Pharmaceutical industry

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ABSTRACT

Pharmaceutical industry is constantly undergoing a change. In the past pharmaceuticals had a different strategy, companies use to build all the products internally and confine access to information or resources to third parties. The past situation is changing.

Outsourcing -

the current mantra of pharmaceutical industry. It is being used more strategically as an ongoing part of a company's overall business strategy. Outsourced activities can be in various fields' right from the drug discovery till manufacturing of the products. Pharmaceutical firms have long outsourced functions such as manufacturing, packaging, clinical trials.

This report starts with the declining trend of R&D productivity. It focuses on providing outsourcing as a solution for the declining productivity. The three drivers: Transaction cost economy, Resources based view and Institutional theory provides theoretical perspective in relation with a pharmaceutical company.

This report will address critical issues, theoretical perspective, conclusion and a future outlook for Pharmaceutical companies.

INTRODUCTION

Pharmaceutical industry has been one of the most profitable industries in the past with a high rate of financial performance and value creation. If we look into the mid 80s and 90s we will get to know that the pharmaceutical sector had certain differentiating features from the rest of the industries. One of the distinguishing features was generation of the high revenues from the sale of blockbuster drugs. These drugs were secured by patents and thus a pharmaceutical company had to counter only monopolistic competition for such a drug. As the pharmaceutical companies had high profit margins, it became an attractive sector for the investors with very low stock volatility. The annual growth return of the industry has been around 9 to 11% in the recent years. The core operations of pharmaceutical companies were Research and Development (R&D) and Sales & Marketing. Most of these operations were carried by companies in-house. The pharmaceutical companies invested heavily in R&D in the hope that this investment will translate into new drugs. The cost of R&D is so high that the companies did not give any importance to internal efficiencies with respect to cost.

Most of the pharmaceutical operations of clinical research, R&D etc were done in developed countries like USA and western European nations as the facilities for carrying out such operations were situated there only.

Leaders to Laggards

But now the scenario has changed in recent years. From December 2000 to February 2008 the top 15 companies in the industry lost roughly $850 billion in shareholder value, and the price of their shares fell from 32 times earnings, on average, to 13 (Garnier, 2008). Even though pharmaceutical industry has an impressive growth background but the current market is showing a steep downturn in shareholder's return. The average annual return to the shareholders which was 20.3% during 1985-2000 has declined drastically to all time low -0.7% during 2001-2007 (Garnier, 2008). The main reasons for industries plight are

* The average time from drug discovery phase to approval has increased over the years. The Tufts Centre for the Study of Drug Development estimates that the average time for a drug to progress from preclinical trials through to approval has risen from 11.6 years in the 1970s through to 14.9 years in 2001. The increased time to roll out a new drug has direct implications on the revenues as each day lost counts lost sales

* The increase complexity of regulatory submissions and clinical trials has led to an increased expenditure on research and development process.

* Expiry of the patents for vital ‘blockbuster' drugs.

Earlier whenever a new drug was launched, it was protected by patents. But after 10-12 years, when the patents expire it lead to the entry of low priced generics which consequently wiped out the revenues of blockbuster drugs in a matter of few weeks. Of the 44 products generating blockbuster sales in 2000, 33 will lose patent protection in the US before 2007, exposing approximately $45.5bn of US ethical revenues to generic competition. Globally, patents protecting 80% of blockbusters in 2000 will expire by 2007, freeing up $67bn to generic erosion (Steve Birch, 2006). Thus there was an increased pressure on pharmaceutical companies to launch new products which in turn led to increase in the cost of R&D. However the desired productivity in the pharmaceutical companies did not show any significant increase. Although the industry's collective investment in R&D from 1980 to 2006 mushroomed from $2 billion to $43 billion, the number of drugs approved by FDA was roughly the same (Garnier, 2006). Also the pharmaceutical industry's profitable heritage provided no impetus to strictly manage company's internal efficiencies with respect to cost, unlike other sectors.

OUTSOURCING AS A SOLUTION

Karsten B. Olsen (2006) defines outsourcing as “the relocation of jobs and processes to external providers regardless of the provider's location”; he defined offshoring as “relocation of jobs and processes to any foreign country without distinguishing whether the provider is external or affiliated with the firm”.

