What are pharma's core competencies?
Pharma has always been a highly profitable industry, and has historically been among the best performing industrial sectors in terms of investor returns.
But new price controls from payors, margin pressures and patent expiries are forcing companies to radically restructure in order to maintain their profitability.
What does all this mean for the industry's future? A lack of product innovation and increasing margin pressures have led pharma companies to reduce headcount, but how can they do this without damaging long-term company performance, and how can they mitigate against potential risks from their actions?
This article examines these issues using findings from Roland Berger's Pharma at the Crossroads, a global survey of the pharma industry's top executives.
Over the last 12 months, many pharma companies have announced headcount reductions that extend across all areas of the value chain. For example, Pfizer has announced reductions of 14,000 full time employees (FTEs) over the last two years, representing more than 16% of the workforce. Many other companies have followed suit.
These cuts are not limited to sales forces. GSK recently announced that it is looking to reduce its R&D staff by 850 full time employees (FTEs). Even biotechs are not immune: Amgen, one of the leading global biotech companies, recently announced cuts of up to 2400 people (mostly in the US), representing almost 14% of the workforce. So what is behind these headcount reductions?
The innovation problem
Major pharma companies are at risk of losing large parts of their revenues in the near future as many rely on products whose patents will expire within the next five years.
Companies with biological drugs don't face quite the same risk, since the production of 'biosimilar' rivals to biotech blockbusters is still in its infancy. So, while 35% of Roche's revenues are at risk within the next five years, almost all of the affected products are biologicals and the impact is likely to be much less severe than if they were small molecules.
All pharma leaders know that the only way to guarantee future sucess is bringing a promising pipeline to market, yet many companies are struggling with pipelines.
The two main sources of new products are in-house and external R&D, and the acquisition of approved products. For example, Pfizer significantly increased its portfolio through the acquisition of Warner-Lambert and Pharmacia in the early 2000s, and has now just sealed a similar deal to acquire Wyeth. This type of activity is likely to continue, as executives see the best opportunities for innovation to be through external sources: in-licensing projects, partnerships, and merger and acquisition activity.
Pharma is now re-engineering its R&D processes, and external partnerships are crucial to this. However, this is also causing problems. "The market for external innovation is becoming increasingly overcrowded," warned one senior executive. "I do not think the market is big enough to satisfy the demands of the industry." External collaboration allows companies to tap into other areas of innovation, such as mid to long-term academic partnerships. But the high price of many deals means senior managers say they need to retain their ability "to say no and walk away from opportunities".
The industry is also experiencing less favourable market conditions, with market access, pricing and reimbursement becoming increasingly difficult. Traditionally, bringing a drug to market required companies to pass three hurdles: safety, efficacy and quality. Now a fourth hurdle has come into play: cost-effectiveness. Today, most European countries evaluate cost-effectiveness of drugs according to their own methodologies and processes. As a result, companies must do more than simply generate demand for their products.
Cost-containment mechanisms are putting increasing pressure on prices. For example, the US is now experiencing pricing pressure, with net pricing being the dominant issue. The effects of this should not be underestimated - one study participant commented how "the net prices in the US, Thailand and South Korea are the same for our products".
Value chain restructuring
Typically, when the bottom line is under pressure, companies focus on their core competencies and review 'make or buy' decisions more stringently. The industry has been relatively conservative so far, with few companies taking serious steps towards value chain disaggregation. However, this could actually be the most appropriate way to fight declining margins. One senior executive commented: "The industry is too conservative. Research, clinical development, production, sales and distribution all provide further potential for outsourcing and thus cost-saving potential."
Value chain disaggregation starts with an assessment of the core competencies of a company. During the course of the study, respondents were asked to identify the top three core competencies of their company. While many respondents identify marketing and sales as core competencies, this is challenged by some top executives. Some believe they are focusing on the execution of established marketing processes rather than on the fulfilment of customer needs, while others believe the function no longer constitutes a core competency.
The concept of R&D as a core competency (43%) is also disputed. Some point out that, in the future, R&D will be the focus of deal making and therefore conducted externally. However, some senior executives feel in-house R&D remains the most economic way to achieve innovation in the long term, and that in-house projects can match the productivity of in-licensed projects. It should be noted that many corporations plan to conduct less research in-house, although they feel the need to maintain some in-house capabilities to ensure that external opportunities can be evaluated appropriately.
