The success of Japanese firms in product development after WWII is seen in the involvement of outsourcing partners in new product development (NPD). This success story became a model and imitated by Western firms leading to early supplier involvement (ESI). The usage of innovation intermediaries such as contract research partners in NPD processes requires networks of external specialist ultimately leading to the creation of added value. Benefits associated with outsourcing are found in various industries. Prominent examples are grouped around banking, automotive or IT. Interestingly, contract partnering is also found in the pharmaceutical marketplace.
The first contract research organization (CRO) was founded in the early American 1980ties. By incorporation of such service providers NPD in medicinal science changed drastically from 100% in-house development towards a flexible involvement of service providers within all stages of NPD. In the following decades outsourcing became the predominant model in pharmaceutical R&D. The contracted services, however, are of enormous cost due to project complexities and regulatory requirements. Changing environmental conditions such as fragmented marketplaces, small pipeline portfolios or changing payer behaviors determine new challenges in the post millennium marketplace.
Business models i.e. contracting models currently used in pharmaceutical outsourcing span a wide continuum starting from transactional (job-to-job) models, via a preferred vendor or co-operational agreement towards long-term business alliances or added-value conditioned models. Job-to-job models are defined by outsourcing work contracted to the supplier on operational needs – step-by-step. Preferred vendor models form alliances on time for a certain developmental phase in NPD, whereas R&D alliances expand this time towards long term strategic partnerships. In comparison to these stage-wise evolving models of contract partnering described earlier we find added-value conditioned contracting models arising in the marketplace. The latter reimburses contracted services either via long-term contracts (e.g. the Merck-Quintiles Model) or via modular flexible approaches (e.g. the Dynamic Milestone Model).
Interestingly, job-to-job, preferred vendor or alliance models utilize a classical approach to reimburse contracted services: milestones. This method of contracting is defined by reimbursing contracted work 1:1 with its occurrence. Sponsors intend to pay for service costs if certain pre-defined goals are met. However, these are often inadequately defined, out-of-scope for one contract partner, or even not directly related to the added value bringing business of the sponsor. This in turn can result in supplier-sponsor discrepancies and uncertainties resulting in long-lasting double work for the vendor if the sponsor is dissatisfied (or vice-versa) or can lead to time and work consuming renegotiations in previously agreed contracts.
Currently value-based approaches are discussed in pharmaceutical outsourcing (e.g. Merck-Quintiles model; ref. GCOF Munich 2010), in that reimbursements to contracted services are value driven and allocated to the project conducting organization only via the long run. B2B partners agree on potential mark-up or penalty payments, conditioned to the project end. Recently, an evolved version of the Merck-Quintiles model has been proposed, called the Dynamic Milestone Model (DMM). The latter model is characterized by a bimodal value adapted reimbursement approach implementing pre-defined dynamic milestones.
Considering the above described new added value driven contracting approaches, major flaws are associated with one of these: the Merck-Quintiles model. First, by following this reimbursement model a high risk of cash negativity is present for the service provider. Contracted work is only reimbursed at the end of the project and a large proportion of project time remains to be unpaid at the time when costs occur. Moreover, with the possibility to receive extra bonus payments or a finally reduced fee the risk lies completely at the side of the service provider. Clearly, only very large and financially strong service providers can effort to follow this reimbursement model. Second, fluctuating talent pools i.e. turn-over rates are of enormous effect. With current industry rates of >45% in the contract research industry (ref. personal communication), brain grain to competitors is sever and highly affects good quality service. Third, company size will play a significant role in relation to the risk of cash negativity. Only organizations with a large and good running project portfolio and continuous sponsor payments (i.e. positive cash flow and liquidity) are eligible to follow this business model, and finally, fourth, project duration is a significant player. Short-term agreements are preferred for service providers, but sponsoring organizations favor long term agreements, inducing again a high business risk for both sides.
On the contrary, the Dynamic Milestone Model (DMM) allows positive effects for both the sponsor and the vendor. Advantages for the vendor are circled around a) cash-flow and liquidity (the workload is paid back soon after its occurrence with the possibility to receive a mark-up payment twice), b) project associated risk (if the business relationship is terminated prior to the defined project end e.g. after approximately 50% of the project duration, the risk of cash-negativity is reduced) and c) client-customer relationship (the business relationship is able to evolve towards a much better synergy and effectiveness). Furthermore, positive effects are also evident for the sponsoring organization. Sponsors see advantages in 1) a much better project control (better oversight in project development and interim reporting) and 2) project cost (potential of reduced fees if pre-defined project goals are not met without the need of renegotiation). By utilizing the dynamic milestone model the CRO is able – if calculating their business case at the lower margin of the project contract – to be of enormous profit. On the other hand, the sponsor – if also calculating at the lower margin of the project contract – is able to realize large cost safeings.
Taken together, contracting outsourcing partners is still a central element to consider if NPD is empowered by the usage of research partners. Classic models are still state-of-the-art and common practice, but their negative effects can be overcome if newly introduced contracting approaches are implemented, especially the Dynamic Milestone Model.
Author profile, thesis information and contact: Martin Koch studied biology (M.Sc.) and genetics (Ph.D.) at the University of Graz. He started his professional carrier in academic life science, changing later to the outsourcing and pharmaceutical industry. By working several years in contract research in various positions he experienced difficulties in the supplier-sponsor business relationship. Based on his outsourcing experience he conducted a post-graduate study in marketing and leadership (PMBA) at the Austrian Business School LIMAK, University of Linz. The latter research work resulted in the identification of business drivers in clinical outsourcing and suggests a new method of project contracting. The thesis was approved in 2012 under the academic supervision of Prof. Volker Mahnke, Ph.D., Copenhagen Business School. Interested readers can contact the author via email (firstname.lastname@example.org) or visit his web-page (www.k-scientific.com). Currently Martin Koch lives in Vienna and works for an international pharmaceutical company in the field of oncology.