Will China Lose Its Cost- Competitiveness In Pharma Manufacturing By 2015?

By Vishal Bhandari, Axel Erhard, and Saurabh Tejwani of A.T. Kearney

With rising cost pressure, Western pharmaceutical companies have aggressively sought low-cost country sources for pharmaceutical manufacturing over the last few years, fueling the growth for the Chinese pharmaceutical industry.

Exports from Chinese pharmaceutical companies grew at double-digit rates over the last few years and were close to $30 billion in 2009. Pharmaceutical firms have continued to move significant activities, such as the manufacturing of APIs to China. For example, in 2009, AstraZeneca announced that it will move all of its current API production in the United Kingdom to China. Also in 2009, Novartis announced a $1 billion investment that will create China’s largest pharmaceutical research plant yet. Eli Lilly axed 5,500 jobs in the United States and added 2,000 in China in 2009.

To fuel this dramatic growth, the Chinese pharmaceutical industry has invested heavily in capabilities and assets. There are more than 4,000 pharmaceutical manufacturers in China today that have Chinese GMP (good manufacturing practices) certification. Currently, more than 100 drug manufacturing sites in China are manufacturing API or drug products for U.S. NDAs (new drug applications) and ANDAs (abbreviated new drug applications). A majority of this investment has been focused on the manufacturing of starting materials, intermediates (usually precursors to APIs in pharmaceutical manufacturing process), and APIs, which typically have less burdensome regulatory requirements compared to the finished drugs. This approach also has allowed the Western pharmaceutical companies (customers of Chinese pharmaceutical manufacturers) to conveniently avoid a “Made in China” label if the final presentation form (e.g. finished pill) was produced in the Western countries.

A 30% to 50% cost savings was the main driver for sourcing starting materials, intermediates, APIs, and (to some extent) finished drugs. Cheaper labor, tax advantages, undervalued currency and lower capital, and overhead costs all contributed to this. All of these advantages are expected to erode in the coming years as inflation in China rises, currency appreciates, and tax rebate structures start to evolve. Although the exact degree and impact of these changes is difficult to predict since these changes will be driven by a complex mix of global economic developments and political decisions, a directionally correct assessment can be made.

China has seen annual wage increases of 19% for last five years, and the trend is likely to continue for next four to five years. These wage increases will also have direct impact on increase in overhead costs. Also, there is a broad consensus that Chinese currency is currently undervalued. Since 2008 China has held the yuan exchange rate constant to counter recession (by promoting exports), but the world pressure to revaluate the yuan is mounting. Olivier Blanchard, chief economist for the IMF, remarked in the April 2010 World Economic Outlook conference, “Yuan appreciation would be highly desirable for China’s sake. An appreciation of the yuan will help reallocate resources towards domestic demand.” Many analysts (including those at Peterson Institute) conclude that China’s real effective exchange rate is presently undervalued by 25 to 40%. While there may be differing points of view on the degree of appreciation, it is likely that the currency will appreciate by up to 15% over the next three to four years.

Rebates For Exporters
China is currently actively promoting its pharmaceutical export industry by providing significant VAT (value added tax) rebates (averaging 13%) to pharmaceutical exporters. Even though these export tax rebates are a direct way for the Chinese government to support pharmaceutical companies through short-term downturns, it does not help the industry to stay competitive in the long term. It is likely that these rebates will start going down as China’s domestic market matures and growth picks up. Currently most pharmaceutical companies are moving generic and low-cost APIs to China where the VAT rebates are more likely to be slashed first. For example, in July 2007, the rebate on low value-added APIs was reduced from 9% to 5% as part of the Chinese government’s attempt to cut down on these API exports (though the rebates went back up to 13% to fuel growth during recession).

With these changes China’s current gross cost advantage of 30% to 50% could easily go down to 13% to 25%. Factor in supply chain complexity (lead times and inventory implications), rising costs of quality assurance, and upcoming stringent environmental regulations, and Western pharmaceutical companies will start to rethink their China outsourcing strategies. Accommodating for these factors, the net cost advantage for some pharmaceutical firms could easily vanish. The supply chain strategy, manufacturing and distribution network, and supply chain policies of individual companies will determine the net-cost advantage and the business case for sourcing/manufacturing in China.

Mitigation Strategies To Implement For Pharma Companies
Western pharmaceutical companies can apply several mitigation strategies to avoid a significant profit and loss impact from these trends. First, the companies need to acknowledge these trends as they develop their long-term sourcing strategies. Outsourcing business cases need to be updated by building scenarios for different cost drivers to allow sound decision making. Western pharmaceutical companies will need to understand the risk profile in the context of their own supply chains. A robust risk analysis and quantification of exposure will be critical before developing a mitigation strategy. This will involve developing scenarios which reflect a company’s currency exposure, breakdown of cost structure of outsourced supplies, and supply chain specifics (e.g. inventory policies, lead times etc.).

