Core Vs. Non-Core Framework

How to combat cost structures in R&D

By Neil MacAllister, Richard Evans, and Katherine Wallace

Across the pharmaceutical industry, dramatic and durable changes to the operating environment are calling for modifications to companies’ strategies and structures. The industry is facing a period of eroding pricing power, falling growth in the consumption of branded drugs, and tighter regulatory standards. As a consequence, companies are finding that revenue growth is becoming both slower and more volatile, and that returns on R&D spending are pushing below the cost of capital. We recommend changes to the current business model that include smaller, more efficient and more flexible cost structures, as well as the increase of efforts to mitigate revenue volatility. Our aim in this article is to apply an analytical framework for how to think about an evolving business model for pharmaceutical companies.

The pharmaceutical industry is operating within an increasingly unfavorable political, economic, and regulatory environment, largely as a result of negative public opinion, rising healthcare costs, and increasing involvement from governments in the purchase, reimbursement and market approval of pharmaceuticals. These pressures are being brought to bear on an industry whose structures reflect past rather than present and future conditions, particularly with costs that are both too high and too inflexible.

To estimate profitability over long time cycles, we compared year one R&D spending to year 10 net income, a rate of return that has been falling for as long as we can measure. Apparent returns are no longer higher than the industry’s cost of capital. Profits must exceed costs of capital for a business to remain viable. In pharma, this gap can be widened by either increasing the revenue return generated by each dollar spent on R&D or by reducing the cost of commercializing the industry’s innovations.

We also see revenue growth slowing and becoming more volatile, consisting of interspersed periods of growth and contraction. As real pricing power and per-capita branded volume effects fade, revenue growth slows. Historically, real pricing power and per-capita volume growth made steady, predictable contributions to total revenue growth and more pricing power could be applied when needed to stabilize growth; as they fade, revenue growth defaults to — or at least toward — the remaining variables: population growth and product mix. Population growth is too small to matter, leaving mix as the dominant variable. Product mix is extremely volatile from period to period, consisting of significant gains (i.e. new products) and significant losses (i.e. patent expiry) interspersed at uneven intervals. Absent the buffers of real pricing and per-capita volume gains, it follows that future revenue patterns contain both ups and downs; unless cost structures become more flexible, periods of revenue contraction will result in outright earnings losses.

Based upon statistics from our Large Cap Pharmaceutical Performance Outlook (LCPPO) – Replacement Ratio Report, the large cap pharmaceutical peer group has a replacement ratio of 0.69 from 2005-2008E and 0.37 from 2009E-2012E. This ratio is a measurement of how quickly a pharmaceutical company is replacing its lost sales with sales from new products; a ratio of 1.0 means that all lost sales are replaced with sales from new products.

These revenue patterns suggest two changes for strategy and structure: either cost structures must be more flexible or revenue volatility must be reduced. Irrespective of whether revenue volatility is effectively dealt with, cost structures must be smaller as a percent of sales in order to correct the imbalance between costs of capital and associated returns.

Core Vs. Non-Core Concept

Due to a steady decline in R&D productivity coupled with a corresponding increase in R&D expenditures, AVOS has examined the discovery and development phases of the product lifecycle in order to determine differing ways to combat the inflexible cost structures and revenue volatility facing large cap pharma companies.

Determining which portions of a company are essential and must be kept in-house (core) and which can be carried out externally through partnerships and outsourcing (non-core) allows companies to begin the process of minimizing cost structures. The core vs. non-core distinction can be made by balancing two main considerations: competitive differentiation and availability of world-class sourcing options.

Competitive differentiation must consider whether ownership or control of the activity is important for competitive and/or strategic reasons, and whether or not the company is able to perform the activities at such a level that it provides them with a point of differentiation against their competitors. The availability of sourcing options needs to examine whether or not there are ample vendors performing the activity that can deliver world-class quality at a cost-effective price.

Core activities

• Enable the overarching business strategy
• Are key components of the company’s value proposition
• Are a major source of durable competitive advantage (e.g., intellectual capital)
• Protect intellectual property
• Have internal capabilities that cannot be matched or exceeded by outside vendors or other partners

Non-core activities

• Can be pushed outside of pharma to improve flexibility within cost structure
• Are general “supportive” activities to the pharma value proposition
• Can be conducted by third parties and match or exceed internal quality/economics

Determining core and non-core activities for your company will depend upon the benefits of outsourcing or partnerships versus keeping the function in-house and the strategic importance of the function relative to your company. The importance and value of these two dimensions will differ depending upon the product stage. For example, elements of screening in discovery that have low risk of IP exposure may be considered non-core, while aspects of lead optimization in development involving high risks of IP exposure are likely to be considered core activities.

We have broken R&D down into four phases: basic research, discovery, preclinical, and development. By examining the key activities within each of these phases, a core or non-core determination can be made based on the strategic context underlying each element. In some cases the activity may be “on the fence” – this simply means that the determination will vary for each company depending on their internal capabilities, capacity, and strategic direction.

