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Role of Distributors

   Executive Summary

Purpose of Study

This white paper presents the findings and conclusions of an independent study conducted by Booz Allen Hamilton as commissioned by the Healthcare Distribution Management Association (HDMA).

The purpose of the study was to address specific questions regarding the role and value of drug distributors in the U.S pharmaceutical industry. The study is intended to foster a better understanding ofimportant issues currently facing the industry regarding the distribution of branded pharmaceuticals in the United States. The following key questions are addressed in this white paper:
  • What services do distributors provide and how do they create value for stakeholders in the healthcare industry?
  • How would the healthcare industry look if pharmaceutical distributors did not exist? What would be the cost to replicate distributors’ services and capabilities and the impact on healthcare stakeholders?
  • How did the compensation of distributors evolve historically? Is this system of compensation viable in the long term?
Consistent with applicable laws, the study results are designed to stimulate discussion among individual trading partners only.

Approach and Methodology

This study focuses on the pharmaceutical distribution network in the United States, specifically the distribution channel involving manufacturers, distributors, and pharmacies (referred to collectively as stakeholders). In order to assess the current distribution network and to develop a perspective on alternatives, inputs were gathered from a cross-section of stakeholders. The network was characterized in terms of services currently provided and service levels currently being achieved today. Alternative approaches were developed to meet these service and service level requirements. By characterizing the system in this way, we were able to test alternative approaches to the replication of distributors and assess the economic impact of their role in the healthcare system.

The basis of the analysis was an assessment of the incremental value of distributors to the healthcare system based on replicating the same functions and services if distributors did not exist. The cost of replication assumed

100 percent replication of the same functions, services, and service levels provided currently by distributors. The analysis assumed that the current distribution system did not exist and that product would move directly from the manufacturer to the retail or provider pharmacy. The analysis further assumed the typical supply chain economics of the large (top ten) pharmaceutical manufacturers. The scope of the analysis was limited to branded product and related services. Our economic framework was constructed using information from a number of sources including interviews and third party research reports. The following illustrates the breadth of interview sources:
  • Manufacturers: 3 major pharmaceutical; 1 major biotech
  • Distributors: 3 major national; 5 regional
  • Pharmacies
    • Chains: 3 major national/regional players
    • Independents: NCPA (trade association) plus two members
    • Institutional: 5 hospitals, clinics, and hospital groups
    • Government: Department of Veterans Affairs, National Acquisition Center
  • Other Service Providers: 1 third party logistics (3PL); 1 returns processor
  • Other sources include IMS Health, HDMA, and industry analysts
With each interview source, a broad set of issues was discussed. This study reflects their collective perspective and none of the statements in this report should be attributed to any particular company or individual interviewed. We have included a diverse group of distributors, manufacturers, and pharmacies in terms of size and geography. In the case of distributors, we interviewed companies that collectively represent more than 95 percent of distribution industry volume. For pharmacies, interviews included large retail chains, hospitals, clinics, independent retail, and government buyers.

Other research resources included industry financial analysts, IMS Health, and HDMA. Specifically, pharmaceutical distributor analyst coverage from Goldman Sachs, Bear Stearns, JP Morgan, Merrill Lynch, and Salomon Smith Barney was reviewed, as well as retail coverage from Morgan Stanley and Bear Stearns.

We have completed the following analyses:

  • A generalized map of the current distribution system was developed. Key material and information flows were identified. The process was mapped from manufacturer distribution center through delivery to consumers—“following the bottle” through the process.
  • The full scope of services currently provided by distributors was characterized. Specific capabilities and services were identified and activities included that went beyond the walls of the distribution centers and beyond forward logistics.
  • The performance of the current system was evaluated. Traditional operational metrics such as cycle-time, fill-rates, and quality control measures were gathered. Cost to serve was also measured (e.g., order management, shipping and logistics, inventory, IT, and other value-added services).
  • Sources of margin and financial returns for the distribution industry were identified. These included traditional margins on sales as well as other sources of revenue and earnings.
  • Viable distributor replacement scenarios were identified based on our understanding of the requirements of the healthcare system. The associated replication and ongoing operational costs were quantified. In each case total system costs were examined—looking beyond traditional fulfillment costs.

Key Findings

Distributors Effectively and Efficiently Provide a Multitude of Services to the Healthcare Industry

  • Today, distributors provide a broad scope of important services, managing a complex supply chain with a high degree of reliability, safety, and efficiency. Manufacturers, retail and healthcare provider pharmacies, and patients enjoy and expect a distribu-tion system they can rely on to deliver pharmaceutical products within hours.
  • The distribution system must efficiently serve more than 130,000 pharmacy outlets in the United States every day on demand. Pharmacy customers expect fill rates in excess of 99% (adjusted for back orders), and a typical pharmacy relies on the distributor to have more than 10,000 SKUs accessible for delivery, often within 12 hours.
  • Over time, distributors have provided on behalf of manufacturers and pharmacy customers continuous improvements in logistics management, specialized customer and product service capabilities, and risk management services, such as extension of credit and receivables management.
  • Substantial structural efficiencies are achieved by the distributors through economies of scope and scale that result from aggregating pharmacy transaction volumes (order, delivery, credit, returns, chargebacks) into consolidated, streamlined transactions for manufacturers, retailers, and healthcare provider pharmacies.
  • Distributors enable the other channel partners (manufacturers and pharmacies) to focus on their respective core competencies in developing and manufacturing pharmaceuticals and in satisfying patient needs for access, service, and reimbursement.
  • Distributors’ share of industry volume has been very stable over the past decade, averaging 63 percent, reflecting their historical role as an efficient and valued partner to the pharmaceutical industry.
  • The response to future industry challenges, such as the continued development of biological products requiring advanced specialized handling and the increased demand for specialized treatments among home users would be more difficult to meet without the distribution system and infrastructure in place today.
The Cost to Replicate Distributors Would Be Significant and Stakeholders Would Be Worse Off Without Drug Distributors

