There’s no doubt about it, the market for pharmaceutical outsourcing is hot. But how does a company decide whether or not to outsource? At its most basic level all outsourced manufacturing decisions should begin by analyzing profitability measures (ie: cost-benefit analyses).
However, all too often companies are considering profitability measures alone without taking into account the potential of benefits gained through economies of scale. Economies of scale refer to the scenario where companies experience decreasing average cost per unit as output increases — thus, it’s good to be big. Consider how Wal-Marts’ ability to offer products at lower prices than their competition can be generally attributed to large-scale quantity discounts received through purchasing negotiations, this is an example of economies of scale. Quantity discounts and purchasing negotiations however, are not the only way to achieve economies of scale.
This article gives a brief overview of economies of scale and methods used to achieve such. As a starting point, consider the three cases regarding the average unit cost and how it relates to the level of output.
In figure 1 the average unit cost is decreasing even as output increases. To conceptualize, think about the average unit cost Ford faces when producing 10,000 F-150’s vs. 100,000 F-150’s. Figure 2 presents the opposite case where the average unit cost is increasing as output increases. As an example, think about the average unit cost Rolls Royce faces when producing 10,000 Phantoms vs. 100,000 Phantoms. Although the market demand increased equally in each scenario, Ford is likely to experience the benefits of economies of scale while Rolls Royce would suffer from dis-economies of scale. This is primarily due to the contrasting cost structures of each manufacturing facility.
Figure 1 Shows an example of pure economies of scale [Ford]
Figure 2 Shows an example of diseconomies of scale [Rolls Royce]
To give a more real-world example, figure 3 presents the case where the average unit cost is decreasing initially but at some point (q*) the economies of scale advantage is lost and dis-economies of scale begin to take effect. The classic example to give here is Joe’s Doughnut Shop. Beginning with only one employee, hiring an additional employee can greatly increase the efficiency of the shop. This continues with the hiring of employee number 2, 3, 4, and so forth… However after some point (q*) employees will suffer from a crowded workplace and will no longer be able to complete their jobs efficiently. Thus, companies currently experiencing the benefits of economies of scale are not guaranteed the same benefits under ever increasing production requirements. However, the focus of this article is not on maximizing the benefits of economies of scale but simply attaining them in the first place.
Figure 3 Shows an example of economies of scale (real-world) [specialization]
Apart from quantity discounts and investments in specialized machinery, economies of scale can also be obtained through specialization of the labor force. Henry Ford is considered a pioneer in this area for his implementation of the assembly line system in his factories. By having workers complete one specific task over and over, workers became more efficient and subsequently more productive. This increase in production and efficiency are the same benefits realized when investing in specialized machinery. However, where investments in specialized machinery and equipment came with high initial fixed costs followed by lower variable costs; investments in labor specialization come with moderate fixed costs and moderate variable costs. While the end result may be the same (reaching economies of scale) it is important to note the differences in each approach in order to select the most applicable method.
Investments in specialized machinery typically take much longer to pay for than investing in specialized labor. For this reason, a company investigating a product which is forecasted to have lower profit margins but stable long-term demand may be able to justify investments into specialized machinery when compared to a product with higher profit margins and more uncertain long term demand. This second product may be better suited for an investment in labor specialization as the uncertainty in demand carries the potential for change in the near future; a situation which labor specialization is more prepared to handle.
One of the most common ways companies achieve economies of scale is through investments in specialized machinery and equipment. The above example of Ford experiencing economies of scale is assumed to be a result of highly efficient – highly specialized machinery. This type of machinery typically requires large initial fixed costs followed by low variable costs. However, due to this cost structure, Ford’s average cost per unit will decrease with every additional F-150 produced. Intuitively, think about if it would be easier to spread the cost of an entire plant over 10,000 trucks or 100,000 trucks? But why wouldn’t Rolls Royce benefit in the same way?
The example of Rolls Royce experiencing dis-economies of scale is assumed to be a result of their focus on quality and craftsmanship rather than efficiency and price-point. This focus affords Rolls Royce the benefits of economies of scope but not economies of scale. While Ford may have an advantage in the ability to mass produce vehicles, Rolls Royce has an advantage in their ability to customize. Thus, if a customer wanted a personalized interior; Rolls Royce would be better prepared to accommodate such a request. This contrasting relationship between economies of scale and economies of scope can be thought of as the catalyst of the pharmaceutical outsourcing market.
Labor specialization is the driving force which allows many CMO’s and CRO’s to offer services at lower costs than the pharmaceutical sponsor could achieve otherwise. In addition to being more productive and efficient, firms utilizing labor specialization as a means to economies of scale are likely to benefit from increased product quality as well as an increase in innovation. To conceptualize, consider the case of 1 worker performing 10 tasks versus 10 workers performing 1 task each. It should seem a bit obvious that through specialization workers would produce a higher quality product; however these are the same forces which foster a higher level of innovation – an often overlooked facet of labor specialization. The presence of this additional quality and innovation may be one of many forces contributing to the expansion of the pharmaceutical manufacturing and outsourcing boom in recent years.
Is it better to be large and efficient or small and versatile? This is the question everyone in the pharmaceutical manufacturing market wonders. There is no one right answer; rather each circumstance is dependent upon a unique set of factors. Of those factors, the potential benefits from economies of scale should be considered significant and investigated accordingly. Just as profitability measures should not be the sole criteria in determining outsourcing decisions; neither should the effects of economies of scale. The purpose of this article is not to give a hard set of rules such as if-this / do-that, but rather to remind decision makers of the many ways in which project profitability can be assessed. Remember, just as businesses not currently experiencing economies of scale can take strategic action to reverse course, so too can a lack of strategic decision making reduce benefits from those currently operating within the economies of scale spectrum. For this reason, a thorough understanding of the concept is encouraged in order to ensure a comprehensive and robust decision making process.
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