Friday, July 31, 2009

Do we see a new paradigm in pharmaceutical manufacturing?

Openings for Outsourcing

By Dr. Enrico T. Polastro

Where does the pharmaceutical industry stand in the shift toward outsourcing of manufacturing? Why is there such debate about using contract manufacturers and bulk supply?

The share of outsourcing has been traditionally modest in the pharmaceutical industry, generally comprising between 20 and 40% of cost-of-goods-sold (COGS). This figure is dwarfed by those observed in other industries (see Fig. 1), such as automotive and aerospace and consumer electronics. In the toys and sporting goods category, the share of outsourcing can approach the 100% threshold. Major companies such as Adidas, Puma or Reebok operate a de facto virtual manufacturing model, entirely outsourcing their production so they can focus on product design and marketing.

The same virtual model has been adopted by fast-moving consumer goods companies such as Sara Lee, which has divested its manufacturing network. So why is there such a gap between the share of outsourcing noted amongst pharmaceutical companies and most other industries?

This can be explained by a combination of factors. For one thing, there is a limited impact of COGS expressed as percentage of sales. It rarely exceeds the 30-50% threshold, a rather modest figure compared to other industries where the comparable benchmark would often be in excess of 70% of turnover. As a corollary of this modest impact of COGS profit — as well as EBIT margins in the pharmaceutical industry that dwarf those noted in other fields — pharmaceutical companies have consistently delivered above average returns on sales as well as on capital employed!
Figure 1: Share of outsourcing as a % of COGS, by industry
Source: Arthur D Little

In addition to this peculiar cost structure and limited pressure to keep an eye on manufacturing costs, the pharmaceutical industry has been characterized by its obsession on quality-related issues, with the general view that quality as well as reliability of supply was best ensured by jealously keeping manufacturing in-house.

This belief was amplified by the general tendency toward risk avoidance and conservatism among pharma executives, an attitude clearly favoring frozen mental models and status quo. All these factors sharply differ from those observed in other industries, where the quest for efficiency began several years ago, obliging companies to explore new business models, including outsourcing and farming out of manufacturing operations.

Branded Vs. Generic Attitudes

However, we note that attitudes towards outsourcing differ among the various segments of the pharmaceutical industry. The share of outsourcing differs between branded Rx and generic pharmaceuticals for both the drug substance (often referred to as bulk API) and the drug product (the formulated drug). In general, branded companies outsource around 40% of their bulk needs and 30% of their drug product needs, while generic companies report outsourcing 80% of bulk and nearly half of their drug product needs.

Traditionally generic drug companies have relied much more extensively on outsourcing, farming out more than 80% of their bulk API requirements, twice the amount noted among branded Rx players. A comparable proportion is reported for the drug product. Why such a difference?

This can be explained by the different dynamics characterizing the two groups. For one thing, generic vendors have narrower profit margins and substantially higher impact of COGS; their costs often stand north of 50%, compared to 30% for branded Rx companies. They also have shorter product life cycles as well as much broader product lines, since line breadth is often a key success factor for generic companies to command shelf space and secure access to distribution channels. In addition, there is the fundamental difference between the two segments’ products, particularly in terms of drug substance / API; branded companies have unique products, patent protected for originators, while generic formulations are widely available almost on a catalog basis.

Combined, these factors have pushed generic companies to explore options to:
  • Maximize their efficiency, optimizing COGS;
  • Ensure optimal flexibility and the ability to redirect their product line, avoiding becoming mired in an inflexible production setup, remaining nimble enough to rapidly redirect the product mix should market and competitive conditions warrant it;
  • Effectively secure access to a broad product line where complexity costs associated with product line breadth can be all but neglected!

This has driven generic players to embrace outsourcing of manufacturing as a standard business practice. Another force that makes outsourcing a logical option is the wide availability of alternative sources for their bulk and formulation requirements. It often makes most in-house production an economic anathema!

Where are the NCEs?

