Fall 2006, Murphy, his staff, and the leadership board of Carilion Health System announced their plan to create a new model for Carilion management characterized by teamwork and salaried physicians and other caregivers focused on patients across the spectrum of care. Murphy explained:

   The essence of the clinic model is that hospitals stop becoming independent businesses and start becoming ancillary services to the physician practice….If hospitals eventually want to provide better and more cost-effective healthcare, it’s a necessary shift.

The transformation was planned for seven years with an 18-month phase -in of its new name, Carilion clinic. Plans for Carilion Clinic included a 50-50 partnership with Virginia Tech University in Blacksburg, Virginia, to establish a private, not-for-profit clinical research institute and a new medical school. Further, from 2007 to 2012 Carilion clinic would add four or five fellowships for physicians to support its mission.

Ground was broken for the much-anticipated university in early 2008. On July 20, 2009, the Virginia State Council for Higher Education approved the Virginia Tech Carilion School of Medicine as a postsecondary institution. It’s first class matriculated in fall 2010.

THE WALL STREET JOURNAL EXPOSE

Usually, an organization is pleased if the Wall street Journal publishes an article about it. That is, of course, unless the story ignites a firestorm that leads to separate citizen and physician coalitions working against the organization and raises the specter of a word from Carilion Clinic’s prehistory: monopoly.

“Nonprofit Hospitals Flex Pricing Power. In Roanoke, Va., Carilion’s Fees Exceed Those of Competitors: The $4,727 Colonoscopy” was published on the front page of the Wall Street Journal August 28, 2008. The author, John Carreyrou, explored Carilion’s history, including the 1989 antitrust case, its expanding”market clout,” and the strides toward its goal of vertical integration. The article suggested that some of the means used were questionable.

   Carreyrou asserted that skyrocketing healthcare costs in Roanoke were partially caused by, or possibly even led by, Carilion Clinic.

   In a press release, Carilion Clinic denied monopolistic practices or exploitative pricing and claimed it faced robust competition from Lewis-Gale Medical Center located in nearby Salem, Virginia. Carilion Clinic defended its pricing practices by noting it must cross-subsidize emergency departments and care for the uninsured.

   Unsettling to some, however, was Carilion’s practice of suing patients for unpaid medical bills. After Carilion obtains a court judgement, a lien is placed against the patient’s home. A lien on real property puts a “cloud” on the title, which prevents the owner from conveying the property with a clear title until the lien has been satisfied. Responding in the Wall street Journal, Murphy stated,

   Carilion only sues patients and places liens on their homes if it believes they have the ability to pay … If you’re asking me if it’s right in a right-and-wrong sense, it’s not...But Carilion cannot be blamed for the country’s “broken” healthcare system.

Murphy asserted that Carilion efforts to protect its financial interests meet legal requirements, but may be morally flawed. This position appears inconsistent with Carilion’s mission that ‘Patient Care Comes First.”

WHERE WERE THE LOCAL MEDIA?

As reported by Carreyrou, Carilion Clinic complained several times to editors of the Roanoke Times regarding reporter Jeff Sturgeon’s coverage of the system. Shortly after the complaints, and mainly in response to a May 2008 article by Sturgeon, Carilion greatly reduced advertising in the Roanoke Times. About the same time, Sturgeon, the paper’s longtime health issues writer, was reassigned.

Even after Sturgeon’s reassignment, Carilion continued to be frontpage news in the Roanoke Times. Reporter Sarah Bruyn Jones covered community reaction to the Wall Street Journal article and the impetus it gave to local coalitions. Her articles included the following: “Carilion Critics Draw Hundreds to Meeting” (September 2008); “Fed Agency Looks into Carilion Purchase” (September 2008); “Carilion Footprint Expands in Deal” (August 2008); and “Carilion to Buy Cardiology Practice” (August 2008). Jone’s reporting put Carilion practices at the forefront for Roanoke’s citizens, but, as noted by Carreyrou, Carilion growth seemed unstoppable.

THE BACKLASH

The August 2008 Wall Street Journal article resulted in a community uproar and fueled physician's’ efforts to air their concerns about Carilion, including its anti competitive actions and unfair pricing, and their desire to have open referrals for patients from outside Carilion’s health network. Citizen and physician coalitions met in hotel conference rooms and community centers to discuss the “unfair practices and behaviors” ifof Carilion Clinic. One, the citizens Coalition for Responsible Healthcare, sponsored a petition that read as follows:

   To Dr. Murphy and the Carilion Health System Board of Directors:

   Please reconsider your Carilion Clinic plans. I want to keep my right to choose my doctor, even if he or she is an independent physician. Please rethink spending $100 million of my community’s money on a Clinic model that could ruin our hospitals! Monopolies are never good for healthcare.

The Coalition’s website offered copies of the Wall Street Journal article, video recordings of their meetings, information about a new forum program, and membership form for those who wished to join their efforts.

   The citizen coalitions stated they intended to focus on the negative impact of Carilion’s transformation to a physician-led clinic that they asserted will increase costs and drive out many local physicians. Murphy’s plan was to bring into Carilion as many physicians as possible; all of whom will be salaried. The concerns of citizen coalitions stemmed from the scope of the effort, which resulted in closure or sale of many physician practices. Unaffiliated physicians asserted they could not compete. Further, Carilion’s system of internal referrals, added to the purchase of existing practices, gave many specialists no choice but to leave, or stay and fight.

   Despite the controversy, Carilion has shown no signs of slowing: it has stayed the course outlined in Fall 2006.

CARILION’S RESPONSE

On August 28, 2008, less than 24 hours after publication of Carreyrou’s Wall Street Journal article, Carilion responded. Statements published in newspapers and posted on Carilion’s website, as well as press releases, stated the allegations and conclusions drawn from them were misleading and misinformed.

   In response, Carilion directed readers’ attention to the Virginia Hospital and Health care Association PricePoint Website. It showed that Carilion’s prices are comparable to surrounding hospitals and are generally lower than its closest competitor, Lewis-Gale Medical center in neighboring Salem, Virginia. To support their position on pricing,Carilion stated “Medical care in hospitals is more expensive … having staff and technology at the ready has its costs. Also mentioned was Carilion’s Lifeguard helicopter, which is subsidized service. Carilion provided $42 million in charity care in 2007 and an additional $25 million in free care (bad debt written off), thus illustrating its dedication and support of its service area. Carilion supports research and education substantial resource commitments that add major costs to the organization and provide subsidize services tiot the community.

   In explaining the policy to sue patients, Carilion stated that efforts are made to qualify patients for public programs, as needed. Further, Carilion said only “a small fraction of the nearly 2 million” patient billings each year go to court.

   Court filings are a final resort, and we try to be flexible. If the judgement includes a lien on an individual’s property, we do not foreclose on the lien. The lien is satisfied if and when the property is sold.

In response to concerns about its internal referral practice, Carilion stated that referrals are sent from physician to physician in the system with the intention of sending patients to better, more-qualified physicians who have earned the referral. The “earn, not force” mentality contributes to the goal of well-coordinated care and service, which is the first choice of patients.

Carilion’s press release closed by describing a wasteful and poorly organized U.S. healthcare system that is hoped to improve with the vertically integrated clinic model of providing care. The hope is that comprehensive, high quality, and cost-effective care will put the patient first. The reader of the press release is reminded that what happened at Mayo could be replicated at Carilion.

CURRENT SITUATION IN ROANOKE

As noted, Carilion Clinic has a medical school partnership, an expanding physician practice with a robust specialty list, and its own accountable care organization, which continues to show progress and increased membership.

Three decades after the hospital merger controversy began in Roanoke, Virginia, the economic and healthcare environments have changed, the population is increasing, and healthcare costs are rising. When the antitrust case was brought in 1988, Roanoke had among the lowest health insurance premiums in Virginia; now, they are among the highest.

Discussion questions to be answered

1) Identify the problems Carilion Clinic faces as it seeks to become a comprehensive, vertically integrated healthcare provider.

2) Briefly explain the summary of the case

3) Identify the most important factors/facts of the Case study

4) Explain the critical issues that is the most important health administration problem/issue to be solved and if applicable, identified secondary problems.

5) Identify the recommended solution of the case. At least three realistic alternative solutions.

6) Identify the relevant concepts and tools for example, methods, techniques, principles,theories, and or models.

Write a one-page article summarizing what you've read. Use Times New Roman 12 font, 1.5 spacing, with no spacing between paragraphs and 1 inch margins. IT STARTS WITH a single cell. The first cell splits to become two and the two become four and so on. After just forty-seven doublings, you have ten thousand trillion (10,000,000,000,000,000) cells in your body and are ready to spring forth as a human being.1 And every one of those cells knows exactly what to do to preserve and nurture you from the moment of conception to your last breath. You have no secrets from your cells. They know far more about you than you do. Each one carries a copy of the complete genetic code—the instruction manual for your body—so it knows not only how to do its job but every other job in the body. Never in your life will you have to remind a cell to keep an eye on its adenosine triphosphate levels or to find a place for the extra squirt of folic acid that’s just unexpectedly turned up. It will do that for you, and millions more things besides. Every cell in nature is a thing of wonder. Even the simplest are far beyond the limits of human ingenuity. To build the most basic yeast cell, for example, you would have to miniaturize about the same number of components as are found in a Boeing 777 jetliner and fit them into a sphere just five microns across; then somehow you would have to persuade that sphere to reproduce. But yeast cells are as nothing compared with human cells, which are not just more varied and complicated, but vastly more fascinating because of their complex interactions. Your cells are a country of ten thousand trillion citizens, each devoted in some intensively specific way to your overall well-being. There isn’t a thing they don’t do for you. They let you feel pleasure and form thoughts. They enable you to stand and stretch and caper. When you eat, they extract the nutrients, distribute the energy, and carry off the wastes—all those things you learned about in junior high school biology—but they also remember to make you hungry in the first place and reward you with a feeling of well-being afterward so that you won’t forget to eat again. They keep your hair growing, your ears waxed, your brain quietly purring. They manage every corner of your being. They will jump to your defense the instant you are threatened. They will unhesitatingly die for you—billions of them do so daily. And not once in all your years have you thanked even one of them. So let us take a moment now to regard them with the wonder and appreciation they deserve. We understand a little of how cells do the things they do—how they lay down fat or manufacture insulin or engage in many of the other acts necessary to maintain a complicated entity like yourself—but only a little. You have at least 200,000 different types of protein 1 Actually, quite a lot of cells are lost in the process of development, so the number you emerge with is really just a guess. Depending on which source you consult the number can vary by several orders of magnitude. The figure of ten thousand trillion (or quadrillion) is from Margulis and Sagan, 1986. laboring away inside you, and so far we understand what no more than about 2 percent of them do. (Others put the figure at more like 50 percent; it depends, apparently, on what you mean by “understand.”) Surprises at the cellular level turn up all the time. In nature, nitric oxide is a formidable toxin and a common component of air pollution. So scientists were naturally a little surprised when, in the mid-1980s, they found it being produced in a curiously devoted manner in human cells. Its purpose was at first a mystery, but then scientists began to find it all over the place—controlling the flow of blood and the energy levels of cells, attacking cancers and other pathogens, regulating the sense of smell, even assisting in penile erections. It also explained why nitroglycerine, the well-known explosive, soothes the heart pain known as angina. (It is converted into nitric oxide in the bloodstream, relaxing the muscle linings of vessels, allowing blood to flow more freely.) In barely the space of a decade this one gassy substance went from extraneous toxin to ubiquitous elixir. You possess “some few hundred” different types of cell, according to the Belgian biochemist Christian de Duve, and they vary enormously in size and shape, from nerve cells whose filaments can stretch to several feet to tiny, disc-shaped red blood cells to the rod- shaped photocells that help to give us vision. They also come in a sumptuously wide range of sizes—nowhere more strikingly than at the moment of conception, when a single beating sperm confronts an egg eighty-five thousand times bigger than it (which rather puts the notion of male conquest into perspective). On average, however, a human cell is about twenty microns wide—that is about two hundredths of a millimeter—which is too small to be seen but roomy enough to hold thousands of complicated structures like mitochondria, and millions upon millions of molecules. In the most literal way, cells also vary in liveliness. Your skin cells are all dead. It’s a somewhat galling notion to reflect that every inch of your surface is deceased. If you are an average-sized adult you are lugging around about five pounds of dead skin, of which several billion tiny fragments are sloughed off each day. Run a finger along a dusty shelf and you are drawing a pattern very largely in old skin. Most living cells seldom last more than a month or so, but there are some notable exceptions. Liver cells can survive for years, though the components within them may be renewed every few days. Brain cells last as long as you do. You are issued a hundred billion or so at birth, and that is all you are ever going to get. It has been estimated that you lose five hundred of them an hour, so if you have any serious thinking to do there really isn’t a moment to waste. The good news is that the individual components of your brain cells are constantly renewed so that, as with the liver cells, no part of them is actually likely to be more than about a month old. Indeed, it has been suggested that there isn’t a single bit of any of us—not so much as a stray molecule—that was part of us nine years ago. It may not feel like it, but at the cellular level we are all youngsters. The first person to describe a cell was Robert Hooke, whom we last encountered squabbling with Isaac Newton over credit for the invention of the inverse square law. Hooke achieved many things in his sixty-eight years—he was both an accomplished theoretician and a dab hand at making ingenious and useful instruments—but nothing he did brought him greater admiration than his popular book Microphagia: or Some Physiological Descriptions of Miniature Bodies Made by Magnifying Glasses, produced in 1665. It revealed to an enchanted public a universe of the very small that was far more diverse, crowded, and finely structured than anyone had ever come close to imagining. Among the microscopic features first identified by Hooke were little chambers in plants that he called “cells” because they reminded him of monks’ cells. Hooke calculated that a one-inch square of cork would contain 1,259,712,000 of these tiny chambers—the first appearance of such a very large number anywhere in science. Microscopes by this time had been around for a generation or so, but what set Hooke’s apart were their technical supremacy. They achieved magnifications of thirty times, making them the last word in seventeenth-century optical technology. So it came as something of a shock when just a decade later Hooke and the other members of London’s Royal Society began to receive drawings and reports from an unlettered linen draper in Holland employing magnifications of up to 275 times. The draper’s name was Antoni van Leeuwenhoek. Though he had little formal education and no background in science, he was a perceptive and dedicated observer and a technical genius. To this day it is not known how he got such magnificent magnifications from simple handheld devices, which were little more than modest wooden dowels with a tiny bubble of glass embedded in them, far more like magnifying glasses than what most of us think of as microscopes, but really not much like either. Leeuwenhoek made a new instrument for every experiment he performed and was extremely secretive about his techniques, though he did sometimes offer tips to the British on how they might improve their resolutions.2 Over a period of fifty years—beginning, remarkably enough, when he was already past forty—he made almost two hundred reports to the Royal Society, all written in Low Dutch, the only tongue of which he was master. Leeuwenhoek offered no interpretations, but simply the facts of what he had found, accompanied by exquisite drawings. He sent reports on almost everything that could be usefully examined—bread mold, a bee’s stinger, blood cells, teeth, hair, his own saliva, excrement, and semen (these last with fretful apologies for their unsavory nature)—nearly all of which had never been seen microscopically before. After he reported finding “animalcules” in a sample of pepper water in 1676, the members of the Royal Society spent a year with the best devices English technology could produce searching for the “little animals” before finally getting the magnification right. What Leeuwenhoek had found were protozoa. He calculated that there were 8,280,000 of these tiny beings in a single drop of water—more than the number of people in Holland. The world teemed with life in ways and numbers that no one had previously suspected. Inspired by Leeuwenhoek’s fantastic findings, others began to peer into microscopes with such keenness that they sometimes found things that weren’t in fact there. One respected Dutch observer, Nicolaus Hartsoecker, was convinced he saw “tiny preformed men” in sperm cells. He called the little beings “homunculi” and for some time many people believed that all humans—indeed, all creatures—were simply vastly inflated versions of tiny but complete precursor beings. Leeuwenhoek himself occasionally got carried away with his enthusiasms. In one of his least successful experiments he tried to study the explosive properties of gunpowder by observing a small blast at close range; he nearly blinded himself in the process. 2 Leeuwenhoek was close friends with another Delft notable, the artist Jan Vermeer. In the mid-1660s, Vermeer, who previously had been a competent but not outstanding artist, suddenly developed the mastery of light and perspective for which he has been celebrated ever since. Though it has never been proved, it has long been suspected that he used a camera obscura, a device for projecting images onto a flat surface through a lens. No such device was listed among Vermeer's personal effects after his death, but it happens that the executor of Vermeer's estate was none other than Antoni van Leeuwenhoek, the most secretive lens-maker of his day. In 1683 Leeuwenhoek discovered bacteria, but that was about as far as progress could get for the next century and a half because of the limitations of microscope technology. Not until 1831 would anyone first see the nucleus of a cell—it was found by the Scottish botanist Robert Brown, that frequent but always shadowy visitor to the history of science. Brown, who lived from 1773 to 1858, called it nucleus from the Latin nucula, meaning little nut or kernel. Not until 1839, however, did anyone realize that all living matter is cellular. It was Theodor Schwann, a German, who had this insight, and it was not only comparatively late, as scientific insights go, but not widely embraced at first. It wasn’t until the 1860s, and some landmark work by Louis Pasteur in France, that it was shown conclusively that life cannot arise spontaneously but must come from preexisting cells. The belief became known as the “cell theory,” and it is the basis of all modern biology. The cell has been compared to many things, from “a complex chemical refinery” (by the physicist James Trefil) to “a vast, teeming metropolis” (the biochemist Guy Brown). A cell is both of those things and neither. It is like a refinery in that it is devoted to chemical activity on a grand scale, and like a metropolis in that it is crowded and busy and filled with interactions that seem confused and random but clearly have some system to them. But it is a much more nightmarish place than any city or factory that you have ever seen. To begin with there is no up or down inside the cell (gravity doesn’t meaningfully apply at the cellular scale), and not an atom’s width of space is unused. There is activity every where and a ceaseless thrum of electrical energy. You may not feel terribly electrical, but you are. The food we eat and the oxygen we breathe are combined in the cells into electricity. The reason we don’t give each other massive shocks or scorch the sofa when we sit is that it is all happening on a tiny scale: a mere 0.1 volts traveling distances measured in nanometers. However, scale that up and it would translate as a jolt of twenty million volts per meter, about the same as the charge carried by the main body of a thunderstorm. Whatever their size or shape, nearly all your cells are built to fundamentally the same plan: they have an outer casing or membrane, a nucleus wherein resides the necessary genetic information to keep you going, and a busy space between the two called the cytoplasm. The membrane is not, as most of us imagine it, a durable, rubbery casing, something that you would need a sharp pin to prick. Rather, it is made up of a type of fatty material known as a lipid, which has the approximate consistency “of a light grade of machine oil,” to quote Sherwin B. Nuland. If that seems surprisingly insubstantial, bear in mind that at the microscopic level things behave differently. To anything on a molecular scale water becomes a kind of heavy-duty gel, and a lipid is like iron. If you could visit a cell, you wouldn’t like it. Blown up to a scale at which atoms were about the size of peas, a cell itself would be a sphere roughly half a mile across, and supported by a complex framework of girders called the cytoskeleton. Within it, millions upon millions of objects—some the size of basketballs, others the size of cars—would whiz about like bullets. There wouldn’t be a place you could stand without being pummeled and ripped thousands of times every second from every direction. Even for its full-time occupants the inside of a cell is a hazardous place. Each strand of DNA is on average attacked or damaged once every 8.4 seconds—ten thousand times in a day—by chemicals and other agents that whack into or carelessly slice through it, and each of these wounds must be swiftly stitched up if the cell is not to perish. The proteins are especially lively, spinning, pulsating, and flying into each other up to a billion times a second. Enzymes, themselves a type of protein, dash everywhere, performing up to a thousand tasks a second. Like greatly speeded up worker ants, they busily build and rebuild molecules, hauling a piece off this one, adding a piece to that one. Some monitor passing proteins and mark with a chemical those that are irreparably damaged or flawed. Once so selected, the doomed proteins proceed to a structure called a proteasome, where they are stripped down and their components used to build new proteins. Some types of protein exist for less than half an hour; others survive for weeks. But all lead existences that are inconceivably frenzied. As de Duve notes, “The molecular world must necessarily remain entirely beyond the powers of our imagination owing to the incredible speed with which things happen in it.” But slow things down, to a speed at which the interactions can be observed, and things don’t seem quite so unnerving. You can see that a cell is just millions of objects—lysosomes, endosomes, ribosomes, ligands, peroxisomes, proteins of every size and shape—bumping into millions of other objects and performing mundane tasks: extracting energy from nutrients, assembling structures, getting rid of waste, warding off intruders, sending and receiving messages, making repairs. Typically a cell will contain some 20,000 different types of protein, and of these about 2,000 types will each be represented by at least 50,000 molecules. “This means,” says Nuland, “that even if we count only those molecules present in amounts of more than 50,000 each, the total is still a very minimum of 100 million protein molecules in each cell. Such a staggering figure gives some idea of the swarming immensity of biochemical activity within us.” It is all an immensely demanding process. Your heart must pump 75 gallons of blood an hour, 1,800 gallons every day, 657,000 gallons in a year—that’s enough to fill four Olympic- sized swimming pools—to keep all those cells freshly oxygenated. (And that’s at rest. During exercise the rate can increase as much as sixfold.) The oxygen is taken up by the mitochondria. These are the cells’ power stations, and there are about a thousand of them in a typical cell, though the number varies considerably depending on what a cell does and how much energy it requires. You may recall from an earlier chapter that the mitochondria are thought to have originated as captive bacteria and that they now live essentially as lodgers in our cells, preserving their own genetic instructions, dividing to their own timetable, speaking their own language. You may also recall that we are at the mercy of their goodwill. Here’s why. Virtually all the food and oxygen you take into your body are delivered, after processing, to the mitochondria, where they are converted into a molecule called adenosine triphosphate, or ATP. You may not have heard of ATP, but it is what keeps you going. ATP molecules are essentially little battery packs that move through the cell providing energy for all the cell’s processes, and you get through a lot of it. At any given moment, a typical cell in your body will have about one billion ATP molecules in it, and in two minutes every one of them will have been drained dry and another billion will have taken their place. Every day you produce and use up a volume of ATP equivalent to about half your body weight. Feel the warmth of your skin. That’s your ATP at work. When cells are no longer needed, they die with what can only be called great dignity. They take down all the struts and buttresses that hold them together and quietly devour their component parts. The process is known as apoptosis or programmed cell death. Every day billions of your cells die for your benefit and billions of others clean up the mess. Cells can also die violently—for instance, when infected—but mostly they die because they are told to. Indeed, if not told to live—if not given some kind of active instruction from another cell— cells automatically kill themselves. Cells need a lot of reassurance. When, as occasionally happens, a cell fails to expire in the prescribed manner, but rather begins to divide and proliferate wildly, we call the result cancer. Cancer cells are really just confused cells. Cells make this mistake fairly regularly, but the body has elaborate mechanisms for dealing with it. It is only very rarely that the process spirals out of control. On average, humans suffer one fatal malignancy for each 100 million billion cell divisions. Cancer is bad luck in every possible sense of the term. The wonder of cells is not that things occasionally go wrong, but that they manage everything so smoothly for decades at a stretch. They do so by constantly sending and monitoring streams of messages—a cacophony of messages—from all around the body: instructions, queries, corrections, requests for assistance, updates, notices to divide or expire. Most of these signals arrive by means of couriers called hormones, chemical entities such as insulin, adrenaline, estrogen, and testosterone that convey information from remote outposts like the thyroid and endocrine glands. Still other messages arrive by telegraph from the brain or from regional centers in a process called paracrine signaling. Finally, cells communicate directly with their neighbors to make sure their actions are coordinated. What is perhaps most remarkable is that it is all just random frantic action, a sequence of endless encounters directed by nothing more than elemental rules of attraction and repulsion. There is clearly no thinking presence behind any of the actions of the cells. It all just happens, smoothly and repeatedly and so reliably that seldom are we even conscious of it, yet somehow all this produces not just order within the cell but a perfect harmony right across the organism. In ways that we have barely begun to understand, trillions upon trillions of reflexive chemical reactions add up to a mobile, thinking, decision-making you—or, come to that, a rather less reflective but still incredibly organized dung beetle. Every living thing, never forget, is a wonder of atomic engineering. Indeed, some organisms that we think of as primitive enjoy a level of cellular organization that makes our own look carelessly pedestrian. Disassemble the cells of a sponge (by passing them through a sieve, for instance), then dump them into a solution, and they will find their way back together and build themselves into a sponge again. You can do this to them over and over, and they will doggedly reassemble because, like you and me and every other living thing, they have one overwhelming impulse: to continue to be. And that’s because of a curious, determined, barely understood molecule that is itself not alive and for the most part doesn’t do anything at all. We call it DNA, and to begin to understand its supreme importance to science and to us we need to go back 160 years or so to Victorian England and to the moment when the naturalist Charles Darwin had what has been called “the single best idea that anyone has ever had”—and then, for reasons that take a little explaining, locked it away in a drawer for the next fifteen years.

