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Stanford University Case Study: Novo Nordisk

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  • 1. Stanford University Graduate School of Business S-SM-22 Rev. July 1995 Novo Nordisk (A) In 1981, Novo was the second largest producer of insulin preparations in the world supplying about 25% of the world's insulin demand, and was the world's market leader in industrial enzymes. Novo held more than 40% of the Western European market for insulin preparations in volume, but its share in the United States was less than 5%. In the US market, which was estimated to be 40-50% of the world market, Eli Lilly held an estimated 83% share. From 1981 to 1995 the world's health care environment changed significantly due to changes in technology, regulation, and competitive forces. Consequently Novo changed as well, broadening its research and development efforts, merging in 1989 with Nordisk, diversifying into consumer products and plant protection products, restructuring its organization several times, and forming marketing and production alliances throughout the world to boost its health care and enzyme businesses. The company increased its research and development expenditures from 9.1% of sales in 1983 to 14.3% in 1993. During the same period sales grew from DKK 3.4 billion to DKK 12.2 billion. As of 1995, CEO Mads Øvlisen can be pleased that the company remains a world leader in insulin and enzymes, but he can look forward to new challenges. The health care industry is poised for even greater changes as providers respond to widespread calls for controlling health care expenditures, particularly in the US, where Novo Nordisk remains a distant second to Eli Lilly in the insulin market. As technology, regulation, and competition continue to change, top management at Novo Nordisk is questioning how it can succeed worldwide into the 21st century. This case was prepared by Mark Leschly, MBA '95, under the direction of Professor William Barnett as a basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1995 by the trustees of Leland Stanford Jr. University. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means - electronic, mechanical, photocopying, or otherwise - without permission of the Stanford University Graduate School of Business.
  • 2. Novo-Nordisk (A) S-SM-22 Novo Nordisk in the Insulin The new technology also eliminated the risks Industry 1 of transferring animal viruses and parasites. Despite these advantages, it was not until six Insulin is used to medically treat years after Eli Lilly that Novo would follow diabetes, a condition where the pancreas does with its own genetically engineered human not produce sufficient insulin to adequately insulin (exhibit 1). regulate blood sugar levels. Traditionally, commercial insulin was produced by Since the early eighties the insulin extracting and purifying animal pancreas industry has consolidated. In 1981, five (porcine and bovine) insulin. In 1980, the companies (Novo, Nordisk, Eli Lilly, Hoechst purchase of porcine and bovine pancreas and Squibb) accounted for more than 90% of glands for the production of insulin accounted the world market. As of 1995 there are only for more than 35% of Novo's total raw two major players left in the insulin industry -- material and energy costs. Novo obtained its Novo Nordisk and Eli Lilly. Novo Nordisk supply from approximately 20 countries; the dominates most of the world outside the US, United States provided over a third of the and Eli Lilly has about 75% of the US market. company's requirements. Because the The only other supplier of any significance is availability of pancreas glands was critical to the German chemical and pharmaceutical Novo's operations, the company maintained company Hoechst. Insulin represents less than several months inventory at all times. As a 1% of that company's $21 billion in result, the supply logistics and production consolidated sales. Although Hoechst has the processes were complex and costly. Aside technology to manufacture genetically from requiring large investments to establish engineered human insulin, it has faced the infrastructure, the total cycle time for considerable opposition from German anti- insulin production could take up to two years. biotechnology interests. Today, the company is primarily a supplier in the German and Through the years, advancements in Austrian markets. the purity of insulin have been accompanied with new methods of production. In 1982, Until recently, the pharmaceutical Novo became the first company to market distribution system included two principal human insulin, Human Monocomponent parties: the doctor and the pharmaceutical drug insulin, which was developed from porcine manufacturer. Decisions about drug purchases insulin by using enzymes to produce an insulin were made by the doctors, whose main molecule identical to human insulin. Six concern was to prescribe the most effective months later Eli Lilly came to market with and safe medicine for their patients. As a genetically engineered insulin based on result, manufacturers spent enormous technology developed with Genentech. Soon resources on promoting their products to it became clear that using genetically doctors through conferences, free samples, and engineered microorganisms in the production gifts. The frequent calls by sales of insulin would revolutionize the insulin representatives from pharmaceutical industry. Procurement costs were reduced. companies to promote their products, combined with doctors' general price _________ insensitivity, meant that patients were usually prescribed premium-priced branded products. 1The material in this case is based on Novo and Nordisk Doctors were familiar with these branded documents and on interviews with current and former Novo Nordisk managers. 2
