Guest Opinion: Getting what you pay for from fee-for-service

The shift to a fee-for-service pricing model in the pharmaceutical wholesaling is slowly but steadily gaining momentum. The wholesale channel will not change overnight, but as evolution occurs, the contribution of wholesalers to sales, marketing, customer service and logistics requirements can also change. Pharmaceutical manufacturers must learn how to use fee structures to leverage their influence and encourage true supply chain partnerships. Otherwise, they risk missing an opportunity to think strategically about these new compensation models.

Since so much of a drug wholesalers’ gross margin comes from manufacturers, channel relationships have predictably become overly focused on negotiations over fees and discount rates. Today, pharmaceutical manufacturers and their cost consultants are focused almost exclusively on tactical cost-avoidance questions in negotiations over fee-for-service. How can we measure wholesalers’ cost-to-serve for our products? What is the cost of logistics alternatives? What is a fair level of profit?

These questions miss the more significant strategic opportunity now open to drug manufacturers. Based on our research and experience in other industries, channel compensation programs can represent powerful tools for motivating change and driving business results. Fee-for-service payments should be designed to reward concrete actions that build your company’s brands, lower supply chain costs, speed new product launches, and take any other actions required to remain relevant to your company’s business objectives.

Barriers to change

For many years, pharmaceutical manufacturers have offered cash discounts and forward-buying opportunities to support the legitimate costs of wholesale distribution for their products. Relatively high product price inflation rates for ethical pharmaceuticals allowed wholesalers to earn 15 to 20 percent return on inventory.

Forward buying was profitable enough to hide the fundamental flaws with this system. Trade discounts, rebates, and payment terms are all indirect and blunt tools that add little value to the healthcare system and warp incentives to lower supply chain costs. For example, the pressure to meet Wall Street expectations encouraged some manufacturing executives to “rent” market share at the end of every quarter.

The adoption of Inventory Management Agreements (IMAs) over the past few years altered this dynamic. In a basic IMA, the wholesaler agrees to reduce or eliminate forward buying of a manufacturer’s products in return for a fee structure or payment from the manufacturer to offset the wholesaler’s economic losses from the discontinuation of forward buying. Essentially, manufacturers have been paying their wholesalers not to speculate with inventory, although the transition away from inventory profits has shrunk wholesaler profits more quickly than most analysts or company executives anticipated.

However, most IMAs are still based on a percentage of sales calculation instead of transaction or fee-based compensation. The transparency and integrity of the drug supply chain is reduced by any wholesaler compensation approach linked to manufacturer price increases. Existing accounting standards and reporting requirements allow manufacturers to bury the wholesale distribution costs for their products and wholesalers to hide the profit contribution of vendor payments. Many manufacturers will resist this transparency, as we estimate that fully accounting for distribution costs would reduce operating profits for pharmaceutical manufacturers by $3 billion.

Paying for Performance

Fee-for-service is a channel compensation approach by which customers or suppliers pay directly for the channel’s services rather than having those services bundled in gross margin and unseen discounts. Manufacturers gain customized support and accountability, while distributors earn fees commensurate with their effort, costs and results. By separating product costs from service costs, fee-for-service pricing provides a more accountable way of measuring and compensating for the value activities in the supply chain.

Since wholesalers are likely to play an ongoing and important role in the healthcare supply chain, pharmaceutical manufacturers must learn how to use fee structures to leverage their influence and encourage true supply chain partnerships.

Pharmaceutical executives should begin by describing the specific, prioritized objectives and requirements for their wholesalers today and in the future. Wholesaler compensation should be directly linked to the specific results or activities that influence your company’s preferred outcomes. Representative outcomes include service levels to retail customers, transparency to customer sales and inventory, control over secondary market activities, price integrity across channels, or reduction of the manufacturer’s internal supply chain costs. In other words, focus on the outcomes that your company seeks rather than trying to measure the cost structure of a third-party wholesale supplier.

The key is to mix the carrot of additional rewards with the stick of margin loss to motivate change and create new wholesaler management tools. Here are best practices from other industries that could be applied to healthcare:

• Shift incremental compensation to require a minimum performance (for basic compensation) and exceptional results (for incremental results).
• Add numerous small penalties for service level performance below requirements (late delivery, incomplete order, incorrect price, etc.).
• Force wholesalers to drive behavior down into the wholesaler’s organization with incentives and penalties targeted at lower level and functional managers.
• Incorporate customer-level metrics of service performance for your largest and most significant retail accounts.
• Require the population of two-way report cards, analyst/management attention, and periodic review and benchmarking.

Superior channel compensation programs offer all wholesalers the same choice – either step up to deliver new results or operate at a lower level of investment and commitment. Distributors that opt in incur higher costs, but also have access to incremental incentives. Channel members that opt out make a decision to focus on different end-customer value offerings. Over time, the end result of this self-selection is a more efficient channel system that is better aligned with your business objectives.

Manufacturers can also use fee-for-service programs to encourage movement toward longer term channel strategy objectives. For example, manufacturers can add partnership incentives to encourage certain wholesalers to become “supply chain superstars” for your company. These incremental incentive would be associated with systems investments, supply chain management training for a wholesaler’s employees, management education, and (above all) working toward customer transaction visibility (ship-to customer orders, not restocking). The “supply chain superstar” label will help reward wholesalers (and retailers) who are hyper-focused on the customer and patient. It could also address the negative public perceptions of the pharmaceutical industry due to supply chain inefficiencies and gaps.

Another option is to offer a customer service development funds to wholesalers that can propose and develop innovations targeted at improving demand-driven supply. Any wholesaler can submit a business plan for developing a supply chain-related customer for-fee service that leverages the combined competencies of the wholesaler and manufacturer. In other industries, manufacturers retain the right to approve plans and require wholesalers to co-fund mutually beneficial programs.

All of these approaches and tools require drug manufacturers to put aside adversarial relationships and focus on ensuring sales to downstream customers and patients. The goal should be to shift costs to the most efficient point in the supply chain and become more sophisticated in managing wholesalers.

Adam J. Fein, Ph.D. is the founder and president of Pembroke Consulting, a firm that helps senior executives of wholesale distribution, manufacturing and B2B technology companies build and sustain market leadership. He can be reached at (215) 523-5700 or on the web at www.PembrokeConsulting.com.