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Testing times

Emerging management practice offers new ways to improve the annual business plan review process

 Testing Times

Pharmaceutical companies vary greatly, from global giants to start-ups, and from speciality firms to those spread across almost every therapy area. Despite this variation, our research into how they make and implement their competitive strategies reveals one process, the annual business review, which is near-universal in all pharma companies and has similar characteristics wherever it is found.

Although details of timing, content and process vary, the general form of the review is similar in most pharma companies. Brand and therapy area leaders expend a great deal of time and effort developing and preparing a document to present to those who own or run the business.

The essence of this presentation is a request and a promise; a request for a given expenditure and a promise to deliver a specific return on that investment.

In almost all of the companies we study, both executives and leaders express dissatisfaction with the process, complaining that it takes up too much time and contributes too little to the success of the business.

Exception to the rule
Frequently, the process is characterised by gaming techniques, in which executives overstate costs and understate sales, while their leaders try to second guess this ploy and demand lower spend and higher returns.

By contrast, a small minority of companies find the process valuable and essential to their success, allowing a better, stronger business plan to emerge without gaming but pooling the knowledge of both executives and their leaders.

These success stories are exceptional, outliers to the main trend and when we interview and analyse these outliers, four distinct and valuable lessons emerge for the industry as a whole.

Lesson 1: Weaknesses in the review process
The first of these lessons concerns the way the two sides think. Executives usually think in terms of sales, profit and return on investment (RoI) and justify their plan in that language. Business owners and their proxies, such as CEOs, think in terms of risk-adjusted RoI and evaluate a plan in terms of not only what it promises but also the probability of it delivering on that promise.

This small but critically important difference in perspective explains the weaknesses of the review process in most companies. When, as typically happens, business leaders demand higher returns and lower investment, it is because they think the plan has significant risk that must be offset by a higher RoI. From the perspective of the business owner or shareholder, a plan which promises returns that are not proportionate to the level of business risk is one that, in effect, destroys shareholder value rather than creates it.

TestingTimes Fig1

Executives who don't consider this risk-based perspective often express frustration and perceive their leaders as unrealistic or, worse, greedy. By contrast, those unusual pharma company executives who have overcome this problem share a common way of thinking about business risk as a three-component model (see Figure 1).

Lesson 2: Understanding and assessing commercial risk
While technical and political risk can be important, they are usually addressed long before business plan review and commercial risk was the most common concern of CEOs and executives among the exemplary companies we researched. It is in the understanding and assessment of commercial risk that these companies and executives demonstrate a more advanced review process and offer the second and perhaps most insightful lesson to other companies. As shown in Figure 2, they break commercial risk down into three further categories, a perspective that makes its analysis and management much more effective and efficient.

TestingTimes Fig2 

This sub-division of commercial risk is practically important for two reasons:

  1. It allows executives to focus their attention on whatever type of risk is most important to their particular business situation and
  2. It allows executives to analyse that critical risk in detail.

Executives who don't consider the risk-based perspectives often express frustration …

The focus is made possible because market, share and profit risk tend to vary in importance according the life cycle of a product category. For example, business plans for innovative new technologies, such as gene therapy, tend to have high market risk but low share and profit risk.

For established but still differentiated technologies where product-based competition is dominant, which is common for most product categories, it is usually share risk that is the most prominent as firms compete against similar competitors.

For very mature technologies, such as in statins or other commoditising categories, profit risk is the central concern of those reviewing the business plan because of the cost pressures caused by generics. This knowledge that risk varies with life cycle is what enables both leaders and executives to focus their commercial risk analysis.

Lesson 3: Analysis of critical risk
After focusing on the most important risk category, the next lesson to emerge strongly from our research concerned the analysis process for that critical risk. We found that leading companies talk of each of the three categories as having multiple sub-components.

Sub categories of business risk

  1. Market risk – a combination of risks associated with estimating total market volumes, market category and forecast growth rates
  2. Share risk – is important in mature markets and arises from the nature of competitive strategy, especially in how well it addresses market segmentation, targeting and positioning, in addition to how well it anticipates the market
  3. Profit risk – understanding concentrations within the income statement and assessing the risk associated with those concentrations from a net income perspective

Market risk, for example, is a combination of risks associated with estimating total market volumes, market category shares and forecast growth rates. In the innovative markets where market risk is important, all of these estimates have wide margins of error and these are the primary cause of commercial risk

Share risk, by contrast, is important in mature markets and arises from the nature of the competitive strategy, especially how well it addresses market segmentation, targeting and positioning and how well it anticipates market trends.

In the commoditising markets where profit risk is the focus of executives' attention, the key issues are costs, prices and competitive response.

Lack of attention to any of these factors leads to commercial risk. In total, our research identified 15 sub-categories of commercial risk and while few companies managed all of them, the best companies have learned to pay detailed attention to those that are important to their particular business.

Lesson 4: Marketing due diligence
Given the innovative, high capital investment nature of the pharmaceutical industry, the first two lessons – the need to think in terms of commercial risk and to dissect and analyse it – are very important. However, there is a fourth, important lesson for pharma companies in what this exemplary management practice implies for improving effectiveness of their annual business planning review process.

A summary of marketing due diligence

  1. Business plan reviews need to discuss risk-adjusted ROI
  2. Commercial risk has three main components
  3. The risk profile of a business is related to its product category life cycle stage
  4. Each component of commercial risk has a number of elements
  5. Each element can be understood and managed by an appropriate technique

Instead of the wasteful, often sub-optimal process we observed in many companies, we saw in some companies the practical application of the risk perspective, which we named marketing due diligence, at two levels.

  1. At the level of those who evaluate and approve business plans, business owners and their proxies such as CEOs use these ideas to assess business plans more rigorously and methodically than in other, less effective, companies. For these most senior executives, the marketing due diligence process becomes a type of diagnostic tool, systematically revealing any areas of the plan in which commercial risk has not been well understood or managed. By focusing on a life cycle stage of a product category, boards find this approach not only effective but efficient, allowing them to prioritise their time on to parts of the plan where poorly-managed risk is most likely to be found.
  2. At the level of those who prepare and present business plans, executives in various commercial functions use these ideas to guide the planning process, in effect using marketing due diligence as a type of check-list to ensure that the plan they present to the board is as strong as it possibly can be and, importantly, is expressed in the language of risk-adjusted RoI.

Again, product category life cycle stage allows executives to prioritise their efforts but each of the three main components of commercial risk can be managed and mitigated by an array of techniques.

  1. Market risk, for example, can be reduced by more or better market research.
  2. Share risk is best addressed by improving strategy, especially segmentation targeting and positioning.
  3. Profit risk can best be managed by careful, objective testing of assumptions about prices, costs and modelling competitive response strategies.
… the marketing due diligence process has become a type of diagnostic tool …

In other words, the risk perspective on business plans acts as both a diagnostic test and as a therapeutic tool to improve the probability of a plan delivering on its promises and, therefore, creating shareholder value.

Evolving management practice
We observed that there has been an evolution of management practice in pharma companies with respect to the business review process. A small number of advanced companies are adapting this near-universal process by using a risk perspective that is most accurately described as marketing due diligence, the headline components of which approach are summarised above.

In doing so, they are providing valuable lessons for their peers in the industry by moving from an often wasteful, ineffective and frustrating process to one that makes better use of executive time to create stronger business plans and greater management team coherence.

Professor Brian D SmithThe Author
Professor Brian D Smith researches strategy in pharmaceutical markets at the Open University Business School and SDA Bocconi, Italy. He welcomes comments and questions at brian.smith@pragmedic.com

19th November 2012

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