  • 3. Novo-Nordisk (A) S-SM-22 products and they were an easy and natural made long-term plans to become the world choice. leader in the insulin market. The company's management crafted a strategy to establish Now this system is changing in prominence in the world's insulin market. response to increased pressure to reduce health According to Sonnich Fryland, a senior care costs, downward pressure on prices, and member of the executive management team the development of managed care in the US. since the 1970s, the most critical element to Buying decisions increasingly are made by a Novo's future position in the insulin market smaller number of people focused on cost came in the late 1970s with the building of the control and the industry is seeing new Kalundborg plant in Denmark for the competitors such as biotech companies, drug production of insulin. The company wholesalers and information technologists aggressively expanded its production capacity, who are increasing their presence in the health signaling its commitment to expansion in the care market. international insulin markets. In the US, the traditional relationship In 1978, the first genetically between doctors and drug manufacturers in the engineered human insulin was developed in US is being affected as pharmacy benefit the US by Genentech. The biotechnology manager (PBM) companies, health company knew from the start that it would maintenance organizations (HMO), and payers lack the funds, given the capital intensive are increasingly involved in managing health nature of insulin production, and the know- care costs. Of increasing importance in the how to effectively bring this product to distribution of drugs are PBMs, who manage market. Eli Lilly, the dominant player in the the pharmaceutical benefits for large industry with an 85% share of the US market, customers or payers and typically encourage was a natural partner for Genentech. Then in the use of less expensive alternatives to 1979 a joint venture was proposed to the top branded drugs (see Appendix). management of Novo, which would combine Genentech, Novo and Eli Lilly. The joint venture proposed that Novo would receive the Novo Background rights to genetically engineered human insulin for the rest of the world; Eli Lilly would In the late 1970s, Novo made several receive the rights to the US market. In return strategic decisions that would pave the path for for these rights, Novo would offer its expertise its future position in the insulin market. These in managing the purification process of moves were driven by fluctuations seen in the genetically engineered insulin production. But enzyme market, especially in the US, the CEO of Novo at that time, Knud Hallas indicating that the pharmaceutical market Møller, felt the offer was too expensive for would be more stable than the enzyme market. Novo. He reasoned that Novo should own its As a result, the company's management placed US strategy and not be constrained by a its hopes for future growth on the Genentech-Eli Lilly joint venture. Novo pharmaceutical business -- in particular, the rejected the deal, and the battle over the US insulin business --which was 75% of the market has raged ever since. company's pharmaceutical sales. Until 1982, Novo's strategy to With renewed focus and a relatively penetrate foreign markets had been based new and aggressive management team, Novo primarily on product differentiation. This 3
  • 4. Novo-Nordisk (A) S-SM-22 branded strategy was contingent on promoting range of insulins produced by Novo and the advantages of Novo's highly purified distributed in the US by Squibb. Having tried insulin -- less needed, increased predictability independently to penetrate the US market, of blood sugar levels, and reduced allergic Novo expected that the Squibb/Novo reactions. Initially the company established partnership would lead to increased sales of foreign subsidiaries, and then relied on the insulin in the US. product to "sell itself" on its superior quality. Given its quality advantages, the company Although Squibb was the second reasoned that it would not need a substantial leading producer of insulin in the US market, sales force in foreign markets. This strategy it had faced serious problems since the 1970s usually was effective, particularly in Europe, with its quality and its ability to generate where the company effectively targeted key innovative new products. Its insulin product doctors, or opinion leaders, and used the fact was low quality and its production process, that Novo's insulin had the lowest ppm according to a former executive, was impurities as a means to penetrate markets. "horrible." In addition, the company had The ability to distinguish itself on the basis of multiple providers of bulk insulin and had impurity levels was a critical factor and a key built up an enormous inventory of low quality selling point to physicians. Novo claimed that insulin. Thus in 1978 Squibb contacted Novo the eye injuries and complications suffered by in an attempt to alleviate its product and some diabetics are a side effect of the quality problems. The outcome was an impurities in insulin, and argued that Novo's agreement whereby Novo became the single purer Monocomponent Insulin was much less bulk source provider of animal insulin for likely to cause these complications. Squibb. Squibb had wanted Novo's high quality Monocomponent Insulin, but Novo, In much the same way, Novo entered which wanted to penetrate the US market on the US market in 1977 with Monocomponent its own, was reluctant to give Squibb this insulin. The company promoted its highly product and instead gave them a medium purified insulin as a better product for all quality insulin product. By the early 1980s it diabetics. But it quickly became evident that became clear that Squibb, given its lower the branded strategy would not work as quality