Dynamic Medical Solutions

Case Questions

After reading the Dynamic Medical Solutions Case answer the questions below. Type your answers to the questions below in a Word document and send in through the designated drop box. Please be sure to fully answer each question. Most questions (with the exception of questions number three and five) will require at least one paragraph (three to five sentences) to answer.

Why are government regulators sensitive to the amount of claims submitted to the government insurance programs in comparison to retail prices?

Why could/would government programs reimbursement amounts exceed the retail sales prices for products?

Consider the information provided for the two products (Nutrition Supplement and Nondurable Gloves) as shown in Table 3. In accordance with the Office of the Inspector General (OIG) for “substantially in excess” are the government programs reimbursement rates for each product presently “substantially in excess” of the “usual charges?”

HINT: To determine your answer use the threshold of 120% of proposed by the OIG from page two of the case narrative and assume that DMS is charging the maximum permitted selling price to the government as shown in Table 3 on page three.

Please provide details of the details of your calculations in your submission.Use the format shown below and fill in the numbers.

	Retail Price Paid by Cash & Carry Customers	Multiplied by 120%	Maximum Amount) Price charged to Government Customers
Nutrition Supplement
Nondurable Gloves

Based on your answer above - Assume at least one of the products violates OIG’s suggestion for “substantially in excess and consider the following scenarios.

DMS reacted by changing the price charged to cash and carry customers. Assume that the government programs reimbursement rate was no more than 20% higher than the newly calculated amount. What effect would this decision be likely to have on the future business of cash and carry customers?

DMS reacted to the dilemma by requesting reimbursement amounts below the maximum allowable reimbursement rates in order to be within 20% of the prices charged to cash and carry customers. What effect would this decision potentially have on the company’s profit margins?

OIG proposed that “good cause” for substantially in excess charges could be established in a number of ways, including, for example, “evidence of increased costs associated with serving Medicare or Medicaid beneficiaries.” Using the information from the time study conducted by DMS that is presented in Table 5 along with the department operating expenses from table 2, determine how customer service, billing, and compliance costs could be allocated by customer type.

Operating Expenses by Dept.	and Cost	Allocations by Customer
	Total Costs	Government Programs	Cash & Carry
Customer Service

Do you think the DMS should track costs for the shipping and receiving departments and try to establish “good cause” for charging Medicare and Medicaid beneficiaries substantially more than cash and carry customers for the same products?

What thoughts do you have concerning how DMS should address the company’s weaknesses in preparation for the upcoming audit?

COMPANY INTRODUCTION AND CASE BACKGROUND
Dynamic Medical Solutions (DMS) is a small company that sells (as a retailer of products manufactured by others) durable and nondurable medical products to customers in seven states across the United States. Some of the popular durable products sold by the company are hospital beds, diabetic footwear, and mobility equipment (i.e., wheelchairs, scooters, etc.). A large portion of the company’s business involves the sale of durable and nondurable medical supplies including nutrition supplements, gloves, and personal care products used in patient care. All of the products carried by DMS are over-the-counter items and thus do not require a physician’s prescription.1 Like most companies in the medical products supply industry, DMS serves a multitude of customers, including those with (1) no insurance (i.e., cash and carry), (2) Medicare and Medicaid benefits (i.e., government programs),2 and (3) private insurance. Accordingly, DMS has a billing department internally for customers with such benefits and insurance. Many customers, including those enrolled in government programs and those who pay for products out of pocket (i.e., cash and carry) are elderly and/or reside in assisted-living facilities. The company employs sales representatives who visit these facilities and interact with the customers and their caregivers on a regular basis and establish the ordering process for the customers via phone or fax. Customers also are able to purchase goods at one of the company’s five retail stores via the company’s website or through the phone/fax process with a sales representative.
In regard to cash and carry customers, DMS strives to offer competitive prices as the company is directly competing with large national retail stores that offer many types of medical products and operate on small profit margins. Serving cash and carry customers is fairly straightforward, involving no other considerations beyond the typical sales initiation (i.e., visits from a sales representative), point-of-sale sales, and warehouse shipping or customer pick-up processes.
On the other hand, serving government programs customers is more restrictive and requires an extensive number of internal processes and procedures. The prices charged to these customers (i.e., the reimbursement amount) are set by the program entity (i.e., Medicaid or Medicare). Most importantly, the process of selling goods involves additional mandated (by law) considerations beyond the normal cash-and-carry process, including the written verification of medical necessity from the customer’s physician, the processing of insurance claims, and the substantiation of product delivery. For many of the nondurable medical supplies, such as nutrition supplements and gloves, the process is even more cumbersome as these products are supplied to customers on a monthly basis. Accordingly, proof of medical necessity for these products also has to be updated on a recurring basis. This involves
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ISSN 1940-204X
Dynamic Medical Solutions:
Expanding the Application of Cost Management Principles to Channel and Customer Profitability Analysis
Casey J. McNellis, Ph.D., CPA
University of Montana
Ronald F. Premuroso, Ph.D., CPA, CFE
University of Montana
additional interaction by the company with primary care physicians and Medicare/Medicaid representatives, as well as increased processing of paperwork.
Sales to customers using private insurance comprise an immaterial amount of the company’s revenues. Most private insurance companies cover only a minor amount of the charges for the products offered by DMS, often after a government program has been billed first and has paid for the majority of the charge billed by DMS.
Table 1 provides a breakdown of DMS’s sales for the most recent financial year, along with other relevant financial information (excluding an immaterial amount for private insurance-related sales).
Table 1: DMS Sales by Customer Type and Other Financial Information
Sales
% of Total Sales
Government Programs Sales
$3,000,000
75.0%
Cash and Carry Sales
$1,000,000
25.0%
Total Net Sales
$4,000,000
100.0%
Cost of Sales
($1,300,000)
32.5%
Gross Profit
$2,700,000
67.5%
Operating Expenses
($2,200,000)
55.0%
Operating Income
$ 500,000
12.5%
The company’s operations are divided into five departments: Customer Service, Shipping, Billing, Compliance, and Administration. Table 2 includes a breakdown of the operating expenses by department along with a brief description of the general functions carried out by each department for the most recent financial year.
Table 2: Department Operating Expenses and Descriptions
Department
Operating Expenses
Description of Functions
Customer Service
$660,000
Process sales orders; support customer base
Shipping
$870,000
Prepare orders for shipment; track shipments to delivery
Billing
$120,000
Submit insurance claims; monitor customer eligibility for government programs
Compliance
$120,000
Monitor company policies regarding government programs
Administration
$430,000
Perform bookkeeping, payroll, and marketing functions; heat, light, and power; insurance expenses; execute strategic plan
Total Operating Expenses
$2,200,000
REGULATORY ENVIRONMENT
As Table 1 depicts, DMS’s primary source of sales are from customers who are eligible for assistance from government-related healthcare programs. As such, the company’s success is largely based on understanding government regulations, policies, and procedures governing Medicare and Medicaid programs, including reimbursements.
Because of past alleged abuses of these government insurance programs by healthcare providers, Federal and state authorities have enacted several regulations under the Social Security Act for providers like DMS involved with submitting reimbursement claims under government programs. For example, the Department of Health and Human Services (HHS) has the power to revoke a company’s privileges to serve Medicare and Medicaid customers if the company has been involved in criminal activity, patient abuse, and/or healthcare fraud. Additionally, the Act also allows HHS to prohibit a company from engaging in business activities with Medicare and/or Medicaid if the company submits product reimbursement claims for government programs customers significantly higher than amounts charged to cash and carry customers. Specifically, Section 1128(b) of the Act states that HHS:
“…may exclude…from participation in any Federal health care program…any individual or entity that the Secretary determines…has submitted or caused to be submitted bills or requests for payment (where such bills or requests are based on charges or cost) under Title XVIII or a State health care program containing charges (or, in applicable cases, requests for payment of costs) for items or services furnished substantially in excess of such individual’s or entity’s usual charges (or, in applicable cases, substantially in excess of such individual’s or entity’s costs) for such items or services, unless the Secretary finds there is good cause for such bills or requests containing such charges or costs.” (Emphasis added.)
The language of this regulation was further interpreted in a proposal by the Office of the Inspector General (OIG) in June 2007.3 The phrase “usual charges” was suggested to include “charges billed directly to cash paying patients” (i.e., cash and carry customers). The term “substantially in excess” was defined by the OIG proposal as charges exceeding “120 percent of an individual’s or entity’s usual charges.” Finally, the OIG proposed that “good cause” for “substantially in excess” charges could be established in a number of ways, including, for example, evidence of “increased costs associated with serving Medicare or Medicaid beneficiaries.”
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DMS’S DILEMMA
DMS sends a member of the management team to a government programs seminar, where firms are provided information and guidelines regarding Federal regulations governing Medicare and Medicaid reimbursements. The team member is amazed by the number of regulations governing these programs, including the one mentioned earlier. Because the team member is not familiar with the methods that ensure DMS is in compliance with these regulations, he holds a meeting with the rest of the management team to discuss the regulations. The management team agrees it is necessary to hire a healthcare consultant to review DMS’s policies, procedures, and billing practices for products sold to customers under government programs.
After examining DMS’s operations in some detail, the healthcare consultant hired by DMS informed management of a grim, unexpected finding: DMS’s product pricing appeared to be in violation of Federal regulations governing Medicare and Medicaid reimbursements. The aforementioned regulation was the issue referenced by the healthcare consultant in determining DMS was potentially in violation of the Federal Act. The consultant examined all of the company’s products and determined many of them had Medicaid reimbursement rates “substantially in excess” of prices charged to cash and carry customers. According to the consultant, DMS would likely have to change its pricing structure and/or potentially eliminate the sale of certain products sold by the company to remedy the violation. Accordingly, the company was advised to employ one of the following courses of action: either raise cash and carry prices for products not complying with the 120% proposed “rule,” or eliminate sales of the two selected products to cash and carry customers. Discouraged by the findings and faced with uncertainty and potentially disastrous consequences, the DMS management team members contemplated their next moves.
DMS’S INITIAL CONCERNS AND RESPONSE
Given the substantial portion of DMS’s sales from customers eligible for government program reimbursements, the issue of product pricing is therefore critical to the company. Prices offered to cash and carry customers must be competitive, yet they must be within a certain percentage of government program reimbursement claims in order for DMS to comply with government regulations. As such, pricing decisions have the potential to not only adversely impact DMS’s market share of cash and carry customers but also may put the company’s ability to sell and receive reimbursement for these products under the respective government programs in jeopardy.
Unhappy with these two alternatives suggested by the consultant, company officials began compiling product pricing and costing data, as well as observing and documenting key operational aspects of the business to determine the extent of the problem revealed by the consultant and to develop potential alternative courses of action.
SELECTED PRODUCT PRICING DATA
The first two products examined by management were the nutrition supplement and nondurable gloves, two products eligible for reimbursement under government insurance programs. Table 3 includes selected information for these two products in the latest financial year.
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Table 3: Information for Selected Products Offered by DMS
Nutrition Supplement (1 can)
Nondurable Gloves (1 box)
Retail sales price (paid by cash and carry customers)
$1.54
$6.95
Maximum permitted selling price to government*
$2.20
$8.82
Product cost
$0.66
$2.65
Product sales as a % of cash and carry sales
3%
4%
Quantity of product sold to cash and carry customers
19,480 cans
5,755 boxes
Product sales as a % of government programs sales
6%
6%
Quantity of product sold to government programs customers
81,800 cans
20,408 boxes
*This maximum permitted selling price to the government applies to all companies in general under specific regulations pertaining to these products issued by the government.
BUSINESS OBSERVATIONS
Management was inclined to believe disproportionate shares of company resources were being devoted to serving government program customers, especially in the case of nutrition and nondurable products (i.e., gloves), which involved additional processing costs in order to comply with regulations. But they had no formal evidence to support this belief and thus needed to obtain relevant information about the efforts being exerted to serve the two different customer types: cash and carry and government programs. As a first step, the officials observed employees from each department to obtain an understanding of the sales and order fulfillment processes, separately, for the cash and carry and government program customers. Information about these processes from new sales origination all of the way through billing are detailed in Table 4.
As part of these observations, company employees from selected departments were asked to keep track of the amount of time they spent on the different types of customer orders and related activities for a one-month period. Because of increased work demands at the time the study was performed, similar time data was not immediately obtained from employees working in the Shipping or Administration departments. The results are presented in Table 5.4
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Table 4: Summary of Relevant Portions of Company Processes
New sales origination
Cash and carry: A company salesperson visits nursing homes, hospitals, and assisted-living facilities, speaking with potential customers and guardians. The salesperson takes orders and phones/faxes them to warehouse customer service representatives.
Government programs: Same as cash and carry.
Recurring sales
Cash and carry: A customer service representative contacts customers and takes sales orders.
Government programs: Same as cash and carry.
Order fulfillment
Cash and carry: A representative from customer service enters the order into the company’s accounting system. The system produces a pick slip, which is forwarded to Shipping. The employees in Shipping fill the order, which is then given to a third-party courier for delivery. A copy of the pick slip is sent back to the customer service representative.
Government programs: Per regulations, DMS must obtain a valid identification card proving the customer’s eligibility for the government program. To establish medical necessity, a doctor’s order is required to be submitted with each order. A customer service representative prepares fax inquiries to the customer’s physician (to establish medical necessity) and to the customer for valid proof of eligibility (if a copy was not obtained by the salesperson). Upon receipt of this documentation, the order is entered into the accounting system. The system produces a pick slip, which is forwarded to Shipping. The employees in Shipping fill the order, which is then given to a third-party courier for delivery. A copy of the pick slip is sent to a Billing representative. Shipping employees track shipments with the courier’s website to confirm delivery.
Billing
Cash and carry: A representative from customer service examines the pick slips sent back from Shipping and prepares an invoice to the customer. The customer has 30 days to pay the invoice.
Government programs: A representative from Billing prepares a government program claim and submits it. The reimbursement usually takes between 15-60 days.
Other
Government programs: Renewals for nutrition and nondurable goods: Periodically, a customer’s physician order and proof of eligibility documentation are required to be renewed. A billing representative tracks these customers and prepares renewal requests when appropriate.
Government programs: Oversight: Per regulations, DMS is required to have a compliance program staffed with a compliance officer, whose sole responsibility is to oversee compliance issues and related employee training.
Retail store and website transactions
Customers also visit the company’s retail stores and website on their own. For cash and carry customers, the retail store process in similar to point-of-sale transactions of major retail stores. For website sales, a sales representative is not involved. Rather, the customer places the order, which is then sent to a customer service representative. At that point, the customer service representative processes the order in the same way as described under “Order fulfillment.” Transactions with government programs customers visiting the retail stores are still processed in accordance with the steps above. But no sales representative is involved in the transaction. In general, government programs customers do not place orders via the company website.
CASE QUESTIONS
1. Why are government regulators sensitive to the amount of claims submitted to the government insurance programs in comparison to retail prices?
2. Why potentially could/would government programs reimbursement amounts exceed the retail sales prices
for products?
3. Consider the information provided for the two products shown in Table 3. In accordance with the OIG’s suggestions for “substantially in excess,” are the government programs
reimbursement rates for each product presently “substantially
in excess” of the “usual charges”? Provide the details of your calculations in your submission.
4. Assuming at least one of the products violates the OIG’s suggestion for “substantially in excess,” discuss the impact of the following three potential solutions to this dilemma on DMS’s market share, operations, exposure to liability, and so on. In your assessment, consider the future financial implications of the three alternatives along with the assumptions you have made in your analysis.
a. Raise prices charged to cash and carry customers such that the government programs reimbursement rate is no more than 20% higher than the newly calculated amount.
b. When submitting government program claims, request reimbursement amounts below the maximum allowable reimbursement rates in order to be within 20% of the prices charged to cash and carry customers.
c. Attempt to establish “good cause.” Refer to some of the principles and concepts you have learned or are learning in your cost management course (for example, Customer Profitability Analysis and allocations of overhead) in establishing “good cause.” Provide details of your calculations, which will aid DMS in establishing “good cause” and apply them to the two specific products shown in Table 3. (Hint: This will require you to perform cost allocations and select appropriate bases for the allocation(s).) What are your revised total cost per unit and overall profit margin amounts on the two products?
5. Looking back at your calculations and analyses performed in question 4c, do you believe the company can establish and support “good cause’ in submitting claims for the maximum allowable rates offered by government programs? In answering the question, first consider the qualitative evidence you have already developed. Second, develop a quantitative analysis appropriate to use in establishing or supporting your qualitative evidence.
6. In anticipation of the regulating agencies performing an investigation into the pricing structure of DMS, identify the strengths and weaknesses of the work performed by DMS in response to the consultant’s findings as well as the analysis you provided in the previous questions. How should DMS address the weaknesses in preparation for the audit?
ENDNOTES
1 On the other hand, customers with private insurance or access to government medical programs are required to provide evidence of medical necessity, which is often indicated by physician orders, for reimbursement.
2 Medicare is a national social insurance program administered by the U.S. Federal Government since 1966, which guarantees access to health insurance coverage for U.S. citizens age 65 or older who have worked and paid into the program. Medicaid is a U.S. government insurance program for all U.S. citizens whose income or personal resources are unable to pay for their personal healthcare.
3 Department of Health and Human Services (HHS) and the Office of the Inspector General (OIG), “Medicare and State Health Care Programs: Fraud and Abuse; Clarification of Terms and Application of Program Exclusion Authority for Submitting Claims Containing Excessive Charges,” Federal Register Volume 72, No. 116, June 18, 2007.
4 The firm does not have any type of bank borrowings or debt, and thus there is no interest expense in overhead-related expenses to consider.

The Limits of Redistribution and the Impossibility of Egalitarian Ends

By JEREMY JACKSON AND JEFFREY PALM

ABSTRACT

One of the many dangers of the modern egalitarian philosophy is that it hides its true
objectives behind the guise of social justice. Adherents would insist that they reject the
materialistic values of their free-market foes. However, not far below the surface
commitment to relational equality and disruption of social hierarchy lies their true motive:
material equality. The modern egalitarian is shifting from a focus on equality of relationships
to a focus on equality in quality of life and more comprehensive measures of well-being
(Arneson 2000). Whether the egalitarian desires to create policies that lead to equality in
distribution of wealth or to equality in well-being, it does not matter. Both are impossible
ends. Inequalities in wealth and well-being are due in part to inequalities in the distribution of
social capital, which can be neither removed nor transferred from one individual to another.
Thus, inequalities in wealth and well-being are the inevitable result of a system reliant on
humans autonomously making decisions.
Page 9 of 21

The Origins of Egalitarianism

1. Egalitarianism as an academic school of thought did not actually begin to concretize
until the post–World War II era, although certain basic ideas go back as far as biblical
times (equality of souls but not “earthly” equality) (Anderson 2014). Many of
egalitarianism’s roots are traceable to a particular understanding of the philosophy of
altruism: the idea that a person has but two options in life—to sacrifice one’s self in the
service of others or to sacrifice others in the service of one’s self (Kelley 1991, 2009).
From this understanding of altruism, egalitarians derive a fundamental
misunderstanding of “the zero-sum game.” Because they mistakenly think of all goods
and services as slices of a (finite) pie, they deduce that for one person to gain, another
must lose. From this either–or conception of altruism, egalitarianism concludes that the
only moral thing to do is to sacrifice one’s self in the service of others (Kelley 1991).

2. Karl Marx himself was no egalitarian, yet many of his ideas have helped to shape
modern egalitarianism. His focus on conflict and the exploitation of the subjugated
worker, derived from his misconceptions of the labour market and the means of
production, contributed to the mid- to late-nineteenth-century push for a shorter
workday and higher wages (Anderson 2014). This push then fed into Otto von
Bismarck’s creation of the first modern welfare state in Germany in an effort to combat
Marx’s more revolutionary socialism. Anthony P. Mueller states that “social policy was
foremost national policy and the social security system was primarily an instrument to
lure the workers away from private and communitarian systems into the arms of the
State” (2003).

3. By the early 1940s, which saw the publication of the Beveridge Report in the United
Kingdom in 1942 and Franklin Roosevelt’s suggestion of the “Second Bill of Rights” in
1944, contemporary crystallization and acceptance of the principles of “distributive
justice” had taken place (Roosevelt 1944; Anderson 2014; “The Welfare State” 2016).

4. Philosopher John Rawls, another one of egalitarianism’s most prominent historical
standard bearers, was himself not strictly an egalitarian. However, his seminal work, A
Theory of Justice (1971), is counted among the most foundational of contributions. In
this volume, Rawls explains his most influential concept, the “difference principle,”
which “gives expression to the idea that natural endowments are undeserved” (Wenar
2012). Rawls felt (as do the so-called luck egalitarians) that just because a person is
more intelligent or a naturally gifted musician or better looking or raised with better
values, or something else, it does not entitle him or her to be better off than others. To
Rawls, being more successful than others by using one’s natural endowments (or by
any other means) can be justified only if people who are worse off are made better off
because of that success.

5. On the face of it and according to their own descriptions, egalitarians have differing
ideas with respect to defining the concepts “justice” and “equality.” However, all
schools of egalitarian thought lead to the same ultimate goal: distribution. Most
egalitarians do not actually advocate equality of outcomes because most realize that a
rigid insistence on the tall being made short or the intelligent being made less so would
lead to disastrous consequences. What they want is what they consider to be “fair”
distribution (Kelley 1991). So their basic notions of equality hinge on whether
distribution is just or in the case of relational egalitarianism that societal relationships
are just. However, before discussing the two broad categories of luck egalitarianism
Page 10 of 21
and relational egalitarianism, we must say a few more words regarding the concept of
justice.

6. To many libertarians and classical liberals, the claim that a free market, an impersonal
mechanism governed by the laws of nature, is either just or unjust is absurd. This
claim is evidence of a complete misunderstanding of how the market functions. As
Hayek aptly points out, such claims amount to nothing other than anthropomorphism
(1998, 62, 75).

7. However, those who advocate free markets certainly cannot claim to have ever
actually seen them. Much of the egalitarians’ perceptions of injustice are the symptoms
of the very root causes that such advocates devote the bulk of their work to exposing,
refuting, and denouncing. This feature of the justice problem is twofold: on the one
hand, egalitarianism incorrectly concludes that the corruption observed is simply the
way free market capitalism works; on the other hand, some market advocates
inadvertently defend the corruption as though it were free-market capitalism. It is
imperative to acknowledge that which is correctly perceived as unjust as such and
simultaneously to point to its being but a symptom of corruption that is rooted in
government intervention in the market. It must always be stressed that this corruption
is not a product of free-market capitalism because it then becomes possible to
illustrate the clear distinction between calls for justice that are grounded in reality and
those that are founded on anthropomorphism.

8. Unfortunately, this distinction does not usually carry much weight in the view of the
egalitarian, who frequently finds it completely irrelevant. As David Kelley (1991) points
out, every form of “social justice” rests on the belief that individual ability is a social
asset, a collective good. John Rawls wrote, “Injustice, then, is simply inequalities that
are not to the benefit of all” (1972, 62). On this point, Rawls and Hayek tend to agree.
“The most common attempts to give meaning to the concept of ‘social justice,’” states
Hayek, “resort to egalitarian considerations and argue that every departure from
equality of material benefits enjoyed has to be justified by some recognizable common
interest which these differences serve” (1998, 80).

9. Luck egalitarianism—what Murray Rothbard (1995) refers to as “old” or “classical”
egalitarianism—is more overtly concerned with distribution of income and wealth. It
holds that no one should have to be worse off just because they were born into
unfortunate circumstance or were the victim of a natural disaster or made a mistake in
business or are unintelligent or something else. Rothbard terms this egalitarianism
“old” because modern-day egalitarians have realized the limitations of using the mere
poverty of individuals as moral leverage for their demands for justice.

10. Relational egalitarianism (sometimes referred to as “democratic egalitarianism”) has
been discovered to be a much more effective means of moral intimidation when it
comes to insisting that justice be done. Rothbard (1995) terms this viewpoint “new
group egalitarianism.” The significance of the “group” distinction will become clear as
we delve a bit deeper into its meanings.

11. The new-group egalitarians are concerned primarily with social hierarchies—
specifically, domination and subjection, honour and stigmatization, and high and low
standing in the eyes and calculations of others (calculations as in government policy,
for example) (Anderson 2014). However, one must always remember that these
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egalitarians employ this technique to rationalize, justify, and affect their ultimate goal of
distribution. Sometimes they assert that just distribution is what is necessary in order
to bring about just social relationships. At other times, they assert that policies to affect
just social relationships are necessary to bring about just distribution. Whether the cart
comes before or behind the horse makes little difference; the end result is always
governmental use of violence, coercion, and central planning to affect distribution (of
other people’s money) (Rothbard 1995).