However, nothing is cast in iron! The environment facing the pharmaceutical industry has greatly evolved during the past 10 years! The facts and the new pharma environment are well known to all of us. If we look at Fig. 2 we see that the number of new molecular entities reaching the market remains at disappointingly low levels, well below the peaks noted in the late ’90s. In 2007 only 25 products — exactly half the number from 1996 — were launched!
Figure 2: The number of NMEs reaching the market remains modest
Source: Arthur D Little

While the reasons behind this protracted drought of new product introductions go well beyond the scope of this article — ranging from increasing scrutiny by the regulatory authorities to gradual saturation of some therapeutic segments — one thing is clear: The flow of new products is proving increasingly inadequate to offset the loss of sales that a number of companies will face as patent expiry dates approach for several top-selling drugs. This spells misery for innovators, while creating new opportunities for generic players!

What are the implications of this? Simply that continue top- and bottom-line growth for pharmaceutical companies — particularly amongst innovators — is far from guaranteed. Senior management must scramble to maintain financial performance at "acceptable" levels.

Large Molecules Get Larger

There are other sources of change are hitting the pharma scene, including the growing share large molecule biologic drugs — mostly recombinant proteins or monoclonal antibodies — both in terms of total pharmaceutical sales — their market share is in excess of 10%, up from 3% 10 years ago (see Fig. 3) — and the number of products in the development pipeline, with around 25% of the pharma pipeline based on large molecules.
Figure 3: The share of biopharmaceuticals in terms of pharma sales is increasing
Source: Arthur D Little

This has far-reaching implications in terms of manufacturing and production base. Traditional synthesis capacity and skills are of little relevance for accessing large molecules!

Another development is the shift in terms of products reaching the market or being developed. For example, the share of anticancer products has steadily increased, reflecting the emphasis among pharmaceutical companies on therapeutic segments characterized by substantial unmet needs as well as — and possibly a corollary of — the move toward specialist drugs as opposed to products for the primary (General Practice) market, an approach often referred to as the "blockbuster" model.

An implication of this is that the new products being developed will target smaller markets, likely requiring reduced volumes of drug substance and drug product. These are now bought in the ton / tens-of-tons range of bulk volumes, as opposed to hundred of tons before. Here too implications in terms of manufacturing can be far-reaching: large-scale synthesis units like those traditionally operated in the industry becoming are increasingly inadequate.

Similarly, start-ups and emerging pharmaceutical players are becoming hotbeds of innovation, as opposed to the large pharmaceutical companies. These smaller companies nowadays account for more than 35-40% of all new molecular entities reaching the market (see Fig. 4).
Figure 4: The role of emerging pharma players in the development of NMEs is increasing
Source: Arthur D Little

Why is this of note?

Start-ups and emerging pharma apply very different business models than their large pharma counterparts; almost all start-ups operate according to a largely virtual mode of operations, including manufacturing.

The Changes

What do all these developments mean in terms of pharmaceutical manufacturing and outsourcing? For possibly the first time in history, pharmaceutical companies are being forced to pay closer attention on both COGS and how they use cash flows. Investing in own production capacity is not always the wisest use of scarce funds.

At the same time, a schism is emerging between the asset base on hand — largely geared towards large-scale organic synthesis — and the evolving requirements facing pharmaceutical companies, including a growing share of large molecules / biopharmaceuticals and a shift of product line towards smaller volume molecules, where economies of scale in manufacturing are substantially lower compared to the blockbuster model of the past.

Last but not least, mental models are evolving as both, new management talent and “fresh blood” joins pharmaceutical companies in key decision-making roles, and emerging pharma becomes the lynchpin of innovation. These latter groups — new management and emerging pharma — are not necessarily committed to the traditional sourcing or manufacturing models applied in the pharmaceutical industry. How does all this translate in terms of manufacturing practices?