product, was unlikely to remain a long- effectively in the US. In Europe, the term player in the industry. At the same time, regulatory requirements for approval of claims Novo's aspirations for a branded US strategy were different than in the US, where had resulted in less than a 5% market share. monocomponent insulin was classified within By 1982, the stage was set for a joint venture. a wide range of impurity. This made Novo less effective in using its high purity to Novo possessed excellent production differentiate its product in the US market. By and purification skills and Squibb had a US the end of 1981 Novo had less than 5% of the distribution network of 800 people and 40 US insulin market. medical specialists. Squibb's strong distribution and access to physicians and Squibb/Novo Joint Venture diabetic specialists meant direct access to the US market. In addition, Squibb's sales force In February 1982, Novo entered into an had a limited range of products to sell and had agreement with E.R. Squibb & Sons, Inc. to ample capacity to sell Novo's insulin. establish Squibb/Novo, Inc., a jointly owned company with the purpose of marketing a full 4
  • 5. Novo-Nordisk (A) S-SM-22 In 1982, Mads Øvlisen became the Nonetheless, in the first year of operation the CEO of Novo. He advocated a change in the joint venture achieved a 15% growth in the US strategy. In addition, the former president sales volume of Monocomponent insulin, and of Novo's pharmaceutical division, who had Novo's market share of the US market left Novo in 1979, was now the president of increased 4%. In October 1983, Novo's Squibb's pharmaceutical division. Having a human insulin preparations were introduced in clear understanding of the needs of both the United States under the Squibb-Novo label companies, he would facilitate the creation of and the joint venture now had a product to go the joint venture in 1982, and his close head-to-head with Eli Lilly's human insulin. friendship with Novo's top management would contribute to sustaining it. Top management Over time Squibb broadened its from both companies were committed to the product portfolio. Particularly with the new company. success of its billion dollar Capoten for the treatment of hypertension, it was placing The joint venture based its operations increased pressure on its sales force to sell and office in Princeton, just ten minutes from Squibb products. Despite the increased the corporate headquarters of Squibb. The demand on its sales force, Squibb still staffing of the new company was primarily allocated sufficient resources to meet the achieved by the transfer of the pharmaceutical needs of the joint venture. By 1989 the joint staff of Novo Laboratories, Inc., Novo's US venture held almost 25% of the US insulin subsidiary. The new company had a mixed market. Meanwhile, Novo was benefiting board of directors, and the board chairmanship from an agreement signed in 1985 for the was rotated each year between Mads Øvlisen marketing of Squibb's pharmaceutical products and the president of Squibb's pharmaceutical in Denmark and Norway, primarily division. It was a 50/50 joint venture and the preparations for cardiovascular diseases. organizational structure of the company was essentially split according to value-added In 1989, the mergers of Squibb with expertise -- Novo producing insulin and Bristol Myers and Novo with Nordisk Squibb distributing it through direct sales, coincided with management's decision to mass retailing, and wholesalers. In addition, totally change its approach to the US insulin the company staff was responsible for market. Under a new agreement, Novo regulatory issues, special sales, and marketing. Nordisk purchased all rights to the joint US According to Henk Bleeker, the new president diabetic care business and Squibb's 50% share of Squibb-Novo and a long-time Novo of the Squibb-Novo joint venture. Squibb employee, the idea was "to learn from a would still be a distributor for Novo Nordisk relationship with a large US company how to but would no longer provide sales force handle the magnitude of the US market. With support. In addition, Novo Nordisk sold back Squibb we gained expertise and an the marketing rights to several Squibb infrastructure much faster than we could have products in Denmark and Norway. on our own." With the breakup of the joint venture, Insulin preparations carrying the Novo Nordisk Pharmaceuticals Inc. (NNPI) Squibb-Novo label appeared on the US market became responsible for the sales and in December 1982. This joint labeling initially marketing of insulin in the US market. This confused much of the American public, who US affiliate has been boosted significantly in thought Novo was owned by Squibb. recent years and employs more than 350 5
  • 6. Novo-Nordisk (A) S-SM-22 people. In 1993, the company's North agreement, effective mid-1985, covering the American work force (pharmaceutical and manufacturing and marketing of insulin enzymes) represented about 30% of all Novo preparations in Australia, New Zealand, and Nordisk employees outside Denmark, and the Oceania. Under this agreement Novo was region accounted for 30% of the company's responsible for purification, and the joint total capital expenditures and approximately venture company, CSL-Novo, would market 15% of total revenues. the complete range of Novo insulin preparations. Worldwide Strategic Joint Ventures In November 1987, Novo entered into Novo's management realized the value an agreement in Japan with Sumitomo of a joint venture in penetrating a foreign Pharmaceuticals to handle diabetic care market where there was an established insulin products. In 1988, Novo increased its supplier. After 1982, the company used the marketing efforts through cooperation with the Squibb/Novo joint venture model in forming pharmaceutical Boehringer Mannheim in the alliances