12. Groups such as ethnic minorities, genders, laborers, elders, the young, and virtually
any other group conceivable conveniently fit into one or more of the social hierarchies
listed earlier (Rothbard 1995). New groups are readily added to the seemingly endless
list whenever anybody says the magic word injustice, and anyone who would oppose
(re)distribution to one of these groups must be considered an oppressor. Rothbard
sums it up nicely by paraphrasing Joseph Sobran: “[I]n the current lexicon, ‘need’ is
the desire of people to loot the wealth of others; ‘greed’ is the desire of those others to
keep the money they have earned; and ‘compassion’ is the function of those who
negotiate the transfer” (1995, 53). The insidiousness of relational egalitarianism lies in
its approach to distribution. Egalitarians have erroneously concluded that the cause of
economic difficulties is rooted in the unjust social hierarchies. Therefore, it follows
(they conclude) that in order to affect just distribution, they must design a system that
eliminates the unjust social hierarchies (Sowell 2005, 249–66).

13. Although unjust social relationships certainly cause an incalculable amount of (often
catastrophic) damage, the currently fashionable notion that these relationships are the
root causes of economic difficulties rather than the other way around is incorrect
(Sowell 2005; Williams 2011). Economic difficulties can always be shown to be the
ultimate root causes of the unjust social hierarchies or relationships. They arise as
resentment for being treated unjustly, as rationalization or justification for treating (or
having treated) others unjustly, as a means of securing the ability to treat others
unjustly in the future, and so on. Upon observing social injustices, we should ask
ourselves what motives the perpetrators might have for their unjust conduct. The
origins of the injustice are never arbitrary. They are economic. They may be
completely immoral and thoroughly unjust, but the fact remains that they exist because
the perpetrators hope to derive some benefit from them (Williams 2011).
Sources of Inequality

14. Regardless of its rhetoric, at its core egalitarianism has as its main goal the elimination
of wealth inequality. It has been argued (Piketty 2014) that wealth inequality itself
comes from one primary source: capital. Yet capital itself can be placed into many
categories. Physical capital includes the factories, buildings, computers, land, and
infrastructure that are ultimately used as the inputs to production. Human capital
comes from the knowledge and creativity possessed by human beings that gives them
the capability to contribute to production. Commonly overlooked but increasingly
recognized as important is the concept of social capital, which refers to the “trust and
norms of civic cooperation . . . essential to well-functioning societies” (Knack and
Keefer 1997, 1283). To the extent that wealth can be taxed and redistributed, the
egalitarian would argue that the desired end of equality of distribution is achievable.

15. Physical capital and the income stream it produces can be taxed from one individual
and transferred to another. Thus, egalitarians conclude that any wealth inequalities
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perpetrated by differences in the distribution of physical capital ownership can be
remedied by the well-intentioned taxing powers. To this end, proposals have
advocated a sweeping global tax on wealth (Piketty 2014) and expansion of the estate
tax (Caron and Repetti 2013). However, taxation and redistribution of wealth will be
able to produce sustained equality in wealth only under a limited set of circumstances.
A wealth tax can be effective if the only sources of wealth inequality are inequalities in
the distribution of physical capital. If there are other sources of wealth inequality, such
redistribution will not be possible with a simple tax system and will be effective only
under continuous management by a totalitarian regime. “So long as the belief in ‘social
justice’ governs political action, this process must progressively approach nearer and
nearer to a totalitarian system” (Hayek 1998, 68).

16. Wealth inequalities caused by differences in the distribution of human capital are more
difficult yet not impossible for the state to overcome. Although it isn’t possible to
directly take one person’s human-capital stock and give it to another, it is possible to
tax the wage income derived from some persons’ human capital in order to provide
educational opportunities for others (Guvenen, Kuruscu, and Ozkan 2013). However,
an increasing amount of evidence has shown that the labor market rewards and
punishes certain noncognitive traits, including personality, with wage differentials
(Heckman 2000; Borghans et al. 2008). An individual’s psychological traits and
characteristics cannot be instilled in others through mere education. The family also
plays a significant role in the development of human capital (Becker and Tomes 1994),
which makes it even more difficult for redistribution to be effective. Rawls himself
states that the family, with its effects on the development of the natural capacities, will
ultimately always stand in the way of “equal chances of achievement,” unless a
solution is found that will “mitigate this fact” (1972, 74; see also Rockwell 2015).

17. Perhaps most problematic for the egalitarian goal of equality of distribution are the
differences in wealth and income that are perpetrated by social capital and networks.
Wage earnings aren’t derived solely from an individual’s human capital. Douglas North
(1990) argues that informal social norms and culture are critical to an understanding of
the sources of prosperity. One way that this idea has been evidenced and measured in
the literature is through the concept of social capital popularized by the works of
Robert D. Putnam (1995, 2001).

18. Social capital itself has proven difficult to define, with no one definition being agreed
upon in the literature. Emily Chamlee-Wright defines it as “a complex structure made
up of community norms, social networks, favours given and received, potluck suppers,
book groups, church bazaars, and neighbourhood play groups” (2008, 45).

19. Even with the complexities and difficulties in measurement associated with social
capital, a large empirical literature has shown that social capital and networks add
significantly to an individual’s labour earnings (Knack and Keefer 1997; Narayan and
Pritchett 1999). Human capital and social capital often function as substitutes
(Boxman, De Graaf, and Flap 1991). Yet not much is known about the production of
social capital, unlike physical capital, with its capacity for direct redistribution, and
human capital, with its capacity for indirect redistribution. We may in a limited sense be
able to tax some of the labour returns to social capital, but it is yet unclear how that tax
income can be used for the creation of social capital. Although we know that there are
great benefits to both the individual and society at large from social capital and that
societies don’t flourish in its absence, we don’t have a well-developed theory or policy
Page 13 of 21
on how to create social trust and cohesion. Perhaps the most obvious policy
recommendations (as evidenced by the empirical relationships) are among the most
illiberal because social capital is known to be highly related to racial, ethnic, and
religious homogeneity (Alesina and La Ferrara 2000; Portes 2014). As it turns out,
people trust those who are most like them.

20. There is also an empirical literature that links free-market institutions to measures of
social capital and trust. Although some of the results in this literature are mixed,
several papers suggest a positive and causal relationship between economic freedom
and social capital (see, e.g., Berggren and Jordahl 2006; Jackson, Compton, and Min
Maw 2016). In this light, it is possible that inequalities caused by gains from returns on
social capital may to some degree be the kind that Rawls deems acceptable. Social
capital brings about benefits to society as a whole. Yet those benefits are not spread
equally among all of society’s members but accrue in increased quantities to those
with the more favoured social network. The inequality of incomes and wealth could be
taxed away, but this increase in taxation and redistribution decreases economic
freedom, with a resultant deleterious effect on social capital. These inequalities serve
the “social good.” Attempting to redistribute them away may cause the benefits that all
receive to disappear.

21. Given the impossibility of equality of distribution, the only option available to meet the
egalitarian end of equality of distribution is complete totalitarianism. Only when every
facet of each individual’s life is completely controlled by the state in a continuous
manner can equality be achieved. If the system is ever left to operate on its own,
inequality in distribution will be the result.
New Directions for Egalitarianism

22. As discussed in a previous section, relational egalitarians may not see equality of
wealth as their most desired outcome. They instead desire equality of social
relationships. To them, equality of wealth has been the most direct path to achieve this
desired end. However, new trends are developing.

23. There has been increased attention in the economics literature on the failings of
policies that target economic growth and income in an effort to make lives better off.
This argument has been the apex of the emerging literature on the economics of
happiness. Ever since the publication of Richard Easterlin’s (1974) work, which
popularized the Easterlin Paradox, some of the literature has set out to explain why
increases in a country’s income do not correlate with higher levels of self-reported
happiness among its citizens. Indeed, now even former Federal Reserve chairman
Ben Bernanke argues that “GDP is not itself the final objective of policy” (2010). The
better objective is well-being (happiness), and the egalitarian now has a new direction
for policy in promoting equality of well-being. Many advocate augmenting the national
measurement of gross domestic product with a national happiness accounting (Diener
2000).

24. In shifting the policy focus away from wealth inequality and toward inequality of wellbeing
(Goff, Helliwell, and Mayraz 2016), a host of interventionist policies are opened
up to the egalitarians’ disposal. Subjective well-being measures are regarded as
Page 14 of 21
comprehensive measures of quality of life, and they have many correlates. A
nonexhaustive list of correlates (Dolan, Peasgood, and White 2008) includes variables
such as income (Diener and Oishi 2000), education (Blanchflower and Oswald 2004),
environment (Welsch 2006), materialism (Kasser 2003), mortality (Kawachi et al.
1997), employment (Stutzer 2004), personality (DeNeve and Cooper 1999), and even
social capital and trust (Helliwell and Putnam 2004). The shift in focus away from
income and toward a more broadly defined well-being measure can open up a
Pandora’s box of progressive policy proposals.

25. However, the egalitarians’ search for policies to attain equality of well-being may in fact
lead to the unraveling of well-being itself. A large literature demonstrates that
autonomy of individual choice leads to greater subjective well-being (Ryan and Deci
2000; Verme 2009), and an ever-expanding literature links high economic freedom to
greater subjective well-being (Veenhoven 2000; Gropper, Lawson, and Thorne 2011;
Nikolaev 2014; Jackson 2016). The problems this literature presents for the goals of
redistribution are in addition to the inherent difficulties in distributing such fundamental
determinates of well-being as personality traits and psychological characteristics.
Perhaps a more pervasive problem for proponents of policies for happiness is that of
adaptation.

26. Adaptation in the happiness literature refers to humans’ innate ability to adapt to new
circumstances. In fact, one explanation of the Easterlin Paradox is that increases in
income can fail to create increases in happiness because people rapidly adjust to their
higher incomes. Although there may be an initial temporal boost in happiness from
increased income, the effects do not persist in the long run. Adaptation also explains
why poor and impoverished countries sometimes report much higher levels of
happiness than might seem reasonable (Graham 2010). People have a baseline
equilibrium level of happiness, and any deviations from that baseline are short-lived. If
well-being inequalities are taken to be meaningful, then any policies implemented with
the intention of combating them must target an element of well-being that isn’t subject
to adaptation. Among the correlates of subjective well-being, social capital is often
referred to as a prominent candidate policy target that is immune to the problems of
adaptation (Bartolini, Bilancini, and Sarracino 2016). Thus, if egalitarianism pursues
equality in the domain of well-being, it will still find itself trying to accomplish an
impossible task in determining the distribution of social capital.
Conclusion

27. Although egalitarians may be reluctant to admit their focus on equality of distribution in
philosophical debate, this singular policy focus has emerged even among the so-called
new-group egalitarians with their emphasis on social hierarchy. Equality of social
relations, they assert, must begin from the establishment of economic equality of
wealth. Unfortunately for these egalitarians, wealth and well-being are partly
determined by the distribution of social capital. Social capital is distinct from physical
capital and human capital in that it can neither be removed from an individual nor
imputed to another. A sovereign’s inability to distribute social capital results in an
impossible equality of distribution in wealth or well-being short of totalitarian control of
the entire system.

SECTION A

QUESTION 1

1.1 Why is it impossible for equality in distribution of wealth? (2)
…………………………………………………………………………………………………
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1.2 What is the moral standpoint of egalitarianism? (2)
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1.3 Why did Otto von Bismarck create a welfare state in Germany? (2)
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1.4 According to egalitarianism, what do their basic notions of equality hinge on? (2)
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1.5 What did Hayek accuse the libertarians and classical liberals of when they classified
free markets as just or unjust? (2)
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……………………………………………………………………………………………..…

…………………………………………………………………………………………………
1.6 On what point does modern day egalitarianism disagree with classical egalitarianism?
(2)
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1.7 What does relational egalitarianism advocate should be removed any unjust system?
(2)
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1.8 On what grounds do egalitarians agree that equality of distribution is achievable? (2)
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1.9 Why is social capital regarded as the most illiberal? (2)
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1.10 According to the text, what is the only way we can achieve equality of distribution? (2)
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1.11 What is meant by the Easterlin Paradox? (2)
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1.12 If egalitarianism pursues equality in well-being, what obstacle will they face? (2)
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TOTAL: 24 marks

Choose one of the attached data sets and analyze using the techniques discussed in class up to this point. This includes the following: Find the appropriate measure of center. Discuss why the chosen measure is most appropriate. Why did you decide against other possible measures of center? Find the appropriate measure of variation. The measure of variation chosen here should match the measure of center chosen in Part 1. Find the graph(s) needed to appropriately describe the data. These may be done by hand and inserted into the Word document. Define a random variable (X) so that your chosen data set represents values of X. Is your chosen random variable discrete or continuous? Explain how you know. Would the Normal or Binomial distribution be a good fit for the underlying sample distribution of X? If one of them is a good fit, state how you would approximate the distribution parameters. Calculate the probability that a flight will depart early or on-time. Calculate the probability that a flight will arrive late. Calculate the probability that a flight departs late or arrives early. Assume now that the random variable X=Arrival Time is exactly normally distributed with mean m= -2.5 and standard deviation s= 23. Compute the probability of a flight arriving late based on this new information. Does this contradict your answer from Part 8? Write a brief description (250–500 words) of the data set including the discussion required in the points above. Year DAY_OF_MONTH DAY_OF_WEEK DEP_Delay ARR_Delay 2015 13 2 -4 0 2015 13 2 -3 -3 2015 13 2 0 -5 2015 13 2 -7 -1 2015 13 2 8 3 2015 13 2 -1 -5 2015 13 2 3 8 2015 13 2 11 6 2015 13 2 -6 0 2015 13 2 -5 -12 2015 13 2 -8 0 2015 13 2 -4 -2 2015 13 2 -13 -10 2015 13 2 -13 12 2015 13 2 -11 -13 2015 13 2 -14 4 2015 13 2 -16 -1 2015 13 2 -14 2 2015 13 2 -18 -14 2015 13 2 -18 0 2015 13 2 -23 -23 2015 13 2 -23 10 2015 13 2 2 -20 2015 13 2 1 26 2015 13 2 -4 -25 2015 13 2 -6 7 2015 13 2 7 -3 2015 13 2 -8 0 2015 13 2 -8 0 2015 13 2 -4 -2 2015 13 2 -4 -3 2015 13 2 -5 -6 2015 13 2 -13 -9 2015 13 2 -9 6 2015 13 2 -12 -7 2015 13 2 -7 -4 2015 13 2 -12 -9 2015 13 2 1 4 2015 13 2 4 12 2015 13 2 -19 0 2015 13 2 -13 -4 2015 13 2 -19 -17 2015 13 2 3 -18 2015 13 2 12 15 2015 13 2 13 20 2015 13 2 2 12 2015 13 2 0 0 2015 13 2 0 -14 2015 13 2 4 5 2015 13 2 -7 7 2015 13 2 8 8 2015 13 2 9 22 2015 13 2 -1 -5 2015 13 2 -10 1 2015 13 2 -6 0 2015 13 2 -12 2 2015 13 2 -14 -3 2015 13 2 -13 7 2015 13 2 9 1 2015 13 2 -15 -2 2015 13 2 -13 1 2015 13 2 -14 -1 2015 13 2 20 6 2015 13 2 -16 -7 2015 13 2 11 0 2015 13 2 -14 6 2015 13 2 18 1 2015 13 2 -19 -17 2015 13 2 -3 -16 2015 13 2 -4 -2 2015 13 2 0 -1 2015 13 2 -3 -6 2015 13 2 2 -17 2015 13 2 6 7 2015 13 2 6 14 2015 13 2 -6 -13 2015 13 2 1 11 2015 13 2 11 12 2015 13 2 -7 -2 2015 13 2 -10 -4 2015 13 2 -13 0 2015 13 2 9 3 2015 13 2 -13 -4 2015 13 2 -18 3 2015 13 2 -17 0 2015 13 2 -11 0 2015 13 2 -20 -6 2015 13 2 -18 -8 2015 13 2 8 -8 2015 13 2 0 -12 2015 13 2 -20 -10 2015 13 2 -3 -9 2015 13 2 1 6 2015 13 2 -1 -13 2015 13 2 -4 3 2015 13 2 -6 0 2015 13 2 -5 -13 2015 13 2 -8 6 2015 13 2 -10 -17 2015 13 2 -9 9 2015 13 2 -6 -19 2015 13 2 8 13 2015 13 2 -9 -2 2015 13 2 -12 -21 2015 13 2 -15 -16 2015 13 2 -14 -28 2015 13 2 -9 -14 2015 13 2 -17 -2 2015 13 2 -13 4 2015 13 2 -17 -2 2015 13 2 2 6 2015 13 2 -18 -6 2015 13 2 -18 -1 2015 13 2 -16 0 2015 13 2 1 -8 2015 13 2 -4 0 2015 13 2 0 2 2015 13 2 -5 -13 2015 13 2 7 2 2015 13 2 -7 -11 2015 13 2 -7 -7 2015 13 2 -5 -1 2015 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-14 -5 2015 13 2 -14 -3 2015 13 2 -17 -1

In February 2012, the Pepsi Next product was launched into the US market. This case study provides students with an interesting insight into PepsiCo’s new product process and some of the challenging decisions that they faced along the way.

Pepsi Next Case Study

Introduction

Pepsi Next was launched by PepsiCo into the US market in February 2012, and has since been rolled out to various international markets (for instance, it was launched in Australia in September 2012).

The new product is described as a mid-calorie cola beverage, having a mix of sugar and artificial sweeteners, designed to deliver a full cola taste with reduced calories. While filling the market gap between full sugar and diet soft drinks, PepsiCo has indicated that its prime target market is lapsed cola drinkers (giving them a reason to return to the product category).

PepsiCo, which owns range of high profile beverage brands in addition to its flagship brand Pepsi, appear to be highly committed to Pepsi Next providing it with strong launch and management support. In fact, according to PepsiCo themselves, this is their most significant product launch for several years.

About PepsiCo

PepsiCo is the second largest food and beverage company in the world, with revenues now in excess of $60 billion. The corporation has 22 brands that achieve retail sales in excess of $1 billion each. Because of their brand diversification, around half of PepsiCo’s revenue is generated from their food lines, such as Frito-Lay (snack food) and Quaker Oats.

In addition, they have progressively expanded internationally and now access over 80% of the world’s population. Their international (non-US) markets account for almost 50% of their total revenues and they still see significant growth potential from these markets, on the basis that per capita consumption of snacks and beverages in other countries is well below US market levels.

As a result, PepsiCo has achieved solid growth is many international markets. While their US beverage sales fell by 2% in 2011, this has been more than offset by double-digit sales increases in Europe, Asia, the Middle East and Africa.

In terms of their overall strategic approach, PepsiCo (as highlighted on their website) see themselves as innovative and adaptive, as stated in the following website quote:

“Pepsi is constantly on the lookout for ways to ensure their consumers get the products they want, when they want them and where they want them.”

PepsiCo Brand Strategy

In their Annual Report, PepsiCo has structured their brands around three related themes, as highlighted in the following table. This brand structure gives some insight into the role of their brands, and how they see their brand portfolio developing in the future.

Emphasis of Brand	Key Brands
Fun-for-you	Pepsi, Mountain Dew, 7-Up, Lays, Doritos, Cheetos, Red Rock
Better-for-you	Pepsi Max, Diet Pepsi, Lays (oven baked), Quaker bars
Good-for-you	Tropicana, Quaker Oats, Gatorade, Nut Harvest
(Note: The various terms, ‘Fun-for-you’ and so on are PepsiCo’s terminology, not the author’s.)

As you can see from PepsiCo’s classification of their brands, it is appears that the firm has the dual goals of supporting and leveraging its existing ‘fun’ brands, while moving towards a broader range of healthier offerings. While this second goal may appear to be mainly related to improving their corporate image, it does have commercial intent, as explained on the PepsiCo website: “Because a healthier future for all people and our planet means a more successful future for PepsiCo.”

To help implement this corporate goal, across their various brands, PepsiCo has focused on providing a wider range of healthier choices, introducing more natural ingredients, reducing fat content, reducing the environmental impact of their packaging, and so on.

Recent Product Innovations

PepsiCo has a history of developing and launching a number of mid-calorie beverages and Pepsi Next is by no means their first attempt with this style of product. In addition to various Pepsi variations (described in the ‘Before Pepsi Next’ section below), they have had some recent success with reduced calorie versions within their Tropicana and Gatorade brands.

One very successful mid-calorie product initiate is Trop50, which was launched in 2010. Trop50, as implied by its name, is a version of Tropicana with 50% less sugar and calories. This new product was ranked as the sixth most successful new food/beverage product in its launch year with retail sales in excess of $70 million. Its initial success has continued over the last two years, with the Trop50 product line now generating over $150 million in sales.

In addition, even more successful was Pepsi’s launch of Gatorade G2 in 2007. (Note: Pepsi acquired the Gatorade brand with their purchase of the Quaker Company in 2001.) This low-calorie version of Gatorade was identified as the most successful new food/beverage product in 2008 in the US market, achieving sales over $150 million in its first year.

Clearly, these recent product successes with reduced calorie offerings under strong brands would have had the effect of buoying Pepsi’s confidence regarding the viability of this style of product. Hence, they believed that it was the right time to revisit a reduced calorie Pepsi variation.

However, as some commentators have pointed out, it should be noted that their success (with Trop50 and G2) has occurred in their ‘good-for-you’ brand range, where consumers are already quite health-conscious and probably more responsive to healthier options. Therefore, whether this perceived benefit (of less sugar) will carry to ‘fun-for-you’ brands as if Pepsi is less certain for the firm.

Before Pepsi Next

Perhaps surprisingly, Pepsi Next is PepsiCo’s fifth attempt at a mid-calorie beverage. In the 1970’s they introduced Pepsi Light, which was lemon-flavored and contained 70 calories (as opposed to a normal Pepsi can at 150 calories). (Not to be confused with the current Pepsi Light brand marketed in various countries, which is a version of Diet Pepsi.)

Then in the late 1980’s the firm introduced Jake’s Diet Cola, which came in at a mere 15 calories, but did not leverage the Pepsi brand name. At the time, Pepsi stated that the beverage had the potential to “revolutionize” the diet segment of the cola market. Prior to launch, Jake’s was extensively taste-tested against Diet Coke and the firm had strong hopes for its success. According to one of their vice presidents at the time, (Edward E. Jenkins), “Jake’s represents a new taste concept in diet beverages and will provide consumers in the booming diet soft drink category with a better-tasting, low-calorie cola”.

In the mid-1990’s, they then introduced Pepsi XL, another 70 calorie formula. In their promotions, they indicated that X stood for ‘excellent taste’ and the L stood for ‘less sugar’. According to reports at the time, Pepsi XL was a year in development at a cost of $1.5 million and was supported by an $8 million advertising budget.

More recently, in 2004, PepsiCo released a 70-calorie beverage branded as Pepsi Edge. Around the same time, Coca-Cola brought out a similar product under the brand Coca-Cola C2. Coke supported C2 quite aggressively, with an estimated launch promotional budget of somewhere around $40 million, making it their most significant launch since Diet Coke. Both of these brands only lasted around 18 months or so in the market before being withdrawn.

About the Soft Drink Market

The US soft drink market generates over $70 billion in sales. Volumes (units) have weakened slightly since 2005, indicating that the market is in late maturity-early decline stage of the product life cycle. Retail dollar sales have been supported somewhat by price increases.

One of the biggest impacts on soft drink consumption has come from bottled water, which now accounts for over 10% of beverage consumption. This is up from just 2% in 2000. In addition, the soft drink market has also been slightly challenged by sports drinks and energy drinks that have seen a minor increase in market share.

The trend towards diet soft drinks continues, with these offerings now representing 30% of the carbonated soft drink (CSD) market, up from 25% just 10 years ago. Overall, these movements indicate changing tastes of consumers because of a stronger health focus.

One of the brands most impacted by these market changes has been the flagship Pepsi brand. In the most recent market share figures available, Pepsi now has less than 10% share of the US CSD market (which ranks the brand 3rd behind Coke and Diet Coke). While still well positioned, keep in mind that they were sitting at over 13% market share ahead of Diet Coke 10 years ago, at a time when the CSD market was still growing at 3% per year.

Their Diet Pepsi product enjoys a solid 5% market share. That product, along with Pepsi’s other soft drink offerings (Mountain Dew in particular), gives Pepsi an almost 30% share of the US CSD market, behind Coca-Cola at 42% (with Coke at 17% and Diet Coke at 10%) and ahead of Dr Pepper Snapple at 17%.

Competitor Offerings

Pepsi is not the only player seeking to tap into the perceived demand for reduced sugar beverages. Dr Pepper Snapple (who has two products in the top 10 in the US CSD market) has also introduced a low-sugar offering. Their new product, Dr Pepper Ten (with 10 calories), is squeezed between their normal Dr Pepper and their Diet Dr Pepper, much in the same way the Pepsi Next product. Reportedly, Dr Pepper Snapple is pleased with the performance of this new product to date.

Independent to the Pepsi Next offering, Coca-Cola is currently (mid-late 2012) in the process of test marketing (in four American cities) mid-calorie versions of their Fanta and Sprite brands. Carrying the sub-brand ‘Select’ (to make Fanta Select) the concept is quite similar to Pepsi Next in that it uses a mix of sugar and artificial sweeteners to cut the calorie count by half.

