AstraZeneca to outsource manufacturing: not such a no-brainer

AstraZeneca has announced plans to outsource all pharmaceutical manufacturing over the next few years, according to The Times of London.

David Smith, AstraZeneca’s executive vice-president of operations, said that the company aimed to become a pure research, development and marketing organisation."Manufacturing for AstraZeneca is not a core activity,” Mr Smith said. “AstraZeneca is about innovation and brand-building . . . There are lots of people and organisations that can manufacture better than we can.”

It sounds like an obvious idea. Companies making low-tech items like shoes and high-tech items like computers and consumer electronics routinely outsource. Nike doesn't make shoes, Apple doesn't make iPods, and so on. They concentrate on their core competencies of R&D, design, distribution and marketing while leveraging outsourced manufacturing to achieve lower costs, higher quality, and greater flexibility.Now that pharmaceutical companies are facing cost pressures they are finally catching up with the times. Right? Actually, no.Manufacturing isn't well understood within pharmaceutical companies. Top management and board members typically have little background in manufacturing and the head of manufacturing usually reports to someone in the commercial organization rather than directly to the CEO. It's unusual for the head of manufacturing to sit on the executive committee at big pharma companies. When top management does examine manufacturing --usually at the behest of the CFO-- they are surprised to find how much capital is invested and how low capacity utilization is. "Why don't we jettison is?," they ask.There are a number of good reasons not to go down the AstraZeneca path. For example:

• It's hard to dispose of the existing assets. Unlike in consumer electronics there are few companies capable of buying and running the facilities. Exceptions --like Cardinal and Patheon --are subject to acquisition by private equity funds or to screwing up their operations and getting into trouble with the FDA.
• Owning manufacturing plants can yield tremendous tax advantages, which are difficult to replicate in a purely outsourced model (though there are ways to achieve some of the benefits through tolling)
• There are increasing opportunities for tight integration between pharmaceutical development and manufacturing, and the interfaces between the two can be much more robust in an in-sourced model. Truly new drugs are rare within pharmaceutical company pipelines. New combination products and modified release formulations require advanced manufacturing knowhow
• Manufacturing costs are a very low percentage of revenue for pharmaceutical companies. Even in these tighter times it makes good sense to keep spare capacity and go overboard on spending on quality and support services. However contract manufacturers look at the world differently. What represents a mere 5 to 20% cost of goods sold for the pharma company is 100% of the contractor's revenue. They are more prone to squeeze out spare capacity and take shortcuts elsewhere simply because they have a greater economic incentive to do so. That can lead to trouble.

However, I don't advocate a purely insourced model either. In general, pharmaceutical companies should make greater use of third-party manufacturers. Left to their own devices, manufacturing divisions will look to keep everything in house. And with top management not understanding the fundamentals of the business, it's easy for the manufacturing folks to exaggerate the dangers of third parties and present unfair cost comparisons. (A favorite approach is to compare the marginal costs of in-house production with fully loaded third-party costs.)AstraZeneca says it will take 10 years to complete its transition to full outsourcing. My guess is they will pull back before they get there. If they do things right they'll end up in a good place.At MedPharma Partners we have substantial experience in working with pharmaceutical companies to evaluate their third-party strategies and with contract manufacturers to understand the mindset of big pharma. If you'd like to discuss how this topic applies to your situation, contact David Williams at dwilliams@mppllc.com or (617) 731-3182.