Most certainly, there are no simple answers to these questions. However, one approach is to employ an analysis technique called Economic Value Added (EVA)1 and to establish a results-oriented management system consistent with the economic benefits obtained.2,3

In addition to the above general management level questions, there are several other drivers important in the pharmaceutical industry, and to API manufacturing in particular. From a top-level perspective, these drivers are business advantage, financial measures and access to technology, all of which are directed to increasing the return to the business. That return is directly proportional to decreasing the time-to-market and the acquisition of market share.

In today’s challenging and competitive pharmaceutical landscape (and now more than ever), a dollar today is more valuable than one tomorrow.4 Economic Value Added (EVA) is a technique and measurement system that can be implemented throughout an organization, tactically and strategically, to align the many functional areas to the common goal of financially successful drug launches. As one example, EVA links capital budgeting, for items such as outsourcing, to employee performance appraisal and executive incentive compensation, and does so in a predictable and equitable manner.

How is EVA Calculated?
Economic Value Added (EVA) is simply an income statement relationship, except there is an additional expense: the cost of capital used to generate the income. One may ask, why is it important to consider the cost of capital? Basically there are two very good reasons:

Below are several equations defining EVA, and depending on the application circumstances (discussed later), EVA can be used to evaluate new projects, perform an enterprise-wide assessment, guide cost allocations, perform capital budgeting and, of course, establish the all-important management compensation and incentive plans. In equation form, EVA is defined with (and can be written in a number of equivalent forms to match) the nomenclature or approach used by various companies:

EVA = Revenue from Sales – (Cost of Goods Sold) – (Cost of Capital Employed)

= (Earnings Before Interest and Taxes) (1 – Tax Rate) – (Cost of Capital) (Capital Employed)

= Operating Income – Cost of Capital Charge

= Net Operating Profit After Tax – [(Cost of Capital) (Total Capital Employed)]

= [((Net Operating Profit After Tax / Total Capital Employed) – Cost of Capital)] (Total Capital Employed)

= (% Spread) (Total Capital Employed)

The savvy manager or financial guru may opine that for years Return on Investment has been calculated as (ROI = Operating Income / Operating Assets) and that EVA is nothing more than a Net Present Value (NPV) calculation.6 Of course, that’s all true! With ROI, senior management’s investment decisions may, again, be based on maintaining the status quo while reasonable risk for substantial rewards may not be considered. The bottom-line appeal7 to EVA is its simplicity in communicating across functional groups and as a clear means for the board of directors to assess the management’s results.

Example Applications of EVA Analysis EVA and Growth
EVA is a technique useful in changing organizational behavior and in driving the decision-making process in a manner that maximizes value to the business. Most businesses want to grow, and grow rapidly, and several scenarios are possible. In a sustainable growth condition, for example, the business is generating sufficient cash to re-invest. To increase a company’s growth beyond the sustainable growth rate, only a few options are available and these are certainly recognizable in today’s pharmaceutical marketplace. The prudent options are:

Obviously, corporate merger in the pharmaceutical industry has been the expedient reaction to pressures on senior management for top-line growth. Historically, this solution has met with limited success and the merger frenzy observed over the last few years is unlikely to produce the desired results in the long term.9,10

Let’s consider each of the options listed above and subject them to an EVA analysis. If the enterprise elects to take on more debt, it’s only natural that the investor will want a return (cost of capital). If the company’s additional debt does not generate sufficient revenue to cover the capital expense and generate profits, the resultant increased liability on the balance sheet does not bode well for the CFO. Reducing dividends to investors is likely to hasten the departure of the CFO. The “profitable pruning” approach is actually a pretty good one, but is most often manifested in discomforting ways, including downsizing, cost cutting, plant closings, “re-engineering,” etc. The positive view is that the senior management is eliminating balance sheet assets (and a cost of capital expense) that do not generate acceptable revenues. For instance, it is not unusual for a large pharmaceutical company to divest those products that they no longer support with marketing expenses. The divestiture may be painful in the short term to some individuals, but the long-term gains from an extended product life cycle may have numerous beneficiaries.

Often, manufacturing groups intertwine the concepts of profitable pruning and outsourcing. Outsourcing is a means to strengthen a company’s financial performance and to leverage its core competencies. Manufacturing jobs are not lost because of outsourcing; production jobs are lost when unprofitable product lines continue to drain company resources away from growth opportunities. In the latter case, “profitable pruning” should occur.