With soaring costs of R&D and R&D capacity shortfalls, pharmaceutical companies eventually had to seek the help of Clinical Research Organisations (CRO's) as a mean of outsourcing clinical trials and R&D. A contract research organization (CRO) is any company to which a pharmaceutical or biotechnology company can outsource part or all of the processes involved in the development of a product from compound to market (Alison Sahoo, 2006).

CROs are emerging as the leading outsourcing partners of pharmaceutical companies. The CROs market has shown a tremendous growth from $2.2 billion in 1993 to $14 billion in 2006 (Sahoo.A, 2006). It has been estimated that pharmaceutical and biotech companies are now using CROs on more than 60% of their clinical projects and that the annual industry spend on contract clinical services rose to nearly US$10 billion in 2001 (Dr Faiz Kermani and Pietro Bonacossa, 2003).

They provide a wide range of R&D service for pharmaceutical and biotechnology companies. It includes Drug discovery services; Pre-clinical testing; Clinical trials management; Clinical management; Regulatory affairs advice; Health economics; Laboratory services; Biostatistical analysis; Clinical packaging; Biomanufacturing. The most common outsourced services are clinical monitoring for phase II-IV trials, clinical trial project management and data management. In recent years CROs have also started providing unusual services like drug discovery services, bio statistical analysis and pre clinical testing.

DRIVERS FOR R&D OUTSOURCING FROM THEORETICAL PERSPECTIVE

Research & development is an imperative function in pharmaceutical industry. The companies which perform successful R&D ensures that they have right systems at right place in order to achieve scientific breakthroughs along with right environment for innovative processes downstream to prosper. Gigantic costs and soaring risk rate makes the R&D process complex for the pharmaceutical companies who have to maintain a balance with market considerations. Therefore a company has to decide whether to perform the job In-house or to get it done from external efficient CROs. Thus in a nut shell it is the matter of seeking best science wherever it resides, inside or outside.

Following are key drivers of R&D Outsourcing

ü Cost pressure

ü Increased complexity of clinical trials and regulatory submission

ü Declining R&D productivity

ü Competitive pressure to bring new drugs

ü Rapid access to additional R&D technology/capacity

ü Reduced fixed costs required

In order to explain the drivers for R&D outsourcing three theories have been outlined namely

* Transaction Cost Economics

* Resource-based View

* Institutional Theory

TRANSACTION COST ECONOMICS

Transaction Cost Economics is proposed by Ronald Coase and further developed by Oliver Williamson. According to TCE, whether a firm produces an input for its production depends on the degree of uncertainty related to the input, the specificity of the input or its underlying asset(s), the frequency of interactions with the supplier, and the opportunistic tendencies of the supplier ( Coase, 1937; Williamson, 1975, 1985).

Coase recognizes the term “transaction costs” while studying why a firm does exist in his famous article ‘The Nature of Firm' in 1937. The cost element of a transaction includes the information costs, the costs of setting up an agreement and costs of maintaining it.

According to Williamson, the determinants of transaction costs are frequency, asset specificity, uncertainty, bounded rationality and opportunistic behaviour. According to Simon, bounded rationality refers to human behaviour that is “intended rational, but only limitedly so” ( Simon, 1961, p. xxiv). Opportunism is explained by Williamson (1975) as “strategic manipulation of information or misrepresentation of intentions”. Williamson found that asset specificity plays an important role in finalizing the transaction. Asset specificity refers to the amount of investment pertaining to a particular transaction, having a high value for this transaction and that could not be “redeployable” (Williamson, 1985) for another transaction. If a transaction require high investment in specific assets by the focal firm, it is less likely for it to outsource.

Therefore low asset specificity for pharmaceutical companies favours outsourcing and the long term cost saving become a key driver. For the pharmaceutical companies, using outsourcing can save long term expenses of establishing a comprehensive in-house infrastructure for pre-clinical and clinical trials which includes costs of human capital (doctors, analysts), extensive testing facilities and equipment and variable costs related to patient recruitment. Depending upon the size and scope of the facility, initial expenses to build such an infrastructure can range from $10m to more than $500m with annual maintenance costs of an additional $2m to $100m. Moreover, the pharmaceutical company must continue to maintain them regardless of their level of use. Using a CRO limits the fixed assets that a drug developer requires, directing financial resources only to the services that are required at the time.

On the CROs' side, however, asset specificity is high. To compensate this, short term R&D outsourcing expense can be extremely high. However, pharmaceutical companies can still achieve net advantage in the use of CRO because long term cost saving can outweigh such short term expenditure.

