Rethinking pharma productivity

Gayane Gyurjyan,
Shail Thaker,
Kirsten Westhues,
and Carla Zwaanstra

Pharmaceuticals & Medical Products January 2017

Many companies’ efforts to do more with less

have stalled. Six situations present opportunities
for executives to reignite programs that optimize
efficiency and cost.

The fundamentals of the pharma industry remain strong. A growing and aging population
with significant unmet needs is creating high demand. New technologies are emerging; these
could revolutionize the way new medicines and devices are developed, tested, and marketed,
as well as the way pharma companies interact and build relationships with their customers.

But today’s industry also faces considerable headwinds. The outlook for pricing and volume
expansion is becoming less attractive across all regions, given sustained pressure on drug
pricing in Europe, the growing size and bargaining power of payors in the United States, the
looming biologics patent cliff, and mounting competitive pressure in emerging markets.
Meanwhile, advances in technology and analytics are opening up opportunities for powerful
tech entrants to engage with patients and consumers in radically new ways and to launch
innovative healthcare offerings in conjunction with payors and providers. These entrants
threaten to disintermediate pharma companies as the primary owners of patient data and
take control of their value story. Should that happen, it would have drastic repercussions for
pharma’s R&D and commercial models.1

Faced with these pressures, pharmaceutical companies have been striving to improve their
productivity since the beginning of the new millennium. They scored early success by bringing
down selling, general, and administrative (SG&A) expenses between 2004 and 2011, but more
recent cost-reduction efforts have yet to reshape the structure of their profit and loss (P&L) (Exhibit 1).

While some companies have bucked the trend by achieving more impressive productivity gains,
pharma as a whole still has a long way to go to match the progress other industries have made
in rethinking the way they operate to cut costs and contain staffing levels (see sidebar, “A tale
of two industries”). This holds true regardless of subsector. Big pharma, smaller companies,
healthcare conglomerates, and generics manufacturers may have different cost structures,
1 David Champagne, Amy
but all have struggled to drive step-change productivity gains. As Exhibit 2 illustrates, the only
Hung, and Olivier Leclerc,
companies that managed to reduce their average cost of goods sold (COGS) between 2011
“How pharma can win in a
digital world,” December and 2014 were those operating in the highly cost-sensitive generics sector. And over the same
2015, McKinsey.com. period, only midcap pharma was able to bring down its SG&A expenses.
Web 2016
Rethinking pharma productivity
Exhibit 1 of 3
Exhibit 1
Efforts to cut costs have yet to reshape profit and loss.

Cost breakdown of combined industry profit and loss,1 %

100% = $541 billion $772 billion $814 billion

Cost of goods sold 25 24 25 10% efficiency

last decade
but stagnant in
past 5 years
Selling, general, 27 27
30
and administrative

16 15
R&D 15
Depreciation and 7 8
6
amortization

Earnings before 26 24
interest and taxes 23

2004 2011 2014

Figures may not sum, because of rounding.

1

Source: S&P Capital IQ; McKinsey analysis

Web 2016
Rethinking pharma productivity
Exhibit 2 of 3
Exhibit 2
No subsector has cracked the code on productivity.

