Did you know that recent changes to the FDA Medical Device Establishment Registration and Listing Regulations (Title 21-CFR Part 807) require that all Contract Manufactures (CM) and Contract Sterilizers register their facilities with the FDA and list all finished medical devices manufactured or sterilized at those facilities? These changes took effect October 1st 2012 and the deadline to register was January 31st, 2013.  

A summary of the changes to Establishment Registration and Listing Regulations can be found through the following link: http://www.fda.gov/MedicalDevices/ResourcesforYou/Industry/ucm314844.htm

How is this different? In the past if a CM made a device they were not required to register or list as long as they sold only to the OEM. Many of the smaller CMs are likely not even aware of the new requirements. One of the challenges facing CMs is to determine which of the products they manufacturer that are considered to be a ‘finished device’. Although the definition has not changed, it is possible that many CMs believe they are not making finished devices because the product they sell still needs to be packaged and sterilized. Are you making a finished device?  21-CFR 820.3 Definitions paragraph (l) says:

(l)Finished device means any device or accessory to any device that is suitable for use or capable of functioning, whether or not it is packaged, labeled, or sterilized.

Properly navigating an ever changing regulatory environment is truly mission critical to OEM success.  This includes an increasing “burden of goodness” on CMs.  As supply chains consolidate the true partners that emerge will include progressive companies that can clearly understand the requirements and responsibilities regarding registration and listing.

Medical Products Outsourcing (MPO) magazine recently published an editorial entitled “Is R&D the Next Sacrificial Lamb?” discussing the impact of the 2.3% medical device excise tax on R&D investment by medical device companies. We at Cadence believe that R&D will continue to be of primary importance for our customers.  What will likely change, however, is fewer internal resources will be available to conduct this R&D while, at the same time, pressure to reduce product costs will increase.  Contract manufacturers (CM) like Cadence will need to be prepared for this new environment:

• The CM must provide both product performance and economic innovation.  Medical device manufacturers will continue to differentiate their products based on functional performance and patient outcomes.  Their manufacturing partners will need to enable this product innovation and improve production economics through creative product and process design.
• CMs will likely need to provide a broader set of capabilities.  Medical device companies have been actively reducing the size of the supply chain to reduce management overhead.  We believe this trend will accelerate as this supply chain consolidation can also help reduce direct product costs.  This is why Cadence has developed precision machining, laser welding, tube fabrication and finished device assembly capabilities over the past several years to complement our critical component capabilities.
• Medical device companies will also need CMs who are willing to support the product development lifecycle on a shared-risk basis.  This will require some new ways of thinking on both sides of the relationship as the CM’s engineers become an integral part of the device companies’ development teams.
• Medical device companies will expect CMs to have a world-class quality system and partner with them during the product development process to complete product validation requirements.  CMs will need to have the engineering resources in place to plan and execute product testing and validation on behalf of their customers.
• The shift of R&D focus toward markets outside of the United States (OUS) is likely to accelerate.  CMs will need to be prepared to support geographically dispersed product development teams and to adjust to market-specific product requirements.

This evolving environment is one where the clear winners will be those companies that can effectively “do more with less.”  This means leveraging increasingly scarce resources in ways that enable true innovation with a sensitivity to lowest total cost to the patient.

The attached article is a short and sweet articulation of a definition for strategy.  Many times I find myself wondering how on earth it is possible for the business illuminati to continue publishing new articles on strategy and competition.  At some level, it seems like everything that every need be said about competing and strategy has already been said, and the world is just rinsing and repeating the same themes.  The flipside of this obsession with creating new commentary on strategy, is that people frequently lose sight of how simple strategic purpose really is when distilled down to its basics.

The author outlines three basic questions he believes “you need only answer” to define the fundamentals of your strategy.  They are:

1. Who is the target customer?
2. What is the value proposition to that customer?
3. What are the essential capabilities needed to deliver that value proposition?

Although these questions can be rephrased in various ways (e.g. “where do I play and why do I win”), in their current form they succinctly lay out the most important elements of strategy.  The process of developing simple answers to simple questions is often far from simple, but in the end the easier it is to articulate your answers to these basic questions, the more likely it is that your strategy makes sense.

Enjoy!

Article Link: www.strategy-business.com/media/file/cs00002_Strategy-Executive-Decision.pdf

To read the full article click here or read in the January/February 2013 ODT Magazine. 

In the attached article “Breaking News,” the authors offer some insightful observations about how disruptive innovation is changing the landscape of journalism and media.  While the changes taking place in the medical device industry are nowhere near as dramatic, some of the insights seem relevant and worth a few moments of reflection.

