In the patented drug manufacturing world, fixed manufacturing costs are not usually a key driver of profitability. Achieving the right price is typically a much greater driver of profit.
Some notable exceptions to this maxim include treatments for orphan diseases and other products with sub-optimal capacity. In these cases, fixed costs do factor heavily in profitability.
In the orphan disease space, it is not unknown to create a drug and a specific manufacturing process for a very limited number of identified patients. In this context, where the fixed costs of manufacturing are distributed across a very low number of products, finding ways to decrease the manufacturing cost remains key to profitability. This exception would also apply to any other segment facing sub-optimal manufacturing capacity.
How can tenders increase return on fixed capital?
Creative tendering and contracting strategies can play an important role across a patented drug manufacturer’s portfolio to increase profitability.
One potential creative approach is to leverage the low-bidder advantage in the formal tendering process. All other things being equal, the low bidder has a greater chance to win contracts. By strategically bidding low, a manufacturer can gain the opportunity to drive their volume significantly upward, increasing fixed asset utilization. In effect, this would translate to covering more fixed costs and increasing profitability of key products.
I’m not familiar with tenders. What are they?
Tenders are a procurement strategy applied by governments to reduce the cost of purchasing. They allow for the open publishing, bidding, and awarding of contracts. Pricing remains a major influence in the awarding process, even when quality dimensions are added to the bidding process.
Given this reality, if a manufacturer is trying to increase its return on fixed capital and is willing to slightly decrease its overall profit margin, they would be able to win significant volumes. This volume increase could lead to an increased utilization of the manufacturer’s fixed capital, leading to improved profitability of key products or key tenders.
The strategy, in this approach, is to create segments of profitability – certain tenders would be used to cover fixed capital costs, while other tenders or contracts would be used to increase profit. This strategy could lead to improved profitability in an area of focus as well as an increased profit overall.
The manufacturer’s approach would be to bid lower to secure the tender award, while still remaining above marginal costs of production for the agreed medicines. The entire strategy should be designed to maximize the probability to win (perhaps by bidding below the marginal costs of the other bidding companies) while keeping some level of profit.
The manufacturer would go into this scenario with the understanding that profit margin on such strategic tenders, in and of themselves, would be lower. Depending on the number of bidders, the price may not have to drop by very much to achieve the high win-rate.
Ultimately, the potential increase in profitability for the initial situation would be equal to:
% of utilization of the fixed capital x fixed capital
This strategy, therefore fits two types of situations:
- When the percentage of utilization is low (which is especially true for many therapeutic areas such as hemophilia or anti-TNF)
- When the amount of fixed capital is high (which is true for most of life sciences companies)
Fictitious company example, for illustration purposes only
For illustrative purposes only, the following fictitious scenario shows how “Company A” uses the described strategy for “Product A”:
“Product A” is a patented drug product, sold only to a limited number of patients. Overall profitability, according to the above, is 20 percent. The utilization of fixed capital is only 50 percent. Applying the above-mentioned concept, let’s assume this company can participate to tenders for a segment of customers matching its manufacturing process. The concept relies on two assumptions:
- Participation in tenders does not impact the pricing power on the initial contracts (which may not always be valid).
- The manufacturing process for the second part does not incur any additional cost.
In this fictitious scenario, winning the tender will only conserve a 2 percent profit margin. The Tender Profit & Loss Statement for such a scenario might look like the table below. For this illustration, the volume for standard sales and tender sales are considered to be equal.
The fictitious company’s overall profit has increased to 29 percent of sales – a 9 percent improvement. Even better, the standard sales profit margin is now at 45 percent. Tender-related sales, on the other hand, have a limited profit, but they are fueling the growth potential. In addition, the societal benefit of cheaper medicines are creating some company goodwill, which is not accounted for in this Profit & Loss Statement.
Because of the formality of the process, tenders are a really interesting way to increase sales. On price-only tenders, the volume gain through a low price is almost guaranteed if the company has an average or better profile. Participation at a low price – ideally slightly above the marginal costs – can therefore have the potential to lead to increased profitability.
The above strategy could theoretically yield significant gain, but it is important to underline two major assumptions:
- Tender sales should not be detrimental to standard sales.
- The manufacturing process of the product sold through tenders should not create additional fixed equipment costs.
Meeting these assumptions is certainly possible. Building such a model would require deep understanding of the products and the manufacturing process at stake. The illustrative example used above provides a glimpse at how tendering could be used strategically to increase profitability – while still bidding at a competitive price and without undertaking a tender shaping initiative.
The only additional high-level constraint is to have two different sets of customers – one purchasing through private contracting methods and the other through public tendering procedures. This detailed methodology can be applied as long as one set is not impacting the other. Aside from this, the type of customer (local or country-level, etc.) won’t change the potential benefit.
For more insight into potential strategies to improve your life sciences tendering and contracting processes, contact Ruven Remo Eul.