Make vs. Buy (Outsourcing)
Let’s step-back a moment and consider some general issues in applying EVA analyses to decision making. Timing, cost of capital and business risk must be weighed together, in the correct proportions, to yield the highest probability of a successful financial return. EVA has been endorsed and validated by Wall Street as an effective tool to aid in these decisions. In the “make vs. buy” decision process, all good general managers know the financial analysis is but one factor in establishing a business’s direction and ultimate performance. However, agreeing to the difficult trade-offs and implications to an organization’s approach to outsourcing can often be resolved quickly and with buy-in from the company’s “stakeholders”—that is, its employees—by use of an EVA analysis. In other words, employee or management faction objections to outsourcing can rationally be addressed by employing the EVA technique. The real message (and advantage) here is that financially strong businesses have the highest probability of providing stable employment while outsourcing; job loss is not due to outsourcing. In the “make vs. buy” decision process, asset utilization and capital expense are particularly important parts of the equation and this is especially true for the capital-intensive requirements of the (bio-)pharmaceutical and API manufacturing segments of the industry. In almost every case, an EVA analysis shows outsourcing11 is preferable to investing in “bricks and mortar”: process equipment and regulatory infrastructure. This is certainly true at the front-end of pharmaceutical projects (IND phase). Depending upon the overall risk assessment in the marketplace for a given API or drug product, manufacturing outsourcing will provide a desired, positive net present value.

Management Compensation and Incentives
Clearly, EVA is a means to measure how well a company’s management is using the assets entrusted to it to create value. Management’s value added contribution can be calculated as:

Management Value Added = (Amount of dollars put to work in the company) minus (Value of the income stream those assets are generating)

Can you imagine boards of directors’ meetings conducted around senior managements’ demonstrated ability to increase EVA? Imagine a scenario in which management’s compensation and incentive rewards are actually based on delivering positive EVA and meeting working capital goals with their reward scheduled to delivering “rolling results” through time! (OK, it was just a crazy thought.)

Let’s consider one form of the original equations to calculate EVA whereby EVA = (percent spread) (cost of capital). Perhaps obviously, there are really only three ways to create EVA:

Either project-by-project, or viewed as the total enterprise, senior management has the responsibility to orchestrate a desired outcome. In the context of this discussion, decision-making should involve an EVA analysis—that is, the cost of capital must be included. Management’s performance and contribution to the actual financial health and longevity of the company can then be objectively measured and rewarded. Almost certainly, mergers and acquisitions are easier routes to growing a company’s top line than performing real and responsible management—in spite of the many arguments for acquiring drug pipelines, establishing therapeutic marketing synergies, improved efficiencies, etc. Natural law and the rules of physics still apply in business too, and most scientists know: you don’t get something for nothing. It’s beyond the context of this discussion, however, but one must wonder (given the current economic environment) if the business school graduates within U.S. corporations have done more harm than good in the past 20 years.

Real Life Lessons and Value Creation
It is very common today to hear about shortening the drug development cycle, reducing time-to-market, extending intellectual property protection and, in general, controlling costs throughout the process. A major driver to this exercise
is maintaining corporate profitability while under attack from legitimate competition, but also withstanding the onslaught of labor law, anti-trust activities, changes to the patent law, state and federal regulations, state and federal subsidy provisions, collective bargaining and buying groups, and accommodating world markets while adhering to a myriad of international laws, local laws and federal mandates from pseudo-legislative agencies. Perhaps the first and easiest way to maintain corporate profitability is to pass the costs onto your suppliers. Clearly, however, there is a limit to this approach, since their livelihood cannot be maintained in this manner. All these factors must be included in the cost component of an EVA analysis.

Recently it was reported that the average cost to bring a drug to market was about $803 million. Even in this day of low interest rates, the cost of capital represents a lot of money! In other words, money could be invested in a less risky business that would generate a return on the capital. This reality is surely overlooked by pharmaceutical company detractors in their haste to vilify corporate profits derived from “expensive” drug sales. Turning it around, how much of their money would they invest today to yield a reasonable return on investment later, given an estimated (even variable) cost of capital? The noise-makers, political activists, and elected officials may play to the uninformed masses, but we all know their mutual funds hold pharmaceutical company stock.