Obviously if these tests are successful and these products are fully rolled-out to the market as a standard product, it appears that there could be a third sub-category of soft drinks; traditional, diet, and now mid-calorie beverages. It would then be interesting to see how and if this sub-category develops, particularly with more offerings and overall promotional support. On the other hand, it might be possible that Coke might be test marketing the mid-calorie Sprite and Fanta options as a form of market research only.

Impact of Substitute Products

Why it may seem strange that a highly successful company like PepsiCo would frequently come back to a product concept that they had struggled with a number of times, it appears that one of the key drivers has been the slight decline in the US carbonated soft drink (CSD) market in recent years. It is estimated that the cola category of the CSD market is reducing by around 90 million cases a year. These consumer purchases have tended to shift to other beverage solutions, such as water, energy drinks and juices.

One of the underlying factors driving this change in behavior has been identified as the preference that some consumers have to reduce sugar. Therefore, PepsiCo see the new Pepsi Next product as a viable low-sugar alternative to traditional soft drinks, and a product that could tap into consumer’s emerging dietary needs and to generate sales from outside the traditional cola market and to win back lost cola consumers.

Therefore, PepsiCo is more confident in the success of Pepsi Next (despite numerous withdrawn similar products) because they believe that the market is now more ready for this type of product, that is, Pepsi Next is the “right product at the right time”.

Pepsi Next Strategy, Development and Launch

As stated above, a key goal of the Pepsi Next offering is to try to win back cola drinkers lost to other beverages. Pepsi’s research suggests that sugar and carbohydrates is an issue for some consumers, but a reasonable proportion of these consumers have not warmed to the taste of diet colas. Therefore, these ‘sugar-avoiders’ have migrated to non-cola beverages as a better product solution for their needs and preferences.

Another important goal, as Pepsi continues to battle Coca Cola’s range of brands for market share in the CSD market, is to keep their flagship brand fresh, exciting, energized and innovative. For instance, Coke Zero was a very successful new product (a sub-brand under the Coke family brand), which also had the impact of adding excitement to the Coca-Cola product. This was achieved primarily by Coke Zero’s main communication theme that Coke Zero tasted just like Coke. The firm used a variety of promotional tools, including a series of humorous YouTube videos with pretend (and somewhat inept) Coke brand managers who were intent on taking legal action against Coke Zero.

Another important aspect to keep in mind for Pepsi Next and its likely financial viability is the overall size of the CSD market. In the USA alone, sales in this market are in excess of $70 billion. And although the market is slightly falling (being in the very early stage of decline), the market is only reducing by about 1% per year, which means that it will remain a very large and profitable market for a long time to come.

With this in mind, even a fraction of market share in the CSD market is significant. For instance, Coke Zero (a product launched in 2005) has a market share just over 1% in the US, which equates to retail sales over $700 million per annum in the US alone – and based on Pepsi’s corporate figures (where almost 50% of their revenue is achieved in international markets), they probably achieve at least equal sales revenues internationally. This should deliver good gross margins, as the product would be produced, distributed and marketed using existing infrastructure and facilities.

Of course, while Pepsi has indicated that they are taking a long-term view of the market and this product, these statements may or may not be true. In these types of markets (fun food and drinks), variety and new flavors are often used as an effective short-term tactic. For example, chocolate manufacturer Cadbury frequently brings out new products for a limited time only. It is also a common tactic in the fast food industry.

This variety approach will help boost short-term sales, energize the main brand, generate media attention, disrupt competitor activities, give freshness to the firm’s promotional messages, and hopefully engage consumers.

Market Gap

Pepsi Next is obviously designed to fill the gap between normal sugar cola drinks and diet colas, trying to appeal to consumers that may sometimes prefer lower-calorie drinks but are concerned with the taste or the social image of diet drinks and vice versa.

The clear challenge here is whether this mid-calorie ‘compromise’ offering provides a strong benefit for existing beverage consumers. That is, will regular consumers of diet colas be tempted to switch and will consumers of regular colas be happy enough with the taste of Pepsi Next to take it up? That challenge is obviously one reason that Pepsi has included a heavy free sample aspect in their promotional mix.

Therefore, there appears to be two main risks associated with targeting this market gap. The first is whether the demand from consumers will be large enough to make the segment financially viable. Moreover, the second is virtually the opposite concern; if the product becomes quite successful, will it cannibalize both the Pepsi and the diet Pepsi offerings. While the second ‘risk’ could have the upside of providing a competitive barrier (without necessarily increasing overall sales), which is generally beneficial for PepsiCo in the longer-term, it does not really advantage Pepsi’s retailer partners who may not benefit to any real extent from this broader product line offering.

However, another way to look at this market gap is to not see it as a gap at all, as suggested by PepsiCo. That is, to consider the product to be competing against substitute products outside the existing cola market. Therefore, this offering may appeal to consumers who do not see a benefit in any existing cola drinks, diet or otherwise.

Market Testing

Given PepsiCo’s experience with mid-calorie beverages (with both Pepsi and other key brands), the firm would have a wealth of knowledge and data surrounding this market need and the resultant behavior of consumers and distribution channels. Despite this background, Pepsi Next still went through the firm’s standard approach of taste testing and market tests. For instance, in 2011, they conducted blind taste-tests with some of their bottlers.

As would be assumed from the launch support for the new product, the results from the consumer taste-tests were very positive. According to Angelique Krembs, VP-marketing for the Pepsi trademark, “When people try the product, they’re just really impressed.”

In addition to taste-tests, Pepsi Next was test marketed in Iowa and Wisconsin. In these tests, it was determined that a broad variety of consumers (in demographic terms) were willing to try Pepsi Next. However, the research was also able to identify that the consumers tended to be regular Pepsi drinkers who saw the benefit of reduced sugar but have not been keen on existing diet soda options.

According to released results of the test markets, Pepsi Next exceeded their internal targets for trial, repeat business and incremental business. While there, is a significant risk that this type of product had the potential to cannibalize Pepsi, Diet Pepsi and Pepsi Max, the firm believes (based upon the test market results) that Pepsi Next will attract new consumers and energize their entire Pepsi brand family.

Ingredients

In order to achieve a taste similar to a standard cola beverage with the sugar content, Pepsi Next uses some sugar along with a mix of three artificial sweeteners and high fructose corn syrup. However, the Pepsi Next product introduced in Australia has a slightly different formulation, as it included a natural sweetener called Stevia. Apparently, Stevia was not part of the US beverage design as it can have a bitter after-taste.

In addition, Coca Cola’s Sprite/Fanta mid-calorie offerings (currently being test marketed) will utilize a different mix of sweeteners, with the major players each trying to get that right combination of taste with reduced sugar content.

Brand Name Selection

The brand name selection for Pepsi Next is quite interesting as it has a significant forward-looking emphasis. As many people are aware, for many years Pepsi has used the tag line, “The choice of a new generation”. This tag line was designed to reposition Coca-Cola as an old-fashioned drink, mainly enjoyed by older people.

With the use of the word ‘Next”, Pepsi are highlighting that this refers to the ‘next generation’ of soda drinkers. In addition, as discussed above, Pepsi believes that health and sugar-reduction is a long-term trend that will become more prominent.

The other aspect about the brand name selection to note is that the firm decided to use the family brand (Pepsi) and create a new sub-brand (individual) – creating Pepsi Next. Of course, both Coke and Pepsi have had a long tradition of successfully establishing new brands, so it is always of interest when they decide to leverage their flagship brands.

Obviously, even though Coke and Pepsi both have enormous brand equity throughout the world, there is still a limit to the range of offerings that each firm would want under these brands. That is, they would want to continue to protect their flagship brands and ensure that they are clearly understood by consumers and ensure that too many products do not confuse their positioning.

Launch of Pepsi Next

The new product’s promotion was based around the tag line “Drink it to believe it“. It is a relatively major launch, which is reflective of their desire to finally achieve success with this style of product and to ensure that the new product is well received by the market in order to further enhance the brand equity of Pepsi itself.

In terms of its promotional mix, Pepsi Next was promoted via TV advertising, digital marketing, direct mail, heavy free trials and in-store point-of-promotion.

The main TV commercial, which was also tested in the test markets, shows a couple becoming very excited about the innovativeness of Pepsi Next. In the background, unnoticed by the parents, the baby does a number of highly remarkable stunts. The main message of the TVC is that Pepsi Next is so amazing and innovative that nothing else seems to stand out.

Obviously, in today’s environment, a social media campaign via Facebook as well as YouTube formed a key platform in their overall promotional mix. A key aspect of the YouTube campaign (billed as the world’s first virtual taste-test) is the potential for consumers own taste-test videos to be parodied by a range of celebrities. This approach not only increases the profile of the campaign, but also the level of the consumer’s engagement with the new brand.

Although the firm has not disclosed the actual promotional budget for Pepsi Next, PepsiCo has announced that they have increased their overall marketing budget (across all their beverage brands) from $500 million to $600 million in 2012.

Pepsi Next was also promoted via leveraging the firm’s relationships with retailers and tapping into retailers’ loyalty card programs. Access to this immense loyalty database has enabled Pepsi to identify consumers that have reduced their cola consumption over time, which is stated as the target market for Pepsi Next.

Free trials/samples have also been heavily utilized. For example, in the USA, free samples of Pepsi Next were offered across 800 Walmart stores as well as in 40 cities via events. In Australia, Pepsi is using several ‘challenge vans’ which will be set up in around 300 outdoor locations during the Australian summer. The focus of the ‘challenge vans’ is for consumers to blind taste-test Pepsi Next against normal sugar cola (presumably Coke, but not explicitly stated).

Therefore, it appears that a key goal of their promotional approach is to generate initial trials, with the hope of generating a reasonable proportion of repeat customers.

It is important to note that despite a significant upfront promotional investment, Pepsi are planning to support and monitor Pepsi Next over the long-term. Again, according to Angelique Krembs, VP-marketing for the Pepsi trademark, “I believe a new product is a new product for two years. We will be watching closely, and we will correct what needs to be corrected. We’re taking a long-term view of support for this brand.”

Product-line Extensions

Although Pepsi Next was only launched into the US market in February 2012, by July 2012 two line extensions were introduced into the market. The two variations are both fruit-flavored colas (Cherry Vanilla and Paradise Mango). Upon their launch (which coincided with summer), PepsiCo indicated that both flavors would only be available for a limited time only. Like the standard Pepsi Next product, the new flavors contained 60 calories, but both carry less caffeine.

To help explain the rationale for these line extensions Angelique Krembs stated, “Earlier this spring, Pepsi Next launched to national fanfare, turning cola lovers into believers by delivering on real cola taste with 60 percent less sugar than Pepsi-Cola and for many, it was love at first sip. We’re continuing the momentum by infusing real cola taste with unique fruit flavor blends, and giving cola lovers two more reasons to ‘drink it to believe it.’”

Pepsi Next Results

Indra Nooyi, the Chairman and CEO of PepsiCo, has publicly stated that the new product is “off to a good start… (and it is) consistent with our objective of bringing back lapsed cola drinkers, While it’s very early, the results are ahead of launch expectations”. This comment further reinforces Pepsi’s goal of sourcing demand from outside the traditional consumer base and regard their competitive set for this product to be non-cola beverages, rather than Coke.

However, Nooyi did temper her above comments with, “It’s too early to call this brand and say it’s a gigantic success. But what is surprising to us is that a few weeks after the launch, it’s almost one share point, which has not happened in a long time for any new product launch”.

While an initial market share of almost 1% represents a significant amount of revenue, it should be noted there is a major difference between initial trial sales volumes and ongoing repeat sales volumes – particularly for a well-executed national launch under the banner of a major brand.

Weakening Sales?

In terms of sales data, it has reported that Pepsi NEXT’s volume market share has since fallen to 0.6%, down from 1.0%. Additionally, a survey of the channel convenience stores found that Pepsi Next has achieved very strong distribution (with 94 % convenience store penetration), but many stated that the brand is generating weak repeat sales.

It could also be argued that the early line extensions were designed to help strengthen and energize the brand, as it is struggling with its repeat sales. Perhaps the initial strong sales results were somewhat propped up by the novelty taste, the extensive free sampling and significant initial discounting.

Regardless, the firm has indicated that they remain very confident in the future of Pepsi Next, particularly given their view of the future market for sugary beverages. PepsiCo Americas Beverages CEO Al Carey has stated that they continue to feel “very good” about Pepsi Next and that the new brand was tracking ahead of its targeted 25 million cases in first year sales, primarily because it was re-winning lost Pepsi drinks – either back to Pepsi Next or Pepsi itself.

QUESTIONS

1. Outline the new product process for Pepsi Next. How consistent is their approach to the process described in marketing textbooks?

2. PepsiCo has been quite persistent with pursing mid-calories beverage products – why do you think this is the case? Do you agree with their decision to introduce Pepsi Next? Why/why not?

3. How is the performance and market acceptance of Pepsi Next likely to impact the overall brand equity of Pepsi? Should PepsiCo have launched this product under a new brand instead?

4. The launch strategy seemed to heavily focus on generating trials. Why was this important? How else could the launch program have been structured?

1. Read and construct 10 questions with Correct answers on food safety below

The questions and answers that you provide should be written in the correct “jeopardy” format-answers first and questions second. The purpose of the assignment is to demonstrate an understanding of the course content.

Foodborne Illness in the United States

When certain disease-causing bacteria, viruses or parasites contaminate food, they can cause foodborne illness. Another word for such a bacteria, virus, or parasite is “pathogen.” Foodborne illness, often called food poison- ing, is an illness that comes from a food you eat.

• The food supply in the United States is among the safest in the world— but it can still be a source of infection for all persons.

• According to the Centers for Disease Control and Prevention, 48 million persons get sick, 128,000 are hospitalized, and 3,000 die from foodborne infection and illness in the United States each year. Many of these people are children, older adults, or have weakened immune systems and may not be able to ght infection normally.

Since foodborne illness can be serious—or even fatal—it is important for you to know and practice safe food-handling behaviors to help reduce your risk of getting sick from contaminated food.

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• Your gastrointestinal tract, when functioning properly, allows the foods and beverages you consume to be digested normally. Diabetes may damage the cells that create stomach acid and the nerves that help

Food Safety:

It’s Especially Important for You

As a person with diabetes, you are not alone—there are many people in the United States with this chronic disease. Diabetes can affect various organs and systems of your body, causing them not to function properly, and making you more susceptible to infection. For example:

• Your immune system, when functioning properly, readily ghts off harmful bacteria and other pathogens that cause infection. With diabetes, your immune system may not readily recognize harmful bacteria or other pathogens. This delay in the body’s natural response to foreign invasion places a person with diabetes at increased risk for infection.

your stomach and intestinal tract move the food throughout the intestinal tract. Because of this damage, your stomach may hold on to the food and beverages you consume for a longer period of time, allowing harmful bacteria and other pathogens to grow.

Additionally, your kidneys, which work to cleanse the body, may not be functioning properly and may hold on to harmful bacteria, toxins, and other pathogens.

A consequence of having diabetes is that it may
leave you more susceptible to developing infections—like those that can be brought on by disease-causing bacteria and other pathogens that cause foodborne illness. Should you contract a foodborne illness, you are more likely to have a lengthier illness, undergo hospitalization, or even die.

To avoid contracting a foodborne illness, you must be vigilant when handling, preparing, and consuming foods.

Make safe food handling a lifelong commitment to minimize your risk of foodborne illness. Be aware that as you age, your immunity to infection naturally is weakened.

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Major Pathogens That Cause Foodborne Illness

Symptoms and Potential Impact

• Fever, headache, and muscle pain followed by diarrhea (sometimes bloody), abdominal pain, and nausea. Symptoms appear 2 to 5 days after eating and may last 2 to 10 days. May spread to the bloodstream and cause a life-threatening infection.

Symptoms and Potential Impact

• Watery diarrhea, dehydration, weight loss, stomach cramps or pain, fever, nausea, and vomiting; respiratory symptoms may also be present.

• Symptoms begin 7 to 10 days after becoming infected, and may last 2 to 14 days. In those with a weakened immune system, including people with diabetes, symptoms may subside and return over weeks to months.

Symptoms and Potential Impact

Associated Foods

• Untreated or contaminated water

• Unpasteurized (“raw”) milk

• Raw or undercooked meat, poultry, or shell sh

Associated Foods/Sources

• Swallowing contaminated water, including that from recreational sources, (e.g., a swimming pool or lake)

Eating uncooked or contaminated food

Placing a contaminated object in the mouth

Soil, food, water, and contaminated surfaces

Associated Foods/Sources

• Many outbreaks result from food left for long periods in steam tables or at room temperature and time and/or temperature abused foods.

• Meats, meat products, poultry, poultry products, and gravy

Associated Foods

• Improperly reheated hot dogs, luncheon meats, cold cuts, fermented or dry sausage,
and other deli-style meat and poultry

Unpasteurized (raw) milk and soft cheeses made with unpasteurized (raw) milk

Smoked seafood and salads made in the store such as ham salad, chicken salad, or seafood salads

Raw vegetables

• Onset of watery diarrhea and abdominal cramps within about 16 hours. The illness usually begins suddenly and lasts for 12 to 24 hours. In the elderly, symptoms may last 1 to 2 weeks.

Campylobacter

Cryptosporidium

Clostridium perfringens

• Complications and/or death occur only very rarely.

Listeria monocytogenes

Can grow slowly at refrigerator temperatures

Symptoms and Potential Impact

• Fever, chills, headache, backache, sometimes upset stomach, abdominal pain, and diarrhea. May take up to 2 months to become ill.

Gastrointestinal symptoms may appear within a few hours to 2 to 3 days, and disease may appear 2 to 6 weeks after ingestion. The duration is variable.

Those at-risk (including people with diabetes and others with weakened immune systems) may later develop more serious illness; death can result from this bacteria.

Can cause problems with pregnancy, including miscarriage, fetal death, or severe illness or death in newborns.

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Associated Foods

• Undercooked beef, especially hamburger

Unpasteurized milk and juices, like “fresh” apple cider

Contaminated raw fruits and vegetables, and water

Person-to-person contact Associated Foods

• Shell sh and fecally- contaminated foods or water

• Ready-to-eat foods touched by infected food workers; for example, salads, sandwiches, ice, cookies, fruit

Associated Foods

• Raw or undercooked eggs, poultry, and meat

Unpasteurized (raw) milk or juice

Cheese and seafood

Fresh fruits and vegetables

Toxoplasma gondii

Associated Foods/Sources

• Accidentalcontactofcatfeces through touching hands to mouth after gardening, handling cats, cleaning cat’s litter box, or touching anything that has come in contact with cat feces.

• Raw or undercooked meat.

Vibrio vulni cus

Associated Foods

• Undercooked or raw seafood ( sh or shell sh)

Symptoms and Potential Impact

• Severe diarrhea that is often bloody, abdominal cramps, and vomiting. Usually little or no fever.

• Can begin 1 to 9 days after contaminated food is eaten and lasts about 2 to 9 days.

• Some, especially the very young, may
develop hemolytic-uremic syndrome (HUS), which can cause acute kidney failure, and can lead to permanent kidney damage or even death.

Symptoms and Potential Impact

• Nausea, vomiting, and stomach pain usually start between 24 and 48 hours, but cases can occur within 12 hours of exposure. Symptoms usually last 12 to 60 hours.

• Diarrhea is more prevalent in adults and vomiting is more prevalent in children.

Symptoms and Potential Impact

• Stomach pain, diarrhea (can be bloody), nausea, chills, fever, and/or headache usually appear 6 to 72 hours after eating; may last 4 to 7 days.

• In people with a weakened immune system, such as people with diabetes, the infection may be more severe and lead to serious complications including death.

Symptoms and Potential Impact

Escherichia coli O157:H7
One of several strains of E. coli that can cause human illness

Noroviruses (and other caliciviruses)

Salmonella (over 2,300 types)

• Flu-like illness that usually appears
10 to 13 days after eating, may last months. Those with a weakened immune system, including people with diabetes, may develop more serious illness.

• Can cause problems with pregnancy, including miscarriage and birth defects.

Symptoms and Potential Impact

• Diarrhea, stomach pain, and vomiting may appear within 4 hours to several days and last 2 to 8 days. May result in a blood infection. May result in death for those with a weakened immune system, including people with diabetes, cancer or liver disease.

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Eating at Home:

Making Wise Food Choices

Some foods are more risky for you than others. In general, the foods that are most

likely to contain harmful bacteria or viruses fall into two categories:

• Uncooked fresh fruits and vegetables

• Some animal products, such as unpasteurized (raw) milk; soft cheeses made with raw milk; and raw or undercooked eggs, raw

meat, raw poultry, raw sh, raw shell sh and their juices; luncheon meats and deli-type salads (without

added preservatives) prepared on site in a deli-type establishment.

. . . about Particular Foods:

KEEP YOUR FAMILY SAFER FROM FOOD POISONING

If you are not sure about the safety of a food in your refrigerator, don’t take therisk.

Interestingly, the risk these foods may actually pose depends on the origin

or source of the food and how the food is processed, stored, and prepared. Follow these guidelines (see chart at right) for safe selection and preparation of your favorite foods.

If You Have Questions . . .
. . . about Wise Food Choices:

Be sure to consult with your doctor or health care provider. He or she can answer any speci c questions or help you in your choices.

When in doubt, throw it out!

Wise choices in your food selections are important.

All consumers need to follow the Four Basic Steps to Food Safety:
Clean, Separate, Cook, and Chill.

Check your steps at FoodSafety.gov

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CLEAN SEPARATE CHILL

CLEAN

WASH HANDS AND SURFACES OFTEN

SEPARATE

SEPARATE RAW MEATS FROM OTHER FOODS

CHILL

REFRIGERATE FOOD PROMPTLY

oF

COOK TO THE RIGHT TEMPERATURE

Common Foods: Select the Lower Risk Options

Type of Food Higher Risk Lower Risk
Meat and • Raw or undercooked • Meat or poultry cooked to a Poultry meat or poultry safe minimum internal tem- perature (see chart on p. 10) Tip: Use a food thermometer to check the internal temperature on the “Is It Done Yet?” chart on page 10 for speci c safe minimum internal temperature.
Seafood	• Any raw or undercooked sh, or shell sh, or food containing raw or undercooked seafood e.g., sashimi, found in some sushi or ceviche. Refrigerated smoked sh • Partially cooked seafood, such as shrimp and crab	• Previously cooked seafood heated to 165 °F • Canned sh and seafood • Seafood cooked to 145 °F
Milk	• Unpasteurized (raw) milk	• Pasteurized milk
Eggs Foods that contain raw/undercooked eggs, such as: At home: • Homemade Caesar salad dressings* • Homemade raw cookie dough* • Homemade eggnog* • Use pasteurized eggs/egg products when preparing recipes that call for raw or undercooked eggs When eating out: • Ask if pasteurized eggs were used *Tip: Most pre-made foods from grocery stores, such as Caesar dressing, pre-made cookie dough, or packaged eggnog are made with pasteurized eggs.
Sprouts	• Raw sprouts (alfalfa, bean, or any other sprout)	• Cooked sprouts
Vegetables	• Unwashed fresh vegetables, including lettuce/salads	• Washed fresh vegetables, including salads • Cooked vegetables
Cheese	• Soft cheeses made from unpasteurized (raw) milk, such as: — Feta — Brie — Camembert — Blue-veined — Queso fresco	• Hard cheeses • Processed cheeses • Cream cheese • Mozzarella • Soft cheeses that are clearly labeled “made from pasteurized milk”
Hot Dogs and • Hot dogs, deli meats, and • Hot dogs, luncheon meats, and deli meats reheated to steaming hot or 165 °F Tip: You need to reheat hot dogs, deli meats, and luncheon meats before eating them because the bacteria Listeria monocytogenes grows at refrigerated temperatures (40 °F or below). This bacteria may cause cause severe illness, hospitalization, or even death. Reheating these foods until they are steaming hot ho destroys these dangerous bacteria and makes these foods safe for you to eat. Deli Meats luncheon meats that have not been reheated
Pâtés	• Unpasteurized, refrigerated pâtés or meat spreads	• Canned or shelf-stable pâtés or meat spreads

7

Taking Care:

Handling and Preparing Food Safely

Foodborne pathogens are sneaky. Food that appears completely ne can contain pathogens—disease-causing bacteria, viruses, or parasites—that can make you sick. You should never taste a food to determine if it is safe to eat.

As a person with diabetes, it is especially important that you—or those preparing

your food—are always careful with food handling and preparation. The easiest way to do this is to Check Your Steps – clean, separate, cook, and chill – from the Food

Safe Families Campaign.

Four Basic Steps to Food Safety 1. Clean: Wash hands and surfaces often

Bacteria can spread throughout the kitchen and get onto cutting boards, utensils, counter tops, and food.

To ensure that your hands and surfaces are clean, be sure to:

Wash hands in warm soapy water for at least 20 seconds before and after handling food and after using the bathroom, changing diapers, or handling pets.

Wash cutting boards, dishes, utensils, and counter tops with hot soapy water be- tween the preparation of raw meat, poultry, and seafood products and preparation of any other food that will not be cooked. As an added precaution, sanitize cut- ting boards and countertops by rinsing them in a solution made of one tablespoon of unscented liquid chlorine bleach per gallon of water, or, as an alternative, you may run the plastic board through the wash cycle in your automatic dishwasher.