At least on its face, outsourcing some (if not all) manufacturing operations normally performed in-house to a suitable third party appears to represent an elegant solution to several of the challenges facing the industry. It would erase at a pen's stroke the need to commit sizeable investments, providing at least short-term relief on free cash flow. It would also avoid inflating own fixed cost base, as some costs are shifted to the third party vendor making labor or infrastructure charges largely variable and thus helping to manage risks associated with demand swings. In addition, it would ensure access to exactly the type of capacity and assets required, ensuring a perfect match between supply and demand, as the most appropriate vendor could be selected on a case-by-case basis in light of the needed capabilities. Drawing on external resources could also provide opportunities for building on new ideas, with outside practices providing a forum for cross-fertilization.

It is therefore not a surprise that, barring a handful of exceptions, most pharmaceutical companies are seriously considering an increase in their share of outsourcing.

In Fig. 5, we see the current and projected share of outsourcing for bulk requirements for seven companies. This is expected to increase amongst most companies surveyed, from 40-50% to 65-70% at the horizon of 2012 or beyond. Quite logically, those companies that are facing the challenge of patent expiries for top-selling products or are in the process of redirecting their product portfolio from the primary segment to a specialist/hospital drug focus are the ones for which the shift from in-house manufacturing to outsourcing is the most dramatic.
Figure 5: Most pharma innovators are considering an increase in the share of outsourcing for their drug substance (bulk) requirements
Source: Arthur D Little

But is outsourcing a panacea for the challenges facing the pharmaceutical industry? As always, the answer needs to be finessed.

Bulk of the Matter

Fig. 6 shows us a correlation between bulk outsourcing and bulk costs. We can see that the two players with the lowest impact of bulk are those almost entirely reliant on outsourcing. Should we therefore conclude that outsourcing is more cost competitive than producing in-house?

This conclusion would be a gross over-simplification. Only companies that engage in large-scale outsourcing precisely know what their real cost of bulk is; other companies include overheads in their estimates, making direct comparison hazardous at best. Other factors — such as the age of the portfolio and sales or therapeutic mix — may also differ, having a major impact on revenues and hence also COGS!
Figure 6: The companies relying the most on drug substance outsourcing appear to have the lowest impact of bulk on sales
Source: Arthur D Little

When it comes to other metrics — such as shorter lead times, decreased risks of stock outs, etc. — the answers here too must be nuanced. Much depends on the particular vendors retained, and the efficiency and effectiveness of the customer / vendor interface.

So how far will the pharmaceutical industry move towards outsourcing? Will it someday operate a virtual manufacturing model? To answer this question, it may be useful to take a look at the generic segment of the pharmaceutical industry.

Traditionally, generic companies have relied extensively on outsourcing for their drug substance requirements. However, recently the trend among generic players seems to be to increase their share of in-house production. This is occurring among several players, including:
  • Teva – traditionally one of the most extensively backward-integrated generic players;
  • Sandoz – one of the largest producers of bulk beta-lactames;
  • Mylan – via its acquisition of Matrix; and
  • Actavis – via its major investment in India.

These companies have secured access to an own bulk production base. Why are generic companies moving in this direction when branded companies appear to be moving in the other?

It is clear that both generic or innovator drug companies are becoming more selective in their sourcing approaches. Depending on well-specified, objective criteria, they are electing to produce in-house or outsource relying on a third-party vendor on a product-by-product basis.

To this end, we have a possible model for the manufacturing setup of the future, in which companies:
  • maintain / develop leading edge project management skills to orchestrate internal as well as external resources,
  • have access to their own process development capabilities, with pilot scale capacity, and
  • keep focused full-scale synthesis units, complemented by a network of selected third-party vendors.

Within this framework, the meaning of "own" resources needs to be clarified; it will include both truly in-house resources accruing to the payroll of the company, as well as these of privileged "partners" acting as extensions of the company’s operations. Physical ownership is not always either required or warranted!

But why develop a hybrid model rather than entirely moving towards a purely virtual setup? Keeping some hands-on capabilities in bulk operations is important so that companies may understand and thus manage vendors effectively. This way, they can ensure alignment while also understanding what does and does not make sense to produce in-house!

Applying such a tailored approa

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