Minding Your P's and Q's

Executives at major pharmaceutical companies are in the midst of an extended effort to drastically reduce costs in the face of dramatic revenue losses. Staff reductions and facility closings have grabbed the headlines, with sales forces and obsolete manufacturing operations taking the brunt of restructuring initiatives. Only the effort to rebuild new product pipelines through in-licensing and acquisitions has garnered so much industry attention in recent years.

Jim Miller

A major element of cost-reduction strategies has been increased sourcing from Asian countries, especially India and China. The appeal, of course, has been the perception that those countries offer abundant scientific talent and investment capital at much lower prices than equivalent human resources in North America and Western Europe. The major beneficiaries thus far have been contract research organizatons (CROs) providing labor-intensive drug discovery services and chemical manufacturers producing low-value intermediates and generic active pharmaceutical ingredients (APIs). Increasingly, however, higher-value activities are migrating offshore, especially in the areas of clinical research, data management, and custom chemical manufacturing.

Considerations

There are strong indications, however, that the terms of trade are becoming less favorable for the emerging Asian economies. Resource prices are rising rapidly across a number of fronts.

Labor rates. Overall labor rate inflation is hovering around 10% annually in India and China, and rates in the pharmaceutical sector appear to be growing even more rapidly. In India, while equipment operator wages remain less than 50% of equivalent labor rates in developed economies, salaries for degreed pharmaceutical professionals in such areas as quality assurance and analytical chemistry reportedly are now equal to those paid in the United States. In China, the heavy dependence on scientists returning from the US and Europe is raising the price of senior scientific knowhow. Further, the New York Times recently reported that the Chinese government is pressuring major employers to allow employees to join the state-approved labor union, which is pushing for better salaries, benefits, and working conditions.

Environmental costs. The avoidance of environmental standards and regulations, which can help lower costs, has long been a dirty secret of outsourcing to India and China. However, the Chinese government appears to be cracking down on major water and air polluters. Word throughout industry is that many companies forced to shut down for the Beijing Olympics may not be allowed to reopen. Chemical firms' pollution mitigation efforts are raising costs, and the reduced number of vendors may be raising prices.

Shipping costs. Rising energy costs and constraints on shipping infrastructure are driving up shipping costs dramatically. According to a report from CIBC World Markets, cited by McKinsey & Company in an August report on the global supply chain, shipping costs from Asia have nearly quadrupled. Where shipping costs from China once added 3% to the cost of a product ex-factory, they now add 11%, according to CIBC.

Quality costs. Naturally, the concerns over product quality from China in the past year have increased the amount of supply-chain due diligence by pharmaceutical companies. Companies are realizing they must audit not only their immediate source of supply, but also the companies farther back in the supply chain that are providing the raw materials to their suppliers. Additional audits are raising the cost of sourcing from emerging markets, especially for companies that don't have sourcing infrastructure established in those regions.

The net result of these changing resource price dynamics is that the resource price advantage of outsourcing to emerging markets (at least to India and China) is eroding rapidly. Major pharmaceutical companies will continue to seek offshore sourcing opportunities, partly because they are committed to emerging markets for top-line growth, and partly because they are slow to realize that emerging markets no longer provide automatic cost savings. But as Lonza's CEO noted in his 2008 mid-year financial review, the "club" of offshore sourcing that major pharmaceutical companies have used to get better pricing from suppliers is much "softer" than it was a year ago.

P's and Q's

If the "low-hanging fruit" of plant closings, sales-force reductions, and Asia sourcing have been harvested, where can pharmaceutical companies turn to reduce costs? Pharmaceutical executives will do well to remember that costs are driven by two factors: the amount of resources being used and the price of those resources. In other words:

Cost = (Q)uantity × (P)rice

Plant closings and sales-force reductions have been obvious opportunities to reduce the Q, but future cuts will start getting closer to the bone. Companies will have to take a closer look at their research and development operations, despite their critical role in revitalizing pipelines. These new efforts are widening the view to see what is being done and who is doing it. One consequence, undoubtedly, will be a continued growth in the volume of activity being outsourced to both CROs and contract manufacturing organizatons (CMOs).

As I noted last month, industry is starting to see some examples of extreme outsourcing initiatives such as Eli Lilly (Indianapolis) outsourcing most of its animal toxicology to Covance (Princeton), and Novartis (Basel, Switzerland) outsourcing its biologics development to Lonza (Basel). Because of their business model, CROs and CMOs have an incentive to manage the quantity of resources used to earn profits. These organizatons are more effective than pharmaceutical companies at managing the Q side of the cost equation, and have been early adopters of resource-saving innovations such as electronic data capture.

A more profound change will come, however, as major pharmaceutical companies rethink their entire drug development model, especially with regard to the amount of work they undertake during each stage of drug development. A prime example of this model change is industry's focus on achieving "proof-of-concept" before investing substantial resources in a new drug candidate.

However, achieving significant cost savings will require a major rethink of the early development model in particular. In an eye-opening article in the March 2008 Harvard Business Review, the founders of Lilly's Chorus virtual drug-development initiative argue that getting to proof-of-concept involves asking a very different set of questions from those asked when moving a drug to commercialization. As they note, early development is about "seeking truth" not about "seeking success," and should be conducted through a series of short, targeted experiments aimed at discovering the "intrinsic attributes" of the candidate. The authors claim this approach has helped reduce early development times by half and early development costs by two-thirds.

Heavy-handed tactics have enabled major pharmaceutical companies to achieve a first tranche of cost reductions. But deeper cuts are needed, and the next round will require much more innovative thinking to determine how to drive down the amount of resources used in drug development.

Jim Miller is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.383.4903, fax 703.383.4905, info@pharmsource.comwww.pharmsource.com.