Although strategic outsourcing is old news in areas such as the automotive and information technology sectors, it is still in its infancy in the pharmaceutical industry. Strategic outsourcing refers to the business practice of using external Resources for non-core activities – some of which have traditionally been considered integral to an organization – and focusing internal resources on one's core competencies. As demonstrated by the success of companies such as Microsoft and Chrysler, the argument for the outsourcing of non-core activities is compelling, as it can lead to significant competitive advantages.
The State of Outsourcing
It is estimated that the U.S. market for outsourced pharmaceutical manufacturing is growing at the rate of 20% each year.1 When compared to a growth rate of 40% for all outsourced manufacturing, it is clear that the pharmaceutical industry has been slow to adopt outsourcing as a business strategy.2 A recent study by PriceWaterhouse Coopers, LLP further revealed that, even among those companies now outsourcing, senior management "did not perceive third-party providers as important, or even necessary elements in their strategic plans."3 These findings indicate that there is room for pharmaceutical companies to rethink the use of outsourcing in their strategic plans.
The success of a pharmaceutical company is measured by its ability to develop and sell new compounds, hence the traditional focus on R&D and marketing. While these companies have routinely used outside alliances to reinforce their core activities, most have chosen to manufacture products internally in order to control the production process and minimize costly mistakes. Until very recently, the use of third-party manufacturing has been limited to peak demand periods or to access technologies not available internally. Consequently, contract manufacturing remains a highly fragmented and relatively immature industry.
CROs: A Model for Outsourcing
The CRO industry, established in the 1960s, was largely a result of more stringent requirements by federal legislators to prove the efficacy and the safety of new drugs. The industry received a further boost from Japanese pharmaceutical companies employing CROs to conduct research in North America. Today, with 14% of R&D being outsourced and 21.5% of clinical evaluations performed by third parties, the CRO segment is growing faster than the pharmaceutical industry as a whole.4
The biotechnology industry and small pharmaceutical companies have been forced to explore non-traditional methods of developing and manufacturing products, due to limited financial resources. In order to bring new technologies and products to the marketplace, they are entering into alliances with large multinationals and partnerships with third-party providers.
Industry experts predict that big pharma will increasingly follow suit in order to access these new technologies as they become available. Fred Hassan, chief executive officer of Pharmacia & Upjohn, has been aggressively expanding his company's pipeline through alliances. "The majority of innovation is occurring outside big pharma," he remarked. "That is why partnering skills are becoming very important, even though they are not well developed in our industry." As much as a quarter of the research budget for several multinationals is now devoted to alliances with biotechnology companies that offer expertise in innovative compounds and drug delivery technologies, according to industry experts.
Recognizing that financial markets assess their worth by how they create value and not by what they own, pharmaceutical companies are beginning to focus their resources around their core competencies. Economic value added (EVA) and other tools are being employed to measure value creation. Such measurements, combined with manufacturing sites that generally run at less than 40% capacity, often reveal operations that drain resources from core areas such as R&D and marketing. These funds can be better used to create or maintain a competitive advantage. Jan Leschly, chairman of SmithKline Beecham, is a strong supporter of reallocating resources from manufacturing to core activities in marketing and R&D. "Our company runs at about 30% capacity at its tableting and formulation facilities," he commented. "I could imagine over time you could simply spin it off and let somebody else produce for you, because it is simply not viable."
Today, pharmaceutical companies are under intense scrutiny. Faced with pressure to fill the pipeline with blockbuster drugs, rising development costs and a slowdown in sales, they must dramatically improve their R&D productivity or ensure that every drug that reaches the market is a blockbuster. If they fail to do either, their stock is sure to plummet. Some companies have begun to make changes, but will they do enough? If they are to survive in their current form, pharmaceutical companies must dramatically change the way they manage their resources. Strategic outsourcing may be part of the solution, just as it has been for many other industries experiencing similar changes in their operating environment.
