Raising the average working capital performance level of pharmaceutical companies to that of the industry’s top quartile would result in freeing up $43B of cash, money which could be productively invested in research, marketing and other value generating initiatives.
Pharmaceutical companies lag many other industries in many key working capital measures, including inventory, receivables and payables. Analysis of inventory performance of Fortune 1000 companies shows that pharmaceutical companies had an average of 170 days of inventory and medical products and equipment companies had an average of 139 days (see figure 1 below), twice that of other industries. In a variety of other measures - accounts receivable, average sales outstanding and accounts payable, pharmaceutical companies lag behind most other industries.
Recent inventory performance trends, over the past 10 years, show that pharmaceutical companies have made some improvements and are moving in the right direction, but the trends for accounts payable and accounts receivable are still worsening. These analyses raise three key questions:
1. What differentiates the pharmaceutical industry from other industries in working capital performance?
2. What is the case for change?
3. What should pharmaceutical companies do to improve performance?
This article explores these key questions and in the process attempts to help executives at pharmaceutical companies improve working capital performance.
What differentiates the pharmaceutical industry from other industries in working capital performance?
Pharmaceutical companies face several issues that pose challenges for smart working capital management and which are unique to the industry. These affect all the 3 key working capital measures.
Inventory turns are poor due to several pharma-specific issues:
· “No Stock-Out Philosophy”: Many pharmaceutical companies strive for “no stock outs”. High margins and high social costs (i.e. impact on patients) are often cited as reasons for pursuing this philosophy. As the focus on reducing stock outs increases so do the investments in inventory.
· Regulations: Pharmaceutical companies are highly regulated. Strong FDA guidelines and regulations guiding the manufacturing and quality release processes often add days or weeks to manufacturing lead times. In addition, any companies have quality policies and procedures which compound the challenge. At times the internal policies and procedures are either outdated or too stringent and can add days to manufacturing cycle times without contributing to improved quality.
· Labeling Requirements: Pharmaceutical companies have to deal with complex labeling requirements. In order to comply with different regulations in different jurisdictions pharmaceutical companies need to have unique labels and hence unique SKUs. A large number of SKUs increases inventory complexity and leads to greater inventory levels.
Accounts Receivable turns have not improved due to characteristics unique to this industry. For example, in some countries there has been a recent trend for manufacturers to go “Direct to Pharmacy,” resulting in much more fragmented customer base and impacting payment cycles. Additionally, geographically-specific characteristics (e.g., extremely long payment cycles in Europe, buying/bargaining power of pharmacy chains in the UK, complex distribution networks in the US ) lead to much longer payment cycles.
While issues affecting Accounts Payables are not necessarily unique to pharmaceuticals, many of them are systemic in the industry and result in poorer DPO performance. These include:
· Lack of a Payables Strategy: Much of the purchasing of indirect materials is done on purchase orders and without formal contracts. There is often inadequate focus on boosting payables / maximizing discounts. Additionally, there is no thorough trade-off study between discount savings with early payment vs. interest gains with full payment.
· Inconsistent Terms and Conditions: Many companies do not have consistent Terms and Conditions across different countries or Business Units. Additionally, there is no comprehensive program in place to consciously negotiate Terms and Conditions that maximize supply value.
· Entrenched Suppliers: Often purchasing departments are not engaged early on in the R&D phase when suppliers lock themselves in and then have most negotiating power when product reaches commercialization.
Given these unique challenges, it is unlikely that pharmaceutical companies can achieve WC positions similar to other industries (e.g. consumer goods). However, significant improvement opportunities exist. This is clear given the wide range of performance even seen within the pharmaceutical industry as shown in Figure 2 below.
Pharmaceutical companies need to be smart about how aggressively they want to focus on working capital management. Obsessive concern with reducing working capital is itself risky, and can actually harm business performance. Carefully weighing risks associated with working capital improvement initiatives against key risk areas (product quality, compliance, customer service and supply continuity) can lead to a well-informed and balanced decision.
What is the case for change?
Last few years have seen many patents expire for big pharmaceutical companies. Patent expirations coupled with thin late stage pipelines have led to slow growth for many large pharmaceutical companies. Faced with slow growth, companies have turned to other levers for shareholder value improvement – e.g. Cost reduction and working capital improvement. Having focused on the top line for several years, these areas were neglected and companies have discovered that there is a big improvement potential.
