Outsourcing has long been a useful tactic in the pharmaceutical industry for containing costs and meeting surges in product demand. Recently volumes have grown rapidly for outsourcers, exceeding the industry’s growth rate. More significant than volume growth, however, is the change in how companies are viewing and using outsourcing for a critical activity: manufacturing.

Forces from within and outside the industry are creating a powerful case for companies to leverage outsourcing not just as a stopgap measure but as part of their overall strategy. We believe companies that become adept at strategic outsourcing can seize a major competitive advantage.

Why Companies Turn to Outsourcing
Recently, Deloitte Consulting interviewed 22 executives at 13 leading pharmaceutical companies and asked for their thoughts on outsourcing. Their comments support our own thinking and experience in the industry.

High on the list of reasons for outsourcing is technology. Companies turn to suppliers for technology that they need but in which they cannot or will not invest. Outsourcing can give companies quick access to new process technology. Using outsourcers, companies can choose to make smaller investments and experiment with new technologies prior to making a more significant investment if the application is shown to have promise.

Companies hesitate to invest in a technology when:

• It is “new to the world” and represents significant risk of failure.

• It is “new to the company” and represents risk from poor integration with existing processes and people, as well as the expense of developing it.

• It is not a competency in which the company wants to develop an expertise.

• Despite its being a valued technology currently, the company is uncertain just how long the technology might remain useful.

For example, lyophilization for sterile injectable products would often require a hefty investment of more than $10 million to be done in-house. Rather than making that investment without knowing how successful the product requiring the process will be, many firms turn to outsource manufacturers such as Ben Venue, which have this specialized capacity in place and validated.

Management of new capital investment is another major reason for outsourcing. Financial considerations may encourage companies to keep investments off their balance sheets. Outsourcing provides companies access to plant and equipment as needed, without the time and cost of building it themselves. Outsourcing, therefore, offers the flexibility of a variable cost-structure.

Cost containment is a goal of virtually every business; market forces are driving pharmaceutical companies to reduce their costs. Mergers and acquisitions, globalization and stock market expectations are increasing the need for efficiency and improved earnings per share. In the pharmaceutical sector, the value of vertical integration is being put more and more into question as best-of-breed companies show they can out-class their larger, more fully integrated competitors. The success of CROs is one example. Therefore, the cost of maintaining all of one’s own production and packaging facilities compared to outsourcing some of these operations to focused companies may not be supportable to the investment community.

Outsourcing suppliers with multiple customers can enjoy massive economies of scale that no single pharmaceutical company could. For example, a supplier can have a lower cost in manufacturing molecules that are used in a variety of drugs marketed by different companies and in manufacturing for the branded and generic versions of a specific drug. Different drugs within a class often share similar intermediate and process operations. The outside provider’s lower cost structure, therefore, can reduce a company’s operating costs and increase its competitive advantage. After finding out through analysis and benchmarking where they are not competitive on a full-cost basis, companies often turn to outsourcing as a much less expensive option.

Speed-to-market has become a major factor in the move to outsourcing. Regulatory forces are making the approval process more complex and expensive, requiring more time and effort to bring drugs to market. Competitive forces are also putting more stress on speed. As generic drugs and alternative therapies pose strong challenges, there is increased pressure for pharmaceutical companies to get as much value as possible out of their patents. To do that they must bring drugs to market as soon as they are approved and have adequate product quantities to serve the largest possible market. An estimate ranging from $2 million to $5 million per day is often used to calculate the lost value of delays.

In some cases, an outsource partner that has a close relationship with its customer can provide innovative solutions that drive growth. For example, a contract manufacturer can suggest production processes that add value to the product and/or lower the production or packaging cost without damaging the product’s differentiating value. This kind of added value is evident in the automotive industry, where first-tier and even second-tier suppliers work with the big auto companies to design innovative features for vehicles. They design and build entire modules of the vehicle, such as the instrument panel, in conjunction with the original equipment manufacturer.

The need for flexibility to meet changing volume requirements often leads to outsourcing, as companies split capacity between internal and external manufacturing. Outsourcing providers make investments for more than one client. The shared investment spreads the risk and reduces the amount borne by a single company. Such partnering arrangements enable companies to handle surges in capacity needs without tying up assets during slower periods. In some instances, a pharmaceutical company will turn a plant over completely to a supplier, eliminating the need to absorb the overhead of idle facilities and staff. Should the plant close, the supplier, rather than the pharmaceutical company, carries the onus of layoffs or a complete shutdown. This fact is especially useful in European countries that tie pricing/approvals to in-country employment.