With the expiration of more than 50 patents by 2005, pharma companies are under intense pressure to increase the rate at which they develop drugs, while also assuring that each of these new drugs achieves blockbuster sales.
In order to meet the industry forecast of 7% annual sales growth, it is estimated that each big pharma company must produce 45 drugs each year to meet shareholder expectations. The top seven pharma companies currently produce 45 new drugs each year combined.5
Lessons from Other Industries
Outsourcing has long been employed in many other industries as a method of improving competitive position and financial performance. In some cases, it has been a method of avoiding financial hardship. In the early 1980s, British Aerospace Regional Aircraft (BA), which had high fixed overhead and inflexible production processes, was facing a slump in demand. Over a 10-year period, BA reduced its engineering staff from 2,100 to 200 and turned to third parties to obtain the leading-edge engineering support necessary to compete in the new aerospace market.
The automotive industry was also forced to make radical changes to its business practices when Japanese car makers entered the North American market. In an industry where just-in-time manufacturing has become the norm, selecting the right third-party providers and monitoring their performance is critical. When Chrysler began to focus on supply chain management and parallel development, the company cut its supplier base in half, reduced the development time for new models by a full year and increased profitability from $250 to $2,110 a car.
Outsourcing: Key Success Factors
Companies that have been successful in using outsourcing are those that have a clear understanding of their core competencies and how they add value. These companies generally have a strong mandate for outsourcing from senior management and an established process for making strategic outsourcing decisions.
For example, after deciding to focus on its core competency of marketing, food sector giant Sara Lee restructured its business. It sold its production facilities and began to outsource all manufacturing requirements. As chairman and chief executive officer John H. Bryan stated, "This new model means that our focus will shift away from the day-to-day management of manufacturing processes and the gathering of raw materials, and toward higher-return activities such as product development, logistics, sourcing and marketing."
In information technology, companies such as Microsoft and Apple subcontract their total manufacturing requirements, allowing them to focus on their core competencies of software development and testing. Texas Instruments now outsources its product development, keeping new idea generation in-house and using external suppliers to access leading-edge technology. In the telecommunications industry, Nortel expects to save $250 to $300 million during the next three years as a result of its recent decision to outsource manufacturing.
The Leap to Strategic Outsourcing
As a company increasingly incorporates the use of outsourcing in its business strategy, the nature of the outsourcing relationship changes. When the company starts to focus on areas of core competency and outsources non-core activities, tactical outsourcing becomes strategic outsourcing. This brings a fundamental shift in thinking within the organization.
More often than not, the pharmaceutical industry has outsourced on a project-by-project basis. Third parties are viewed as ordinary suppliers and utilized to manage peaks and troughs in demand. Outsourcing is also commonly used to access capabilities not available internally. This tactical subcontracting is undertaken in isolation from a company's overall business strategy.
When a company decides that contractors can provide ex-pertise or value-added services, they rise to the role of preferred supplier. The relationship loses its transactional nature and both parties view the relationship as ongoing.
If significant value-added benefits are attached to the relationship, either in terms of the volume of work performed or the importance of the technology provided, the supplier is often viewed as a partner. Cross-functional relationships between the client and service provider are established and often include representation from such diverse areas as quality, finance, account management and technology. Clearly defined performance criteria are created, measured and reported regularly to support continuous improvement.
The shift to strategic outsourcing will only occur when there is an explicit policy stating what the organization itself will do and what will be entrusted to a third party. In an alliance, the organizations share common goals and objectives. The third party will be rewarded for the client's success through the development of shared risk and reward systems. On a strategic platform, the alliance may imply sole sourcing. In its highest form, outsourcing becomes a core competency for the client organization.
In the pharmaceutical industry, Quintiles has taken the first step in the shared risk and reward arena. Earlier this year, the company announced a deal with CV Therapeutics that suggests Quintiles is willing to fund some of the costs of developing a new drug. In exchange, Quintiles will use its own sales force to launch the drug and get a share of the revenue, should it gain FDA approval.