Use paper towels to clean up kitchen surfaces. If using cloth
towels, you should wash them often in the hot cycle of the washing machine.

Wash produce. Rinse fruits and vegetables, and rub rm-skin fruits and vegetables under running tap water, including those with skins and rinds that are not eaten.

With canned goods: remember to clean lids before opening.

8

2. Separate: Don’t cross-contaminate

Cross-contamination occurs when bacteria are spread from one food product to another. This is especially common when handling raw meat, poultry, seafood, and eggs. The key is to keep these foods—and their juices—away from ready-to-eat foods.

To prevent cross-contamination, remember to:

• Separate raw meat, poultry, seafood, and eggs from other foods in your grocery shopping cart, grocery bags, and in your refrigerator.

• Never place cooked food on a plate that previously held raw meat,
poultry, seafood, or eggs without rst washing the plate with hot soapy water.

• Don’t reuse marinades used on raw foods unless you bring them to a boil rst.

• Consider using one cutting board only for raw foods and another only for ready-to-eat foods, such as bread, fresh fruits and vegetables, and cooked meat.

3. Cook: Cook to safe temperatures

Foods are safely cooked when they are heated to the USDA-FDA recommended safe minimum internal temperatures, as shown on the “Is It Done Yet?” chart (see next page).

To ensure that your foods are cooked safely, always:

• Use a food thermometer to measure the internal temperature of cooked foods. Check the internal temperature in several places to make sure that the meat, poul- try, seafood, or egg product is cooked to safe minimum internal temperatures.

Cook ground beef to at least 160 °F and ground poultry to a safe minimum internal temperature of 165 °F. Color of food is not a reliable indicator of safety or doneness.

Reheat fully cooked hams packaged at a USDA-inspected plant to 140 °F. For fully cooked ham that has been repackaged in any other location or for leftover fully cooked ham, heat to 165 °F.

Cook seafood to 145 °F. Cook shrimp, lobster, and crab until they turn red and the esh is pearly opaque. Cook clams, mussels, and oysters until the shells open. If the shells do not open, do not eat the seafood inside.

Cook eggs until the yolks and whites are rm. Use only recipes in which the eggs are cooked or heated to 160 °F.

Cook all raw beef, lamb, pork, and veal steaks, roasts, and chops to 145 °F with a 3-minute rest time after removal from the heat source.

9

3. Cook: Cook to safe temperatures (cont.)

Bring sauces, soups, and gravy to a boil when reheating. Heat other leftovers to 165 °F.

Reheat hotdogs, luncheon meats, bologna, and other deli meats until steam- ing hot or 165 °F.

When cooking in a microwave oven, cover food, stir, and rotate for even cooking. If there is no turntable, rotate the dish by hand once or twice during cooking. Always allow standing time, which completes the cooking, before checking the internal temperature with a food thermometer. Food is done when it reaches the USDA-FDA recommended safe minimum internal temperature.

Is It Done Yet?

Use a food thermometer to be most accurate. You can’t always tell by looking.

4. Chill: Refrigerate promptly

Cold temperatures slow the growth of harmful bacteria. Keeping a constant refrigerator temperature of 40 °F or below is one of the most effective ways to reduce risk of foodborne illness. Use an appliance thermometer to be sure the refrigerator temperature is consistently 40 °F or below and the freezer temperature is 0 °F or below.

To chill foods properly:

• Refrigerate or freeze meat, poultry, eggs, seafood, and other perishables within 2 hours of cooking or purchasing. Refrigerate within 1 hour if the temperature outside is above 90 °F.

Never thaw food at room temperature, such as on the counter top. It is safe to thaw food in the refrigerator, in cold water, or in the microwave. If you thaw food in cold water or in the microwave, you should cook it immediately.

Divide large amounts of food into shallow containers for quicker cooling in the refrigerator.

Follow the recommendations in the abridged USDA-FDA Cold Storage Chart (see page 11). The USDA-FDA Cold Storage Chart in its entirety may be found at www.fsis.usda.gov/Fact_Sheets/Refrigeration_&_Food_Safety/index.asp.

USDA-FDA Recommended Safe Minimum Internal Temperatures
Beef, Pork, Veal, Lamb Steaks, Roasts & Chops 145 °F with 3-minute rest time	Fish 145 °F	Beef, Pork, Veal, Lamb Ground 160 °F	Egg Dishes 160 °F	Turkey, Chicken & Duck Whole, Pieces & Ground 165 °F

10

USDA-FDA Cold Storage Chart

These time limit guidelines will help keep refrigerated food safe to eat. Because freezing keeps food safe inde nitely, recommended storage times for frozen foods are for quality only.

Product	Refrigerator (40 °F)	Freezer (0 °F)
Eggs
Fresh, in shell	3 to 5 weeks	Don’t freeze
Hard cooked	1 week	Don’t freeze well
Liquid Pasteurized Eggs, Egg Substitutes
Opened	3 days	Don’t freeze well
Unopened	10 days	1 year
Deli and Vacuum-Packed Products
Egg, chicken, ham, tuna, & macaroni salads	3 to 5 days	Don’t freeze well
Hot Dogs
Opened package	1 week	1 to 2 months
Unopened package	2 weeks	1 to 2 months
Luncheon Meat
Opened package	3 to 5 days	1 to 2 months
Unopened package	2 weeks	1 to 2 months
Bacon & Sausage
Bacon	7 days	1 month
Sausage, raw—from chicken, turkey, pork, beef	1 to 2 days	1 to 2 months
Hamburger and Other Ground Meats
Hamburger, ground beef, turkey, veal, pork, lamb, & mixtures of them	1 to 2 days	3 to 4 months
Fresh Beef, Veal, Lamb, Pork
Steaks	3 to 5 days	6 to 12 months
Chops	3 to 5 days	4 to 6 months
Roasts	3 to 5 days	4 to 12 months
Fresh Poultry
Chicken or turkey, whole	1 to 2 days	1 year
Chicken or turkey, pieces	1 to 2 days	9 months
Seafood
Lean sh ( ounder, haddock, halibut, etc.)	1 to 2 days	6 to 8 months
Fatty sh (salmon, tuna, etc.)	1 to 2 days	2 to 3 months
Leftovers
Cooked meat or poultry	3 to 4 days	2 to 6 months
Chicken nuggets, patties	3 to 4 days	1 to 3 months
Pizza	3 to 4 days	1 to 2 months

	Check Your Steps Check “Sell-By” date Put raw meat, poultry, or seafood in plastic bags • Buy only pasteurized milk, soft cheeses made with pasteurized milk, and pasteurized or juices that have been otherwise treated to control harmful bacteria. • When buying eggs: – Purchase refrigerated shell eggs – If your recipe calls for raw eggs, purchase pasteurized, refrigerated liquid eggs • Don’t buy food displayed in unsafe or unclean conditions
	Is It Done Yet? You can’t tell by looking. Use a food thermometer to be sure. USDA-FDA Recommended Safe Minimum Internal Temperatures Beef, Pork, Veal, Lamb Steaks, Roasts & Chops 145 °F with 3-minute rest time Fish 145 °F Beef, Pork, Veal, Lamb Ground 160 °F Egg Dishes 160 °F Turkey, Chicken & Duck Whole, Pieces & Ground 165 °F
	Ordering “Smart” When Eating Out Higher Risk: ✘ Cheese made from unpasteurized (raw) milk. ✘ Raw or undercooked seafood. ✘ Cold hot dogs. ✘ Sandwiches with cold deli or luncheon meat. ✘ Raw or undercooked fish, such as sashimi or some kind of sushi. ✘ Soft-boiled or “over-easy” eggs, as the yolks are not fully cooked. Lower Risk: ✔Hard or processed cheeses. Soft cheeses only if made from pasteurized milk. ✔Fully cooked smoked fish or seafood. ✔Hot dogs reheated to steaming hot. If the hot dogs are served cold or lukewarm, ask to have the hot dogs reheated until steaming, or else choose something else. ✔Grilled sandwiches in which the meat or poultry is heated until steaming. ✔Fully cooked fish that is firm and flaky; vegetarian sushi. ✔Fully cooked eggs with firm yolk and whites.

Clip out these handy Info Cards and carry them for quick reference when shopping, cooking, and eating out!

In the Know:

Becoming a Better Shopper

Follow these safe food-handling practices while you shop.

• Carefully read food labels while in the store to make sure food
is not past its “sell by” date. (See Food Product Dating

• Put raw packaged meat,
poultry, or seafood into a
plastic bag before placing it
in the shopping cart, so that
its juices will not drip on—
and con taminate—other foods.
If the meat counter does not offer plastic bags, pick some up from
the produce section before you select your meat, poultry, and seafood.

Buy only pasteurized milk,
cheese, and other dairy products
from the refrigerated section. When buying fruit juice from the refrigerated section of the store, be sure that the juice label says it is pasteurized.

Purchase eggs in the shell from the refrigerated section of the store. (Note: store the eggs in their original carton in the main part of your refrigerator once you are home.) For recipes that call for eggs that are raw or undercooked when the dish is served—homemade Caesar salad dressing and ice cream are two examples—use either shell eggs that have been treated to destroy Salmonella by pasteurization, or pasteurized egg products. When consuming raw eggs, using pasteurized eggs is the safer choice.

• Never buy food that is displayed in unsafe or unclean conditions.

When purchasing canned goods, make sure that they are free of dents, cracks, or bulging lids. (Once you are home, remember to clean each lid before opening the can.)

Purchase produce that is not bruised or damaged.

When shopping for food,
it is important to read the label carefully.

on page 13)

12

Food Product Dating

Read the “Safe Handling Label” for food safety information on raw foods.

Types of Open Dates

Open dating is found primarily on perishable foods such as meat, poultry, eggs, and dairy products.

A “Sell-By” date tells the store how long to display the product for sale. You should buy the product before the date expires.

A “Best If Used By (or Before)” date is recommended for best avor or quality. It is not a purchase or safety date.

A “Use-By” date is the last date recommended for the use of the product while at peak quality. The date has been determined by the manufacturer of the product.

CHICKEN SAMPLER PACK

SELL BY JAN 13.06 576 PRICE/LB NET WT LB

270567 005093

BEST IF USED BY

1.99 2.56 lb

MEAT DEPT.

$5.09

TOTAL PRICE

P—7903

“Closed or coded dates” are packing numbers for use by the manufacturer. “Closed” or “coded” dating might appear on shelf-stable products such as cans and boxes of food.

Transporting Your Groceries

Follow these tips for safe transporting of your groceries:

• Pick up perishable foods last, and plan to go directly home from the grocery store.

Always refrigerate perishable foods within 2 hours of cooking or purchasing.

Refrigerate within 1 hour if the temperature outside is above 90 °F.

In hot weather, take a cooler with ice or another cold source to transport foods safely.

13

10 NOV 06

Eating out can be lots of fun—so make it an enjoyable experience by following some simple guidelines to avoid food-

borne illness. Remember
to observe your food
when it is served, and
don’t ever hesitate to ask
questions before you order.
Waiters and waitresses can
be quite helpful if you ask how a
food is prepared. Also, let them know you don’t want any food item containing raw meat, poultry, sh, sprouts, or eggs.

1. Read and construct 10 questions with Correct answers on food safety below The questions and answers that you provide should be written in the correct “jeopardy” format-answers first and questions second. The purpose of the assignment is to demonstrate an understanding of the course content.

Foodborne Illness in the United States When certain disease-causing bacteria, viruses or parasites contaminate food, they can cause foodborne illness. Another word for such a bacteria, virus, or parasite is “pathogen.” Foodborne illness, often called food poison- ing, is an illness that comes from a food you eat. • The food supply in the United States is among the safest in the world— but it can still be a source of infection for all persons. • According to the Centers for Disease Control and Prevention, 48 million persons get sick, 128,000 are hospitalized, and 3,000 die from foodborne infection and illness in the United States each year. Many of these people are children, older adults, or have weakened immune systems and may not be able to ght infection normally. Since foodborne illness can be serious—or even fatal—it is important for you to know and practice safe food-handling behaviors to help reduce your risk of getting sick from contaminated food. 2 • Your gastrointestinal tract, when functioning properly, allows the foods and beverages you consume to be digested normally. Diabetes may damage the cells that create stomach acid and the nerves that help Food Safety: It’s Especially Important for You As a person with diabetes, you are not alone—there are many people in the United States with this chronic disease. Diabetes can affect various organs and systems of your body, causing them not to function properly, and making you more susceptible to infection. For example: • Your immune system, when functioning properly, readily ghts off harmful bacteria and other pathogens that cause infection. With diabetes, your immune system may not readily recognize harmful bacteria or other pathogens. This delay in the body’s natural response to foreign invasion places a person with diabetes at increased risk for infection. your stomach and intestinal tract move the food throughout the intestinal tract. Because of this damage, your stomach may hold on to the food and beverages you consume for a longer period of time, allowing harmful bacteria and other pathogens to grow. Additionally, your kidneys, which work to cleanse the body, may not be functioning properly and may hold on to harmful bacteria, toxins, and other pathogens. A consequence of having diabetes is that it may leave you more susceptible to developing infections—like those that can be brought on by disease-causing bacteria and other pathogens that cause foodborne illness. Should you contract a foodborne illness, you are more likely to have a lengthier illness, undergo hospitalization, or even die. To avoid contracting a foodborne illness, you must be vigilant when handling, preparing, and consuming foods. Make safe food handling a lifelong commitment to minimize your risk of foodborne illness. Be aware that as you age, your immunity to infection naturally is weakened. 3 Major Pathogens That Cause Foodborne Illness Symptoms and Potential Impact • Fever, headache, and muscle pain followed by diarrhea (sometimes bloody), abdominal pain, and nausea. Symptoms appear 2 to 5 days after eating and may last 2 to 10 days. May spread to the bloodstream and cause a life-threatening infection. Symptoms and Potential Impact • Watery diarrhea, dehydration, weight loss, stomach cramps or pain, fever, nausea, and vomiting; respiratory symptoms may also be present. • Symptoms begin 7 to 10 days after becoming infected, and may last 2 to 14 days. In those with a weakened immune system, including people with diabetes, symptoms may subside and return over weeks to months. Symptoms and Potential Impact Associated Foods • Untreated or contaminated water • Unpasteurized (“raw”) milk • Raw or undercooked meat, poultry, or shell sh Associated Foods/Sources • Swallowing contaminated water, including that from recreational sources, (e.g., a swimming pool or lake) Eating uncooked or contaminated food Placing a contaminated object in the mouth Soil, food, water, and contaminated surfaces Associated Foods/Sources • Many outbreaks result from food left for long periods in steam tables or at room temperature and time and/or temperature abused foods. • Meats, meat products, poultry, poultry products, and gravy Associated Foods • Improperly reheated hot dogs, luncheon meats, cold cuts, fermented or dry sausage, and other deli-style meat and poultry Unpasteurized (raw) milk and soft cheeses made with unpasteurized (raw) milk Smoked seafood and salads made in the store such as ham salad, chicken salad, or seafood salads Raw vegetables • Onset of watery diarrhea and abdominal cramps within about 16 hours. The illness usually begins suddenly and lasts for 12 to 24 hours. In the elderly, symptoms may last 1 to 2 weeks. Campylobacter Cryptosporidium Clostridium perfringens • Complications and/or death occur only very rarely. Listeria monocytogenes Can grow slowly at refrigerator temperatures Symptoms and Potential Impact • Fever, chills, headache, backache, sometimes upset stomach, abdominal pain, and diarrhea. May take up to 2 months to become ill. Gastrointestinal symptoms may appear within a few hours to 2 to 3 days, and disease may appear 2 to 6 weeks after ingestion. The duration is variable. Those at-risk (including people with diabetes and others with weakened immune systems) may later develop more serious illness; death can result from this bacteria. Can cause problems with pregnancy, including miscarriage, fetal death, or severe illness or death in newborns. 4 Associated Foods • Undercooked beef, especially hamburger Unpasteurized milk and juices, like “fresh” apple cider Contaminated raw fruits and vegetables, and water Person-to-person contact Associated Foods • Shell sh and fecally- contaminated foods or water • Ready-to-eat foods touched by infected food workers; for example, salads, sandwiches, ice, cookies, fruit Associated Foods • Raw or undercooked eggs, poultry, and meat Unpasteurized (raw) milk or juice Cheese and seafood Fresh fruits and vegetables Toxoplasma gondii Associated Foods/Sources • Accidentalcontactofcatfeces through touching hands to mouth after gardening, handling cats, cleaning cat’s litter box, or touching anything that has come in contact with cat feces. • Raw or undercooked meat. Vibrio vulni cus Associated Foods • Undercooked or raw seafood ( sh or shell sh) Symptoms and Potential Impact • Severe diarrhea that is often bloody, abdominal cramps, and vomiting. Usually little or no fever. • Can begin 1 to 9 days after contaminated food is eaten and lasts about 2 to 9 days. • Some, especially the very young, may develop hemolytic-uremic syndrome (HUS), which can cause acute kidney failure, and can lead to permanent kidney damage or even death. Symptoms and Potential Impact • Nausea, vomiting, and stomach pain usually start between 24 and 48 hours, but cases can occur within 12 hours of exposure. Symptoms usually last 12 to 60 hours. • Diarrhea is more prevalent in adults and vomiting is more prevalent in children. Symptoms and Potential Impact • Stomach pain, diarrhea (can be bloody), nausea, chills, fever, and/or headache usually appear 6 to 72 hours after eating; may last 4 to 7 days. • In people with a weakened immune system, such as people with diabetes, the infection may be more severe and lead to serious complications including death. Symptoms and Potential Impact Escherichia coli O157:H7 One of several strains of E. coli that can cause human illness Noroviruses (and other caliciviruses) Salmonella (over 2,300 types) • Flu-like illness that usually appears 10 to 13 days after eating, may last months. Those with a weakened immune system, including people with diabetes, may develop more serious illness. • Can cause problems with pregnancy, including miscarriage and birth defects. Symptoms and Potential Impact • Diarrhea, stomach pain, and vomiting may appear within 4 hours to several days and last 2 to 8 days. May result in a blood infection. May result in death for those with a weakened immune system, including people with diabetes, cancer or liver disease. 5 Eating at Home: Making Wise Food Choices Some foods are more risky for you than others. In general, the foods that are most likely to contain harmful bacteria or viruses fall into two categories: • Uncooked fresh fruits and vegetables • Some animal products, such as unpasteurized (raw) milk; soft cheeses made with raw milk; and raw or undercooked eggs, raw meat, raw poultry, raw sh, raw shell sh and their juices; luncheon meats and deli-type salads (without added preservatives) prepared on site in a deli-type establishment. . . . about Particular Foods: KEEP YOUR FAMILY SAFER FROM FOOD POISONING If you are not sure about the safety of a food in your refrigerator, don’t take therisk. Interestingly, the risk these foods may actually pose depends on the origin or source of the food and how the food is processed, stored, and prepared. Follow these guidelines (see chart at right) for safe selection and preparation of your favorite foods. If You Have Questions . . . . . . about Wise Food Choices: Be sure to consult with your doctor or health care provider. He or she can answer any speci c questions or help you in your choices. When in doubt, throw it out! Wise choices in your food selections are important. All consumers need to follow the Four Basic Steps to Food Safety: Clean, Separate, Cook, and Chill. Check your steps at FoodSafety.gov 6 CLEAN SEPARATE CHILL CLEAN WASH HANDS AND SURFACES OFTEN SEPARATE SEPARATE RAW MEATS FROM OTHER FOODS CHILL REFRIGERATE FOOD PROMPTLY oF COOK TO THE RIGHT TEMPERATURE Common Foods: Select the Lower Risk Options Type of Food Higher Risk Lower Risk Meat and • Raw or undercooked • Meat or poultry cooked to a Poultry meat or poultry safe minimum internal tem- perature (see chart on p. 10) Tip: Use a food thermometer to check the internal temperature on the “Is It Done Yet?” chart on page 10 for speci c safe minimum internal temperature. Seafood • Any raw or undercooked sh, or shell sh, or food containing raw or undercooked seafood e.g., sashimi, found in some sushi or ceviche. Refrigerated smoked sh • Partially cooked seafood, such as shrimp and crab • Previously cooked seafood heated to 165 °F • Canned sh and seafood • Seafood cooked to 145 °F Milk • Unpasteurized (raw) milk • Pasteurized milk Eggs Foods that contain raw/undercooked eggs, such as: At home: • Homemade Caesar salad dressings* • Homemade raw cookie dough* • Homemade eggnog* • Use pasteurized eggs/egg products when preparing recipes that call for raw or undercooked eggs When eating out: • Ask if pasteurized eggs were used *Tip: Most pre-made foods from grocery stores, such as Caesar dressing, pre-made cookie dough, or packaged eggnog are made with pasteurized eggs. Sprouts • Raw sprouts (alfalfa, bean, or any other sprout) • Cooked sprouts Vegetables • Unwashed fresh vegetables, including lettuce/salads • Washed fresh vegetables, including salads • Cooked vegetables Cheese • Soft cheeses made from unpasteurized (raw) milk, such as: — Feta — Brie — Camembert — Blue-veined — Queso fresco • Hard cheeses • Processed cheeses • Cream cheese • Mozzarella • Soft cheeses that are clearly labeled “made from pasteurized milk” Hot Dogs and • Hot dogs, deli meats, and • Hot dogs, luncheon meats, and deli meats reheated to steaming hot or 165 °F Tip: You need to reheat hot dogs, deli meats, and luncheon meats before eating them because the bacteria Listeria monocytogenes grows at refrigerated temperatures (40 °F or below). This bacteria may cause cause severe illness, hospitalization, or even death. Reheating these foods until they are steaming hot ho destroys these dangerous bacteria and makes these foods safe for you to eat. Deli Meats luncheon meats that have not been reheated Pâtés • Unpasteurized, refrigerated pâtés or meat spreads • Canned or shelf-stable pâtés or meat spreads 7 Taking Care: Handling and Preparing Food Safely Foodborne pathogens are sneaky. Food that appears completely ne can contain pathogens—disease-causing bacteria, viruses, or parasites—that can make you sick. You should never taste a food to determine if it is safe to eat. As a person with diabetes, it is especially important that you—or those preparing your food—are always careful with food handling and preparation. The easiest way to do this is to Check Your Steps – clean, separate, cook, and chill – from the Food Safe Families Campaign. Four Basic Steps to Food Safety 1. Clean: Wash hands and surfaces often Bacteria can spread throughout the kitchen and get onto cutting boards, utensils, counter tops, and food. To ensure that your hands and surfaces are clean, be sure to: Wash hands in warm soapy water for at least 20 seconds before and after handling food and after using the bathroom, changing diapers, or handling pets. Wash cutting boards, dishes, utensils, and counter tops with hot soapy water be- tween the preparation of raw meat, poultry, and seafood products and preparation of any other food that will not be cooked. As an added precaution, sanitize cut- ting boards and countertops by rinsing them in a solution made of one tablespoon of unscented liquid chlorine bleach per gallon of water, or, as an alternative, you may run the plastic board through the wash cycle in your automatic dishwasher. Use paper towels to clean up kitchen surfaces. If using cloth towels, you should wash them often in the hot cycle of the washing machine. Wash produce. Rinse fruits and vegetables, and rub rm-skin fruits and vegetables under running tap water, including those with skins and rinds that are not eaten. With canned goods: remember to clean lids before opening. 8 2. Separate: Don’t cross-contaminate Cross-contamination occurs when bacteria are spread from one food product to another. This is especially common when handling raw meat, poultry, seafood, and eggs. The key is to keep these foods—and their juices—away from ready-to-eat foods. To prevent cross-contamination, remember to: • Separate raw meat, poultry, seafood, and eggs from other foods in your grocery shopping cart, grocery bags, and in your refrigerator. • Never place cooked food on a plate that previously held raw meat, poultry, seafood, or eggs without rst washing the plate with hot soapy water. • Don’t reuse marinades used on raw foods unless you bring them to a boil rst. • Consider using one cutting board only for raw foods and another only for ready-to-eat foods, such as bread, fresh fruits and vegetables, and cooked meat. 3. Cook: Cook to safe temperatures Foods are safely cooked when they are heated to the USDA-FDA recommended safe minimum internal temperatures, as shown on the “Is It Done Yet?” chart (see next page). To ensure that your foods are cooked safely, always: • Use a food thermometer to measure the internal temperature of cooked foods. Check the internal temperature in several places to make sure that the meat, poul- try, seafood, or egg product is cooked to safe minimum internal temperatures. Cook ground beef to at least 160 °F and ground poultry to a safe minimum internal temperature of 165 °F. Color of food is not a reliable indicator of safety or doneness. Reheat fully cooked hams packaged at a USDA-inspected plant to 140 °F. For fully cooked ham that has been repackaged in any other location or for leftover fully cooked ham, heat to 165 °F. Cook seafood to 145 °F. Cook shrimp, lobster, and crab until they turn red and the esh is pearly opaque. Cook clams, mussels, and oysters until the shells open. If the shells do not open, do not eat the seafood inside. Cook eggs until the yolks and whites are rm. Use only recipes in which the eggs are cooked or heated to 160 °F. Cook all raw beef, lamb, pork, and veal steaks, roasts, and chops to 145 °F with a 3-minute rest time after removal from the heat source. 9 3. Cook: Cook to safe temperatures (cont.) Bring sauces, soups, and gravy to a boil when reheating. Heat other leftovers to 165 °F. Reheat hotdogs, luncheon meats, bologna, and other deli meats until steam- ing hot or 165 °F. When cooking in a microwave oven, cover food, stir, and rotate for even cooking. If there is no turntable, rotate the dish by hand once or twice during cooking. Always allow standing time, which completes the cooking, before checking the internal temperature with a food thermometer. Food is done when it reaches the USDA-FDA recommended safe minimum internal temperature. Is It Done Yet? Use a food thermometer to be most accurate. You can’t always tell by looking. 4. Chill: Refrigerate promptly Cold temperatures slow the growth of harmful bacteria. Keeping a constant refrigerator temperature of 40 °F or below is one of the most effective ways to reduce risk of foodborne illness. Use an appliance thermometer to be sure the refrigerator temperature is consistently 40 °F or below and the freezer temperature is 0 °F or below. To chill foods properly: • Refrigerate or freeze meat, poultry, eggs, seafood, and other perishables within 2 hours of cooking or purchasing. Refrigerate within 1 hour if the temperature outside is above 90 °F. Never thaw food at room temperature, such as on the counter top. It is safe to thaw food in the refrigerator, in cold water, or in the microwave. If you thaw food in cold water or in the microwave, you should cook it immediately. Divide large amounts of food into shallow containers for quicker cooling in the refrigerator. Follow the recommendations in the abridged USDA-FDA Cold Storage Chart (see page 11). The USDA-FDA Cold Storage Chart in its entirety may be found at www.fsis.usda.gov/Fact_Sheets/Refrigeration_&_Food_Safety/index.asp. USDA-FDA Recommended Safe Minimum Internal Temperatures Beef, Pork, Veal, Lamb Steaks, Roasts & Chops 145 °F with 3-minute rest time Fish 145 °F Beef, Pork, Veal, Lamb Ground 160 °F Egg Dishes 160 °F Turkey, Chicken & Duck Whole, Pieces & Ground 165 °F 10 USDA-FDA Cold Storage Chart These time limit guidelines will help keep refrigerated food safe to eat. Because freezing keeps food safe inde nitely, recommended storage times for frozen foods are for quality only. Product Refrigerator (40 °F) Freezer (0 °F) Eggs Fresh, in shell 3 to 5 weeks Don’t freeze Hard cooked 1 week Don’t freeze well Liquid Pasteurized Eggs, Egg Substitutes Opened 3 days Don’t freeze well Unopened 10 days 1 year Deli and Vacuum-Packed Products Egg, chicken, ham, tuna, & macaroni salads 3 to 5 days Don’t freeze well Hot Dogs Opened package 1 week 1 to 2 months Unopened package 2 weeks 1 to 2 months Luncheon Meat Opened package 3 to 5 days 1 to 2 months Unopened package 2 weeks 1 to 2 months Bacon & Sausage Bacon 7 days 1 month Sausage, raw—from chicken, turkey, pork, beef 1 to 2 days 1 to 2 months Hamburger and Other Ground Meats Hamburger, ground beef, turkey, veal, pork, lamb, & mixtures of them 1 to 2 days 3 to 4 months Fresh Beef, Veal, Lamb, Pork Steaks 3 to 5 days 6 to 12 months Chops 3 to 5 days 4 to 6 months Roasts 3 to 5 days 4 to 12 months Fresh Poultry Chicken or turkey, whole 1 to 2 days 1 year Chicken or turkey, pieces 1 to 2 days 9 months Seafood Lean sh ( ounder, haddock, halibut, etc.) 1 to 2 days 6 to 8 months Fatty sh (salmon, tuna, etc.) 1 to 2 days 2 to 3 months Leftovers Cooked meat or poultry 3 to 4 days 2 to 6 months Chicken nuggets, patties 3 to 4 days 1 to 3 months Pizza 3 to 4 days 1 to 2 months Check Your Steps Check “Sell-By” date Put raw meat, poultry, or seafood in plastic bags • Buy only pasteurized milk, soft cheeses made with pasteurized milk, and pasteurized or juices that have been otherwise treated to control harmful bacteria. • When buying eggs: – Purchase refrigerated shell eggs – If your recipe calls for raw eggs, purchase pasteurized, refrigerated liquid eggs • Don’t buy food displayed in unsafe or unclean conditions Is It Done Yet? You can’t tell by looking. Use a food thermometer to be sure. USDA-FDA Recommended Safe Minimum Internal Temperatures Beef, Pork, Veal, Lamb Steaks, Roasts & Chops 145 °F with 3-minute rest time Fish 145 °F Beef, Pork, Veal, Lamb Ground 160 °F Egg Dishes 160 °F Turkey, Chicken & Duck Whole, Pieces & Ground 165 °F Ordering “Smart” When Eating Out Higher Risk: ✘ Cheese made from unpasteurized (raw) milk. ✘ Raw or undercooked seafood. ✘ Cold hot dogs. ✘ Sandwiches with cold deli or luncheon meat. ✘ Raw or undercooked fish, such as sashimi or some kind of sushi. ✘ Soft-boiled or “over-easy” eggs, as the yolks are not fully cooked. Lower Risk: ✔Hard or processed cheeses. Soft cheeses only if made from pasteurized milk. ✔Fully cooked smoked fish or seafood. ✔Hot dogs reheated to steaming hot. If the hot dogs are served cold or lukewarm, ask to have the hot dogs reheated until steaming, or else choose something else. ✔Grilled sandwiches in which the meat or poultry is heated until steaming. ✔Fully cooked fish that is firm and flaky; vegetarian sushi. ✔Fully cooked eggs with firm yolk and whites. Clip out these handy Info Cards and carry them for quick reference when shopping, cooking, and eating out! In the Know: Becoming a Better Shopper Follow these safe food-handling practices while you shop. • Carefully read food labels while in the store to make sure food is not past its “sell by” date. (See Food Product Dating • Put raw packaged meat, poultry, or seafood into a plastic bag before placing it in the shopping cart, so that its juices will not drip on— and con taminate—other foods. If the meat counter does not offer plastic bags, pick some up from the produce section before you select your meat, poultry, and seafood. Buy only pasteurized milk, cheese, and other dairy products from the refrigerated section. When buying fruit juice from the refrigerated section of the store, be sure that the juice label says it is pasteurized. Purchase eggs in the shell from the refrigerated section of the store. (Note: store the eggs in their original carton in the main part of your refrigerator once you are home.) For recipes that call for eggs that are raw or undercooked when the dish is served—homemade Caesar salad dressing and ice cream are two examples—use either shell eggs that have been treated to destroy Salmonella by pasteurization, or pasteurized egg products. When consuming raw eggs, using pasteurized eggs is the safer choice. • Never buy food that is displayed in unsafe or unclean conditions. When purchasing canned goods, make sure that they are free of dents, cracks, or bulging lids. (Once you are home, remember to clean each lid before opening the can.) Purchase produce that is not bruised or damaged. When shopping for food, it is important to read the label carefully. on page 13) 12 Food Product Dating Read the “Safe Handling Label” for food safety information on raw foods. Types of Open Dates Open dating is found primarily on perishable foods such as meat, poultry, eggs, and dairy products. A “Sell-By” date tells the store how long to display the product for sale. You should buy the product before the date expires. A “Best If Used By (or Before)” date is recommended for best avor or quality. It is not a purchase or safety date. A “Use-By” date is the last date recommended for the use of the product while at peak quality. The date has been determined by the manufacturer of the product. CHICKEN SAMPLER PACK SELL BY JAN 13.06 576 PRICE/LB NET WT LB 270567 005093 BEST IF USED BY 1.99 2.56 lb MEAT DEPT. $5.09 TOTAL PRICE P—7903 “Closed or coded dates” are packing numbers for use by the manufacturer. “Closed” or “coded” dating might appear on shelf-stable products such as cans and boxes of food. Transporting Your Groceries Follow these tips for safe transporting of your groceries: • Pick up perishable foods last, and plan to go directly home from the grocery store. Always refrigerate perishable foods within 2 hours of cooking or purchasing. Refrigerate within 1 hour if the temperature outside is above 90 °F. In hot weather, take a cooler with ice or another cold source to transport foods safely. 13 10 NOV 06 Eating out can be lots of fun—so make it an enjoyable experience by following some simple guidelines to avoid food- borne illness. Remember to observe your food when it is served, and don’t ever hesitate to ask questions before you order. Waiters and waitresses can be quite helpful if you ask how a food is prepared. Also, let them know you don’t want any food item containing raw meat, poultry, sh, sprouts, or eggs.