Also pharmaceutical R&D outsourcing is a bit controversial as there could be opportunistic behaviour on the side of supplier, because outsourcing R&D could lead to leakage of valuable information related to the company's core competencies. Therefore it advisable to pharmaceutical companies to follow a ‘networked' pharmaceutical model to face the longer-term challenges which states that major pharmaceutical companies, which currently operate approximately 80% of activities in-house, will eventually perform only 40% in-house. 60% of remaining activities will be conducted externally, via a carefully selected, risk managed portfolio of straight outsourcing arrangements and strategic alliances. As a result, pharmaceutical company normally outsources some mandate activities like clinical trials and data management while retain in-house more critical steps like drug discovery.

Another important aspect which gives rise to transaction costs is uncertainty. Uncertainty refers to the inability to foresee the eventualities that might occur during the course of the transaction. The main reason for this is the duration of time over which the transaction will take place. Technological uncertainty refers to unanticipated changes in circumstances surrounding technology, i.e., new generations of technology that render existing technology. Technological uncertainty may serve as an incentive to outsource because internalization often requires greater resource commitments. Bounded rationality and opportunism along with uncertainty creates difficulties and increases the costs in a transaction.

New drug requires new methods of delivery using technologies unfamiliar to the company.

The speed of development of new drug discovery technologies makes it much more difficult for pharmaceutical companies that are not already up to date with the newest drug discovery techniques to remain ahead of the field. Therefore, it is simpler and less risky for pharmaceutical companies to obtain the most advanced drug discovery expertise from outside organizations.

RESOURCE BASED VIEW

The Resource Based View is concerned with explaining how organisations strive to acquire a new combination of strategic resources and gain competitive advantage. These resources can be physical resources, human resources and organisational resources (Barney, 1991). In essence, RBV puts forward that competitive advantage is not a function of just opportunities in the external environment but also a function of which resources the firm can identify, develop, deploy, and protect (Barney, 1991; Penrose, 1959; Wernerfeldt, 1989). In the context of increasing global competitive pressure, companies are advised to concentrate on their core competencies and utilize outsourcing to capitalize on the expertise of others ( Domberger, 1998; Porter, 1990; Prahalad and Hamel, 1990)

According to Barney (1991), a resource with the potential to create competitive advantage must meet a number of criteria, including value, rarity, imitability and organization. For example a resource is unable to generate competitive advantage if it is easily imitated by the competitors. There is support that firms outsource non-strategic items when they believe suppliers have superior capabilities (Argyres, 1996).

Resource based view suggests that in order to develop strategy that provides competitive advantage, companies should focus on their core competencies and acquire complementary resources from outside specialised agencies, means of outsourcing to capitalize on the expertise of others.

Resource view based for a pharmaceutical company would be outsourcing non-core activities within R&D, i.e., clinical trials, while retaining core activities in-house, i.e. drug discovery. The CRO provide complimentary resources and services after the drug discovery process which is retained in-house by the Pharmaceutical companies. The core competency within R&D is drug discovery. The pharmaceutical companies can outsource their clinical trials to CROs. By doing this, a Pharmaceutical company can achieve competitive advantage by improving the efficiency of the overall R&D process and sharing risk of drug failures.

The core competencies and the limited internal resource and capabilities of a pharmaceutical company can be combined with the complimentary resource and capabilities of Contract research organization to produce benefits like time to market, coat reduction and risk sharing.

The relational view of risk sharing is that RBV emphasize strategic outsourcing. Being strategic means outsourcing should adopt a “relational view” - linkage with exchange partners. The Drivers reduce risk and achieve win-win situation

Risk sharing helps in establishing a successful and stable relationship. It helps to improve outsourcing process and internal resource planning. The overall business risks are reduced and there is minimum loss of intellectual property.

INSTITUTIONAL THEORY

Institutional theory provides a rich, complex view of organisations (Zucker, 1987). This theory states that organizational decision-making is influenced by normative pressures that arise from both external sources (i.e. government, industry alliance) and internal sources. These normative pressures and assumptions determine what constitutes appropriate or acceptable behaviour for the organisation (Oliver, 1997). Firms operating in a general environment are under pressure to behave in a similar way so as to gain legitimacy, resources and survival capabilities.

According to institutional theory there are both external sources like government polices competition, regulatory factors and social factors and internal sources. These decision to outsource to taken by keeping these factors in mind. A pharmaceutical company, using the institutional perspective, when undergoes outsourcing in an alien country faces threats from government, competition, regulatory factors. These factors may either help the firm in doing wee or fail in that market.