  • Full replacement of distributors with direct distribution by manufacturers on a daily basis, assuming the current extensive services and exceptionally high service levels currently provided by distributors to their pharmacy customers, would add at least $10.5 billion per year to industry costs. This is the equivalent of an 11.6 percent increase in pharmaceutical manufacturers’ total costs. This also represents 10.3 percent of the manufacturers’ revenue that distributors handle.
  • If drug manufacturers chose an alternative approach of weekly pharmacy deliveries, the cost increase would be $3.6 billion. This is the equivalent of a 4 percent increase in pharmaceutical manufacturers’ total costs. This also represents 3.5 percent of manufacturers’ revenue that distributors handle. In addition, there would be a number of other significantly negative consequences.
  • Either scenario to fully replace pharmaceutical distributors results in significantly negative financial and operational outcomes for the healthcare industry (see Table 1).
Table 1. Impact of Full Replacement of Distributors
Impact Daily Delivery Scenario Weekly Delivery Scenario
Financial and Operational Outcomes
  • Industrywide annual cost increase is $10.5 billion
  • This is equivalent to a 34% profit reduction for manufacturers…
  • or $169 billion in lost shareholder value
  • In addition, pharmacies must be willing to build the resources and capabilities necessary to order from scores of manufacturers versus one or two distributors.
  • Industrywide annual cost increase is $3.6 billion
  • This is equivalent to a 12% profit reduction for manufacturers…
  • or $57.5 billion in lost shareholder value
  • In addition to expanded ordering capabilities, pharmacies would need to find the space and develop the competencies necessary to maintain and manage much higher inventory levels (retail space, warehousing, forecasting, planning, etc.).
  • Further, pharmacies would need to be willing to commit the financial resources to finance the additional inventory.
Additional Implications for Manufacturers
  • Even under a scenario in which manufacturers invest in direct distribution and/or utilize third-party logistics firms, they would not have the full ability to aggregate volume and amortize costs across the entire spectrum of product categories (i.e. branded products, generics, health and beauty aids, medical supplies, and OTC.) These benefits represent an additional cost that was not quantified in this study.
  • Direct drug distribution would require manufacturers to develop a new core competency—the management of a highly complex drug distribution business.
Services and Service Levels
  • The scenario was developed with an objective to maintain the current services and service levels, using daily deliveries.
  • However, implementation of this scenario presents significant risks— retailers and providers would have to manage substantially more complex daily ordering from multiple sources. This complexity will likely result in an increased number of ordering mistakes, causing stockouts and reducing service levels.
  • The scenario was developed with an objective to maintain the current services and service levels by using weekly deliveries and carrying higher pharmacy/provider inventory to achieve the same service level to the end customer.
  • However, implementation of this scenario presents significant additional risks—beyond those associated with ordering from multiple sources. Retailers and providers would also have to perform a more complex inventory planning function. Increased complexity may result in increased number of both ordering and inventory management mistakes, causing stockouts and reducing service levels.

Open Questions Remaining
  • The analysis presented in this white paper suggests that there will be a substantial cost increase to the industry to replicate the current role and value of distributors. It also raises a number of additional questions that were beyond the scope of this work but need to be considered by stakeholders in evaluating potential alternatives.
  • Full replacement of existing distributors would result in the establishment of a new business model in the drug distribution industry. What would be the full extent of the impact of this change in the existing distribution business model on each segment of the business, i.e., pharmacy chains, independent stores, mass merchandisers, hospitals, and other providers?
  • A wide range of patients depend on the reliable supply of pharmaceutical products as currently pro-vided by distributors. What would be the impact on patients and on healthcare outcomes of the full replacement of existing distributors?
The Traditional System of Compensating Distributors Is Not Sustainable in the Long Term
  • As stated earlier, many of the services currently provided by distributors go well beyond the traditional fulfillment and logistics functions. These additional services such as pharmacy education, in-store assistance, and repackaging are highly desired by pharmacies, yet are not linked to the compensation distributors receive.
  • The traditional distributor compensation model was an indirect system with major sources of margin coming from cash discounts and inventory appreciation. This system has evolved as a rational competitive response, but it depends on drug manufacturer price increases to cover the costs associated with the full range of services provided.
  • Any compensation systems, including Inventory Management Agreements (IMAs) that rely on manufacturer drug price increases are not likely to offer a long-term solution for the industry given existing government and patient pressure on drug prices. If distributors are unable to offset their traditional sources of margin, they will face difficulty meeting their cost of capital and potentially will become unprofitable. This would threaten future investments in efficiencies and new technologies essential to maintaining a complex and efficient distribution system.
  • Because the traditional manner of compensating distributors is not sustainable in the long term, a new compensation model(s) will be necessary. Of course, any discussion about new compensation models must occur only between individual trading partners.
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