Article insight: The authors note a recurring pattern across industry after industry in which established players slowly walk up the value chain, adding services, features and associated overhead to broaden their customer reach and expand into more value added, higher margin products and services.  This process takes place because companies typically assess strategies using the voice of the customer from the folks who are their best customers, and are thus inclined to be influential and the source of future growth.  The voice of the customer process typically does not focus on the customer set at the bottom end of the food chain that is not interested in new features, but wants low cost, simply executed good and services.  The result is that incumbents become more entrenched up the value chain, and have organizations designed to support delivering higher value vs. low cost/no frills.

Device industry relevance: For leading companies in the medical device supply chain, the feedback from the larger device OEMS is driving more services, systems and ultimately overhead.  Quality excellence, project management, design services, supply chain management, and regulatory process management are all perceived hallmarks of best in class supply chain partners.  Top tier contract manufacturing companies are adding these services at a rapid pace, working to position themselves as best in class full service companies.  Just read the tag lines and corporate messaging at the next MD&M show and count the number of times you see “total solutions” or “one-stop shopping.”  But is this just the beginning of the pattern the authors describe?  Are we creeping up the value added chain just to risk forgetting how to be lean and mean?

Article insight: In the next stage of the pattern, new entrants come into the market, entering at the low cost/no frills category and establish a foothold.  The more they succeed, the more they begin to demonstrate the viability of the simple and low cost product category for those consumers.  Often this is done through a new business model which is not hampered by needing to fit with the business models used to serve the top end.  Think about Craig’s List vs. the old classified section.  Once established, the new entrants themselves start walking up the food chain, and eventually cause the historic incumbents quite a lot of pain, as noted with Toyota vs. GM.

Device industry relevance: It is hard to forecast exactly how new leaner entrants may arise to take advantage of the general building of overhead services into the device supply chain, but emerging market migration seems to be one possibility.  In their recent investor communications, Medtronic has explicitly noted their intent to develop products in emerging/value markets and then leverage this activity through reverse innovation into developed markets.  Developing these defeatured value products with tight cost targets will almost certainly require an innovation process and manufacturing infrastructure that does not impart as much total cost into the device.  As these products return to developed markets, will this activity threaten the viability of the extended supply chain structures we are evolving in the same way the Huffington Post disrupted the New York Times?

Ultimately it is very difficult to avoid striving for excellence as defined by the best in class device companies and associated supply chain expectations.  However, we need to be ever vigilant about measuring the real value being created in relation to the increases in overhead and compliance costs.  To some degree, medical contract manufacturers and supply chain partners are building the infrastructure that once lived exclusively at medical device companies.  We need to be very careful not to just duplicate a cost structure that the device companies themselves have identified as too costly, or we will find an article like the attached written about us one day.

Over the long haul, population demographics has to be the single biggest driver in most economic equations.  Despite having a label of “The Joy of Stats,” this is really one of the most fascinating depictions of population, health and wealth change over time.  It can tell us a lot about the opportunities lying before the device industry in delivering increased care globally.

There is a reasonably strong consensus in the market place that medical device outsourcing will continue to increase over the next 5 years anyway.  Market estimates differ about how much it will increase, but most industry watchers believe that the outsourced market for medical device and diagnostic outsourcing will continue to grow faster than the market for medical device and diagnostic products themselves. 

Here’s an estimate of the growth in the global medical device market from Ben Dunn and team at Covington Associates:

Similarly, here is their estimate of the medical device outsourcing market over the same period:

As you can see, Covington predicts that the outsourced market will grow substantially faster than the device market itself over the next five years.  The important question, which is not well analyzed or understood, is why?  There are certainly a variety of factors contributing to the trend, but as with most phenomena like this, there have to be underlying economic benefits to the activity transfer if such a growth spread will really occur. 

I am not going to cover all the possible economic drivers, but thought instead to highlight a few of the big ones and their associated implications.