throughout the world with major marketing of Novo's insulin products in insulin suppliers as a means to penetrate Germany. This agreement would become very markets and significantly consolidate the profitable for Novo due to the huge pay-off on industry. In time, the company built NovoPen® and NovoLet®, Novo's considerable expertise in establishing both revolutionary delivery systems for insulin marketing and research alliances. users. Novo also formed marketing alliances with Kabi in Sweden and Orion in Finland. In February 1984, the Canadian government approved Novo's establishment of Novo was not alone in its efforts to insulin production in Canada. Following an form marketing alliances. Soon after the agreement between Novo and Connaught Squibb-Novo alliance was formed, Nordisk Laboratories Ltd, a new Novo subsidiary, formed a marketing alliance with Wellcome in Novo Laboratories Ltd, was established to the UK and in 1987 signed a similar agreement produce insulin in Connaught's former insulin with Institut Merieux in France. By 1988, production facility. The insulin preparations there were three significant players and one produced by Novo would be sold and marginal player left in the worldwide insulin distributed in Canada by Connaught, whereas market -- Eli Lilly, Novo, Nordisk and promotion, clinical investigations, and medical Hoechst, respectively. This was reduced in services would be the responsibility of 1989 when the two Danish rival insulin Connaught-Novo. The joint venture, like the suppliers merged to form Novo Nordisk. Squibb-Novo company, was jointly owned by the parent companies, but Novo would receive Becoming a Diabetic Care Company a larger portion of the profits. The establishment of insulin production in Canada, After 1983, Novo's pharmaceutical which was Novo's first such establishment sales declined despite increased focus on outside Denmark, was a starting point for the marketing and distribution, continued efforts future expansion of Novo's insulin production to upgrade its insulin, restructuring of research capacity in North America. programs, and the company's innovative record. Management decided the company In 1984, Novo and Commonwealth would have to expand its business base within Serum Laboratories (CSL) entered into an diabetic care as a means of differentiating 6
  • 7. Novo-Nordisk (A) S-SM-22 itself. The company increased its emphasis on develop pumps for intravenous medication. developing delivery systems, and although Instead, the company pursued the development projects on insulin pumps and nasal delivery of a simple device for multiple injections. In of insulin were not completed, the company 1984, Novo began large-scale clinical testing achieved a breakthrough innovation with the of NovoPen®, a simple and convenient development of the NovoPen®. fountain pen-like insulin injection syringe. NovoPen® This innovation would increase Novo's ability to differentiate itself. Instead of relying Traditional insulin therapy usually solely on product differentiation as a source of involved one or two daily subcutaneous competitive advantage, Novo would also offer injections, allowing poor metabolic control. In delivery differentiation emphasizing the 1970s, the increasing use of measurements convenience of use. The NovoPen® came to of blood glucose and insulin levels, the market in May 1985 in Denmark and by the development and widespread use of home end of 1985 had been introduced in six monitoring of blood glucose, and the advent of markets. The NovoPen® was a major step in small portable pumps for continuous the transition of Novo from an insulin supplier subcutaneous insulin infusion made it clear to a diabetic care company. that it would be better for diabetic therapy to mimic the body's own mechanisms. This led The NovoPen® was developed as an to the development of the "Basal-Bolus" insulin administration system for convenient strategy in diabetic therapy, based on injection of rapid-acting insulin. The system combining longer-acting insulin injections was designed to be simple, portable, small, ("basal" component) and rapid-acting insulin accurate, and safe. The NovoPen® was injections ("bolus" component). The longer- constructed so that the insulin container and acting insulin injections were to maintain delivery device were an integrated system. sufficient insulin levels in the blood during the The NovoPen® was loaded with a siliconized night and between meals. The rapid-acting glass cartridge of Human Monocomponent injections were to curb the rapid increase in insulin, sealed by a rubber membrane and a blood glucose levels induced by meals and plunger, which contained approximately one snacks. This therapy requires that diabetics week's supply of rapid-acting insulin for the adhere to fixed times of injection and rigid average diabetic. In dosage accuracy, tests timing and content of meals and snacks. Even indicated that the average dose differed from more troublesome was the handling of the intended by less than 1 percent. Before syringes and insulin vials several times during injection the patient simply attached a sterile, the day. disposable needle to the end of the pen; insulin was delivered by operating a push button on After the advent of human insulin the top of the pen. The NovoPen® offered preparations, Novo recognized that one of the considerable advantages over conventional remaining challenges in insulin therapy was therapy: convenience, unobtrusiveness, better more convenient insulin administration. control, increased flexibility in injection and Having decided their expertise was not in meal pattern, and a generally improved quality electronics (and that people did not want to of life. Patients could now carry a sleek wear insulin devices on their bodies), Sonnich looking pen in a small case with extra needles Fryland, Novo's marketing director at the time, and insulin cartridges instead of bulky decided to ignore competitors' efforts to 7