Furthermore, the relevance of outsourcing is becoming increasingly clear. While many companies embrace traditional outsourcing strategies (eg data management), more far-reaching strategies are already in use, providing a glimpse of a different future. For example, Lilly is transforming its integrated in-house R&D into a 'network structure' of outside contractors, service providers and others. In 2007 AstraZeneca announced it would outsource its entire drug manufacturing activities. This statement was later withdrawn, but nevertheless shows these activities are no longer considered a core competency.
Cost savings across the value chain
Executives were asked to identify other areas for cost-saving potential. Over one-third of senior executives attributed a cost-cutting potential of at least 5% to sales and marketing, while a quarter cite the potential to be higher than 10%.
Top executives also indicate that production, manufacturing, supply chain and logistics still offer significant cost-saving potential, particularly for small molecule drugs. Many respondents consider the capacity and supply chains to be 'idle' and 'inefficient' despite the large manufacturing margins made in the past. It is believed that a more focused product portfolio would enable firms to maintain even fewer but more efficient manufacturing sites.
In most areas of R&D, roughly one-fifth of respondents identify a cost-saving potential of at least 5%. However, this is not always associated with mere cuts. Many feel R&D needs to be more productive, but point out just how sensitive this is in terms of cutbacks. "While development projects are the easiest and fastest to shed, this can jeopardise the future of the entire company," commented one manager.
Corporations depend on the output to renew their manufacturing portfolios and will be particularly reliant on these over the course of the next five years. Emerging markets can provide cost-saving potential for clinical development, but this needs to be balanced by the continued demand for clinical data generated in Europe or the US.
To sum up, manufacturing and the distribution supply chain are considered major improvement opportunities, particularly compared to other industries under margin pressures. However, most managers associate marketing and sales with the largest short-term cost-cutting potential.
Risks of value chain restructuring
Value chain restructuring is not without risks. Firstly, consider the risks of not retaining R&D as a core competency. As we have already discussed, maintaining a strong product pipeline is essential for sustaining future revenue, so relying on external opportunities alone could be a risk for pharma companies. Secondly, outsourcing manufacturing may provide cost savings, but would put a high level of risk on quality control. Thirdly, outsourcing logistics or sales teams risks damaging long-term customer relationships.
Before competencies are lost from an organisation, pharma companies need to understand exactly what the risks are if things go wrong, and what they can do to mitigate against them.
The guiding principles for change
Four guiding principles will help executives reconfigure core competencies whilst preserving critical functions in-house.
1. Differentiate decision-making from executive activities
Executives need to maximise the creation of value through decision-making whilst limiting the in-house execution of labour and/or capital intensive tasks. For example, focus on clinical trial design rather than clinical trial quality monitoring.
2. Excellence in all in-house activities
Companies must look to be superior or best in class in all in-house activities through continuous benchmarking to ensure operational excellence.
3. Retain activities with strategic long-term implications on the profit pool
Experience from other industries shows that the increasing power of suppliers and scarce resources could lead to a redistribution of the profit pool. A potential example could be biologicals production, given their increasing proportion of drug approvals.
4. Investigate activities with regard to their relevance for focused franchise strategies
Typical examples include commercial activities like key account management for customers such as pharmacy chains and hospital groups.
The industry in a state of flux, and needs pharma companies need to think ahead more than ever. It is still unclear whether the pharmaceutical operating model is broken, but one thing is certain, the industry cannot afford the cost-intensive in-house structures it has built along the entire value chain.
Looking ahead, pharma executives need to go back to basics and ask again the fundamental questions: What are our core competencies? How can we optimise our value chain? Do we need to reconsider our traditional approach?
While many executives claim that "pharma is different from other industries," this cannot explain the huge difference in the degree of integration along its value chain. This can only be explained by the level of profit the industry was able to make in the past, rather than what it can achieve in the future.
David Stern is managing partner and Sophie Lamle is a senior consultant in Roland Berger's London office. Aleksandar Ruzicic is a principal at the Zurich office of Roland Berger Strategy Consultants. For more information visit: www.rolandberger.com