Customer forces are also a reason companies turn to outsourcing. Managed care organizations and governments have intensified pressure on prices, purchasers are more involved in deciding what products are used and more self-administration of drugs has necessitated specialized packaging to ensure patient compliance. Outsourcing provides pharmaceutical companies with an ability to respond quickly to changing customer needs. In addition, outsourcing can give these companies the flexibility to offer a range of solutions to different customer segments, based on what each segment values most. For example, different packaging solutions might be valued for the home health market rather than for hospitals. While packaging in smaller, customized “batches” might be cost-prohibitive for a big pharmaceutical company, an outsourcer’s greater scale and range of packaging capabilities might allow it to offer such a menu of options.

Strategic Vs. Tactical Outsourcing
The relationship today between the pharmaceutical company and outsourcer is changing. Rather than being a tactical arrangement formed on a project-by-project basis, outsourcing in many instances is becoming a strategic, long-term partnership. Outsourcers compete for these relationships not on price alone but on their ability to add value and provide full service to their clients. For instance, Glaxo Wellcome saw strategic value when it sold its plant in Greenville, NC, to full chemicals maker Catalytica and wrote $800 million worth of manufacturing contracts.

Instead of using outsourcing for added capacity project-by-project companies are looking at the capacity issue on a strategic, organizational basis. They ask questions such as: “How much capacity do we need over the next 3-5 years?” “Which steps in the manufacturing chain are we willing to outsource?” “What stages in a product’s development and approved life-cycle should we keep in-house?” “How much do we have to have in house?” “What is the right balance to get products to market quickly, at the best cost, without compromising quality?”

Flexibility — the ability to increase or decrease capacity as needed — is the key. As the industry becomes more dynamic, predicting the volatility of product requirements is more difficult. Consequently, the industry is moving toward planning for a range of capability, instead of for specific product requirements. Companies need to have in place the bulk capacity, the tabletting capacity, the outsourcing partnerships—all the facilities and processes—that enable them to shift rapidly from one product to another as demand dictates.

In the past, companies had relatively simple supply chain operations because they had few products in their portfolios. Glaxo Wellcome, for example, thrived on sales of Zantac (ranitidnine) for years. Facilities dedicated to a few products were often sufficient. Companies could more easily predict demand, plan supply and optimize the supply chain. Today, particularly with all of the merger and acquisition activity, companies have larger and more complex portfolios, manufacturing redundancy and excess capacity, all of which increase the complexity and inefficiency of the supply chain. At the same time, most plants built by major pharmaceutical firms lack the flexibility to produce different products or convert swiftly from one to another to meet fluctuating demand. Strategic outsourcing that provides a range of capability offers a viable alternative.

While outsourcing can provide flexible capabilities that enable customer companies to reconfigure swiftly for changing requirements, any one outsourcer’s ability to partner with a pharmaceutical firm is limited. For that reason, pharmaceutical firms are quickly moving to lock up strategic relationships with leading suppliers by buying equity stakes, selling key facilities, providing first refusal rights on future needs, and signing formal alliances. For example, SmithKline Beecham has entered into a strategic relationship with Lonza, building on their successful Famvir relationship. This trend may accelerate as the supplier base consolidates with mergers and acquisitions, such as the one recently announced between DSM and Catalytica.

The advent of the e-commerce revolution has created even greater opportunities for companies to form strategic partnerships with outsourcers. E-commerce enables companies to exchange information quickly and securely, while increasing both the quality and volume of the information, enabling the pharmaceutical company and outsourcer to work more productively. This information can be used for demand management as well as to monitor risk-contracting or contingency fee agreements, which would be otherwise too burdensome to undertake. In addition, the potential of market exchanges further down the road could allow a more robust marketplace to develop. In the auto industry, Ford, General Motors and DaimlerChrysler have already started an online exchange through which these three competitors will purchase parts from a number of suppliers.

Implications of Strategic Outsourcing
Viewing outsourcing on a strategic basis has a number of significant implications. Many companies still see outside providers as “vendors” or “suppliers.” These cultural barriers have to come down as they have in other industries, where companies can work as “partners” and share information, to the success of both.

Managing such arrangements, however, raises still another implication in strategic outsourcing — the need for a different set of managerial skills. Managers have to be able to work with their partners in a more intimate relationship — sharing information, responding quickly and being more aware of the partner’s needs in fulfilling the client’s needs. Relationship management will be required; that will mean getting over the “culture of secrecy” that has prevailed in the pharmaceutical industry for years. These managers will have to be “negotiators,” with the ability to influence the employees of other companies, employees over whom they have no direct authority.

Reliance on outsourcers for a greater degree of functional capabilities may also require pharmaceutical companies to revise their strategic intent, to ask: “What business are we going to be in?” “What is our value proposition?” and “Where and how can we be most effective?”

