Features

Creating Value Through Effective Drug Substance Sourcing

How Emerging Pharma can build value

August 23, 2005

Arthur D. Little

I would like to discuss how drug substance sourcing can be leveraged for a competitive edge. Such leverage can provide companies with a “broad stroke” overview of the ap-proaches followed in the industry. I shall also highlight the challenges and some of the commonly observed pitfalls. But before entering into the depth of the subject, it may be useful to take a step back and have a look to the situation facing the pharmaceutical industry at large.

The challenge in pharma is well known: R&D expenditures have escalated during the past few years and now account for more than 15% of total pharma industry sales. However, despite these increasing outlays and the investments undertaken in new forefront technologies—such as genomics, rational drug design and high throughput screening, to name just a few—the number of new molecular entities reaching the market has been stable at best, if not declining. The past two years (2001-2) have been a drought for the industry!

This dearth of NMEs has combined with other factors to create a challenging environment. These factors include:

The imminent patent expiry for several top-selling products. For the period from 2002-2007, drugs accounting for approximately 20-25% of total pharmaceutical sales will become targets for generics, potentially leading to catastrophic losses in turnover for innovators;
The increasing cost containment measures imposed by governments and private insurers all around the world; and
Some high-profile operational problems.

These factors are translating into more and more pressures facing pharmaceutical companies. Big Pharma is also under constant strain to keep its earnings momentum, or face a sector re-rating by financial markets. This would lead (and has led) to melting share prices!

Going back to the issue of pharma R&D productivity, a brief analysis shows that, over the past few years, speed and time-to-market have been the main rallying themes in drug development. In fact, the industry has succeeded in reducing time-to-market by around one-third in the last decade. See Figure 1 for a more detailed illustration of this.

This remarkable result has been achieved through various avenues, including:

Technological advances such as high throughput screening;
Widespread use of information technology;
Improved focus on project management; and
Undertaking parallel rather than sequential activities.

Yet it is important to note that decay rates and attrition in new product development have apparently deteriorated during the past 10 years (See Figure 2). This reflects a number of factors, including:

more careful R&D portfolio management, particularly following the wave of mergers that have occurred over the past couple of years; and
the increasing role of Emerging Pharma, following more aggressive (and hence intrinsically more risky) development targets and approaches.

All in all, this also means that outlays and investments re-quired to bring new products to the market are continuing to escalate, despite the prom-ises associated with new technologies. How can this be explained?

The most important thing to keep in mind is the extreme complexity of developing a new pharmaceutical product. See Figure 3 to get an idea of just how complicated a process it all is.

Developing a new drug is probably one of the most complex processes invented by man. It involves undertaking a myriad of activities, some in parallel, other sequentially, with a proliferation of key decision points. In fact, the complexity of new drug development has no parallel . . . except perhaps in the aerospace industry!

In light of this—and without being facetious—the popular expression “rocket science”, currently used to designate something extremely complex, and barely achievable by common persons or unsophisticated organizations, could well be replaced by “pharmaceutical science”!

But how does this pertain to my subject—namely the access to the drug substance and its impact on gaining a competitive edge in pharmaceuticals?

Accessing Substance
Effective access to the drug substance is of paramount importance at all stages of the product lifecycle. In the product development phase, having an effective access to the drug substance often plays a decisive role in time-to-market, particularly given the combination of compressed development cycles and increasing complexity of the NCEs being developed. Some industry observers have stated, “Everything simple in small molecules has already been developed!”

Similarly, in the launch phase, where the exact timing as well as the volumes required are still unclear, access to the drug substance can play a make-or-break role. Clearly, none of us wants to lose a single cent of revenues because of inadequate bulk availability.

In this respect, an interesting example is represented by Enbrel of Immunex (a large molecule drug), when bottlenecks in the production of the drug substance resulted in a major revenue shortfall. The product was put on an allocation scheme given a restricted supply availability.

Sunset
In the later stages of the product life cycle, effective access to the drug substance can often play a critical role in ensuring a competitive cost-of-goods sold, as an example against “me-too,” second generation products or generics.

While cost-of-goods considerations are increasingly important in the maturity and sunset phases of the product life cycle, it would be wrong to ignore their importance also in the earlier phases, given the combination of:

pressures on feasible unit prices at the dosage form level; and
escalating molecular complexity.