  • 8. Novo-Nordisk (A) S-SM-22 syringes and vials. Injections could now be thousands of NovoPens® in the US market to performed discreetly and quickly. patients and doctors without adequate instruction. As a result, NovoPens® lost much The NovoPen® was introduced in the of their perceived value and the company lost US in 1986, but it fell short of management's some credibility with diabetic educators. expectations. Marketed as a product for every diabetic, the product created high expectations In 1987, Novo introduced two new in the market that resulted in disappointing Penfill® insulin cartridges containing longer- sales when it was discovered the product was lasting insulin -- Actraphane HM Penfill®, appropriate for only a narrow segment of containing a ready-made mixture of 70% diabetic patients. The product had several longer-acting NPH (Isophane) and 30% weaknesses that contributed to its limited soluble insulin, and Protaphane, containing success. It was expensive and required 20-30 100% longer-acting NPH (Isophane) insulin. minutes of instruction before use. The dosage These longer-acting insulin cartridges were system could only provide two units of insulin used with the NovoPen II®, which became a for every push on the top of the button. This vehicle for the sale of Novo's insulin. meant patients had to count each depression. Although Novo had a patent on the NovoPen® In addition, NovoPen® provided only rapid- , competitors began to focus on developing acting insulin. Longer-acting insulin was not their own delivery systems and, alarmingly for available. Novo, on manufacturing insulin cartridges that could be used in NovoPen II®. The NovoPen II® (NovoLinPen®) company's next challenge was to develop a proprietary delivery system that could not be In October 1987, NovoPen II®, a copied and that would differentiate Novo from plastic version of NovoPen® with a dosage the competition. regulation system, was introduced in Denmark to address many of the problems with the NovoLet® (NovoLin Prefilled®) original NovoPen®. It wasn't until 1992 that the improved product was launched in the US Initially introduced in Holland in market. Whereas the original NovoPen® November 1989, Novolet® (called Novolin delivered two units of insulin per push of the Prefilled® in the US) was a prefilled, button at the top of the pen, NovoPen II® disposable pen and Novo's next innovative allowed the patient to preset the size of the product for insulin users. Also known as dose to anywhere between two and thirty-six NovoPen III®, this product was Novo's units of insulin. In addition, NovoPen II® answer to mounting pressure from competitors provided longer-acting insulin so that in who were trying to develop their own delivery combination with NovoPen® and rapid-acting systems as well as cartridges for NovoPen II®. insulin, patients could use both to control their glucose level during meals and during the day In February 1988, Novo formed a joint and night. But NovoPen II® also had several venture with Pharma Plast, a company that problems. Some patients disliked the stiffness developed plastic medical devices and of the locking mechanism, which presented disposable syringes. Combining Novo's problems for older people, and others expertise in insulin and diabetic care with preferred the feel of the of the heavier metal Pharma Plast strength and experience with NovoPen®. In addition, Novo had distributed syringes, plastics, and high-volume 8
  • 9. Novo-Nordisk (A) S-SM-22 manufacturing, the companies sought to to take more frequent injections of lower doses develop a closed-system medical device. during the day. The result is that US diabetics Patent applications were filed for Europe in perceive less need for an easy-to-use and less April 1988, for international in October 1988, obtrusive delivery system. and for the US in February 1989. For these reasons the NovoLet® pen Being a closed system containing would not be brought to the US until 1992, insulin, the disposable pen had to meet contrary to the hopes of the US subsidiary, substantial safety requirements. This also which wanted the new product. Despite its meant that in the US the disposable pen had to late arrival, the product was the first prefilled, be approved as a drug rather than a device, disposable insulin pen on the US market. which involved extensive clinical trials and time-consuming procedures. Nevertheless, the Eli Lilly and the US Market closed system also offered the opportunity to position the product as a replacement for the Since genetically engineered human traditional syringe and vial system instead of insulin, Humulin, was introduced in 1982 by merely another pen upgrade. The new system Genentech and Eli Lilly, the product has offered advantages beyond being disposable. almost become a generic term for human In hospitals patients were normally injected insulin in the US market. Eli Lilly's early with insulin from 10 ml vials, which contained move gave it an early lead in market share in 1,000 units, and if patients didn't require all the US (83% in 1981). This was a tough the insulin in the vial the remainder was challenge for Novo, because patients and discarded. With the NovoLet® pen this waste doctors tend to resist changing once they have was reduced, since the pen could inject from adopted a particular insulin preparation. two units to a total of 150 units of insulin. In addition, the new insulin pen did not have to Unable to use product purity or pricing be refrigerated once used, and was stable for to their advantage, Novo's US subsidiary up to a month. attempted to use the NovoPen® delivery system to differentiate itself from Lilly. To With launches throughout Europe in counter this threat, Eli Lilly in 1988 