Cost breakdown of combined industry profit and loss,1 by industry subsector, %

Cost of Selling, general, R&D Depreciation and Earnings before

goods sold and administrative amortization interest and taxes

Healthcare Big pharma (excluding Midcap pharma1 Generic origin

conglomerates conglomerates) companies

$214 $214 $346 $324 $190 $202 $59 $73

billion billion billion billion billion billion billion billion

19 19 27 27
28 29
45 41

25 26

30 29 28
31
17
19 27
25
13 13 16
10 9 17
5 6
6 6 7
6 5 6

23 27 22
23 30 19 20 20

2011 2014 20112 2014 2011 2014 2011 2014

1
Includes small molecules and biotechs.
2
Figures may not sum, because of rounding.

Source: Corporate Performance Analytics by McKinsey

2
 A tale of two industries

One industry where productivity 27 percent of revenues in 1996–2001

transformation has been key to survival to just 20 percent in 2002–09. But
is semiconductors. This is an industry these averages mask a picture of few
with strong cyclical behavior. During winners and many losers, with attrition
a typical upturn of a couple of years, remaining high. The winners were the
most companies generate profits that companies that took decisive steps to
they use to fund capital investment and optimize return on invested capital by
sustain their operations during the next introducing lean operations, improving
downturn. But because investment asset utilization, expanding outsourcing,
runs ahead of demand in the upturn, and executing a range of operational
what follows is a period of slow improvement programs.1
growth with high overcapacity, during
which poor performers struggle. The For banks, the challenges are different
rocketing costs of R&D and the rising but equally acute. The financial crisis,
capital sums required to build a state- persistently low interest rates, and the
of-the-art fabrication plant add to the digitally driven commoditization of key
1 Stefan Heck, Sri Kaza, and
industry’s challenges. banking products are cutting deep
Dickon Pinner, “Creating
into their profits. Incumbents face
value in the semiconductor In response to these higher costs, a powerful threat from fintechs that
industry,” McKinsey on many semiconductor companies continually improve their technology
Semiconductors, Autumn
have resorted to “fab light” or even to deliver a more appealing customer
2011, McKinsey.com.
“fabless” strategies, outsourcing experience at lower cost. With
2 The fight for the customer:
more and more of their chip design attackers’ costs at least 25 percent
McKinsey global banking
and production and shifting much lower than incumbents’, radical cost
annual review 2015,
September 2015, McKinsey manufacturing to Asia. This drove reduction is high on banks’ agenda as
.com. down average capital expenditure from a route to improving profitability.2

Firing up the productivity engine

As the need for higher productivity in pharmaceuticals becomes ever more acute, standard
industry responses are losing their effectiveness. The main levers that companies have pulled
over the past decade to increase productivity—reinvesting in R&D, reallocating resources
to emerging markets, and improving COGS—will not be enough to deliver the scale of
improvement that the industry needs to thrive in today’s challenging environment.

Reinvesting in R&D. Over the past five years, pharma companies have refreshed their innovation
pipeline, improved their decision making, and reversed their decade-long decline in clinical

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 success rates. A recent Nature article noted, “For the first time since we started analysing such
data, cumulative success rates are up in the three years to 2014, compared with the previous
three-year period.”2 However, companies will need to commit to significant further investment if
this upward trend is to continue. Funding is needed in three areas in particular: developing new
capabilities such as advanced analytics to improve R&D effectiveness, capturing the promise
of new tools and technologies such as immuno-oncology and gene editing, and reshaping
business development and licensing as deals with small start-ups and other external partners
become an increasingly common route for accessing innovation.

Reallocating resources to emerging markets. The pharma industry has sought to benefit from
faster market growth and lower operating costs by shifting frontline resources from developed
to emerging markets, but this strategy has recently received a double blow. Growth rates are
slowing, particularly in Brazil, Russia, India, and China, while labor-cost advantages are eroding
quickly. In addition, local competitors are eating into market-share gains in many countries.

Improving COGS. Generics companies have led the industry in reducing COGS by optimizing
their procurement and manufacturing processes. However, this gain has been offset by a shift
to more expensive-to-produce drugs at other pharma companies, leaving COGS flat across
the industry as a whole. Future improvements will be difficult to achieve, now that generics
manufacturers have exhausted the easy gains. At the same time, originators in small molecules
and biologics will come under increasing pressure to reduce costs as competition from
biosimilars intensifies.

The recent surge in pharma M&A has also been prompted by the quest for higher productivity,
as well as other factors such as increasing specialization. As a recent In Vivo article explained,
“This [M&A] boom was fueled partly by the overcapacity that persists throughout the industry,
particularly in support and commercial functions.”3 The article notes that the largest deals have
declared significant cost synergies even if that was not their chief objective.