The cost of the drug substance increasingly represents a make-or-break factor in the development of new drugs; as a rule of thumb, the impact of bulk in a new drug has to be below 20% of ex-manufacturer unit prices to be worth developing further!

Another consideration associated with the access to the drug substance is the contributions it can play in effectively extending the period of market exclusivity. For example, some companies achieve this by developing new patented processes or finding other stumbling blocks to hinder generic competition!

But what is the typical impact of drug substance accessibility for an average integrated pharmaceutical company?

As suggested by Dupont’s analysis of the financial performance drivers (see Figure 4), access to the drug substance plays substantial roles at two levels:

On the overall return-on-sales, the cost of the active substance is on average estimated at 10% of total sales. Such a figure obviously varies widely depending on the product, its dosage, molecular structure and position on the life cycle; and
At the asset base level (primary manufacturing including plants, pilots), it accounts for around 30% of all fixed assets.

The latter is certainly not a negligible figure; these assets are freezing substantial amounts of capital and hence involve rather significant financing costs, particularly if one takes into account the true cost of capital to pharmaceutical companies!

But why is there such a substantial asset base? Simply because, until recently, most pharmaceutical companies have been glad to invest in an extensive number of plants—often too small to be operated efficiently—due to considerations such as market access or tax optimization!

Strategies
What then are the attributes expected from the ideal strategy for accessing the drug substance? Developing the ideal strategy for accessing drug substance represents a very difficult exercise. It involves finding a subtle equilibrium between various factors, some of which appear to be in opposition to each other. These include:

Securing a timely access to the product;
Ensuring security of supply and product availability;
Maintaining absolute control on quality;
Creating flexibility in the overall supply chain setup (to meet unforeseen demand peaks, for example);
Establishing barriers against competition;
Striving for optimal unit costs to ensure competitiveness;
Guaranteeing an efficient use of capital (avoiding building a massive asset base that will eventually represent a burden on Return on Capital!);
Making sure that tax optimization strategies can still be applied or that market access in certain regions— like France, the UK or Asia—is not jeopardized because of the absence of a local manufacturing base or local content!

Obviously, finding such a “happy medium” and addressing the conflicting agendas and expectations of the various stakeholders can represent a major challenge. Indeed, it is typical of one’s marketing department to ex-pect to have immediate access to un-limited product stocks, given its notorious inability in coming up with accurate demand forecasts! At the same time, the finance people do not want capital expenditure (capex) in production assets to exceed depreciation, while asking that all degrees of freedom associated with transfer pricing and tax optimization among various countries can be effectively leveraged.

Not surprisingly, the quality department wants to have access to the most modern production facilities. This is reflected in the design principles applied by the engineering department, which often cannot conceive of settling for anything less than perfection.

Senior managers often prefer to have little to do with the access to the drug substance—a rather different world from what they are used to—starting from the unit of measure applied, namely kg or lbs., as opposed to dollars or the number of dosage forms.

In-House Concerns
But how has the industry fared in terms of access to the drug substance and how have the strategies applied been able to meet the various attributes? Traditionally, the emphasis of integrated pharma has been to maintain extensive in-house synthesis capabilities, based on market access and tax optimization considerations.

Within this framework, effective capacity utilization and capex efficiency considerations rarely represented a main issue. They were often overruled by other factors, such as security of supply or control of technology. However, as suggested by the various arrows on the spiderweb represented in Figure 5, increasing attention is given to elements such as flexibility, capex and cost effectiveness, as well as barriers against competition through effective life cycle management. Tax optimization considerations are being reassessed somewhat.

Generic Developments
At the other extreme, generic marketers are following quite different approaches. With the salient exception of Teva, most, if not all, generic companies have no in-house bulk production capabilities. They outsource the entirety of their drug substance requirements.

Such a setup is dictated mainly by the ready availability of most off-patent drug substances they need on the merchant market. Other considerations, including flexibility and cost effectiveness—generic marketers typically carry extremely broad and diversified product lines often characterized by short life cycles—make in-house drug substance production both unpractical and often uncompetitive for these firms. See Figure 6 for an illustration of the concerns of generic marketers.