Senior pharmaceutical managers may have little influence on factors outside the company that impact the corporation’s success, so it is imperative they implement and control activities within the organization supremely well. With so much at stake and continuing over extended development periods, complicated issues arise with potentially severe consequences to a corporation. This is especially true when the technical aspect of product development is not properly matched to the financial investment. Returning to the question I raised at the beginning of this article: How do you focus R&D on advancing the cause? It is clear the EVA analysis can assist in this process. Unfortunately, reconciling the R&D expense to the chief financial officer’s expectation of offsetting revenues that may occur many years out is a daunting task, if not an impossible one. However, a negotiated “stop order” could be placed so that expenditures on a given project do not exceed a certain amount. Alternatively, the cash burn rate once a drug enters advanced clinical trials or commercial manufacturing can be tremendous, so the probability of success better be high. At this point, an iterative calculation can be performed to determine what the drug’s selling price must be to maintain a positive EVA. Obviously, there are no simple answers, however rigorous and disciplined application of the EVA analysis can assist managers in leading the company to financial success.

The EVA analysis tool is a means to link balance sheet performance to the income statement. And again, this linkage can be analyzed for the entire business or on a per project basis. Balance sheet assets need to be evaluated for their ability to generate revenue, but a fair analysis must include the capital charge for that asset. There’s nothing new here, but often these simple features are overlooked. In the chemical industry, where huge capital assets are engaged in producing products—with amortization schedules of 15 years for equipment and 30 years for buildings—the capital assets may remain on a balance sheet long after a product’s life cycle has ended—at that point, they need to be sold, written off or employed elsewhere. A good EVA analysis will account for these circumstances.

The finance and accounting functions are not the only input sources management must use to make good decisions. An Economic Value Added analysis is a quantitative tool that can provide direction and guidance in the decision-making process. The analysis cannot, for instance, let you know

The EVA analysis may look great, but it cannot overcome these potentially disastrous conditions—and as experienced managers know, there are many other unfavorable situations that may befall the firm.12 An applicable quote for the business manager is, “In military as in other human affairs, will is what makes things happen. There are circumstances that can modify or nullify it, but for offense or defense, its presence is essential and its absence fatal.”13 Do the EVA calculation.

Notes

1. “The Real Key to Creating Wealth”; Shawn Tully; Fortune; September 20, 1993, p. 35.

2. “EVA a New Tool For Measuring Chemical Managers”; Chemical Market Reporter; June 26, 1995, p. 34.

3. “EVA and the Chemical Industry: How Do Companies Rank?”; John Ballow, Henri Perrson and Fred Knechtel; Chemical Market Reporter; September 3, 2001; p. 27.

4. “Playing the Economics Game With Outsourcing”; John K. Borchardt; Modern Drug Discovery; March 2000, p. 28.

5. “The Outsourcing Project Checklist: Tech Transfer, Timing and Costing/Pricing”; Roger Laforce; Paper presented at Outsource 2000; Organized by Scientific Update, Montreal, July 13, 2000.

6. “Analysis for Financial Management”; Robert C. Higgins, Irwin/McGraw-Hill, ©1998; pp. 298 – 302.

7. “The Transformation to an EVA-Based Chemical Company”; Marie S. Dreher; Chemical Management Review; September/October 1999, p. 14.

8. “Strategic Outsourcing”; James Brian Quinn and Frederick G. Hilmer; The McKinsey Quarterly; 1995, Number 1, page 48.

9. “Joining Forces—Why Scale Fails to Deliver”; Chris Neild and David Alcraft; Scrip Magazine; April 2000, p. 23.

10. “M&A Malaise”; Desiree de Mye; BioPharm International; June 2003, p. 18.

11. “The Benefits of Outsourcing Drug Development”; Beth A. Hollister; Pharmaceutical Manufacturing International 2000; Published in Association with Interphex March 21 – 23, 2000, p. 36 – 39.

12. “Financial Insights: EVA Trends in the Chemical Industry”; Leslie C. Ravitz and Anthony Bova; Chemical Market Reporter; October 6, 2003, p. 13.

13. “Stillwell and the American Experience in China 1911 – 1945”; Barbara W. Tuchman; New York, Bantam Books, 1971, pp. 561 –2.