Basic Research

Basic research functions are core only if they provide a point of differentiation for the company. For example, in therapeutic areas in which very few companies are working on a limited number of mechanisms, target identification and validation activities may be a point of differentiation. Beyond this, the activities are thought to be non-core. In therapeutic areas with multiple mechanisms and multiple companies competing, it is likely in the best interest for the company to change their orientation to search for and evaluate targets rather than to generate IP. Basic research around different mechanisms may be found within academia, but increasingly commercial organizations are developing platforms necessary to conduct these activities – providing a variety of capable vendors and partners.

Discovery

Discovery efforts should be considered for outsourcing because they are easily systematized and — in some instances — are automated. For companies that have already built discovery capabilities in-house — e.g., high through-put screening — the cost effectiveness and quality standards must be evaluated against outsourcing options.

Preclinical

Preclinical activities are increasingly being outsourced in order to take advantage of specialist modeling capabilities. Assembly of the information gathered in preclinical development will remain in-house, while the actual generation of perspectives will move to outsourcing. The vendor environment for preclinical work, particularly in specialty areas, is maturing quickly, allowing pharmaceutical companies to tap into new efficiencies by outsourcing in these areas.

Development

In clinical development, strategy, development plans, and management functions should always be kept in-house. In all development activities, consideration should be given to two rules: the protection of critical relationships and the active management of the outsourcing. Another factor that influences outsourcing in development is the philosophy of the company. This should be considered when examining “on the fence” activities; some companies may view certain activities as generic skills where others see a core strategic advantage.

Outsourcing Approaches

Once the core vs. non-core determination has been made, companies must assess the optimal outsourcing approach for non-core activities. We have divided outsourcing approaches into two categories, functional and integrated, based on the degree of integration necessary between the sponsor and the vendor. As a general rule, if a core activity must be outsourced for some reason, integration with vendors is essential. For non-core activities, a functional approach is usually best.

Integrated outsourcing arrangements would focus on accelerated decision making and minimizing time to proof of concept. Vendors would work with integrated workflows and pre-established standard operating procedures (SOPs), with IT decision support. In many cases, integrated outsourcing calls for a component of risk sharing in the compound’s success, and an economic model should be established in which there is an emphasis on quality, not quantity, and it is in the interest of the vendor to “kill” compounds as soon as they begin showing unfavorable results.

Functional outsourcing arrangements are designed for those activities that are generic and can be systematized, typically non-core activities. In this relationship, outsourcing should be managed through unit cost payment (fee-for-service), using self-contained SOP workflows engineered by the vendors to minimize time and cost. Operational management should remain in the hands of the service provider/vendor.

Case Studies and Examples

1) Wyeth and Accenture – Data Management

Clinical data management has been one area of development activity that is routinely outsourced and has been increasingly off-shored. As a very basic example of the application of the core/non-core decision process, we have used the example of the partnership between Accenture and Wyeth to illustrate the use of our framework.

To begin, from the company perspective, data management is not a differentiating activity. It does not provide a point of competitive advantage over a competitor, and it is unlikely that any one company possesses a leadership position in this area. As a result, in outsourcing there is very little executional or IP risk associated with outsourcing data management. In terms of capacity, many companies have been moving away from holding data management capabilities in-house over the last decade, so many may not even have internal resources. Additionally, there are no key relationships associated with the data management function. From a company situation standpoint, all variables point toward data management being a non-core activity.

The vendor situation for data management points toward the same conclusion. Sophisticated vendor environments already exist for conducting data management, particularly in off-shore communities. Because of the ample supply of vendors, quality standards are high and generally well trusted, and competition has lowered prices to a very attractive level.

With both situations pointing toward outsourcing, there is very little by way of company situation that would compel a pharmaceutical company to keep data management activities in-house. Below we have profiled an example of Wyeth’s shifting of data management to an outsource partner and the impact the relationship has had.

Wyeth and Accenture formed a deal in which Wyeth gave its entire data management operation to Accenture over a 10-year contact. In doing so, half of Wyeth’s 300 data management positions were eliminated, and the remaining employees were transferred to Accenture for employment. The more mundane data management tasks, such as data entry, would be sent offshore to India to make use of Accenture’s specialized facilities. In order to get the contract, Accenture had to accept a risk-sharing arrangement and meet highly specific performance criteria all while cutting Wyeth’s data management costs by 50%.

The result was a deal that provides significant cost savings for Wyeth, shifting fixed costs to variable costs while also tapping into new capabilities through Accenture’s service delivery center in India. New efficiencies can also be reached; functions that would have taken Wyeth more than 100 days must be reduced to about 20 days under the deal, or Accenture will have to pay Wyeth.

2) Program Management

In contrast to the data management example, program management activities can be examined as an extreme illustration of an activity that is core and must be kept in-house. As a result, we do not have a case studied to apply to this framework because we are not aware of outsourced program management arrangements.