A shift in mindset is necessary to be able to ensure sustainable low-cost sources. The key will be to consider these strategic manufacturers/suppliers from China as an extension of a company’s network rather than low-cost country sources. Western pharmaceutical companies have a range of options which can be applied to counter these macro trends and stay cost-competitive. The solution they choose will need to be aligned with their strategy, supply chain capabilities, and the product / supplier portfolio. The options will have varying degrees of reward and implementation complexity.

Favorable Terms and Conditions – Companies can reduce their immediate exposure by establishing terms and conditions which protect the firm against any movements in currency/inflation. Working collaboratively with strategic suppliers, companies should establish clear guidelines on how these risks will be shared. As a first step, companies can start by reviewing current contracts with the large Chinese suppliers and engage them in negotiations to establish clarity on sharing currency exchange risks.

Using financial hedging strategies – In the short term, companies also can use financial instruments to hedge currency risk exposure. While this may be relatively quick to implement, there is a definite cost involved in establishing these hedges. External manufacturing and procurement groups should work closely with the finance department at these companies to better understand these instruments and mitigate financial risks

Collaboration beyond qualification - It is often observed that pharmaceutical firms engage heavily with the suppliers in the qualification phase, but the collaboration diminishes once the supply chain is established. Collaborating closely with suppliers to ensure productivity improvements can counter the increasing costs. Pharmaceutical companies can work closely with strategic suppliers to share technical know-how, capital excellence methodologies and best practices for production processes/quality assurance to help them with productivity improvements.

Diversifying supply sources – Western pharmaceutical companies can reduce their exposure to China, for example, by sourcing new API/Intermediates/formulations from other countries or validating alternative country sources for current Chinese supplies. Currently China has a relative cost advantage over other low-cost countries in low-value API/generic production. Based on how some of the above discussed macro trends play out, the balance may tilt in favor of other countries. Diversifying the portfolio of suppliers across multiple low-cost countries can also be helpful in minimizing overall risks. India and several countries in South-east Asia (e.g. Singapore, Thailand, Philippines) and Eastern Europe can be promising candidates for broadening the supply base for western pharmaceutical companies that are currently heavily weighted on China. Companies need to start developing facts based on suppliers specific to their needs in these alternative low-cost countries. They can start developing relationships with these suppliers by involving them on smaller projects and including them in the sourcing exercises.

Making sourcing decisions based on product category and future outlook of cost advantages – Companies need to conduct a robust analysis to identify which products can be outsourced. When doing this analysis, the companies need to forecast the price advantages that will exist long term as compared to the present since source changes are time consuming (can take years) and difficult in this industry. For example, final product formulations where labor is an important driver for price competitiveness may enjoy this advantage for a longer duration as compared to APIs where the labor component is relatively small.

Aligning sourcing decisions with Revenue Streams - Companies can mitigate currency and inflation risks by aligning low-cost country sourcing decisions with the revenue stream in those emerging markets. For example, companies with substantial revenues in India could look at developing supply sources in India to counter any such risks. To pursue this path, companies need to start by developing a future revenue outlook by country based on their market participation strategy. Next, they need to review the supply base capabilities available in different countries aligned with their external manufacturing needs. Having a good fact base around these two topics will allow companies to take steps toward aligning sourcing decisions with revenue streams.

While the reward potential and the implementation ease will be different for different options, all of these will require significant cross-functional collaboration. For example, aligning sourcing decisions with revenue streams will require significant collaboration between strategy, marketing, sales, supply chain and procurement functions. Also, there is a need to actively monitor the supply chain strategy in light of an actively changing market landscape. Firms need to understand the risk exposure and be well prepared to utilize different levers to maintain cost competitiveness. It takes 18 to 36 months to move drug manufacturing sources, creating barriers to both entry and exit. Hence, acting before a cost advantage erodes will differentiate market leaders from the rest.

About The Authors

Vishal Bhandari is a manager in the Pharmaceutical and Healthcare Practice at A.T. Kearney. He has more than 10 years of consulting experience serving clients in North America, Europe, and Asia. He has worked for a wide array of clients in the healthcare industry including pharmaceutical / biotech / medical device manufacturers and retail pharmacies. His areas of expertise include M&A planning, operational performance improvement, and supply chain strategy.

Axel Erhard is a principal at A.T. Kearney. His area of focus is pharmaceutical and consumer goods industry. He has experience in market entry strategic assessments, pre-merger planning /post-merger integration and operations improvements. Prior to joining A.T. Kearney, Axel worked with J.P. Morgan in M&A Advisory in London.

Saurabh Tejwani is an associate at A.T. Kearney. His area of focus is chemicals, energy and pharmaceutical industry. He has experience in market entry strategic assessments, operations improvements, and cost transformation projects. Prior to joining A.T. Kearney, Tejwani earned his Ph.D. in Chemical Engineering at Massachusetts Institute of Technology, Cambridge with minors in Finance from Sloan School of Management and his undergraduate degree in Chemical Engineering from Indian Institute of Technology, Bombay.