Vertical Integration & Turnkey Contract Manufacturing

A turnkey offering to a customer by a contract manufacturer (CDMO) is challenging but rewarding when managed properly. You will hear phrases such as “one-stop shop” or “full-service CDMO.” Turnkey implies a high level of convenience and customer service. A pure turnkey offering is as carefree as it is rare, allowing the customer simply to provide the CDMO with the requirements and, in due time, received a finished product ready for immediate use.

To truly become a turnkey provider, a CDMO must perform the delicate balancing act of growing the company’s suite of core capabilities without sacrificing quality. For a variety of reasons – changing business relationships, employee attrition – these competencies tend to shuffle over time. A worthwhile CDMO has steadily accumulated capabilities without any drop off in the service level of any one of those capabilities.

But it isn’t enough merely to possess these capabilities. A CDMO claiming to be turnkey must have the wherewithal to apply these competencies to fit the specific needs of a wide range of customers. In other words, without integration, turnkey service is an abstract notion rather than a tangible accomplishment.

Both vertical and horizontal integration are necessary to client servicing that is truly turnkey. With vertical integration a CDMO may internalize some or all steps in the manufacturing of a product. For example, a CDMO whose specialty is powder filling might decide that – for purposes of both economics and client convenience – it will bring bottle making into its portfolio of competencies. This is an example of backwards integration. If the company also decided to internalize logistics, warehousing or shipping for the customer, that would be an example of forward integration. Both backward and forward integration are subcategories of vertical integration.

Horizontal, or lateral, integration is used to expand a CDMO’s reach into a market with a current technology, skillset, asset, or core competency. Examples of this are plentiful. A CDMO may already possess world class quality systems in order to produce and package over-the-counter (OTC) powders. These quality systems, scaled in the appropriate direction, may be very applicable for medical device, or pharmaceutical products. Therefore, a CDMO may leverage this competency to horizontally integrate from powders into other technologies, such as tableting.

But though the options are seemingly limitless, a CDMO can’t be all things to all people. A well-developed strategy and vision for what services a CDMO should offer is critical. As a CDMO grows into more competencies, it must use discretion and prevent over-commitment.

At some point, quantity of competencies affects the competency of competencies and – to any proud, reputable CDMO – this is simply unacceptable. After all, who wants to be a big company with a poor reputation? Here’s the hard fact: The contract manufacturing of pharmaceuticals is one of the most quality-controlled and quality demanded fields of service in the world. Your best bet is to do what you do best and expand outward – but not so far outward that you stray from your true forté.

In his popular 2001 book Good to Great: Why Some Companies Make the Leap… and Others Don’t, Jim Collins describes the “Hedgehog” concept, which is based on the common-sense argument that there is a limit to what one person or company can be “best” at. A company can be good at a lot of things, but invariably won’t be great at things outside of their true areas of specialty. Factoring in the demands of the pharmaceutical industry when compared to other fields, a sober moral is this: Don’t be good at 20 things – be great at three or four.

When a potential customer assesses a CDMO, he is naturally looking for the hallmark competencies relevant to his particular manufacturing process. These competencies are, of course, weighed against those on a short list of other candidate CDMOs. A turnkey solution is often desired but, as mentioned before, rare is the situation where a 100% turnkey process is possible (or even desired). Customers usually want to internalize some of the project inputs where they themselves possess certain competencies. It is important for the CDMO to be able to integrate the customer’s competencies (and, often, make up for customer limitations) into its portfolio efficiently and effectively.

Following is a list of competencies most often desired by pharma manufacturing customers. Though by no means entirely comprehensive, this list provides insight into many of the common CDMO competencies toward the goal of offering turnkey or nearly turnkey client service.

1. 1. Horizontal Integration (HI)
      
      HI was defined earlier. It is a critical competency in the early stages of conversation with a potential customer. However, prior to any discussions, a CDMO may not even be noticed or contacted unless a customer sees that the CDMO is already in the business of what the customer is attempting. For example, it is rare that a customer desiring the launch of a pharmaceutical drug (Rx), would select a CDMO that has no prior history with Rx products. The risk in the mind of the customer is oftentimes too great. This is a substantial barrier for HI when expanding from topical and OTC powders into Rx powders. This situation is difficult but not impossible. If the desire is there and the effort is within the CDMO strategy, other competencies can be marketed that outweigh the disadvantages.Other examples of HI that are easier to accept by customers from a powder filler CDMO might include production of tablets and capsules. A plastics or molding CDMO may horizontally integrate from consumer disposables to class I and class II medical devices. Again, this all depends on a CDMO’s strategy and how well each decision leverages its core competencies.
   2. Vertical Integration (VI)
      