A well-known example of a company with heavy reliance on outsourcers is Nike. This global athletic shoe company doesn’t actually make a single sneaker but outsources all of its manufacturing. The company has made the decision to focus its attention on finding new uses for and variations of its basic products. It also devotes considerable energy on managing and expanding its network of star-athlete endorsers. Nike’s partners handle manufacturing and Nike manages them in strategic arrangements. A parallel in the pharmaceutical industry is American Home Products, which does not manufacture any of its bulk active material in-house.

Potential Drawbacks of Outsourcing
Executives we spoke to revealed that the chief obstacles they see in outsourcing are the need to maintain product quality and control, lack of information to support the business case, a preference for using internal capacity and potential tax impacts. Depending on the company’s approach, these obstacles can be major barriers or merely speed bumps on the road to strategic outsourcing.

Need to Maintain Product Quality and Control
Some companies feel they must maintain control of the product to ensure quality and avoid potential problems. The company owns the NDA and is ultimately responsible for the product. Regulatory issues aside, the company’s reputation is damaged if a problem arises with a product. While Bridgestone/ Firestone, for instance, manufactured the allegedly faulty tires, Ford was ultimately responsible for the safety of its vehicles on which those tires were placed and Ford’s image was tarnished.

An outsourcing relationship, however, does not necessarily mean every activity will be outsourced. Schering-Plough, for instance, typically outsources only mature products and selected steps in the manufacturing process. Because of secrecy concerns, the company never outsources strategic products. AstraZeneca, among others, frequently purchases bulk chemicals from an outsourcing organization, yet generally does not relinquish responsibility for formulation and tabletting.

A pharmaceutical company also has to be concerned when sharing proprietary information with an outside source that provides similar services or products to a competitor. Such concerns are reason for caution, but companies are able to work through these issues. An internal organization designed to oversee the relationship sand ensure confidentiality can mitigate the potential risk. In all cases, the use of outsourcers requires an internal mechanism for oversight and quality control.

Lack of Information to Support the Business Case
Suppliers, it is thought, often do not have good information on their own economics, such as the total cost of ownership. This puts outsourcing decisions on a less-than-rational basis. Because little is known about some suppliers and because selecting and approving an outsource supplier takes time and analysis, some companies aren’t willing to make that effort. Through internal analysis, companies often compare their own variable cash cost to an external supplier’s price without considering the internal cost of capital. This can result in outside suppliers looking more costly than what the true economics, or total cost of ownership, would imply.

A Preference for Using Internal Capacity
Companies also feel they have sufficient capacity across different divisions that they would rather tap into before going outside. Considering a large asset base, a company looks first to maximize its utilization. But what often happens is that a company will leave mature products in valuable production equipment and will later be caught in a capacity squeeze when newer, more strategic products are approved. The only choice at that point is a rushed capacity addition, with a significant cost premium.

Potential Tax Impacts
Taxation also impacts the outsourcing decision. Many firms realize Section 936 tax credits from their Puerto Rico operations (although these are being phased out) as well as reduced tax rates in Ireland and Singapore, among others. Earnings kept offshore are never taxed at the average 40% U.S. federal and state rate. Transfer of intellectual property ownership offshore can be structured to allow even more savings. These tax provisions, however, are often under attack in Congress and may be repealed. However, as the law stands now, these benefits are more difficult to realize with non-owned facilities.

Making Outsourcing Decisions
Essentially companies have to make three over-arching decisions:

• Do we outsource?

• If so, what do we outsource?

• With whom do we partner?

Senior management, not product managers, should make the decision to outsource. Product managers look at outsourcing tactically and can easily miss significant opportunities or sub-optimize an outsourcing solution by making selection and management decisions based only on their own products’ needs. Taking the holistic, or strategic, perspective, the company can discover the greater possibilities. For example, the company can see that, instead of tying up resources on a product that has reached a plateau or one that involves low risk, it could be using company talent and equipment for newer products or those with higher risk and returns — a more productive use of resources. Senior management can also identify needs across the company, identifying an assortment of products whose production and/or packaging volumes would not independently merit an outsourcing solution, but whose combined volume might present such an opportunity.

Outsourcing should be included in the company’s strategic planning process as an approach used to attain corporate objectives. As part of the long-term, strategic planning process, outsourcing decisions can be made based on a three-to-five-year investment horizon.

Traditionally, pharmaceutical companies tend to make planning decisions based on certainty, rather than on probability. Capacity requirements are seriously considered only for late Phase II candidates, when options are already limited. Shifting that thinking, companies can become more proactive. Incorporating outsourcing into the strategic vision, a company can create more flexible plans that allow for a variety of future scenarios. This in turn can encourage a quicker response to market discontinuities or opportunities when they occur. If the company has already planned for and accommodated such a change, it can activate this plan, using outsourcers to supply extra capacity, new technology and the like, as needed. For example, although a company does not know which products will be approved in three-to-five years, it can project a “probable range” for primary and secondary capacity needs.