While specific company situations will vary, all companies will find a very high executional and IP risk associated with outsourcing the program management function. Program management is one of the remaining areas where companies can hold a significant leadership advantage over competitors and continue to build internal know-how (intellectual capital). Additionally, it is critical that internal program management teams develop and leverage key relationships along the value chain.

The vendor situation further reinforces that program management remains in-house. While program management functions may be a portion of outsourcing specific activities, vendors solely dedicated to program management do not readily exist. Even if an extreme company situation dictated that program management activity be outsourced, a fully integrated outsourcing approach would be necessary. This arrangement would require oversight from the pharma company and would therefore result in significant overlap of responsibilities.

3) Wyeth and ReSearch Pharmaceutical Services (RPS)

The application of the core/non-core decision process can be demonstrated through the example of Wyeth’s outsourcing of clinical monitoring functions to RPS. In this case, Wyeth was able to shift fixed costs to variable costs while shifting a portion of their own risks onto the vendor. The following case study aims to examine Wyeth’s strategic decision to outsource this activity.

As a general market condition, clinical research associates (CRAs) tend to be in short supply. Additionally, they present a significant fixed cost burden for the pharmaceutical company, especially since one company can rarely make use of CRAs full-time, typically needing access to them with little advanced notice. For these reasons — high cost, internal inefficiencies and lack of capacity — clinical monitoring would appear to be a non-core activity. The vendor situation, however, points toward keeping clinical monitoring in-house. CRA vendors are available, but demand is usually high in popular therapeutic areas and accessing CRAs at precisely the time that a drug candidate is ready can prove problematic. Additionally, the cost of outsourcing CRAs is high, and does not present a significant cost advantage over holding existing CRA capabilities internally.

The mixture of non-core company situation and core vendor situation has led us to label clinical monitoring as “on the fence.” From there, a company must consider its individual strategic direction. For a company entering a new therapeutic area, outsourcing of clinical monitoring is the best solution. This is because the company is not likely to have key relationships built up with site investigators and other stakeholders in this therapeutic area; by outsourcing to a CRA vendor with expertise in this area, the company will be able to utilize these key relationships. Additionally, if the company only intends to have a one-off drug in development in this therapeutic area, the cost of outsourcing to CRAs with existing expertise will be less expensive than building this capability from scratch for just one drug candidate. If, however, the company plans to develop multiple compounds in this therapeutic area, they should build the capabilities in-house for long-term cost savings, increased capacity, and to develop internal key relationships.

This logic can be applied to Wyeth’s deal with RPS. In this arrangement, Wyeth has transferred its entire regional clinical monitoring function to RPS, working across all studies and therapeutic areas. Wyeth did so because clinical monitoring represents a high cost element of clinical trial activity, sometimes accounting for 30% of its clinical trial budgets. CRA shortages have also been an issue for them, and in the past Wyeth has worked with a variety of third-party vendors to meet their clinical monitoring needs.

Through this deal, Wyeth’s CRA employees actually shifted employment status and became employees of RPS. In doing so, Wyeth was able to convert their fixed expenses for clinical monitoring to variable cost status, while still preserving the CRAs’ focus on Wyeth trials.

While cost savings were the impetus behind the arrangement, Wyeth and RPS are also looking at other measures to quantify improvements in efficiencies and productivity as well. The contract between Wyeth and RPS outlines 15 different measures that are to be used as metrics throughout the duration of the partnership. Of these measurements, four are considered core: speed, quality, customer service and cost. It is critical that RPS ensures that Wyeth sees improvements and success in their clinical trials, as RPS only benefits if Wyeth succeeds.

As a result of this deal, Wyeth not only shifted fixed costs to variable costs, but also realized productivity gains by taking a functional outsourcing approach, increasing site visits per CRA.

The pharmaceutical industry grew up in an environment of rapid, smooth revenue growth and significant positive spreads between capital returns and capital costs. Accordingly, the industry enters these new strategic pressures with a cost structure that is too large and inflexible, and with a tradition of wholly-owned development portfolios constructed with inadequate consideration for predictability of product flow.

Across the industry’s R&D functions, significant un-tapped degrees of freedom exist for making the cost base more variable. Opportunities for flexibility gains have to be balanced against IP and organizational know-how risks; in general the economic value of flexibility gains increases toward the sell end of the continuum while IP concerns lessen. Means for reducing revenue volatility clearly exist, including co-development of products and/or sharing of commercial rights/returns with commercial partners, and expansion of effective portfolio size in partnership with passive investors. Whether such volatility gains are worth the associated costs can and should be analyzed.

Determining a company’s degrees of freedom and how they may be leveraged is a two-step process. First, this general framework of core vs. non-core needs to be fine-tuned by persons having greater proximity to each component of the value chain (in general), and to the company’s business circumstances and organizational status (in particular). Second, available degrees of freedom (i.e. owned non-core functions) should be prioritized according to likely gains, associated risks, and the extent to which well-developed external platforms for performing these functions exist.

Neil MacAllister is the president and founder of AVOS Life Sciences, LLC. Richard Evans is a vice president. Katherine Wallace is a research analyst. They can reached at info@avoslifesciences.com.