The recent economic downturn has compounded challenges for the industry. While the pharmaceutical industry has largely avoided a direct blow because of the essential nature of pharmaceutical products and services, the downturn has significantly changed the economic landscape. Access to capital is not easy forcing companies to unlock cash tied up in the operations. Many customers (e.g. small chain or independent retailers/pharmacies) are struggling, impacting their ability to pay on time. Financial viability of many suppliers is also a question mark. These issues are further compounding how pharmaceutical companies manage their working capital. The key is freeing up enough cash while maintaining a healthy supply chain.
It is difficult to flip through the newspapers in the US these days and not see dozens of articles on healthcare reform. It is on top of the administration’s agenda. The key areas of the reform are improving quality, increasing access and reducing costs. While these are all laudable goals, they will have an impact on pharmaceutical companies: the focus on reducing costs will increase pressure on pharmaceutical companies to tighten their belts; while the focus on improving quality will increase regulatory pressures on pharmaceutical companies, which in turn will have an impact on the supply chain and hence working capital requirements. This is the right time for companies to have a hard look at how they have managed working capital and how they can improve given the changing macro environment.
Improving working capital position will allow companies to reinvest cash more productively (e.g. R&D, marketing initiatives to develop and bring to market new drugs) and drive future top-line growth. Analysis shows that if performance of industry players could be improved to 1st quartile performance, it could help unlock over $43B in cash as shown in Figure 3 below.
What should pharmaceutical companies do to improve performance?
There are several steps pharma companies can take to improve performance.
Step 1: Adopt lean production techniques. Toyota is the leading global example of eliminating waste and becoming lean in all areas, and working capital is no exception. They recently launched a company-wide initiative called “GAME ON” (Gain Advantage, Maximize Efficiencies, and Overlook Nothing) to get back to profitability. The CFO’s goal is to return the company to profitability, focusing on both reducing fixed costs and growing the top line. Toyota is diligent about keeping inventories in line with the market and with what customers need. Their main metrics are cost structure and return on sales – benchmarking Toyota’s historical trends. Toyota balances supply and demand through production-planning and distribution processes that go hand-in-hand with the manufacturing arm, both in Japan and the US. They have actively reduced both WIP and finished goods inventories during the global economic downturn as a means of preserving cash. At the same time, they have been careful about not moving aggressively on DPO as they did not want to further impact the already precarious automotive supply base. Companies should carefully examine all aspects of current operations with a focus on working capital to identify inefficiencies in current processes and practices that can be eliminated rapidly. This is necessary, but not sufficient.
Step 2: Deploy a differentiated, ‘surgical’ approach: Pharmaceutical companies need to design and deploy a differentiated approach to optimizing working capital performance. Each company has to identify the 3-5 key levers that they are going to pull in DIO, DSO and DPO to rapidly unlock cash and maximize long-term benefits. Based on best practices seen at some of the leading players, the following improvement levers can be evaluated and implemented…
· Inventory Improvement Levers –A number of approaches exist for rapidly improving inventory. Shown below (figure 4) is a checklist of some high-impact levers that pharmaceutical companies should consider to improve their inventory position.
· Receivables Improvement Levers – While receivables performance, too, has a number of drivers, country specific regulations, payment practices as well as distribution systems need to be carefully examined with an eye toward developing customized action plans.. Figure 5 below outlines key sources of value in trade receivables that pharmaceutical companies can use to improve their receivables position.
· Payables Improvement Levers – A segmented approach to the supply base is necessary to maximize value from payables. The supply base and spend both need to be segmented into strategic and tactical groups based on 4 key criteria – value to business, level of spend, payables levels and Level of Sales Organization Integration. Working capital reduction can often be a secondary objective for categories and spend that are strategic in nature. The focus there is to ensure a) the security of supply, b) innovation collaboration, as well as c) technology exclusivity. However for tactical categories, companies should focus on optimizing payment terms by aggressively leveraging buying power to extend payment terms or improve early payment discounts. Pharmaceutical companies can generate tangible improvements in DPO by systematically addressing the eight value levers shown in figure 6 below.
The pharmaceutical industry clearly has significant opportunities to address working capital and generate substantial amounts of cash, which can be productively invested in new drug discovery, marketing etc. While the industry certainly has many unique issues and challenges, there are a numerous levers that can be applied in a systematic fashion to improve working capital. Additionally, there is significant variability in performance within the industry, and companies can leverage best practices from both the industry as well as from outside to significantly improve performance.
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