1. Technology efficiency: It is reasonably obvious that different products require different production methods.  A vertically integrated device company has a fixed portfolio of assets from which to choose in addressing their breadth of products.  The broader the product technology span in their portfolio, the less efficient vertical integration becomes.  Using outsourced providers allows a better product to process match for customers, providing cost benefit.  You can see this evidenced in what OEMs choose to do themselves versus outsource.  For example, the large Orthopedic implant makers like Zimmer, Depuy and Stryker typically make many of their implants themselves because the product variety is not high and the relative value of integration makes sense.  By contrast, diverse instrument providers like Covidien and Ethicon tend to outsource all of their precision metals because there is no comparable aggregate technology that they should centralize.  It is also the case that as arms dealers, suppliers can fill capacity with work from multiple customers whereas a vertically integrated OEM has a harder time working toward optimal utilization on equipment because they can only service their own demand.  
2. Risk transfer: A less openly discussed economic benefit of outsourcing lies in a basic transfer of investment risk from the OEM to the outsourced provider on production equipment.  The basic recipe of outsource contracts involves commitments from the OEM to the outsourced provider at a certain price over a certain period in exchange for the outsourced provider funding the manufacturing capacity to support production.  However, agreements where the OEM guarantees minimum volumes regardless of what they are able to sell in the market are exceptionally rare if they exist at all.  Device companies may guarantee exclusive purchasing of all requirements, but almost never insulate the outsourced provider from the market risk itself.  If they aren’t selling devices, they are not obliged to purchase them from their outsourced partner.  This is a powerful derisking of the OEM’s balance sheet, often enabled by relatively unsophisticated smaller outsourced companies who do not do a good job of the risk assessment. 
3. Compliance cost:  As FDA increases its regulatory stranglehold on the industry, compliance costs across the entire value chain have gone up.  However, the cost increases are at least temporarily unequal between OEMs and outsourced partners: OEM compliance cost of similar activities is higher than outsourced provider costs.  For example, product qualification costs for suppliers have been increasing as OEMs have been imposing increasingly substantial processes on the value chain to bring new products to market.  But if you compare the cost in the supply base to the cost of the same activity at the OEM level, it is still lower.  OEMs regularly say that the validation activities or requalification of a component/assembly will cost them hundreds of thousands of dollars.  While supply chain costs are higher than they once were, they are not this high.  Furthermore, if you reflect on the various instances where an OEM has asked us to take over a vendor because they are not compliant to the OEM and it gets them off their radar screen, this at its economic root is a cost differential transfer, which remains to be seen how long it will last.  Unless companies in the supply chain are simply better at delivering cost of quality, this differential is likely temporary.

Overall the above economic drivers represent simultaneous opportunities and threats for suppliers. The first step is to be aware of them.  If you do not understand the root economics at work, you are most certainly not going to be good at managing the associated risks.  Arms dealers are not warlords, but still need a good understanding of how wars are fought and won.

Venture capital deployment is a process involving the evaluation of an opportunity’s likelihood of succeeding, assessing the potential reward associated with its success and making a judgment on the risks to the potential opportunity – a basic risk reward calculation.  In the medical device and diagnostic outsourcing world, companies are constantly uncovering new opportunities and allocating scarce resources to service the ones chosen.  Each opportunity chosen to resource has both an immediate cost as well as an opportunity cost.  The resources committed to a project are unable to be used on something else.

With this in mind, medical device and diagnostic outsourcing companies need to think like venture capitalists.  As long as there are sufficiently many options, companies need to be highly selective about which to attack, evaluating things like the customer’s business model and strength, the likelihood of the project’s success, and their suitability as an enabling partner.  Doing this well will create competitive advantage through sharing project risk with customers (something they highly value) without overreaching.

Similarly, device companies should be aggressive in evaluating their supply chain partners against this measure.  For any given supplier, device OEMs should ask themselves questions like:

• Does this supplier think like venture capitalists? 
• Do they dig into what we are trying to accomplish for the patient and why it is different from existing devices? 
• Do they make exacting judgments about our likelihood of succeeding?
• Do they have the best sense of why they are the right choice themselves? 

Device companies who do not have this sense from their key suppliers should understand that it is unlikely they are sharing an appropriate amount of the project risk.   A true partner on a project should be willing to invest themselves, either in engineering resources, new technologies, or other things that cost real money, betting that together with their customer they will succeed.  If suppliers are not really interrogating projects or making any meaningful evaluation of their success they are very likely engaging in a transactional manner – cut me a PO, give me a contract, fund 100% of our non-recurring engineering charges, insulate me from risk, and I will do what is “paid for.”  Risk sharing requires risk analysis.

One of the drivers for increased outsourcing is the shift in fixed assets and their associated risk from the device companies to supply chain companies.  While this makes sense in theory, is it evidencing itself in reality?  How can we measure it?

Fortunately, many of the larger medical device companies are publicly traded, providing access to their income statements and balance sheets.  If the increased outsourcing trend is really taking place, we would assume a simple thing to be happening over time: sales growth at the medical device companies should be reasonably outpacing the value of plant, property and equipment assets.  In other words, as companies grow their revenue through new products and processes, a lower and lower percentage of the equipment used to support that revenue would be insourced and thus on their financial statements.  Reviewing the sales growth information over the last three reported years for nine of the larger medical device companies, we can see their revenue has collectively grown by roughly 10% in total over two years:

The same period balance sheet information shows that their Plant, Property and Equipment assets have grown much less, at only 3% in total:

Here is a table showing the asset intensity of these businesses and their change over time as well.  Not our PP&E intensity is just under 50%...

As can be seen above, assets have grown about 6.5% less than revenues.  This delta represents around $740 million in assets not on the medical device companies balance sheets, that despite productivity gains and some asset efficiency gains, likely exist somewhere in the supply chain.  Keep in mind, that’s $740 million just at these nine companies…

This is the kind of change we should expect to see in the financial statements of the device companies confirming increased outsourcing.