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Fallout from Pharmaceutical Inventory Management Agreements
Study suggests IMAs produce opposite effect on healthcare system
Inventory Management Agreements (IMAs), used for the past three years by drug manufacturers and wholesalers to reduce investment buying in the pharmaceutical channel, have had the opposite of their intended effect, according to research by Pembroke Consulting, Philadelphia, PA. The research data underscores the difficult transition distributors and manufacturers are navigating as they seek better profitability models.
By Thomas P. Gale
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In theory, these agreements should shift costs to the most efficient point in the supply chain without compromising patient access to medicines. Pembroke’s white paper, released this week, says that inventory has shifted one step up the channel back to manufacturers rather than vanishing from the supply chain. Manufacturers added nearly $4 billion in drug inventories during the period when the largest three wholesalers avoided adding $4.6 billion in incremental inventory.
Pembroke Consulting’s paper further contends that the introduction of IMAs may have also increased the risks and velocity of drug product shortages, raising critical questions about the impact of new supply chain agreements on patient care and the additional costs imposed on institutions such as hospitals and pharmacies.
"Pharmaceutical manufacturers are bearing substantial and generally unrecognized costs associated with this shift," says Pembroke Consulting President Adam J. Fein. "On a broader scale, this is about changing ways that distributors are compensated for channel functions. IMAs were intended to fix the dysfunctional system in which distributors sold products to customers below cost and then made money through investment buying in advance of price increases.
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"IMAs have succeeded spectacularly in lining up supply and demand," Fein told MDM. "Distributors have seen a large drop in inventory levels and a corresponding increase in cash. The surprise is that the inventory appears to have moved up to the manufacturer level instead of disappearing from a theoretically more efficient channel."
Background
More than any other wholesale sector, gross
margins have crashed and burned in the pharmaceutical industry. The
pharmaceutical channel over the past 25 years has seen average wholesaler gross
margins decline sharply, from 11.2 percent in 1980 to 4.3 percent in 2003,
according to Pembroke. That contrasts with average gross margins for all U.S.
wholesaler-distributors increase slightly from 20.1 percent in 1993 to 20.5
percent in 2002.
Large buyers effectively were able to drive wholesaler margins down with their buying power as the industry consolidated. Distributors responded by adopting investment buying practices. Investment buying, where distributors bought more inventory than required for short-term sales demand, developed as a profitable model for distributors because of drug price inflation. Essentially, distributors could load up on inventory and make up to 15-20 percent margins due to the impact of price increases.
According to Pembroke Consulting, the composition of wholesalers’ gross margin in the past 20-plus years has shifted from primarily sell-side mark-up paid by customers to almost entirely buy-side compensation by manufacturers. By 2002, approximately 40 percent of the wholesaler’s total gross margin on pharmaceutical distribution came via investment buying opportunities. Another 40 percent came from cash discounts offered by manufacturers.
A Tough
Transition
The
transition from investment buying has been a bumpy one for the channel. The past
three years have seen a rapid shift in the pharmaceutical industry to IMAs
between distributors and manufacturers, with up to 70 percent of distribution
volume covered by IMAs by the end of 2004, Fein says. Effectively, manufacturers
pay wholesalers through an IMA to not speculate with inventory, in return for a
fee structure or payment to offset the distributor’s economic losses, Fein adds.
The industry is moving toward fee-for-service contracts, but clearly hasn’t been
able to escape the intense focus on cost rather than how to create stronger
value and profit models.
Example: AmerisourceBergen this week lowered its fiscal year 2005 earnings estimate to $3.10 to $3.50 from $4.00 to $4.10 due primarily to reduced buy-side profits resulting from lower than anticipated inventory levels associated with its ongoing transition to fee-for-service (FFS) contracts with branded pharmaceutical manufacturers. With certain manufacturers restricting inventory availability under IMAs and in anticipation of FFS contracts, the company expects inventory during the March through September fiscal 2005 quarters to be in the low to mid $4 billion range, down significantly from the $5.2 billion at the end of the December fiscal 2005 quarter.
The company expects the transition to FFS to provide more stable and predictable operating margins with reduced levels of working capital. It expects to have most of its branded pharmaceutical revenues under some form of FFS contract by the end of calendar 2005.
Cardinal Health last June reported that its product inventories were $500 million lower than expected in the second quarter of 2004 due to the adoption of IMAs with manufacturers.
The other large pharmaceutical distributor, McKesson, has made similar disclosures, and said its "goal is to reach new agreements with pharmaceutical manufacturers that improve the visibility and predictability of our economics while maintaining appropriate compensation."
New Profitability
Model
Key question:
Why did this transition to a more efficient supply chain on paper in fact create
some major heartburn for both manufacturers and distributors? Fein speculates
that several factors are at play, including sales pressures internally at
manufacturers as well as certain regional demand pressures.
For distributors, investment buying provided higher liability but also higher return on investment; IMAs reduce inventory and increase cash, but in a fundamentally different financial structure, as investors have painfully pointed out to the publicly traded pharmaceutical distributors in the past year. There is no solid profitability model in place to supplant the old one, even with significantly lower working capital costs.
Ultimately, the solution for the pharmaceutical channel is for manufacturers and distributors to figure out how to craft performance-based agreements that lower total supply chain costs, Fein says. Successful fee-for-service agreements can reward concrete actions by wholesalers to build manufacturer brands, lower healthcare supply chain costs, or speed availability to patients of new products. Distributors have to be more creative in developing new service innovations for customers and recapturing sell-side profitability.
"The transitions in the pharmaceutical channel hold some important lessons for other types of distributors," Fein said. "Unseen discounts and rebate structures are generally poor ways for manufacturers to manage a channel. The ultimate solution is for manufacturers to think through how to compensate good distributors for what they want to accomplish. In the pharmaceutical industry, that means creating fee-for-service agreements that restore some balance to what has become a very unbalanced channel."
A free copy of the research paper titled "Challenge in the Channel: A Critical Review of the U.S. Pharmaceutical Industry" may be downloaded here.
Thomas P. Gale is the editor of Modern Distribution Management newsletter.
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