Faced with empty pipelines, expiring patents, pricing pressures, generic competition, and growing government and consumer challenges, pharmaceutical companies are increasingly transforming their product value chains in order to increase overall profitability. Many big pharma companies are deconstructing their vertically integrated value chains. Some, for example, are selling manufacturing facilities or divesting mature products that are not part of their core business. Conversely, many small companies are creating supply chains that can accommodate expected growth, as demand for their products outstrips fledging value chains.
But whether they are growing or disaggregating their value chains, companies face a growing number of increasingly difficult and complex decisions: whether to insource or outsource or to license. They must also build in capacity flexibility, to adapt quickly to changing business conditions. In this demanding environment, the usual supply chain objectives of efficiency and effectiveness alone no longer suffice. The new mantra is efficiency, effectiveness, and excellence – what we call “value chain E3.” Simply stated:
- is doing things right.
- is doing the right things.
- is doing “the right things right” and achieving the highest quality.
In the past decade, many organizations have diligently focused on efficiency, in some cases to a fault. Despite the complexity of the choices they face, they make one-off decisions, often simply trying to optimize as cost-effectively as possible one isolated activity in the value chain. But value chain interdependencies preclude separate, sequential focus on each issue or option. While optimizing one element may improve that particular activity, it can also have a negative impact on another interdependent element somewhere else along the value chain.
Focus can no longer be separate and sequential. Instead it must be systematic and simultaneous, examining all strategic issues and options in order to optimize the overall E3 of the value chain and to maximize its financial value. This article will outline a proven approach for building “options thinking” into value chain decision-making and a method for accurately evaluating supply chain decisions, while explicitly accounting for the unique risks and uncertainties that make those decisions difficult. Although these techniques have been used at the “macro” level, for corporate decisionmaking, they can also be applied at the “micro” level, of the individual division, facility or line level.
Understanding “Options Thinking”
Building E3 into product value chain decisions requires a standardized decision-making process. There are a number of organizational structures that can be adopted, such as a steering committee composed of the decision-makers and a separate working team of individuals who provide the insights and analyses to support the steering committee discussions. But regardless of the structure employed, the goal of the decision-makers should be to identify the most valuable actions among all the many value chain choices by examining multiple competing alternatives and options. Decision-makers should be able to consistently, repeatedly, and reliably help the company strike the right balance across investments in product supply, capacity flexibility, total cost, and timing of profitability in the face of risk and uncertainty.
In this more holistic approach, the operative principle is to optimize the flow of the entire value chain and make decisions about its various interdependent parts in relation to each other. Therefore each alternative to be considered will comprise an entire mosaic of interdependent elements. Moreover, the alternative must be genuine. In other words, it must be:
- It should generate reasonable financial return or other business advantages.
- It should be achievable, given existing resources.
- It must differ in some significant way from others. It can, for example, require a more aggressive approach, a different strategy or investment level.
In addition to generating multiple genuine alternatives, a consistent method and appropriate metric must be used to evaluate and compare those alternatives. A number of value-chain metrics are typically used, including inventory turns, service level performance, and forecasting errors.
However, one financial measure, net present value (NPV) of free cash flow is the best choice. NPV is a good surrogate measure for shareholder value creation; it can be applied across all of the various product value chain decisions; and rigorously and explicitly addresses risk and uncertainty. Understanding the impact of value chain decisions through the NPV of free cash flow creates a level playing field of comparison for all decisions, and enables the integration of the impact of these decisions to provide a clear understanding of why one comprehensive strategy is better than another.
It should be noted, however, that even with a variety of genuine alternatives and a consistent basis of comparison like NPV, the approach does not produce the “right” answer. Rather, it provides you with the basis for reaching a good decision. Armed with attractive alternatives and the knowledge of what each alternative is worth, you can make your decision based on such factors as your appetite for investment, tolerance for risk, on total value, on return on investment, and the like. The right answer is the answer that is right for you.
Options Thinking in Action
To understand how options thinking works in detail, consider the case of one pharmaceutical manufacturer. The company was grappling with the strategic decision of either becoming a “vertically integrated” or a “virtual” business.