However, it is interesting to note that several generic marketers are reviewing their access to drug substance in the quest of creating some form of competitive edge. Some are establishing privileged links with suppliers, for example. Against this background, a number of factors are impacting access to the drug substance. These include:

Escalating technology complexity leading together with tighter operating and regulatory constraints to surging capex requirements; and
Increasingly hostile public attitude against chemical-related operations as typified by the widespread NIMBY (Not In My BackYard!) and BANANA (Build Absolutely Nothing Anymore Nor Anywhere!) syndromes.

This is coupled with limited senior management support. This group is often not only uninterested, but also reluctant to invest into expensive assets, particularly when some analysts suggest that funds could be allocated to more productive activities!

All these elements are further compounded by the increasing pressures on prices, as well as the harsher competitive environment, facing the pharmaceutical industry. So it comes as no surprise in such a context that pharmaceutical companies are proactively reassessing their strategies in terms of access to drug substance.

Best In Show
Some “best in class” practices are emerging under this new model, a focus on closer coordination of the entire supply chain as opposed to delegation. Until recently, the various national subsidiaries of Pharma companies led to a less-than-holistic view on the supply chain. The new approach starts from process development up to the supply of the packaged dosage form.

Also, companies are relentlessly pursuing optimization initiatives and monitoring performance; they are following implementable action programs by:

Identifying tangible key performance indicators and applying these consistently;
Monitoring performance according to these indicators;
Measuring against targets; and
Applying feedback to improve performance

At the same time, they plan for optimal flexibility and must try to avoid falling into frozen mental models. To that end, they are not hesitating to review:

Processes applied;
Targets realistically achievable; and
“Cannot-do” attitudes.

This all points to a move toward strategic sourcing, as opposed to full backward integration or virtual operations as originally envisaged in the mid-1990s. In addition, companies are forging closer links with an evolving core list of preselected vendors. This is a shift away from the traditional “you-against-me” approaches or the strategic partnerships considered by some industry majors (like SmithKline Beecham) a few years ago. They are also investing in selected chemical synthesis facilities, including flexible pilot units and multipurpose plants to be used as launch platforms. At the same time, they are restructuring the asset base by divesting or closing non-strategic assets.

The idea advocated in the mid-1990s, calling for full outsourcing and a move towards virtual operations, where pharma companies would fully delegate their chemical production to a vendor, has largely failed to materialize—at least for the time being. This is due to a number of practical considerations, as well as frozen mental models on issues such as technology ownership and control of product quality.

Similarly, the model of full vertical integration so popular in the 1980s, where the pharma company sources on the open market only simple standard intermediates, performing all synthesis processes in-house, appears to be obsolete, given the imperatives set by Economic Value Created used as metrics by senior management, as well as simply common sense. Indeed, why perform all chemistries in-house when third-party vendors can do it more effectively?

Rather, most pharmaceutical companies are now skillfully combining in-house production with outsourcing from third-party vendors—companies systematically formulate “make-or-buy” decisions based on a number of factors (see Figure 7). These include:

Product types and position in the life cycle;
Technology involved;
Investment requirements and EVA considerations;
Availability of third-party suppliers; and
Tax optimization issues.

Interesting to note, most pharmaceutical companies outsource for NCEs mainly n-x intermediates, as opposed to the full API. The outsourcing of the finished molecule is usually considered only in the maturity or sunset phases, mainly for technology ownership and tax optimization considerations.

Few companies have explicit sourcing strategies—Wyeth being a salient exception. In most companies, outsourcing is driven by short-term tactical considerations—including the availability of in-house excess capacity—as is unfortunately the case for several industry majors today!

Vendor Relations
In parallel with this increasing emphasis on strategic sourcing, pharmaceutical companies are reassessing their mode of interaction with vendors. See Figure 8 for a description of these various models.

The antagonistic model is increasingly viewed as an obstacle to the imperative to compress lead times and the trend to go beyond the outsourcing of just basic intermediates, given the hurdles associated with qualifying suppliers.

At the other end of the spectrum, the strategic partnership model, with the emergence (as in the automotive industry) of Tier-1 suppliers providing ready-to-use full components to the customer and managing discrete chunks of its supply chain (as originally envisaged by some pharmaceutical companies in the mid 1990s as a logical corollary of virtual operations) also appears to have fallen out of fashion. Companies like SmithKline Beecham eventually moved out of it after it failed to meet their value expectations.