As these established levers become less and less effective, we believe the industry urgently
needs to find new ways to bring about the next S-curve in pharma productivity.
2 Katarzyna Smietana, Marcin
Toward a systematic approach to productivity improvement
Siatkowski, and Martin
Møller, “Trends in clinical To equip their companies for a rapidly changing pharma landscape, executives need to seize
success rates,” Nature, every opportunity to embed productivity in their thinking and incorporate it into every change
May 20, 2016, nature.com. effort they undertake. As leaders consider their company’s path forward, any improvement
3 Ankur Agrawal, Ruth De program, whether limited and local or broad and far-reaching, should have productivity at its core.
Backer, Spring Liu, and
Matthew Van Wingerden, Drawing on recent conversations with a number of pharma CEOs, we have identified six situations
“Institutionalizing M&A
that make excellent triggers for executives to drive their productivity agenda (Exhibit 3). Each
excellence in health care,” In
Vivo, March 21, 2016, invivo needs to be handled in a different way. Together the situations represent a full spectrum of
.pharmamedtechbi.com. possibilities, beginning with functionally focused initiatives at the narrow end of the spectrum

4
and ending with whole-company transformation at the broad end. Our advice to any company
facing one of these situations is to make productivity improvement a central plank of its response
and to bear in mind lessons learned by other pharma companies as they plan and execute
their transformations.

1. Surgical functional intervention

Sometimes companies need to reduce costs or improve productivity in an individual business
function, such as procurement, clinical operations, supply chain, finance, or HR, with a view to
achieving rapid results in a matter of months. These are usually healthy organizations looking
Web 2016
Rethinking pharma productivity
Exhibit 3 of 3
Exhibit 3
Six situations can drive the productivity agenda.

Situation Key characteristics

• Limited to single functional area (eg, R&D, HR, finance)
Surgical functional • Short- to midterm results (3 months–1 year)
intervention • Healthy company with desire for incremental benefits
(eg, innovator company)

• Specific to business unit

Business-unit • Short-term must-haves (6–24 months)
turnaround • Underperforming unit within healthy company/conglomerate
• Could be innovator or harvester-type company

• Company-wide
• Mid- to long-term results (1–3 years)
“Good to great”
• Healthy company with desire to become best in class; could
transformation
use innovator or harvester model
• No need to fix basics

• Company-wide
Event-triggered • Synergies to be captured within 3 years
transformation
• Recently merged or acquisitive company

• End-to-end cross-functional processes

Digital • Short- to midterm results (3 months–1 year)
transformation • Any company with need to streamline cost base or to
improve agility and internal or external customer experience

• Company-wide
• Short-term must-haves (3–6 months)
Extreme • Distressed situation with a need to deliver immediate results
makeover (eg, financial distress)
• Typically used in harvester companies (eg, large portfolio,
master at extracting value)

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to capture incremental benefits from superior clinical operations or back-office functions. For
instance, an innovator company may want to optimize its clinical-trial operations by improving
its site selection or extending its outsourcing relationships.

To maximize productivity improvement in a functional strike, we recommend executives take

several steps:

ƒƒ S
tart by creating a clear picture of the function in question. What are its main activities?
How does it create value? How does it connect with other functions? How do its practices
compare with best practice in other sectors, such as consumer goods or advanced
industries? One company we worked with decided to rewire its marketing function to take
out 30 percent of the cost base. It started by defining key deliverables and reallocating roles
and responsibilities between global, regional, and local marketing to reduce duplication
between layers and cut any noncritical activities. The company exceeded its target savings
and was able to reinvest in the marketing capabilities it needed for future success.

ƒƒ M
ap out which activities are truly mission critical and should be kept in-house and which
can be outsourced. Similarly, identify which capabilities are needed to carry out these
activities, and find ways to ring-fence them. After reorganizing, one company added so
many reporting and controlling demands that it ended up with a finance function twice
the size of its peers’. By challenging the scale and granularity of reporting and delegating
preparatory work to a low-cost shared-services center, the company was able to improve
productivity in the function by 30 to 40 percent.

ƒƒ E
nsure that the transformation is run by a capable and dedicated team and is visible enough
to senior leadership that it doesn’t disappear into a functional silo. Successful pharma
transformations strike a fine balance between making local line leaders accountable for
results and providing support from the center. Senior leaders must have a clear view of
performance and support local teams in finding the best path forward. The most successful
transformation programs are those that focus on improving efficiency and effectiveness at
the same time.

2. Business-unit turnaround
Sometimes a company has broadly successful operations but feels that one of its business
units needs improvement. Perhaps its performance is weak in a certain therapeutic area, or
its sales force needs to be more responsive to changing market needs. This kind of effort is
usually confined to the business unit itself and has little or no effect on the rest of the business.
It typically addresses one or two specific objectives over about six months to two years.