formed a 1990, NovoLet® quickly became a success. needle and insulin alliance with Becton- Focusing on the European introduction, and Dickinson, the American medical equipment mindful of the problems faced by the company. Combining Eli Lilly's insulin with NovoPens® in the US, Novo's management Becton-Dickinson's therapy product was in no rush to launch the new insulin technology would further increase Novo's delivery device in the US. Instead the difficulties in the US market. This alliance has company continued to carry out market been successful in the US, and in 1991 research to improve understanding of Becton-Dickinson launched a 1.5 ml insulin customers' and doctors' preferences and pen in Europe that used insulin cartridges from practices. This research highlighted Eli Lilly. differences in preferences among US patients, especially concerns about the potential misuse Novo Nordisk has attempted to of the dosage regulation system, the removal increase acceptance of its delivery system in of the needle, and the package design. the US, using a sales force of some 150 Patients in the US tend to take one or two very representatives to cover the 5,000 diabetes large dose injections, whereas Europeans tend specialists in the market. The most notable 9
  • 10. Novo-Nordisk (A) S-SM-22 effort by Novo Nordisk was a strong in its core businesses. In response, marketing initiative started in April 1990 with management began to broaden Novo's the launch of the NovoCare program. This business base to create growth in related fields was a wide-ranging educational program for and reduce its financial dependence on the diabetic patients and their care givers tailored insulin business. But it would not be until five specifically for the US market. By providing years later (in 1988) that the company would innovative tools, services, literature, starter be able to reverse a five year decline in its kits, tapes, and other information, the program earnings (exhibit 2). A combination of sought to educate and form alliances with declining sales growth, currency losses, and health care professionals. The program gained increasing costs would bring operating recognition for simplifying the process of margins to below 15% in 1987. The company glycemic control and improving the was particularly hard hit in 1984, when it understanding and care of diabetes among experienced a 6% decline in earnings per health care professionals and patients. In share. The company's return on sales dropped addition, in 1992 the company introduced from 21% in 1983 to below 10% in 1987. Captain Novolin® in the US market. A Super Nintendo game developed in collaboration with a software company, Captain Novolin® Broadening the Business Base features a super hero battling bad guys (glucose cells). This became the first patient- By the end of 1983 Novo planned and education video game for children with initiated a broadening of its business base. diabetes and gained significant press coverage. Novo's management wanted to continue Despite these efforts, at the end of 1992 Eli growing in its existing markets while Lilly maintained a 75% share of the US expanding its business base, even if such a market. strategy could have a short-term negative impact on earnings. The idea was to apply the Deploying R&D: 1983-1989 company's expertise in biotechnology into new areas. To ensure that products other than During the late 1970s and early 1980s insulin and enzymes were given the necessary Novo was recognized throughout the world as attention by top management, Novo an exciting growth company. At the time it established new product groups: the Health was a two-business company with strong Care Products Group and the Industrial positions in the world industrial enzyme Products Group. market and in insulin-based health care. Between 1978 and 1983 the financial The cornerstone of this strategy was performance of Novo was outstanding, with Novo's ability in research and development. increasing sales and an increase in operating Investment in research and development was margins from 14% in 1978 to over 28% by increased. Novo increased its work force by 1983. The company's consolidated sales over 5% in 1983 and increased its allocation of increased by a compound annual rate of 30%, resources to research and development pre-tax profits increased tenfold, and earnings projects and facilities. Between 1983 and per share grew by about 45% per annum. 1987 the company increased its R&D costs from 9.1% to 11.5% of consolidated sales. Between 1983 and 1988, the company Novo hoped to develop new products faced new challenges threatening the independently and to be an attractive partner sustainability of the past years' strong growth for other research groups. 10
  • 11. Novo-Nordisk (A) S-SM-22 NovoBiolabs ZymoGenetics In 1984, the company acquired the In 1982, Novo established a research production and marketing rights for cooperation with (and acquired a 16% monoclonal antibodies used in the diagnosis of minority stake in) ZymoGenetics of Seattle, lung cancer. This acquisition was combined Washington. The two companies would work with its existing facilities in cell biology and closely in yeast and mammalian cell immunology to form a new business unit, technology and develop the process Novo Novo Biolabs. The primary objective was to would use for the production of genetically use monoclonal antibody technology for the engineered human insulin. In addition, the development and production of test kits for the collaboration would lead to the development diagnosis and monitoring of diabetes, cancer, of Factor VIIa, a treatment for hemophilia. cardiovascular disease, and other diseases. In ZymoGenetics had expertise in molecular January 1988, NovoBiolabs was consolidated biology. Over time, this increased Novo's with I.Q. Bio, a British manufacturer of knowledge