Outsourcing R&D by a Pharmaceutical company benefits in low cost and obtain greater flexibility. This results in competitive advantage. A company outsourcing its R&D waits for other firms to outsource so that it can look at their performance and take a decision whether to enter that particular market or not.

In the pharmaceutical industry, there are two kinds of pressure to outsource.

First of all, regulations require more clinical trials before a new drug can be forwarded to approval (it can be extended also). This increases the cost pressure. Secondly, if there are firms that already adopt R&D outsourcing and reap the benefit and thus gain an advantage. The other firms who follow feel the pressure. Otherwise, they might not be able to survive the competition.

Newcomers to R&D outsourcing face the following issues:

1. Operational Complexity:

The operational complexity of is primarily characterised by the uncertainty of the system.

2. Intellectual property protection:

There is risk of loss of intellectual property due to prevalent law related to protecting intellectual property The Pharmaceutical companies need to protect their patent rights.

3. Security issues

From the transactional cost point of view, these indicate high initial uncertainty. But still, many more Pharmaceutical firms are adopting outsourcing. That's because those early adopters have found means of overcoming or managing these issues and so as to gain benefit. As discussed in the resource based view, establishing a close relationship is the key. This creates pressure for the whole industry to increasingly outsource their R&D.

There are a number of benefits that a Pharmaceutical company can gain by taking an intuitional perspective. A firm can benefit by being a follower and waiting to see if other firms are successful in a given location. A firm can also adapt to pressures in order to gain power and control over the resources they need to be successful (Brito, 2001)

SUMMARIZING THE THREE THEORIES

Source: adapted from Tate et, al, 2009

The main insights from the theoretical lenses when all the three theories are applied together have been summarized in the figure above. When all the theories are applied together the company will simultaneously considers corporate image, external environment threats and opportunities, best governance structure, cost efficiency and supplier relations/employee retention.

FUTURE OUTLOOK & CONCLUSION

Though the concept of outsourcing R&D to Critical Research Organisations is relatively a young concept, just over 20 years, but in a very short span of time CROs have established themselves as an indispensible part of pharmaceutical industry. CROs now account for about 20% of the pharmaceutical and biotechnological R&D budget and the market for critical research services is still growing (Ed Tomlinson, 2002). The critical research market which was $9.3billion in 2001 is expected to grow up to $36 billion in 2015 with an average annual growth of 16.3% (Sahoo,A, 2006).

This growth in outsourcing is expected to continue because of increasing demand for access to modern R&D technologies such as genomics, high through put screening etc from big specialty pharmaceutical companies and lack of infrastructure in small pharma and biotech companies.

Although CRO market is establishing a strong foothold in pharmaceutical industry in a short span of time but still it is suffering from a few shortcomings like problems in evaluating and monitoring CROs performance, clash of cultures, lack of shared vision and objectives etc.

It's a great challenge to successfully manage the outsourcing relationship and generate value. Outsourcing allows pharma companies to exploit the potential of new drug discovery technologies. When pharma companies provide their core competencies and CRO's supply new innovate products, a relationship is built which helps in solving problems for pharma companies.

REFERENCES

Tate, W.L., Ellram, L.M, Bals, L and Hartmann, E. (2009). “Offshore outsourcing of services: an evolutionary perspective”, International journal of production economics. Vol.120. pp.521-524

Garnier, J. P. (2008), “Rebuilding the R&D Engine in Big Pharma”, Harvard Business Review.

Sahoo, A. (2006), Pharmaceutical outsourcing strategies. Business Insights.

Argyres, N., 1996. Evidence on the role of firm capabilities in vertical decisions. Strategic Management Journal 17 (2), 129-150.

Barney, J., 1991. Firm resources and sustained competitive advantage. Journal of Management 17 (1), 99-120.

Brito, C.M., 2001. Towards an institutional theory of the dynamics of industrial networks. Journal of Business and Industrial Marketing 16 (3), 150-166.

Domberger, S., 1998. The Contracting Organization: A Strategic Guide to Outsourcing. Oxford University Press, Oxford, UK.

Prahalad, C.K., Hamel, G., 1990. The core competence of the corporation. Harvard Business Review 68 (3), 79-91.

Zucker, L.G., 1987. Institutional theories of organization. Annual Review of Sociology 13 (1), 443-464.

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