Today, the à-la-carte model—where pharmaceutical companies draw from a short list of “core-prequalified” vendors selected on a project by project basis—appears to be more robust and most suited to meet the quest for value and expectations of excellence vested by pharma companies in their vendors.

Another important trend among large pharma is to reconfigure their chemical production assets. A consistent vision appears to emerge for these assets when companies invest heavily in the following areas:

Process develop capacity including state-of-the-art pilot units designed as small replicas of the launch plants (some do not hesitate to allocate 5% of their yearly R&D budget to process development); and
Modern launch units designed for optimal flexibility.

Located close to the development center, the mission of these units is to handle the product in Phase III and the launch phase. The idea is that they will eventually transfer the molecule to a dedicated plant once volumes pick up; the underlying concept is speeding time-to-market by optimizing the overall technology transfer process.

These launch facilities are complemented by some dedicated, larger scale units located in tax havens. Parallel to these investments, peripheral plants are being divested. A web of cooperation agreements with selected third-party vendors is often established in the process.

Emerging Pharma
How can these considerations be of value or even simply be of interest to us, Emerging Pharma companies?

The implications may be far-reaching! For Emerging Pharma, effective access to the drug substance is of outmost importance, as it is to their large Pharma counterparts!

In fact, effective access to bulk is probably one of the most critical elements for Emerging Pharma to eventually capitalize on its innovation track record. Emerging Pharma has to rely extensively on outsourcing for several tasks and processes associated with drug development. The reasons are simple: most companies falling in this segment do not have the resources nor the intention to develop all the capabilities of an integrated Pharma player. Otherwise they would lose some of their key sources of competitive advantage: reactivity and agility!

However, for Emerging Pharma to be successful, it is imperative to effectively manage outsourcing, including particularly for the drug substance. They must make sure of several things:

The best vendor is actually retained for any given activity and task!

Value for money is clearly achieved: be careful to note that this parameter does not necessarily go in parallel with the lowest price offer!

The deliverables provided by the various vendors are fully compatible and meet the expected deliverables on:

Time
Budget
Quality!

This is particularly critical for having effective access to the drug substance, as the penalties for failure can be daunting. There are, one should note, many opportunities for failure. Just think about the number of interfaces and transfers involved between process research or route design, process development and scaling up, not to mention ultimately full-scale production!

Can you imagine the consequences of an amateurish approach to outsourcing? For example, try subdividing the tasks between some poorly selected vendors chosen based on the apparent lowest price offer?

Do not even think about what could (or rather, will) go wrong. Think also in terms of incompatibility between the inputs provided by the various vendors and the inevitable “their fault, not ours” disputes that will emerge when the focus will be on CYA rather than finding productive solutions!

For start-ups, it is important to learn from best industry practices that managing access to the drug substance leads to competitive edge.

Some elements are worth remembering. They tend to be deceptively simple, deriving from common sense, not rocket science (oops: “Pharma science”!):

Set clear objectives in your drug substance sourcing strategies, avoiding hidden agendas and articulating clear and measurable key performance indicators;
Go beyond just unit cost considerations when selecting your vendors: a full-time equivalent rate of $50,000/yr./person may look attractive compared to the $250,000/yr./person applied on a routine basis by best in class competitors. But what about value delivered and possible waste of time?
Avoid applying standard solutions or one-size-fits-it-all recipes. Rather, go beyond static mental models, listening and learning to new ideas and concepts—including those of your suppliers. (For example, you may insist on having your product synthesized in a fully segregated bay environment with pyrogen-free water, but this may not be necessary. In this case, a competent quality manager within the vendor organization may well propose to you a more cost-effective solution that you may want to take into consideration!)
Most importantly, be extremely selective in the selection of the vendors you are dealing with. In addition to technical competence, “soft elements” such as empathy and ability to interact productively between the staff of the two organizations is of paramount importance to avoid frustrations and loss of time. But once you have selected the right partner, it is important to stick to him and treat him with fairness: avoid falling into the “them-against-us” syndrome!

Very often, pharma companies attempt to pass the burden to their vendors, applying price leverage or continually raising their demands. However, this represents only a quick fix, particularly as the dynamics of drug substance production are very different from those of automotive components.

Rather, it is important that the vendor also achieves a fair return on his investments and is able to predict his revenue stream with a certain level of certainty. After all, we are all in the same boat and your successes are also your vendors’ successes (and vice-versa)!