of blood coagulation and diagnostic kits that Novo had acquired in July fibrinolysis, and involved Novo in human of 1987. This extended Novo Biolabs' efforts growth factors research. In May 1988, Novo to develop and market diagnostic products, acquired the small US-based company for since I.Q. Bio already had several products on $23.3 million and has maintained it as an the market. independent research unit. Alfred Jørgensen Laboratories Novo Diagnostic Systems In September 1984, Novo purchased In the early 1980s Novo increased its Alfred Jørgensen Laboratories (AJL), which emphasis on diagnostic systems and developed was an internationally recognized consultant to a new business unit, Novo Diagnostic Systems the brewing and food industries and supplier (DS). This unit had evolved out of the 1981 of pure yeast cultures. In December 1986, acquisition of the production and marketing Novo acquired a minority equity interest in the rights for BMC-Lab 22, a system for the non- California-based company Idetek Inc., invasive measurement of bone mineral specializing in food, feed, and veterinary content. Novo would benefit from the analysis based on monoclonal antibody increased worldwide efforts on preventive technology. AJL began cooperating with treatment for osteoporosis, a condition found Idetek on food and beverage analysis using in a considerable number of post-menopausal this technology. women in which the strength of the bones is reduced due to mineral loss. Ferrosan In 1984 the company made several In November 1986 Novo acquired a minor acquisitions. Most notably, Novo 75% stake in the Danish firm Ferrosan for $64 acquired the rights to a SPECT (Single Photon million; it increased its stake to 90% in 1987. Emission Computerized Tomography) brain Novo management's rationale for the scanner to expand into the field of brain acquisition was to exploit the combined imaging. strength of the companies in the central nervous system (CNS) field. But because Ferrosan's trading record had been weak and it 11
  • 12. Novo-Nordisk (A) S-SM-22 needed funding to survive as a research-based continued doing so through the 1980s. The ethical drug company, some market analysts company emphasized new enzyme questioned whether the acquisition was merely technologies that served various purposes, because the company was Danish, such as breaking down cell walls of green manageable, and affordable. In addition, plants (useful for the food and wine and juice Ferrosan brought with it a broad product industries), enabling the manufacture of edible portfolio within OTC and prescription oils and fat from cheap raw materials, and pharmaceutical preparations, vitamins, and processing proteins. Some of these veterinary activities. Ferrosan's sales were technologies used genetically engineered primarily based in Scandinavia with 50% of its microorganisms as a base for enzyme sales in Denmark. Although Ferrosan was production. Novo's enzyme research would originally intended to operate as an encompass general microbiology, fermentation independent research-based company, some of technology, enzymology, protein chemistry, its activities were integrated into the Novo chemical engineering, and recovery and group and others were divested during the purification technology. In addition, Novo's restructuring of 1987 and 1988. enzyme R&D department would draw on in- house expertise in gene technology, Enzymes monoclonal antibody technology, toxicology, and immunology. In 1981, Novo was the largest producer of enzymes for industrial users and had an Two new and important enzyme estimated 50% of the worldwide market. It products were announced in 1982: produced enzymes for multiple industries -- Promozyme, a debranching enzyme to detergent, starch, wine & fruit, and dairy -- improve yields and economies for starch and was unrivaled in product and process processors, and Rennilase XL, an improved technology. microbial rennet that offered cheese producers an enhanced alternative to animal rennets. Enzymes are proteins that consist of Over the following years the company would long chains of amino acids held together by continue to develop enzymes and enzymatic peptide bonds. They are present in all living processes to meet customers' needs. cells, where they perform the vital function of controlling the metabolic processes whereby In 1982 Novo began strengthening its nutrients are converted into energy and fresh research activities in Japan, adding to the cell material. In addition, enzymes take part in research already carried out in Denmark, the breakdown of food materials into simpler Switzerland, and the United States. In 1984, compounds; since they are catalysts, they are the company established a laboratory for not consumed in the process but merely technical service and application development accelerate chemical processes. in local markets in Kuala Lumpur, Malaysia. Then in September 1986, the most highly In the early 1980s Novo wished to advanced enzyme production plant in the maintain and improve its position in the world was inaugurated in Hokkaido, Japan. market for industrial enzymes. The company The objective was to build a broad-based recognized that this required continued enzyme organization in Japan comprising innovation in new products and processes. research, product development, production and Novo began allocating considerable resources marketing. The new plant would illustrate to research in enzyme technology and Novo's strong commitment to the Japanese 12