This is a groundbreaking deal in industry, marking the first time a contract services provider is betting on its own horse. It implies that Quintiles has a high degree of confidence in this drug and that it has the expertise to pick a winner. On the other hand, this strategy can backfire if the drug fails to reach market. In that case, other companies looking for drug development services may insist that their providers remain neutral third parties.
Even at the strategic level, each and every relationship with a third party need not be an alliance. The importance of the relationship will dictate the resources applied to its development. There will always be a need for a variety of relationships to meet the diverse needs of the organization.
It is widely held that pharmaceutical companies will continue to move from tactical to strategic outsourcing. They will increasingly seek partners with whom they can establish value-added relationships. Service providers that can offer a broad range of capabilities, a global presence, financial stability and best-in-class quality will benefit the most from the growth in this industry. Recent alliances between multinational pharmaceutical companies and service providers, such as those between the Roche Group and Patheon or Hoechst Marion Roussel HMR and Quintiles, signal a shift toward strategic outsourcing. In both these cases, the contractors have purchased the client's operations complete with multi-year agreements for the provision of contract services.
Deals of this scope must be win-win agreements if they are to be successful. In each case, the deals allowed big pharma companies to shed operations that were working at approximately 40% capacity. They transferred ongoing capital costs and operating costs to a third party and still had access to skilled employees who understand unique sets of requirements.
The service organizations benefited by gaining capabilities that they previously may not have had. These groups gain long-term contracts, providing financial stability, while also being able to seek other customers to fill excess capacity. In some cases, the transaction may also open up access to markets in which they had no prior presence.
Managing Outsourcing: Skills For Success
Many pharmaceutical companies have tried to manage outsourcing relationships with purchasing agents or scientists familiar with the service to be outsourced. With little direction from senior management, these managers may be unprepared to face the wide range of challenges inherent in managing outsourcing relationships. In a sense, they may be too familiar with the details, often getting caught up in the tactical aspects of the relationship rather than managing high-level performance objectives. To derive the maximum benefit from strategic outsourcing, pharmaceutical companies must assign senior managers with a unique set of skills and experience.
It takes a broad range of skills and talent to manage strategic outsourcing relationships. Direction must come from a higher level within the organization than it has previously. The executive must have experience in leading an organization through change, as well as in managing the initial stage of insecurity that change creates. Ideally, this individual has good working knowledge of all functional areas and is able to manage all aspects of the alliance, from contract negotiation to performance measurement. Supported by a cross-functional team, this senior manager must have the team-building skills to create commitment to the process. Future oriented, proactive in anticipating challenges and decisive when the time comes to make choices, this manager epitomizes the new philosophy of outsourcing and strives to make it a core competency for his or her organization.
The Benefits of Outsourcing
There are enormous benefits to outsourcing. By contracting non-core activities, pharmaceutical companies can allocate assets to areas that generate the greatest value, generally research and marketing. They can minimize capital investment in new compounds prior to regulatory approval and, through third parties, access capabilities and expertise not available internally. The use of external resources can also advance lower priority projects, thus increasing the number of new compounds in the pipeline. Furthermore, effective outsourcing strategies improve the ability of companies to respond to changes in the marketplace by allowing them to move their capital more rapidly from declining markets into emerging ones.
Notes
1. Hughes, Dr. R. Graham, "Strategies for Contracting Out–What we can Learn from Other Industries," European Pharmaceutical Contractor, November 1998, p 50.
2. Ibid, p 44.
3. White, Glenn A., "Emerging Perspectives in Prioritizing and Integrating the Outsourcing Relationship," American Pharmaceutical Review, Vol. 2, Issue 1, February 1999, p 79-86.
4. Miller, Ken and Stacy Price, Hambrecht and Quist, LLC, "Better, Faster Worldwide II," Industry Report, January 4, 1999.
5. R&D Directions, Vol. 5, No. 6, June, 1999.