Please read the article and answer about questions.

International Strategies

When you are struggling to get through that first year of business, international sales are about the last thing on your mind. The U.S. Department of Commerce, however, indicates that large compa- nies account for only about 4 percent of all exporters, meaning the other 98 percent of the exporters in 2010 were small businesses.22

Entrepreneurs typically fall into three categories. There are those who realistically will never go international (for example, a restaurant owner or dry cleaner working from a single site). There are those who intentionally start international businesses23 (for example, import-export businesses), such as Peter P., the director of procurement for a Russian trading company, who saw a trading opportunity with the opening up of Eastern Europe and the former Soviet Union. Educated in the United States, he is of Ukrainian descent and speaks both Russian and Ukrainian.24 Last, there are those who think international business might be something they’ll do someday way off in the future. This section is primarily for the last two categories.

Thanks to the Internet, once a company has a website, it is essentially an international business, a whole new breed of firms known as born internationals.25 Potential foreign customers see the website and before you know it—or before you are prepared—the first international order rolls in. Even “website–free” companies aren’t exempt. A foreign visitor comes across your products and sees a need for it in his or her country, and here comes that order.

Some international orders aren’t all that difficult to handle. If the order is small enough, if the product or service is not highly regulated domestically, and if the country is one with which the United States has rather liberal trade such as Canada, the order processing may offer few or no head- aches. The customer may use a credit card or international money order, and the product ships in the mail without much more effort than figuring the extra postage. That’s okay for the occasional order, but more complex situations will require more time and effort on the part of the entrepreneur. The ideal situation is to consider and prepare an international strategy before it becomes a hit-and-miss method that is too cumbersome or before serious and costly mistakes are made.

Entrepreneurs have available to them the same options as large companies including wholly owned subsidiaries, joint ventures, licensing, franchising, and exporting. For most, though, an ex- port strategy is sufficient and is all that is covered in this section. It’s usually inexpensive, quick to start, easy to change, and less risky than other ventures. It has the additional advantage of allowing the entrepreneur the opportunity to learn about doing business abroad in case the company reaches the point of moving further. For U.S. entrepreneurs, the U.S. government offers detailed and useful help for exporters, including seminars and other training, export assistance, websites and reports, financing, insurance, and legal and collection assistance.

Putting together an export strategy involves answering three questions:

1. Are we ready? 2. Where should we go? 3. Whom do we contact over there?

There are many sources for assistance in answering these questions, and many good ones are free or almost free. One excellent resource is the U.S. Commerce Department’s report entitled, “A Basic Guide to Exporting” that can be found at www.unzco.com/basicguide.

Question 1: Are you ready to export? Exporting requires a different kind of thinking and prepa- ration from selling locally or even nationally. Are you going to target one country, a region, or the whole world? Do you know what customers want? Do you know what the import requirements are? What aspects will you handle, and which ones will you contract out? Are you ready for the costs and headaches of exporting? To see how you are coming along, you can check your readiness online at the U.S. government’s exporting site www.export.gov/, which provides extensive exporting basics, including a “readiness test” at www.fas.usda.gov/agexport/exporttest.asp.

Consider your product as well. Will your U.S. designed product fit an international lifestyle or needs? Clothing sizes are different—both in how they are numbered and what the sizes mean. A woman’s medium in the United States is an XXL in mainland China. Electrical currents are

different, as are various other safety and product standards, and the United States is one of only two countries that’s not on the metric system.27

There are several ways you can export. One is to use online services such as eBay. Approximately one-fifth of eBay’s sales are out of country.28 If you’re handling your international business this way, a lot of the rest of this section isn’t really for you until you want or need to change methods. Another is to work from personal contacts gained through school, travel, or family. Most exporting small businesses start with countries where they have had personal experience or support.29 These two methods are called direct exporting, since you are selling directly to foreign buyers or distributors.

If you want to use outside experts, there are three intermediaries who can help. With indirect exporting, you use agents, export management companies, or export trading companies as inter- mediaries to handle most of the exporting process. Direct exporters can also get help from freight forwarders. Freight forwarders are specialists in export-related activities including tariff sched- ules, shipping, insurance, packing, transportation arrangements, customs clearing, and other export details. (By the way, many agents, export management companies, export trading companies, and freight forwarders are themselves small businesses. They know exactly what problems you’ve faced and are much easier to approach than some megacompany.) The Small Business Administration’s Export Assistance Center can help you find one.

Question 2: Where should we go? The United Nations has 193 member countries in the world; chances are not all of them are right for your product. Even if your product should have wide appeal, it makes good sense to pick one or two as first markets. One of the safest bets is to consider countries that are similar to the United States—Canada, United Kingdom, Australia, for example. In those countries, you have few language issues, the culture is pretty close, the governments and economies are stable, and the people there are likely to want or need about the same kinds of products as people in the United States do. Should you decide to go further afield, those are the same sorts of things you want to look for—language and culture issues, government and legal situations, economic situ- ations, and peoples’ wants and needs. Here’s a good time to use those personal contacts mentioned earlier; if they live there, they are likely to be able to tell you if the product makes sense or not.

International marketing research isn’t cheap and can be difficult to do. Contacts are a valuable resource. Additionally, the U.S. government and world trade centers can give a lot of free or low-cost assistance. See Table 11.1 for a list of some of the major ones.

TABLE 11.1   Sources of Export Assistanc Question 3: Whom do we contact over there? You may already have international contacts through school, friends, travel, or other methods. If so, you’re ahead of the game. Even if they cannot help you with specific questions, they probably know someone who can. On the other hand, if you do not have any contacts, a lot of the government services you have already used can provide lists of poten- tial intermediaries or end users. In addition to the free services available, U.S. Commercial Services (www.export.gov) provides a number of levels of fee-based customized services. For $500, they offer their International Partner Search service, which will identify up to five potential businesses to work with you as licensees, agents, distributors, or strategic partners, and prequalify them based on your criteria. The government’s www.export.gov site offers a database of sales leads that can be searched for free by industry, region, or country. They also are the point of contact for catalog exhi- bitions which can get your product or service catalogs into the hands of potential buyers in specific markets (or at specific trade shows) overseas.

Other good ways to make international contacts are to participate in trade shows and trade mis- sions. In a trade mission, a U.S. government official takes a small group of business owners to dif- ferent foreign countries in order to help establish relationships and promote exporting. There are not a lot of these missions, and they are usually specific to a particular type of business and region of the world, so they are not always appropriate. At an international trade fair, similar to domestic trade fairs, you have a booth displaying your products or services and the opportunity for exposure to thousands of potential clients. Again, some fairs are industry-specific, while others are more general. The U.S. government often has a U.S. pavilion featuring export-oriented companies. These companies often have the opportunity to tie into other U.S. government services such as meeting with local U.S. embassy officials, prearranged meetings with qualified customers, market research information, trade barrier information, transportation and customs information, and assistance and access to U.S. trade show experts. Even if you can’t exhibit in the fair, attending the fair may give you a chance to meet the sort of people you need to know.

The U.S. government through www.export.gov also provides such services as printed and video catalogs, online databases, and personalized (fee-based) contact services. The U.S. Commercial Service will also assist a company in arranging private promotional activities, including exhibitions, press releases, and receptions when appropriate.

Still another way is to look for foreign companies with a resident representative in the United States, a type of private importing agent. Often these representatives are interested in bringing U.S. products back to their home countries and will already have a good idea if your product is right, and how to promote and distribute it.30 To find these resident representatives, try a Google search with the terms “resident representative” US, importing-site:.gov.

The next step is to export your products. But there are a few other things to consider first. Pricing becomes complicated as you need to cover transportation, the additional documents you may need,

possible tariffs (taxes on incoming goods), potential currency valuation changes, the cost of convert- ing currencies, and the additional packaging necessary to ship abroad. The importer usually covers foreign taxes, tariffs, additional shipping charges, port handling fees, and the like, but this must be carefully spelled out in your contracts in order to avoid potential differences of opinion.

Shipping documentation and other paperwork are very specific to the product and the country to which it is going. The International Trade Administration (www.ita.doc.gov) provides extensive information about tariffs, taxes, specific country information, and other general exporting informa- tion. The U.S. Country Commercial guides also provide some assistance in this area, as do some country government websites. The Bureau of Export Administration (www.bxa.doc.gov) provides information about when export licensing is necessary and also information on exporting of politi- cally sensitive products. In addition, companies such as NetShip (www.netship.net) have arisen specifically to handle shipping and documentation issues for e-commerce.31

There are a variety of payment procedures available. The easiest for you is to require up-front cash payment prior to shipment (or credit card if appropriate). This eliminates your risk, but puts the customer at risk. Providing credit to your customers reverses the risk, and puts it all on you. Both of these are possible methods of receiving payments, but less often used. More typical meth- ods include letters of credit or documentary drafts. In both cases, the payment procedure now includes four parties—you, your customer, and both of your banks—and payments are made upon proper presentation of certain documents, including the letter of credit or draft, bills of lading, and other paperwork. Although the system is somewhat complex, it provides a lower level of risk for all parties than cash in advance or an open account. You can find assistance about these methods at your current bank.

Financing and insurance become important because of the length of time it may take for interna- tional payments to be processed and the risk of default, as well as the difficulty of recovery in case of default in international transactions. The Small Business Administration (www.sba.gov), the Ex-Im Bank (www.exim.gov), and the Overseas Private Investment Corporation (www.opic.gov) provide loans and insurance to cover exporting. In some cases, these loans may also be used to finance trade show participation, to translate brochures and catalogs for international distribution, to renovate or expand existing facilities necessary to produce products for export, to set up lines of credit for potential customers, to provide export working capital, and to provide funding for developing an export program.

Last is the consideration of conflict resolution. Although the possibility exists for pirating, prod- uct misuse, and other unfortunate occurrences, the primary areas for conflict resolution include nonpayment and contract default issues. There is no universal court of law that can handle these situations. The U.S. Department of Commerce can provide advice and offer reputable local coun- sel, but only for sizable losses, typically several thousand dollars or more. The U.S. Council of the International Chamber of Commerce (www.iccwbo.org) provides international arbitration services and offers some other suggestions, but arbitration, too, is costly and probably not worthwhile un- less the loss is significant. This difficulty in international dispute resolution underscores the need to carefully select partners and to do a thorough job of prescreening. This is an area in which various government agencies can help you. The U.S. Commerce Department, for example, prequalifies potential customers in many cases prior to recommending them; you should check the particular program specifics to verify. Ex-Im Bank provides credit information on potential customers and, as mentioned earlier, many agencies provide insurance for export payments.

Importing

Importing strategy is similar to exporting, but with the buyers and sellers reversed. Instead of cus- tomers to buy your products, you are looking for sources to sell products to you (which, of course, you’ll eventually resell). If you have the opportunity to travel abroad, look for products that are selling well in the country you’re visiting and aren’t available in the United States or products that are considerably cheaper than similar ones found in the United States (labor and manufacturing costs are often cheaper in other countries than the United States). Trade mission and domestic and international trade shows are also good sources. If you can’t travel, ask your international contacts for this information. Next, find out who manufactures them and write the manufacturer a letter, introducing yourself and your company and the potential you see in your market for its product. You’re selling yourself, so be sure to tell the producer why you are the best person or company to be representing the product (i.e., experience in that product or in importing, contacts and distribution systems already in place, familiarity with the market, etc.). International mail can be painfully slow, so a fax or e-mail letter is probably best. Also, avoid slang terms (e.g. “your product is da bomb!”) and idiomatic expressions (like “break the ice”) that are likely to be misunderstood. Since English is rapidly becoming the language of business, a translation is usually not necessary. Follow up with a phone call or visit in which you can pitch the specifics of your marketing plan for the product.32 One way to conduct international calls for free is to register for Skype, an Internet service which lets you use a broadband connected computer to call other Skype users for free (www.skype.com). If you and the overseas company both use Skype, having long conversations to get an understanding of each other will not pose a financial problem. Along the same lines, it is worthwhile these days to check to find out whether an overseas company has video capabilities. Video cameras for PCs are inexpensive, and videoconferencing services are often available on campuses or at commercial locations such as FedEx Kinko’s for low costs.

With importing, many of the paperwork and insurance details will be your source’s responsibil- ity. Import buying works the same way as export selling, that is, the same sorts of paperwork and procedures are followed only in reverse.

Concluding Thoughts on International Business

One of the major mistakes commonly made by U.S. businesspeople (entrepreneurs or major compa- nies) is being insensitive to cultural differences. You’re likely to make some mistakes, but take time to learn at least the basics about the culture you’re dealing with to avoid the biggest errors. Travel guides and U.S. government country reports often offer brief cultural assistance as do books such as Kiss, Bow or Shake Hands and a plethora of “doing business in ———” guides.33

Although international business might seem a little daunting with all the paperwork and regula- tions, small businesses just like yours do it every day. There’s a lot of free or very inexpensive help out there; make use of it.

Location

When you ask real estate agents the best three things to look for in a house, they will tell you, “Loca- tion, location, location.” The same holds true in your business. What location—in particular, good location—means for your business is highly dependent on what your business is, the amount of money you can afford to budget for it, your particular business philosophy, and the marketing niche you are seeking. Let’s start with some general information about location, then move onto specific issues for services (including retailing) and manufacturing businesses. We then discuss some spe- cific choices such as site selection and layout and the buy, build, or lease option.

The first choice, and often only choice, for many entrepreneurs is their hometown because it offers convenience and a familiar setting, and it eliminates a lot of possible family issues. There may also be valid business reasons for this choice: The local banker knows you and is more likely to loan you money; you know your market—the potential customers in the area—and understand their wants and needs; you have seen an unmet need that you can fill; and, for many entrepreneurs, friends and family (usually local) are often the first customers and are great at spreading the word about your business. (Remember that word-of-mouth is often the first method of getting to your customers.)

There may also be some compelling reasons to consider a different location. What are the busi- ness laws like in your area? Local zoning ordinances specify what sorts of businesses are allowed and not allowed in specific locations.34 Certain types of businesses—usually those deemed hazard- ous or that produce foul odors—may be banned or severely restricted. State and local pollution standards, worker’s compensation, wage rates, and other such legislation might increase the cost of doing business to the point that other locations become much more favorable. State and local taxes in particular vary considerably from state to state. For example, Wyoming has no personal or corpo- rate income tax, while California has relatively high rates. On the other hand, certain locations often offer attractive incentives for new businesses ranging from tax credits to low-interest loans, from favorable business laws to business incubators (discussed later). Most of this information can be found on the Internet. Try the state or city business development office (a good place to start is the Federation of Tax Administrators’ state list at www.taxadmin .org/fta/rate/tax_stru.html) or the local chambers of commerce (look in the phone book or at www.uschamber.com/chambers/directory/default to find your local Chamber affiliate). There is also information by state available for your state at business.USA.gov, and the Small Business Ad- ministration offers links to state-based resources at www.sba.gov/category/navigation-structure/ counseling-training. Site Selection Magazine’s website (www.siteselection.com) has a number of tools that can help you find the right location. Many of these require being a registered user, but registration is free.

Other reasons to consider other locations are tied to your customer. Your hometown may not be the best place for you to find your target market customers. Are you close to the people who will use your product or service? Other considerations include population growth or decline (especially in your target sector), income levels, and predicted increases or decreases in income. Is the location expanding economically or slowly dying? Perhaps the best source for this infor- mation is the US Census Bureau. State and local municipality business development offices may also carry such information, but they are likely to be slanted toward attracting new businesses. Being positioned to benefit your customer can also be key. Zappos’s primary distribution hub was placed in Louisville, Kentucky, to be close to a major UPS air cargo hub in order to speed delivery.

Also consider the type of business you are planning. Do you need skilled labor? If so, what areas will provide you with the necessary employees? Do you need to be near raw materials or particular methods of transportation? These issues will help determine your choices. Where are your competitors? Certain industries tend to be clustered in certain regions where they can make efficient use of services and employees. Think of California’s Silicon Valley or the financial district of New York City.

Doing business in your hometown may be perfectly appropriate; however, the cost of moving a company—whether across town or across the country—can be very expensive. It pays to plan ahead.

Service Firms

There are three typical locations for services: at the client’s location, at a mutually accessible loca- tion, and at your firm’s location. Traditionally, services may have been tied to one or another of these, but marketing niches have been carved out by people daring to be different. Typically, dry cleaning and restaurant dining are services provided at a place accessible to both parties, but some dry cleaners now offer pick up and delivery from the client’s home, and not only pizza restaurants offer delivery these days. Thanks to the Internet, video rental like Netflix.com and other services are handled electronically, and the customer and service provider may never meet face to face. Whatever innovative niche you select, there are a few things to keep in mind.