In our experience, a few efforts are important for companies tackling such a situation:

ƒƒ S
et ambitious productivity targets, and ensure they’re fully supported by the board or
corporate center. For the best results, corporate leaders need to summon the courage to

6
 take radical steps. One deep cut is preferable to a long series of salami slices, because it
allows the unit to complete its transition much more quickly.

ƒƒ L
ay out a vision for the future of the business unit to ensure it is not alienated from the rest
of the business. One company separated a unit from the rest of the organization without
explaining what would happen to it. Speculation spread that it was destined for a sell-off,
and staff became disengaged. Even though the company did not actually sell the unit,
the uncertainty and poor morale caused its performance to falter. That could have been
avoided if the company had set out a clear vision for the unit from the start.

ƒƒ K
eep energy levels high, and minimize the drag on other parts of the business, by ensuring
the turnaround does not spill over into other business units that are performing well. The
management team of the affected unit needs to own a big portion of its P&L, not just its cost
centers. Locate full accountability with the unit, and charge its management with turning
the business around and achieving a target for earnings before interest, taxes, depreciation,
and amortization. Make it clear that any failure will have serious consequences, such as the
sale of the unit.

3. ‘Good to great’ transformation

Every so often, we encounter a pharma company that is striving to move from good to a
best-in-class standard. Unlike the companies in the previous examples, it isn’t trying to fix
the basics—which are already in good shape—but instead seeks to improve its costs and
revenues by using more sophisticated levers, such as advanced analytics to raise R&D
productivity or advanced segmentation to identify priority customers. This more ambitious type
of transformation tends to take longer, perhaps one to three years.

Companies can best improve their productivity in this situation by doing a few things:

ƒƒ C
ommunicate the rationale for change to everyone in the organization, check that it is
widely understood, and foster a sense of ownership for the effort. Building a solid fact
base that identifies sources of waste and areas where productivity gains are needed—and
realistically can be captured—will help to minimize disruption in the business and forestall
any impression that leaders are pursuing change for its own sake.

ƒƒ C
ompensate for the lack of a burning platform to motivate the organization by creating
and articulating a clear vision based on how the industry is likely to develop and what
the company’s new operating model will look like. The vision should include a carefully
calibrated level of ambition to energize the organization. One pharma company we
worked with explained to its staff that it was changing the way it operated not because its
performance was lacking but because it sought to become a partner to the health system.
Since many employees had joined the company because they wanted to create a better
world, the introduction of a vision that was in tune with their aspirations deepened their
sense of ownership and increased engagement throughout the organization.

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 ƒƒ Build success stories early on, and share them widely in the organization. One large pharma
company had a specialty business unit with a strong pipeline and great performance in
general, but a mixed record for drug launches. To improve its capabilities, the company
selected a handful of launches in different countries and used them to pilot innovative new
approaches. By communicating the success stories and explaining how they could be
scaled up, leaders were able to combat skepticism about the transformation and energize
the organization.

4. Event-triggered transformation
Some transformations come about as the result of an external event, typically a merger or
acquisition or the intervention of activist investors.

The recent boom in M&A in the pharma industry is partly the result of attempts to address
short-term productivity challenges. An acquiring or merging company typically designs
organization-wide integration programs to capture synergies, especially in costs. Such
programs usually take up to three years to complete and deliver results.

Pharma has also seen a rise in shareholder activism in the past few years. Although companies
often regard them as antagonists, activist investors can prompt positive action that brings
benefits in both strategy and long-term value creation.4

A couple of efforts can help companies make sure they capture the full scope of productivity
improvements during integration programs:

ƒƒ D
evelop a clear vision of what the merged entity should look like and what productivity
gains can be achieved. In discussions with partners—whether newly merged entities or
activist investors—they should address productivity issues with an open and collaborative
mind-set. McKinsey analysis shows that reaching agreement with activists tends to lead to
higher shareholder returns over a three-year time horizon.5

ƒƒ U
se the merger or acquisition as an opportunity to capture efficiencies across the whole
business. One pharma company that went through a very large merger found this out the
4 Dominic Barton and Tim hard way. Relying on overoptimistic growth synergies, it decided only to address back-
Koller, “What CEOs can office savings, not front-office opportunities. This left inefficiencies in place, and when
learn from activist investors,”
increased austerity measures in Europe caused a market slowdown, the company had to
December 2015, McKinsey
.com. go through a series of further restructurings to finish the job.