      VI was defined earlier. It is a critical component when marketing the competencies of a CDMO to a potential customer.Packaging is a competency that fits well within VI. A customer in need of powder filling is usually delighted to learn of the ability of the filler CDMO to also produce bottles. Margins from different suppliers in the process can be consolidated for a lower total margin benefiting both the CDMO and the customer. Added benefits include reduced warehouse space and lower freight charges.
   3. Freight
      
      Freight cost reduction could be considered a favorable consequence of VI but is separated here to provide some additional detail. To continue the above example of vertically integrating bottle production, there is nothing worse for freight than shipping empty bottles. It is essentially the shipment of air, which is costly and inefficient. Colocation of both bottle production and filling is ideal for eliminating this cost. However, bottle production is a skill not many possess and even fewer filler CDMOs possess. CDMOs must realize the risk of acquiring this skillset and making it one of their core competencies.The other aspect of freight is managing shipment of raw materials, work in process product / components, and finished goods. Customers may not want to handle freight themselves so part of a turnkey offering is to provide this for the customer. Internal resources are then required at the CDMO to manage logistics.
   4. Engineering
      
      Almost any example of vertical or horizontal integration requires a strong competence in engineering. A customer must be confident that the CDMO can manufacture its product… but there is much more in the process leading up to production. If the project scope is a transfer of technology or a new product, there is a significant requirement for competent engineering. A transfer requires a discontinuation of a process and/or equipment and a restart at the new CDMO location. A new product may require a startup of acquired equipment in which equipment vendors must be managed. The marketability of a CDMO’s engineering ability will be much better if the CDMO has a previous history of working with the technology or products that the customer desires to place with the CDMO. If the technology is new to the CDMO, the difficulty of the sale is much greater. It is very difficult in this situation to achieve the level of customer confidence to move forward. This, however, provides the opportunity for vertical and horizontal integration. Adequate staffing, depth of knowledge, a wide range of technical skills, and a technical staff that has the ability to communicate well to the customer are all competencies that make the CDMO turnkey approach possible.
   5. Warehousing
      
      Warehousing can also be a favorable consequence of VI. Requirements for testing of both finished goods and raw materials have increased over the years. Product must be segregated and held while waiting for test results. This increases the need for warehouse space and warehouse management by the CDMO in order to accommodate this customer requirement. Warehousing as a part of the marketing plan to the customer is almost essential.
   6. Raw Material Management
      
      As a CDMO grows, it will find itself dealing with more raw materials and more raw material suppliers. At a certain level of production, it may become more efficient for the CDMO to manage the customer’s raw materials. For some small companies, this management by the CDMO is desired from day 1. The CDMO will often have better buying power than the customer since the CDMO can buy in volume with the combined business it has with all its customers. This part of a turnkey offering, as with the others, requires CDMO resources. Staff with purchasing and negotiating experience is then required to manage suppliers and keep inventories at sufficient levels.The product cost structure is often dominated by materials. Proper management of raw materials is sometimes the only way to address issues of cost.
   7. Validation ServicesIf a CDMO intends to work in areas governed by the FDA, expertise in validation is required. A medical or pharmaceutical CDMO cannot be competitive without a core competency of validation services. A validation, whether it is product, process, equipment, etc. must be thorough but efficient. This area can be the bottle neck and the single greatest contributor to a late project delivery. It can also be the source of a regulatory violation such as 483 or a product recall. A CDMO will pay the price if an integration move into this area is taken lightly.
   8. Analytical and Micro Lab Services
      
      As mentioned before, testing has been a major customer requirement, but it is ever-expanding. As finished goods wait in the warehouse for test results before they can ship, the costs continue to add up. Time is money. Onsite laboratory capabilities are desired and sometimes required by the customer. It reduces lead times for materials and increases turn times in the warehouse. The supply complexity is reduced and provides the CDMO with more overall control of the supply chain. However, the capital and resource investment to obtain onsite lab testing is significant. Marketability is usually there but a CDMO needs to make sure it fits the strategy.
   9. Fixed Overhead Absorption
      
      One thing is for sure: fixed overhead spread over few products is more costly than fixed overhead spread over many products. A potential new customer placing its product with a CDMO that has other customers will, likely, find a better price with that CDMO because fixed OH allocation will be more favorable. Vertical and horizontal integration provide for more products and processes. Resources and fixed overhead can be spread further providing the best overall cost value to the customer.

Some or all of these competencies may be required for a turnkey solution for a customer depending on which customer knocks on the door. In the end, much may depend on the trust and the relationship established between the CDMO and the customer. However, attempting to obtain many competencies, devaluing the meaning of “core” in core competency, to suit any one possible customer could result in disaster. A strategy for direction must be established to help guide a CDMO’s future decisions on if and how to offer the turnkey solution to a particular customer. If one doesn’t know where they want to go, they could end up anywhere and it may not be a place where they want to be.