At the Client’s Location

Typically, these services include things such as house or office cleaning, pest control, remodeling, lawn and gardening services, carpet cleaning, and similar services which must be performed at the client’s location. Business headquarters can be a home office with enough room to store and maintain any necessary equipment used in the service. Reliable transportation, preferably modified to organize and store tools efficiently, is imperative. More importantly, the range of your client’s locations must be planned to prevent transportation times from being unmanageable. For example, facing a one-hour drive to a client’s location might mean you have tied up two hours in commuting. If you cannot charge for travel and do not have other clients nearby, it means you have two hours in which you cannot make any money that day.

If you’ve done your homework carefully, you already know the geographic area(s) most likely to use your service. Certain services may be organized into a rotating schedule. For example, a house cleaning service may clean a certain set of neighborhoods on Monday, different set on Tuesday, and so on. In other cases, more remote clients may be charged a transportation fee. In some cases, a mile- age fee may be appropriate for your business (delivery services, for example).

As the firm grows, it may outgrow its home-based headquarters. As your clients seldom, if ever, visit you, you have more latitude in where you can be located and the ability to seek out low-cost space (see site selection section below). Reasonable distance to the clients and adequate storage room for your expanded fleet and equipment are key to choosing a site.

Mutually Accessible Location

Services using this approach often have too much specialized equipment to be readily transported and a need for at least some client involvement. Barbershops, dentist offices, video rental stores, and restaurants are services typically located at a site that is extremely convenient for the client and reasonably so for the owner and employees.

Even though your service may be traditionally located in a mutually accessible area, consider what you might do to make it home-based (see Chapter 5). Your watch repair shop might generate clientele by being located in a shopping center, but will the added sales be offset by the high cost of rent, utilities, insurance, and other payments? Can you offer pickup and delivery and do the work at

home? Your restaurant idea might work as a catering service. Instead of a specialized clothing shop, why not try mail order or Internet-based sales?

Remote Location

In this type of service, face-to-face meetings with the client are infrequent. Typical services that meet this criterion include medical transcription, data processing, fulfillment centers, and some consulting work. These services generally are ideal for home-based businesses. Certain services, for example, fulfillment centers, generally take more space—at the minimum, an attic, garage, or basement. The biggest advantage of these sorts of businesses is that they can be located anywhere in the world. U.S. hospitals, for example, use medical transcription services located in India. One such company, Infoflow/TSVI, operates from a U.S. sales base (which makes handling calls from U.S. hospitals easier) with transcription being done in India, managed there by a co-owner, who is a cousin and long-time friend of one of the two American owners (www.tsviinc.com).35 Other than perhaps some initial sales meetings, all business is transacted via phone, fax, electronic exchanges, or mail.

Manufacturers

What if you are selling a product and not a service? What are your considerations about location now? Where you make the product is really dependent on the product. Some products that do not require a lot of specialized or bulky equipment can be produced at home unless zoning ordinances forbid it. In addition to whatever office space is needed, adequate work space is also required. The basement, a garage, or a home workshop may be adequate for some time. As business expands and as you add employees, it will become awkward if not illegal to continue production at home (see Chapter 5).

Some products require bulky and specialized equipment, utility demands atypical of homes, or sizable warehousing requirements and are never suitable for home businesses. Certain production characteristics—for example, use of hazardous materials and materials with strong odors or noisy operations—may make a home-based business undesirable. Many cities have zoning ordinances prohibiting manufacturing in residential areas. When you start to hire employees, providing the amenities they will expect or that are required by law will usually require moving the business from your home.

Contract manufacturing might be a better option, at least for awhile. In this case, a firm with the capabilities to produce your product is contracted to manufacture it for you, usually for a flat per unit fee and a possible setup charge. Some firms will also assist in marketing and sales as well. Trade magazines in your field often list ads for contract manufacturers. An interesting possibility here is to use sheltered workshops to perform light manufacturing or assembly sorts of businesses. These workshops exist in nearly every state and offer very competitive pricing, often including tax benefits for the business.

Site Selection

Once you have determined the general location of your business, you need to determine the exact location for your operation. What you should look for falls into three main categories: home-based businesses (covered in Chapter 5), high customer contact (e.g., retail), and low customer contact (e.g., manufacturing). Each has certain criteria to be considered.

High Customer Contact Businesses

Businesses with high customer contact include such diverse operations as medical or legal offices, restaurants, retail establishments, dry cleaners, and other businesses that are highly dependent on being convenient to the customer. For these operations, there are three critical site selection consid- erations: traffic, customer ease, and competition.36

First of all, you want a site that is convenient to your target market and to enough of the customers to make you profitable. If you are considering a franchise, many will offer site criteria to help you make your selection. If you are going it alone, consider the population density of the area and how many of the people in the area meet your target market criteria. The U.S. Census Bureau website

and a number of free nongovernment sites like www.zipwho.com and www.city-data.com can be a good starting place for free information. See Skill Module 11.2 and the Online Learning Center. If plowing through the Census Bureau website doesn’t get you what you want, several commercial services mentioned in Chapter 10 including Prizm and ESRI will sell you data about the population in a particular zip code for several hundred dollars. More detailed and specific commercial infor- mation is also available and can range in price from several thousand dollars to over $100,000 and is probably not an option for most entrepreneurs.37 Again, the website of Site Selection Magazine (www.siteselection.com) mentioned above has tools and additional articles that can help. Another consideration is the presence of traffic generators in the area. These are other busi- nesses that draw customers to the area and may include supermarkets, office complexes, schools, and malls. If the customers are drawn there, for example, to grocery shop, might they not stop at your video store next door? Reflect on the type of customer you are seeking and the likelihood of these businesses in attracting them. If you want a teen customer, a location near a high school works well. If you are looking for evening clientele, offices that close at five aren’t the right traffic genera- tors for you. Drive around likely areas and locate possible sites. Visit during the hours you anticipate to be peak times for your business and evaluate foot and car traffic.38 Look at the crowds or lines in similar businesses and decide whether there is room for you. If most businesses seem empty, you probably will be too.

Intersections of major streets offer high automobile traffic, but because of divided roads and other barriers, they may not make it easy for your customers to get to you. Businesses along inter- states have high visibility, but the frontage roads can be so convoluted that the clients seek easier- to-get-to competitors. Even some malls and shopping centers have such tortuous access problems that customers avoid them when possible. Sometimes entry is easy, but getting out is difficult. For example, no signals for left turns when most of the traffic needs to head in that direction can turn off customers.

Parking is also an issue. Is it conveniently located to your place of business? Do customers need to cross busy streets to get to you? Is parking free or paid? Are parking areas well lit and safe? Are there wheelchair ramps or other accommodations for disabled customers?

Customers have strong ideas about how far they should have to drive for things. These vary some- what from major metropolitan areas to more rural towns and from one region of the United States to another. Generally convenience stores, fast-food restaurants, and gas stations need to be close to con- sumers. Grocery stores and banks can be somewhat farther away, but not much. Discount stores and midscale restaurants can be even farther away, while specialty stores, upscale restaurants, and malls can be relatively remote. Where does your business fit? How far are customers willing to drive to get to you?

Malls are great traffic generators, but space at malls is costly. If it is appropriate for your product, you might consider a kiosk or cart in the mall as a way of testing the market and location without making a large investment.39 Neighborhood shopping centers (those anchored by a supermarket, drugstore, or major retailer) or strip centers (shopping centers without major anchors) are more modestly priced, but lack the drawing power of malls.4 Generally, competition in the area can draw away valuable clients, but this is not true in every case. Many cities have a restaurant row, an antique district, or an automobile mile (as well as other business types) where many competitors cluster. Clients wish to comparison shop or have choices and are drawn to areas where they can see several similar businesses at one time. Locating far from these will mean that you are free from competition, but this benefit may easily be offset by the cost of at- tracting customers to a different place. Additionally, you can capitalize on competitive advertisements that bring potential customers to the area. Your competitor’s high-budget TV ad might get customers to the neighborhood, but the “sale” sign in your window may get them to stop at your place instead.

Another instance when you want to be near competitors is when your business provides a strong contrast to the competition in the area. Do you offer better assistance, additional services, unique advantages, or other benefits that can easily be seen by customers? They may be drawn to the area by a well-known competitor’s name, but they may select your establishment instead because of what you offer that differentiates you.

Low Customer Contact Businesses

Generally low customer contact businesses are manufacturing businesses, the headquarters of client location-based services, or remote location services. Customer access is relatively unimportant. More critical are access for your employees, reasonable cost, and the space necessary to do your business. Certain manufacturing operations will need adequate utilities and specialized transportation too. Unless you plan to use some of this space as a high-traffic showroom, commercial space in a business park or light industrial park might be appropriate. These parks are located near major transportation routes, often have rail spurs, and are designed for industrial utilities; that is, they have adequate electricity, gas, water, waste water treatment, and the like. Frequently, support businesses will be located in or near the park such as warehousing, shipping firms, copy centers, and office supply stores. Industrial or business park space tends to be cheaper in smaller cities and rural towns than in major metropolitan areas. If distribution to customers can be arranged, these locations are certainly cost-effective.

Some major metropolitan areas offer empowerment zones. These zones, often in economically depressed areas, offer businesses low-cost space and tax advantages for locating there. For more information, see www.rurdev.usda.gov/BCP-EZEC-Home.html or www.siteselection.com.

A third possibility is a business incubator. The National Business Incubator Association (www .nbia.org) shows over 1,400 business incubators in North America sponsored by government, uni- versities, or private investment groups. These business incubators are specifically designed for the entrepreneur, and, in addition to relatively low cost space, they offer a multitude of small business support services. These services range from copy machines, faxes, and conference rooms to ac- counting, finance, and consulting services. Since the building is populated by other entrepreneurs, it’s a great place to talk to others who might have had some of the same problems or to brainstorm new ideas. Most incubators require a stake in your company in exchange for their assistance— maybe as much as 50 percent—and often have quite a bit to say about how you run your business. Opinion is mixed on how much real help a company can get; just like all businesses, there are better and worse incubators, so do your homework.42

General Comments on Site Selection

How do you go about finding potential sites? Looking for “for sale” and “for rent” signs is a start, but not all space will be advertised that way. Just as a good real estate agent can warn you about the pro- posed freeway project going through the backyard of the house you are considering or let you know about houses not yet listed but likely to be, an experienced real estate broker will also be able to assist you in your search for your business location. Many have relationships with landlords that can work to your benefit. They are also likely to have at least some of the market statistics you may need to help you decide if the location is right for your business.43 Level with them about what you can spend. You have your business plan and know the cost per square foot you can afford and be profitable. If you are looking at property more expensive than that, you’ll need to cut corners elsewhere.44

Leasing

It is rare that a small business start-up buys its first location. The reason is financial. It takes a lot of money to buy a place, and beyond that a long-term commitment to pay for it. For most small busi- nesses, it is not a worthwhile risk. It makes more sense to rent or lease your facility to leave more money for other aspects of the business. But leasing is one of the most complex of the issues an entrepreneur faces when starting a business.

In reality, most landlords (especially those from big national commercial real estate and mall companies) have fairly standard contracts which they don’t like to change. These typically start out as very pro-landlord. That said, in many cases they are also likely to accept certain standard clauses that are more tenant-friendly. However, it is unlikely they will offer those. You will need to ask for them. In this section you will learn about the major types of tenant-friendly clauses you might want to seek. However, it makes tremendous sense to get a real estate lawyer involved to help you. They should be able to tell you what kinds of clauses are typical, and who else offers them in your area, and if there are any other likely traps in the lease. You can learn how to choose a lawyer in Chapter 18.

You should start the leasing process by looking for locations. You can start using the local news- paper’s or business journal’s classified ads for commercial real estate. If you know of a great loca- tion, but there is no “for rent” or “for lease” on it, consider asking the owner or current renter about subleasing a portion of the location. If your product or service complements the current tenant, you could find a home. Local real estate websites may also have listings, and there are national websites like LoopNet.com which compile listings from a variety of sources. There is a how-to video for

using LoopNet on the Online Learning Center. You may contact a real estate agent with commercial experience to help you, but make sure you know how the agent is making his or her money. You want the agent to work in your best interests.

It helps to have two or three possibilities identified before you begin negotiating leases. This is a use of the idea of the power of rivalry from Chapter 7. This gives you a basis for comparison, and an alternative for leasing when negotiating. But note that the more alike the properties, the greater your power at the negotiating table. Also, if you are opening a franchised operation, you will want to contact your franchisor before you start looking for locations. Most franchisors have specifications for locations, and advice on costs and other features. They often have a lease review department to help you with this process.45

The best way to start thinking about the clauses is to separate them into those clauses related to choosing a property, day-to-day operations, and endings. In reality, though, all of these clauses will get negotiated when you and the landlord discuss the lease agreement.

There are several issues that could pop up as you are narrowing your choices and trying to decide which location and deal is the best for you. These are:46

?          “As is” versus compliant property: If the location has problems, who should fix them? The landlord would like to have you do it, and will try to push you to accept the property “as is.” You, of course, want the landlord to fix it before you move in, so you would ask the property to be “in compliance with all applicable laws, rules, and regulations.” Realize that the landlord will get back the money paid for repairs eventually, through fees or higher rents, but it can save you money on the front end.

?          HVAC: This is the commercial jargon for “heating, ventilation, and air conditioning.” It can be the most expensive type of repair, and since it is mechanical, one of the types most likely to go wrong. The landlord wants it to be your responsibility. You want it to be the landlord’s. This is particularly important if the location has a central air system so everyone shares the same air conditioner and heating equipment. This type of equipment needs to be the landlord’s responsibility. For any type of equipment, you want the landlord to at least guarantee the first year of operation.

?          Signs: Called “signage” in the business, it can be on the street, on the building, or around the door. You probably have ideas for your signs. If you are a franchise, you face signage require- ments from the franchisor. You want a landlord who will work with you on the size, place- ment, and visibility of signs. Make sure you have written

agreement on the signs and, if possible, a clause that says approval cannot be unreasonably denied for future changes.

There are other benefits possible if you know to ask for them. Often these are called concessions. Examples include “leasehold improvements,” which are permanent changes made to the loca- tion to fit your business’s needs. You cover these by seeking a “tenant improvement allowance” or “construction allowance” which are rent dollars (typically $5 to $25 a square foot) they agree to let you put into improving your location.47 This amount should be based on a firm estimate from a construction profes- sional. Another concession is a “rent-free use period” which cov- ers the time while you prepare your location prior to opening.

As you start thinking about how you would operate day-to- day, there will be several different issues you will face. These include:

?          Hidden charges: Many leases include charges that do not have to be listed in the term sheet given you for the prop- erty. An example is a monthly operating expense. This may be justified. You may be leasing a thousand feet of space, but there are also common areas, restrooms, parking and the like that the landlord keeps up for everyone. Ask spe- cifically for a list of all expenses or charges for which you will be liable, and compare to other locations. Also make sure to learn the conditions under

which you can lose all or part of your security deposit. ?     Use of premises: You specify in the lease what you will sell or do at the leased location, but

too exact a description could prevent you from expanding the products or services you offer. Try to add the clause “and related goods and services” to any description you give to provide reasonable flexibility.

?          Noncompete: If you have a pet store in a strip mall, you’d like to be the only one there. For many types of businesses, you negotiate a clause limiting the landlord’s ability to lease to a competing business. This can be just for your facility or for a radius. You should expect to pay for the exclusivity and the farther you want it, the more it will cost. Note that competition in terms of different types of restaurants, or another store selling some of your products, is still likely.

?          Hours of operation: Mall landlords want stores open the same hours and days, and landlords of other types of properties may have some of the same desires. You need to negotiate times that fit your business model. Look for stores in the landlord’s properties that match your hours. Precedence helps here.

?          Rent default: When you are late paying rent, all sorts of penalties and problems emerge. It also hurts your credit rating. Some leases require the renter to keep track. Ask to change the lease to specify the landlord needs to alert you immediately on the rent due date in written or telephonic (usually fax) form, and get the 5–10 day default period for paying rent before default starts from that notice.

?          Moves and remodels: There may be a clause that gives the landlord the right to move your business elsewhere, at their discretion. If this is to update or repair an area, fine, but what if it is to get a higher-paying tenant in your space? Set time limits and return rights on any forced move. Similarly, if the landlord decides to remodel, you should not have to pay for it.

As an entrepreneur negotiating a lease, you need to prepare for the good and the bad as time moves along. The good is the prospect your business grows and you need more space. The bad is that your business doesn’t do well, and you need to get out of your lease before the end of the term. Dealing with these issues is like worrying about a prenuptial agreement while you are taken with the romance of getting married. It might be painful to imagine, but it is important to keeping what is yours.

If your business falters, you are obligated to continue paying your monthly rent and fees for the duration of the lease. A landlord has the power to let you out of a lease, but he or she is only likely to do this if a better tenant is lined up. Once you tell your landlord you may need to vacate the prem- ises, she or he is supposed to look for a replacement tenant, but not all do, or do a good job of it. If you can find a replacement tenant, it can help this process along, but you need to make sure there is a clause that lets you sublease the property, and further, that the landlord can’t unreasonably deny the sublease. If your pet store is closing, finding a dress shop is probably reasonable (as long as it doesn’t violate some other tenant’s noncompete clause), but finding an adult book store is probably not a reasonable replacement.

Three other ways to handle an early termination are to set up a short-term (e.g., 6 months) lease initially, ask for a bailout clause, or for a “cap” or limit on how long you need to continue paying rent. The bailout clause lets you out of the lease if sales do not meet an agreed-to level. You negotiate this with the landlord up front. To understand a cap, think about a three-year lease. If you close down after only six months, you are still obligated to pay 30 more months’ rent. With a one-year cap you are only obligated to pay 6 months’ more rent. This is like a type of insurance, and like insurance policies, you will probably have to pay a slightly higher rent from the start to cover this possibility.

Realize there can be problems you face caused by the property itself. What if you move into a mall with a major chain like Sears, Penny’s or Macy’s, or a strip mall with a major supermarket or discount store. Part of what you are paying a premium for is the traffic and reputation these anchor stores bring. What if they leave? Your location’s quality could dramatically drop. To get out of your lease under these unfortunate circumstances, you want to ask for a cotenancy clause.

Although we’ve segmented a renter’s concerns by stage of the leasing process, all of these issues need to be negotiated at the start when crafting a lease. Although landlords often start with a lease they call “standard,” nearly everything about it can be negotiated. But be fair; the space may mean a lot to you, but it is a drop in the bucket to large commercial realtors. You can learn more about negotiating in general in Chapter 18, but there are some special considerations for lease negotia- tions. Because so many aspects are potentially negotiable and areas have different norms for what are typical tenant-friendly clauses, work with a real estate lawyer of your own to help you in the negotiation and phrasing of the lease terms.

Layout

Since so much of this is particular to the type of business you are in, what you’ll read below is a general guide. Check out competitors or similar types of businesses to see what you like and don’t like, what seems to work well, and what seems to cause a lot of problems. In addition, certain categories—restaurants and retailing, for example—have numerous books from college textbooks to do-it-yourself books, like the “For Dummies” series. Try your local library or bookstore.

The layout of a potential site must be considered carefully. Is the building setup appropriate for your use? A restaurant will have different needs than a retail area or a manufacturing plant. The amount of area allocated to the “front room” (e.g., eating or retail areas) versus “back room” (storage, kitchen, warehouse, and office areas) needs to be adequate for the purpose of your business. If you are operating a restaurant or retail operation, how important is space in the front room? A coffee shop or fast-food restaurant squeezes in more customers per square foot than a gourmet restaurant. Do you need specialized areas, such as a kitchen or laboratory that are expensive to retrofit into existing buildings? Is there adequate storage area? How much dock space is appropriate for your business? A manufacturing firm usually needs more dock space and storage than a retailer or a restaurant, while a service company may need very little of either. Retail operations need display windows, while manufacturers do not. For restaurants or other services, this need varies. Is there room for expansion should the business grow? Remember: Moving can be expensive. A good strategy is to rough out the desired layout of your operation on graph paper to get a basic idea of the square footage needed and how it should look. What exactly you want may not be out there, but you’ll be able to see what’s close and what’s impos- sible to live with.

Consider the amenities that are already there. Carpeting may be appropriate for a retail area and perhaps the office or dining area of a restaurant, but not appropriate for manufacturing or cooking areas. What about the walls? What sort of ceilings and lighting is appropriate? Again, a visit to the competition will help you decide what works and what doesn’t, as well as where you want to be different.

Check the exterior, too. Is the building attractive and inviting? Are the sidewalks and landscaped areas in decent shape? Is parking adequate, well lit, and safe? Is employee parking separate from customer parking? What about handicap accessibility? The 1990 Americans with Disabilities Act (ADA) specifies that businesses (with few exceptions) must accommodate persons with disabilities. Many buildings have been brought up to code, and all new construction should meet the require- ments of this act, but keep your eyes open.

Once the building has been selected, how you lay out the interior also needs to be considered. While retailers, restaurants, offices, and manufacturers all have different layout needs and consider- ations, two facts hold true: (1) layouts need to be designed so as to eliminate unnecessary and exces- sive employee movement, and (2) the layout says something about who you are to your customers, employees, and visitors. In retailing, this last factor is called atmospherics. While the opportunities for variation are limitless, let’s consider the major types of retail and manufacturing layouts as well as what atmospherics might mean to a business.

Traditionally, manufacturing processes are laid out in one of two formats: production line layout and process layout displayed in Figure 11.2. In the production line layout, material flows in on one side of the operation and continues to the other end of the operation. Most assembly manufacturing is done this way, often with conveyors moving subassemblies from one station to another. Although a rather rigid flow, it works well for mass production and high-volume manufacturing. The second method, process layout, groups similar machines/or functions together, not unlike a typical machine shop. This format is much more appropriate for lower-volume, flexible manufacturing.

There are also two traditional layouts for retail operations, which are shown in Figure 11.3. The first one, the grid layout, has aisles running from the front of the store to the back like the typical grocery, discount, or convenience store. It’s a very efficient and organized layout although it lacks some visual impact. The second layout, the free-form layout, alleviates this problem. In this layout, the store is laid out in sections with aisles that angle or meander through the store. This is the layout more typically found in upscale department stores, clothing stores, and the like.

Atmospherics include all the ambiance items that might be considered in your business. An up- scale women’s clothing store is likely to have wider aisles, deep carpeting, soft “elevator music,” indirect lighting, and, perhaps, a lightly perfumed aroma. These are appropriate atmospherics for the target market. A shop catering to edgy teen fashions may be done in black and chrome with loud rock or alternative music and strobe or black lights. Both of these send a message about whom the store is likely to appeal to. Restaurants use atmospherics, too. Compare a family restaurant to a gourmet restaurant to an ethnic restaurant. Services and the office and public areas of manufacturing firms do this as well in their choice of colors, furniture styles, and background music.48

Build, Buy, or Lease49

Ultimately, there are three choices available to the business: build, buy, or lease. Building has the advantage of having the perfect layout in the perfect location and the street appeal of a new build- ing, but it is costly and slow. Buying something already in existence shortens the time and may be

somewhat cheaper, but any remodeling or retrofitting that needs to be done may overshadow any time or money savings. In both cases, though, business owners have an asset that they can leverage, as well as the depreciation tax advantage. They have the flexibility to make the changes they need and know what the long-term costs will be.

Leasing, which we detailed earlier in the chapter, is an option with a considerably lower initial cash outlay, and it is often the only feasible choice for new businesses. Lease expenses are deduct- ible business expenses. One of the main downsides of leasing is that you are usually limited in the renovations you can do. Another one is that leases tend to get higher with each renewal contract, and your landlord may choose not to extend a lease, forcing you to move before you are ready to do so.

The issues of location and distribution are decisions that business owners make only occasion- ally. Many businesses operate from the same location for their entire existence. Distribution deci- sions may come up more often. For example, a business started on eBay develops its own website, and then grows into a store in the city’s commercial center. Regardless of how often these decisions are made, they are central to the success of the small business, because placing a business in the right location and equipping it with the right channels of distribution are essential to finding and connecting with customers. Done right, managing the issues of location and distribution can turn an average firm into a major success.

1. According to this chapter, what are three key considerations in determining the location of your business?

2. According to this chapter, what are the typical locations for service businesses?

3. What are the advantages and disadvantages of buying, building or leasing your business’ facility?

In the ZZZZ Best case, explain the kinds of evidence that the auditors gathered and how the auditors failed. just write one or two paragraph to support

ZZZZ Best Case

On May 19, 1987, a short article in the Wall Street Journal reported that ZZZZ Best Company, Inc., of Reseda, California, had signed a contract for a $13.8 million insurance restoration project. This project was just the most recent of a series of large restoration jobs obtained by ZZZZ Best (pronounced “zee best”). Located in the San Fernando Valley of Southern California, ZZZZ Best had begun operations in the fall of 1982 as a small door-to-door carpet cleaning operation. Under the direction of Barry Minkow, the extroverted 16-year-old who founded the company and initially operated it out of his parents’ garage, ZZZZ Best experienced explosive growth in both revenues and profits during the first several years of its existence. In the three-year period from 1984 to 1987, the company’s net income surged from less than $200,000 to more than $5 million on revenues of $50 million.