Most companies outsource selectively. They examine the life-cycle of each product, from development through off patent. Where the product stands in its life-cycle can help determine whether its production and/or packaging should be outsourced. For example, companies concerned about stock-outs of important growth products may decide to outsource a product only in the latter phases of its life-cycle, when volatility is lower and demand is more constant. A product at this stage needs less management input and more routine processing. So the company would feel safe in turning the production of such a mature product over to an outsource partner, freeing capacity for newer, more volatile, in-demand products.

Companies should also consider each production step. They might outsource intermediate production steps but want to handle the final steps, such as packaging, on their own. The thinking is that they want to control the product just before it is released to the customer. Even firms that rely heavily on outsourcing, such as DuPont, maintain control over the final stages of production.

Surveying the field of opportunity from the earliest to the latest phases of the product life-cycle and production steps can shed light on the possibilities. For each of these possibilities, determine how good the available outsourcing answer is. That is, determine if putting the mature product in the hands of an outsourcer is safe and cost-efficient. Can the outsourcer demonstrate its ability to meet that constant demand? Running out of stock is usually a greater risk for the pharmaceutical company than for the supplier, so the assurance has to be there. To mitigate that risk, weigh the benefits for the supplier as well as for the customer company. Are the supplier’s incentives for meeting demand as strong as the company’s? Compare the supplier’s value proposition against the company’s. Are they aligned? Use that sense of alignment and measure the volatility and risk in making the decision to outsource or not.

Partner Selection
In selecting one outsourcer over another, executives we spoke to cited quality, price, service and experience as the primary qualifications to look for in an outsource partner.

Overall quality is the primary qualifier. Suppliers must be able to deliver quality products. They can demonstrate quality through ISO certification, cGMP compliance, FDA approval and inspections history, as well as commitment to quality systems and vendor-certification processes. Various companies use different methods to measure quality, such as adherence to specification, defect rates, contamination and tracking ability. In addition, training programs for employees and customers may be seen as a commitment to quality. The supplier should have quality systems and a reputable process to achieve quality. It must “not be willing to lose a $30 product for a $0.14 container.”

As for price, the supplier should be competitive against both the market and the internal alternative. An important sign of a good supplier is value, which can be defined in different ways, with unit price being the most common. There should also be a commitment to ongoing cost reductions. Most outsourcing contracts include cost reduction clauses.

Companies look for world-class service. To assess a potential outsourcer’s order management/fulfillment process, companies consider order lead times, on-time delivery and the percentage of invoices that are incorrect. The supplier should be able to adapt to the client’s business requirements; meet delivery dates, lead times and cycle times; address problems quickly; demonstrate reliability; offer the best resources for a particular project; track and report performance and make customer service representatives accessible. Companies must also look at current utilization and capacity metrics to determine whether the outsourcer has sufficient assets, process technology and people to manage production and/or packaging volume.

Companies prefer to partner with suppliers that have experience and know the customer’s sphere of the industry and various activities. Suppliers should demonstrate their understanding of regulatory requirements, cGMP and relevant product information.

In addition to these four qualifiers, companies expect suppliers to apply innovative technology to their problems and come up with cutting-edge solutions. They want the attention of experts and they value insight into leading edge technology, which can apply to materials, process, design or information. The most common measures of a supplier’s innovative technology capability include patents, design awards, articles in publication and investments.

A majority of companies we spoke with also prefer doing business with suppliers that are larger and well established and can demonstrate a financial stability. Larger companies have more resources to meet customer requirements. Some measurements of financial stability include the supplier’s current and historic revenue and earnings, revenue and earnings trends, market share, market valuation and bond rating.

As sponsor companies start to expand, they prefer suppliers with global coverage. Global purchasing enables product standardization, volume discounts and supplier consolidation. A supplier’s capability to deliver a consistent product and service globally may be measured by the number of its plants and countries served, as well as by the consistency of its offering.

While most pharmaceutical companies are using outsourcing, they are not using it strategically. Because much of the pharmaceutical industry still approaches outsourcing tactically, a significant opportunity exists to unlock the value of a strategic approach. Companies can seize a competitive advantage by strategically aligning themselves with the right partners for the right mix of products and services.

Patrick Kager is a partner and Susan Dettmar a senior manager in the Life Sciences practice of Deloitte Consulting. They both have extensive experience in the areas of business strategy, global process improvement, e-enablement and merger & acqusitions.