5 Joseph Cyriac, Ruth De

5. Digital transformation
Backer, and Justin Sanders,
Over the past decade, more and more companies have turned to digitization and automation
“Preparing for bigger, bolder
shareholder activists,” to streamline and speed up their processes and to capture efficiency and productivity gains.
March 2014, McKinsey.com. These efforts generally cut across functions, involve rethinking entire processes from end

8
to end, and deliver results quickly, within three months to a year. They are undertaken for a
wide range of reasons, from reducing the cost base to improving agility or creating a superior
customer experience.

Companies can take a few measures to gain the maximum benefits in these circumstances:

ƒƒ A
pply an agile, iterative test-and-learn approach, rather than running long and expensive
development processes to concoct the perfect solution. One specialty-pharma
company we worked with set up a stand-alone unit to develop digital solutions for patient
engagement and new customer-interaction models. The unit was designed to have a start-
up culture and an innovation process that took an idea to minimum viable product in no
more than 100 days.

ƒƒ R
oll out the new process by incorporating it into existing business processes so that the
company can start operating in the new way as soon as possible. The specialty-pharma
company deliberately kept its new unit separate from the existing organization but located it
in the same city so the two could be in regular contact. In addition, the company set up an
advisory board that not only guides the start-up but also exposes company executives to
new ideas.

ƒƒ S
et up business-led, customer-centric transformation teams staffed with A-grade talent. In
reworking its customer-interaction model, the specialty-pharma company ensured that its
idea-generation sessions were led not by IT (though the group was closely involved) but by
sales, because this function had the deepest insight into what customers value. Later in
the process, the fact that sales leaders took visible ownership of the new interaction model
helped increase buy-in among frontline employees.

6. Extreme makeover
When a company commits to rethinking its strategic direction and embracing a new vision,
culture, and way of doing business, improving productivity will usually be central to the
effort. A total transformation is often undertaken in response to a crisis or financial distress—
circumstances where the organization needs to act fast to improve its performance immediately.
It will strive to achieve results in as little as three to six months so that it can demonstrate its
ability to turn the situation around, save money to fund later stages of the transformation, and
build momentum and conviction in the organization for broad, long-lasting change.

To keep productivity central to the effort, companies in this situation should home in on a
few areas:

ƒƒ A
rticulate a clear change story that does not focus exclusively on the immediate crisis
but acknowledges the organization’s strengths. It is important to remind people of what
unites them, what they can be proud of, and why they have what it takes to go through a
difficult transformation.

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 ƒƒ S
et targets by taking an independent, clean-sheet approach to encourage more radical
thinking. Leaders are often preoccupied with last year’s performance and confine their
strategy to cutting back on the current model. Starting from scratch forces them to set
a new level of ambition that goes beyond what seems possible today. Our experience
supporting businesses with transformations indicates that such an approach typically
identifies two or three times more potential impact than that suggested by an initial
internal assessment.

ƒƒ N
ever underestimate the importance of the “soft” skills. In interviews with industry
leaders, we found that four practices in particular make a transformation more likely to
succeed: communicating openly, leading by example, engaging employees, and fostering
continuous improvement.6

As the productivity imperative in pharmaceuticals looms ever larger, now is the time for
companies to think through their strategic options. In particular, leaders facing any of the
six situations described here should put productivity at the heart of any change program or
improvement agenda they undertake.

The best practices outlined for these situations are intended not as a comprehensive checklist
but as a starting point for discussion. To be sure, these are conversations worth having. A
6 Gayane Gyurjyan, Shail
healthy, productive pharmaceuticals industry benefits the whole world.
Thaker, and Carla
Zwaanstra, “Change
Gayane Gyurjyan is an associate partner in McKinsey’s London office, where Shail Thaker is
lessons from pharma and
med tech,” May 2016, a senior partner and Kirsten Westhues is a senior expert; Carla Zwaanstra is a specialist in
McKinsey.com. the Amsterdam office.

Copyright © 2017 McKinsey & Company. All rights reserved.

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