When ZZZZ Best went public in 1986, Minkow and several of his close associates became multimillionaires overnight. By the late spring of 1987, the market value of Minkow’s stock in the company exceeded $100 million, while the total market value of ZZZZ Best surpassed $200 million. The youngest chief executive officer in the nation enjoyed the “good life”, which included an elegant home in an exclusive suburb of Los Angeles and a fire-engine red Ferrari. Minkow’s charm and entrepreneurial genius made him a sought-after commodity on the television talk show circuit and caused the print and visual media to tout him as an example of what America’s youth could attain if they would only apply themselves. During an appearance on The Oprah Winfrey Show in April 1987, Minkow exhorted his peers with evangelistic zeal to “Think big, be big” and encouraged them to adopt his personal motto, “The sky is the limit.”

Less than two years after appearing on Oprah, Barry Minkow began serving a 25-year sentence. Tried and convicted on 57 counts of securities fraud, Minkow had been exposed as a fast-talking con artist who swindled his closest friends and Wall Street out of millions of dollars. Federal prosecutors estimate that, at a minimum, Minkow cost investors and creditors $100 million. The company that Minkow founded was, in fact, an elaborate Ponzi scheme. The reported profits of the firm were nonexistent and the large restoration contracts, imaginary. As one journalist reported, rather than building a corporation, Minkow created a hologram of a corporation. In July 1987, just three months after the company’s stock reached a market value of $220 million, an auction of its assets netted only $62,000.

Unlike most financial frauds, the ZZZZ Best scam was perpetrated under the watchful eye of the Securities and Exchange Commission (SEC). The SEC, a large and reputable West Coast law firm that served as the company’s general counsel, a prominent Wall Street brokerage firm, and an international public accounting firm all failed to uncover Minkow’s daring scheme. Ultimately, the persistence of an indignant homemaker who had been bilked out of a few hundred dollars by ZZZZ Best resulted in Minkow being exposed as a fraud.

How a teenage flimflam artist could make a mockery of the complex regulatory structure that oversees the U.S. securities markets was the central question posed by a congressional subcommittee that investigated the ZZZZ Best debacle. That subcommittee was headed by Representative John D. Dingell, chairman of the U.S. House Committee on Energy and Commerce. Throughout the investigation, Representative Dingell and his colleagues focused on the role the company’s independent auditors played in the ZZZZ Best scandal.

The ZZZZ Best prospectus told the public that revenues and earnings from insurance restoration contracts were skyrocketing but did not reveal that the contracts were completely fictitious. Where were the independent auditors and the other that are paid to alert the public to fraud and deceit?

Like many other daring financial frauds, the ZZZZ Best scandal caused Congress to reexamine the maze of rules that regulated financial reporting and served as the foundation of the U.S. system of corporate oversight. However, Daniel Akst, a reported for The Wall Street Journal who documented the rise and fall of Barry Minkow, suggested that another ZZZZ Best was inevitable. “Changing the accounting rules and securities laws will help, but every now and then a Barry Minkow will come along, and ZZZZ Best will happen again. Such frauds are in the natural order of things, I suspect, as old and enduring as human needs.”

The Early History of ZZZZ Best Company

Barry Minkow was introduced to the carpet cleaning industry at the age of 12 by his mother, who helped make ends meet by working as a telephone solicitor for a small carpet cleaning firm. Although the great majority of companies in the carpet cleaning industry are legitimate, the nature of the business attracts a disproportionate number of shady characters. There are essentially no barriers to entry: no licensing requirements, no apprenticeships to be served, and only a minimal amount of start-up capital is needed. A 16-year-old youth with a driver’s license can easily become what industry insiders refer to as a “rug sucker,” which is exactly what Minkow did when he founded ZZZZ Best Company.

Minkow quickly learned that carpet cleaning was a difficult way to earn a livelihood. Customer complaints, ruthless competition, bad checks, and nagging vendors demanding payment complicated the young entrepreneur’s life. Within months of striking out on his own, Minkow faced the ultimate nemesis of the small business person: a shortage of working capital. Because of his age and the fact that ZZZZ Best was only marginally profitable, local banks refused to loan him money. Ever resourceful, the brassy teenager came up with his own innovative ways to finance his business: check kiting, credit card forgeries, and staging of thefts to fleece his insurance company. Minkow’s age and personal charm allowed him to escape unscathed from his early brushes with the law that resulted from his creative financing methods. The ease with which the “system” could be beaten encouraged him to exploit it on a broader scale.

Throughout his tenure with ZZZZ Best, Minkow recognized the benefits of having an extensive social network of friends and acquaintances. Many of these relationships he developed and cultivated at a Los Angeles health club. After becoming a friend of Tom Padgett, an insurance claims adjuster, Minkow devised a scheme to exploit that friendship. Minkow promised to pay Padgett $100 per week if he would simply confirm over the telephone to banks and any other interested third parties that ZZZZ Best was the recipient of occasional insurance restoration contracts. Ostensibly, Minkow had obtained these contracts to clean and do minor remodeling on properties damaged by fire, storm, or other catastrophes. Minkow convinced the gullible Padgett that the sole purpose of the confirmations was to allow ZZZZ Best to circumvent much of the bureaucratic red tape in the insurance industry.

From this modest beginning, the ZZZZ Best fraud blossomed. Initially, Minkow used the phony insurance restoration contracts to generate the paper profits and revenues he needed to convince bankers to loan him money. Minkow’s phony financial statements served their purpose, and he expanded his operations by opening several carpet cleaning outlets across San Fernando Valley. Minkow soon realized that there was no need to tie his future to the cutthroat carpet cleaning industry when he could literally dictate the size and profitability of his insurance restoration “business.” Within a short period of time, insurance restoration, rather than carpet cleaning became the major source of revenue appearing on ZZZZ Best’s income statements.

Minkow’s “the sky is the limit” philosophy drove him to be even more innovative. The charming young entrepreneur began using his bogus financial statements to entice wealthy individuals in his ever-expanding social network to invest in ZZZZ Best. Eventually, Minkow recognized that the ultimate scam would be to take his company public, a move that would allow him to tap the bank accounts of unsuspecting investors nationwide.

Going Public with ZZZZ Best

Minkow’s decision to take ZZZZ Best public meant that he could no longer completely control his firm’s financial disclosures. Registering with the SEC required auditors, investment bankers, and outside attorneys to peruse ZZZZ Best’s periodic financial statements.

ZZZZ Best was firm subjected to a full-scope independent audit for the 12 months ended April 30, 1986. George Greenspan, the sole practitioner who performed that audit, confirmed the existence of ZZZZ Best’s major insurance restoration contracts by contacting Tom Padgett. Padgett served as the principal officer of Interstate Appraisal Services, which reportedly contracted the jobs out to ZZZZ Best. By this time, Padgett was an active and willing participant in Minkow’s fraudulent schemes. Minkow established Interstate Appraisal Services and Assured Property Management for the sole purpose of generating fake insurance restoration contracts for ZZZZ Best.

In testimony before the congressional subcommittee that investigated the ZZZZ Best scandal, Greenspan insisted that he had properly audited Minkow’s company. Greenspan testified that while planning the 1986 audit he had performed various analytic procedures to identify unusual relationships with ZZZZ Best’s financial data. These procedures allegedly included comparing ZZZZ Best’s key financial ratios with industry norms. Regarding the insurance contracts, Greenspan testified that he had obtained and reviewed copies of all key documents pertaining to those jobs. However, Greenspan admitted that he had not inspected any of the insurance restoration sites.

Congressman Lent: Mr. Greenspan, I am interested in the SEC Form S-1 that ZZZZ Best Company filed with the SEC….You say in that report that you made your examination in accordance with generally accepted auditing standards and accordingly included such tests of the accounting records and other auditing procedures as we consider necessary in the circumstances….You don’t say in that statement that you made any on-site inspections.

Mr. Greenspan: It’s not required. Sometimes you do; sometimes you don’t. I was satisfied that these jobs existed and I was satisfied from at least six different sources, including payment for the job. What could you want better than that?

Congressman Lent: Your position is that you are an honest and reputable accountant.

Mr. Greenspan: Yes, sir.

Congressman Lent: You were as much a victim as some of the investors in this company?

Mr. Greenspan: I was a victim all right….I am as much aghast as anyone. And every night I sit down and say, why didn’t I detect this damned fraud.

Retention of Ernst & Whinney by ZZZZ Best

Shortly after Greenspan completed his audit of ZZZZ Best’s financial statements for fiscal 1986, which ended April 30, 1986, Minkow dismissed him and retained Ernst & Whinney to perform the following year’s audit. Apparently, ZZZZ Best’s investment banker insisted that Minkow obtained a Big Eight accounting firm to enhance the credibility of the company’s financial statements. At approximately the same time, and for the same reason, Minkow retained a high-profile Los Angeles law firm to represent ZZZZ Best as its legal counsel.

The congressional subcommittee asked Greenspan what information he provided to Ernst & Whinney regarding his former client. In particular, the subcommittee wanted to know whether Greenspan discussed the insurance restoration contacts with the new auditors.

Congressman Wyden: Mr. Greenspan, in September 1986 Ernst & Whinney came on as the new independent accountant for ZZZZ Best. What did you communicate to Ernst & Whinney with respect to the restoration contracts?

Mr. Greenspan: Nothing. I did—there was nothing because they never got in touch with me. It’s protocol for the new accountant to get in touch with the old accountant. They never got in touch with me, and its still a mystery to me.

Representatives of Ernst & Whinney later testified that they did, in fact, communicate with Greenspan prior to accepting ZZZZ Best as an audit client. However, Ernst & Whinney did not comment on the nature or content of that communication. (Greenspan was not recalled to rebut Ernst & Whinney’s testimony on this issue.)

The engagement letter was signed by Ernst & Whinney and Barry Minkow in September 1986. The engagement letter outlined four services that the audit firm intended to provide ZZZZ Best: a review of the company’s financial statements for the three-month period ending July 31, 1986; assistance in the preparation of a registration statement to be filed with the SEC; a comfort letter to be submitted to ZZZZ Best’s underwriters; and a full-scope audit for the fiscal year ending April 30, 1987. Ernst & Whinney completed the review, provided the comfort letter to ZZZZ Best’s underwriters, and apparently assisted the company in preparing the registration statement for the SEC; however, Ernst & Whinney never completed the 1987 audit. The audit firm resigned on June 2, 1987, amid growing concerns that ZZZZ Best’s financial statements were grossly misstated.

The congressional subcommittee investigating the ZZZZ Best fraud questioned Ernst & Whinney representatives at length regarding the bogus insurance restoration contracts—contracts that accounted for 90 percent of ZZZZ Best’s reported profits. Congressional testimony disclosed that Ernst & Whinney repeatedly insisted on visiting several of the largest of these contract sites, and that Minkow and his associated attempted to discourage such visits. Eventually, Minkow realized that the auditors would not relent and agreed to allow them to visit certain of the restoration sites, knowing full well that none of the sites actually existed.

To convince Ernst & Whinney that the insurance restoration contracts were authentic, Minkow plotted and carried out a series of sting operations that collectively cost millions of dollars. In the late fall of 1986, Larry Gray, the engagement audit partner for ZZZZ Best, told client personnel that he wanted to inspect a restoration site in Sacramento on which ZZZZ Best had reported obtaining a multimillion-dollar contract. Minkow sent two of his subordinates to Sacramento to find a large building under construction or renovation that would provide a plausible site for a restoration contract. Gray had visited Sacramento a few weeks earlier to search for the site that Minkow had refused to divulge. As chance would have it, the building chosen by the ZZZZ Best conspirators was the same one Gray had identified as the most likely site of the insurance restoration project.

Minkow’s two confederates posed as leasing agents of a property management firm and convinced the supervisor of the construction site to provide keys to the building one weekend on the pretext that a large, prospective tenant wished to tour the facility. Prior to the arrival of Larry Gray and an attorney representing ZZZZ Best’s law firm, Minkow’s subordinates visited the site and placed placards on the walls at conspicuous locations indicating that ZZZZ Best was the contractor for the building renovation. No details were overlooked by the two co-conspirators. They even paid the building’s security officer to greet the visitors and demonstrate that he was aware in advance of their tour of the site and its purpose. Although the building had not been damaged and instead was simply in the process of being completed, the sting operation went off as planned.

Congressional investigators quizzed Gray regarding the measures he took to confirm that ZZZZ Best had a restoration contract on the Sacramento building. They were particularly concerned that he never discovered the building had not suffered several million dollars in damages a few months earlier, as claimed by ZZZZ Best personnel.

Congressman Lent: Did you check the building permit or construction permit?

Mr. Gray: No, sir. That wouldn’t be necessary to accomplish what I was setting out to accomplish.

Congressman Lent: And you did not check with the building’s owners to see if an insurance claim had been filed?

Mr. Gray: Same answer. It wasn’t necessary. I had seen the paperwork internally of our client, the support for a great amount of detail. So, I had no need to ask—to pursue that.

Congressman Lent: You understand that what you saw was not anything that was real in any sense of the word?....You are saying you were duped, are you not?

Mr. Gray: Absolutely.

Before allowing Ernst & Whinney auditors to visit a bogus restoration project, Minkow insisted that the firm sign a standard confidentiality agreement. Members of the congressional subcommittee were troubled by the following stipulation of the confidentiality agreement: “We will not make any follow-up telephone calls to any contractors, insurance companies, the building owner, or other individuals involved in the restoration contract.” This restriction effectively precluded the auditors from corroborating the insurance restoration contracts with independent third parties.

Resignation of Ernst & Whinney

Ernst & Whinney resigned as ZZZZ Best’s auditor on June 2, 1987, following a series of disturbing events that caused the firm to question Barry Minkow’s integrity. First, Ernst & Whinney was alarmed by a Los Angeles Times article in mid-May 1987 that revealed that Minkow had been involved in a string of credit card forgeries as a teenager. Second on May 28, 1987, ZZZZ Best issued a press release, without consulting or notifying Ernst & Whinney, that reported record profits and revenues. Minkow intended this press release to restore investors’ confidence in the company—confidence that had been shaken by the damaging Los Angeles Times story. Third, and most important, on May 29, Ernst & Whinney auditors discovered evidence supporting allegations made several weeks earlier by a third-party informant that ZZZZ Best’s insurance restoration business was fictitious.

The informant had contacted Ernst & Whinney in April 1987 and asked for $25,000 in exchange for information proving that one of the firm’s clients was engaging in a massive fraud. Ernst & Whinney refused to pay the sum, and the individual recanted shortly thereafter, but not until the firm determined that the allegation involved ZZZZ Best. (Congressional testimony disclosed that the individual recanted because of a bribe paid to him by Minkow.) Despite the retraction, Ernst & Whinney questioned Minkow and ZZZZ Best’s board of directors regarding the matter. Minkow insisted that he did not know the individual who had made the allegation. On May 29, 1987, however, Ernst & Whinney auditors discovered several cancelled checks that Minkow had personally written to the informant several months earlier.

Because ZZZZ best was a public company, the resignation of its independent auditor had to be reported to the SEC in an 8-K filing. This requirement alerts investors and creditors of circumstances that may have let to the change in auditors. At the time, SEC registrants were allowed 15 days to file an 8-K auditor change announcement. After waiting the maximum permissible time, ZZZZ Best reported the change in auditors but, despite Ernst & Whinney’s insistence, made no mention in the 8-K of the fraud allegation that had been subsequently recanted.

The SEC requires a former audit firm to prepare a letter to be filed as an exhibit to its former client’s 8-K auditor change pronouncement. That exhibit letter must comment on the 8-K’s accuracy and completeness. In 1987, formed audit firms had 30 days to file an exhibit letter, which was the length of time Ernst & Whinney waited before submitting its exhibit letter to the SEC. In that letter, Ernst & Whinney revealed that ZZZZ Best’s insurance contract might be fraudulent.

The congressional subcommittee was alarmed that 45 days had passed before the charges of fraudulent misrepresentations in ZZZZ Best’s financial statements were disclosed by the public. By the time the SEC released Ernst & Whinney’s exhibit letter to the public, ZZZZ Best had filed for protection from its creditors under Chapter 11 of the federal bankruptcy code. During the period that elapsed between Ernst & Whinney’s resignation and the public release of the 8-K exhibit letter, ZZZZ Best obtained significant financing from several parties, including $1 million from one of Minkow’s close friends. These parties never recovered the funds invested in, or loaned to, ZZZZ Best. As a direct result of the ZZZZ Best debacle, the SEC shortened the length of time that registrants and their former auditors may wait before filing auditor change documents.

The congressional subcommittee also quizzed Ernst & Whinney representatives regarding the information they disclosed to Price Waterhouse, the audit firm that Minkow retained to replace Ernst & Whinney. Congressman Wyden wanted to know whether Ernst & Whinney had candidly discussed its concerns regarding Minkow’s integrity with Price Waterhouse.

Congressman Wyden: I am going to insert into the record at this point a memo entitled “Discussion with successor auditor,” written by Mr. Gray and dated June 9, 1987. Regarding a June 4 meeting, Mr. Gray, with Dan Lyle of Price Waterhouse concerning the integrity of ZZZZ Best’s management, you stated that you had no reportable disagreements and no reservations about management integrity pending the results of a board of directors investigation. Then you went on to say that you resigned because, and I quote here: “We came to a conclusion that we didn’t want to become associated with the financial statements.”   Is that correct?

Mr. Gray: That is correct.

Mr. Wyden: …Mr. Gray, you told the committee staff on May 29, 1987, that when you uncovered evidence to support allegations of fraud that you decided to pack up your workpapers and leave the ZZZZ Best audit site. How did your leaving without telling anybody except the ZZZZ Best management and board of directors the reasons for leaving help the public and investors?

A final twist to the ZZZZ Best scandal was an anonymous letter Ernst & Whinney received one week after the firm resigned as ZZZZ Best’s auditor. At that time, no one other than Ernst & Whinney and ZZZZ Best’s officers was aware of the firm’s resignation. The letter contained several allegations suggesting that ZZZZ Best’s financial statements were fraudulent. According to the congressional testimony, Ernst & Whinney forwarded this letter to the SEC on June 17, 1987.

Collapse of ZZZZ Best

The Los Angeles Times article published in mid-May 1987 that disparaged Barry Minkow ultimately doomed the young entrepreneur and his company. Several years earlier, a homemaker had fallen victim to Minkow’s credit card forgeries. Minkow had added a fraudulent charge to a credit card slip the woman had used to make a payment on her account. Despite her persistence, Minkow avoided repaying the small amount. The woman never forgot the insult and tracked down, and kept a record of, individuals who had been similarly harmed by Minkow. At the urging of this woman, a reporter for the Los Angeles Times investigated her allegations. The woman’s diary became the basis for the Los Angeles Times article that, for the first time, cast doubt on the integrity of the “boy wonder” that was the talk of Wall Street.

The newspaper article triggered a chain of events that caused ZZZZ Best to collapse and disappear less than three months later. First, a small brokerage firm specializing in newly registered companies with suspicious earnings histories began short-selling ZZZZ Best stock, forcing the stock’s price into a tailspin. Second, Ernst & Whinney, ZZZZ Best’s law firm, and ZZZZ Best’s investment banker began giving more credence to the allegations and rumors of financial wrongdoing by Minkow and his associates. Third, and most important, the article panicked Minkow and compelled him to make several daring moves that cost him even more credibility. The most critical mistake was his issuance of the May 28, 1987, press release that boldly reported record profits and revenues for his firm.

EPILOGUE

Among the parties most vilified for their role in the ZZZZ Best scandal was Ernst & Whinney. The transcripts of the congressional testimony focusing on the ZZZZ Best fraud included a list of 10 “red flags” that the audit firm had allegedly overlooked while examining ZZZZ Best’s financial statements. Ernst & Whinney officials flatly rejected assertions that their firm was even partially to blame for the ZZZZ Best fiasco. In his congressional testimony, Leroy Gardner, the West Coast director of accounting and auditing for Ernst & Whinney, maintained that when all of the facts were revealed, his firm would be totally vindicated:

The ZZZZ Best situation proves at least one thing: a well-orchestrated fraud will often succeed even against careful, honest, hard-working people…The facts that have begun to emerge establish that Minkow, along with confederates both inside and outside ZZZZ Best went to extraordinary lengths to deceive Ernst & Whinney. For example, Thomas Padgett, an alleged conspirator, revealed in a recent televised interview that Minkow spent $4 million to deceive Ernst & Whinney during a visit to one of ZZZZ Best’s job sites….Ernst & Whinney never misled investors about the reliability of ZZZZ Best’s financial statements. Ernst & Whinney never even issued an audit opinion for ZZZZ Best….We are not part of the problem in this case. We were part of the solution.

In one of the largest civil suits stemming from the ZZZZ Best fraud, a court ruled that Ernst & Whinney was not liable to a large California bank that had extended ZZZZ Best a multimillion-dollar loan in 1986. The bank alleged that in granting the loan, it had relied upon the review report issued by Ernst & Whinney on ZZZZ Best’s financial statements for the three-month period ending July 31, 1986. However, an appellate judge ruled that the bank was not justified in relying on the review report since Ernst & Whinney had expressly stated in the report that it was not issuing an opinion on the ZZZZ Best financial statements. “Ernst, because it issued only a review report, specifically declined to express an opinion on ZZZZ Best’s financial statements. The report expressly disclaimed any right to rely on its content.”

In the late 1980s, ZZZZ Best’s former stock-holders filed a class-action lawsuit against Ernst & Whinney, ZZZZ Best’s former law firm, and ZZZZ Best’s former investment banker. An Internet publication reported in March 1996 that this lawsuit had been settled privately. The defendants reportedly paid the former ZZZZ Best stockholders $35 million. However the contribution of each defendant to the settlement pool was not disclosed.

Barry Minkow was released from prison in late 1994. Minkow secured the reduction in his 25-year prison sentence for “good behavior and efforts to improve himself.” These efforts included earning by correspondence bachelor’s and master’s degrees in religion from Liberty University. Shortly after being paroled, Minkow married a young woman introduced to him by a fellow inmate. That inmate was a former subordinate of Charles Keating, the principal architect of the massive Lincoln Savings and Loan fraud.

In early 1995, Minkow began serving as the associate pastor of an evangelical church in a community near his hometown of Reseda. Two years later, Minkow was appointed the senior pastor of a large nondenominational church in San Diego. Besides his pastoral duties, Minkow serves as the spokesperson for an Internet company, the Fraud Discovery Institute, which markets various fraud prevention and detection services.

Minkow regularly presents lectures and seminars across the United States that focus on his “experience” with corporate fraud. He has spoken to groups of CPAs, educational institutions, and, most notably, the FBI Academy at Quantico, Virginia. Minkow, who typically delivers his lectures while dressed in an orange prison jumpsuit, often chastises he accountants and auditors in his audience. During one presentation, Minkow noted that, “CPAs are creatures of habit. You’re interested in making tick marks and footnotes, not in thinking outside the box.” Minkow also chides auditors for being overly willing to accept weak forms of audit evidence, such as client representations. He warns auditors “Don’t give up objectivity for convenience.”

Journalists frequently interview Minkow and ask for his views on corporate fraud and related issues. In January 2005, Minkow gave the following response when he was asked by CFO Magazine whether the Sarbanes-Oxley Act of 2002 would likely serve to mitigate or deter corporate fraud: “Let me tell you why this legislation is brilliant. Sarbox hit a common denominator of corporate fraud: bypassing systems of internal control. I would not have been able to perpetrate the ZZZZ Best fraud if I had not been able to bypass the internal controls.”

Ten Red Flags that ZZZZ Best’s Auditors Allegedly Overlooked.

1. The amounts called for by the insurance restoration contracts were unrealistically large.

2. The number of multimillion dollar insurance restoration contracts reportedly obtained by ZZZZ Best exceeded the number available nationwide during the relevant time period.

3. The purported contracts failed to identify the insured parties, the insurance companies, or the locations of the jobs.

4. The contracts consisted of a single page which failed to contain details and specifications of the work to be done, such as the square yardage of carpet to be replaced, which were usual and customary in the restoration business.

5. Virtually all of the insurance restoration contracts were with the same party.

6. A large proportion of the ZZZZ Best insurance restoration contracts occurred immediately and opportunistically, prior to a planned offering of stock.

7. The purported contracts provided for payments to ZZZZ Best or Minkow alone rather than to the insured or jointly with ZZZZ Best and the insured, contrary to the practice of the industry.

8. The purported contracts provided for payments by the insurance adjustor contrary to normal practice in the industry under which payments are customarily made by the insurance company directly to its insured or jointly to its insured and the restorer.

9. ZZZZ Best’s purported gross profit margins for its restoration business were greatly in excess of the normal profit margin for the restoration industry.

10. The internal controls at ZZZZ Best were grossly inadequate.