  • 13. Novo-Nordisk (A) S-SM-22 market, one the world's largest markets for in production and marketing to expand its industrial enzymes, and would supply enzymes fields of interest into adjacent business areas. to the Japanese, South Korean and South East Mads Øvlisen commented on Novo's Asian markets. international strategy, "We can only compete with the large pharmaceutical players by not Experience gained from using competing with them and becoming a global genetically engineered microorganisms for the niche player." production of human insulin by fermentation was of great importance to the development Novo's management felt the company and production of other products, in particular had a competitive edge in production due to enzymes. Using genetic engineering the combination of vast capacity, modern technology, Novo developed enzymes with equipment, flexible design, and production improved properties that could more know-how. With enzyme plants operating effectively serve the needs of its customers. In simultaneously in Denmark, the US, Japan, 1987, the new Japanese enzyme plant began and Brazil, Novo could serve several divisions producing the world's first detergent enzyme, and could be market-oriented. In addition, the Lipolase, manufactured with genetic plants were a valuable experimental and engineering and recombinant-DNA applications resource for local and regional technology. technical service personnel, enabling quick turnaround on problem solving. Coupled with its drive to pioneer development of new enzymes and enzymatic In 1987, top management wanted to processes, the enzyme division took on a new implement the Novo 2000 scenario through a customer approach. Thinking of their business Five Point Program (see exhibit 3). Mads as offering customer solutions and not selling Øvlisen called this program an attempt "to enzymes, Novo developed very close links translate 500 pages of long-term strategic with its customers. The enzyme R&D planning into everyday life." departments increased their with customers. In 1985, the company developed a mobile Novo Nordisk Merger and Aftermath enzyme application pilot plant in Switzerland and the US to demonstrate at the customer's Ever since 1925 when Harald and plant the advantages of enzyme processes. Thorvald Pedersen left Nordisk Gentofte, founded in 1923, to start Novo, the companies had been fierce competitors in the insulin Novo 2000 Scenario - Articulating a Vision market. Located in a small country with just over 5 million people, however, the rivalry Starting in 1986, Mads Øvlisen began was a constant source of motivation and would articulating a vision for Novo with the aim of last until 1989 when the companies had successfully guiding the company into the next become two of the world's largest insulin century. "Novo 2000" was top management's producers. Mads Øvlisen describes Novo's statement of the abilities needed to make Novo views about Nordisk before 1989: "We had a into a broad-based international biotechnology very antagonistic relationship, and I never company. The company would build on its talked to their management even though they tradition as a research-oriented and innovative were only fifteen minutes away and we were producer of insulin and industrial enzymes. In the two most advanced insulin production addition, the company would use its expertise companies in the world." 13
  • 14. Novo-Nordisk (A) S-SM-22 and North America 11%. Like Novo, Nordisk Then in 1989, Henry Brennum, the developed technologies for the production of CEO of Nordisk Gentofte, approached Novo human insulin both through an enzymatic with a proposal to merge the companies. conversion of porcine insulin and through Nordisk was preparing to make large capital recombinant DNA technology. In 1988, the expenditures to expand its business base and company was the third largest producer of was facing a generational shift in its insulin in the world, with a global market management. The combined company would share of 13% and marketing alliances with no longer have to compete for human Wellcome in the UK and Institute Merieux in resources in Denmark and would, by virtue of France. In addition, the company produced its size, have a stronger position in the and developed equipment and devices such as international market. The new company pen systems for insulin injections, Insuject, would have a global market share of the and pumps for continuous insulin infusion, insulin market of about 34%, making it the Nordisk Infuser Mark II. world's largest producer of insulin and diabetic care systems. In addition, the merger would Although primarily an insulin consolidate two very strong R&D groups, company, Nordisk had also focused on expanding the scope of their combined R&D. developing human growth hormone, used for the treatment of dwarfism and Turner Mads Øvlisen commented that the Syndrome (an inherited chromosomal defect in merger was "an aggressive effort to maximize girls). Growth hormone is an anabolic sales and increase return on invested capital hormone, promoting protein synthesis in and principally not to rationalize the various tissues. It stimulates fat breakdown organization." There were no lay-offs and affects carbohydrate metabolism through following the merger, and the number of Novo an anti-insulin like effect. Growth rates, Nordisk employees continued to grow. In the reflected in the heights of children, are directly four years following the merger the total related to the secretion of growth hormone, number of employees increased almost 44% as which promotes longitudinal bone growth. In 3,554 new employees were hired between the 1960s, the company drew on its knowledge year-end 1989 and year-end 1993 (exhibit 2). of insulin purification to produce human growth hormone, Nanormon, which was Nordisk extracted from human pituitary glands. By 1988, Nordisk had become one of the leading At the end of 1988, Nordisk sales were manufacturers of genetically engineered over DKK 1 billion and earnings were over human growth hormone. Its product DKK 100 million. 2 Approximately 70% of Norditropin had a 10% share of the market. the company's sales were in insulin, with The company also introduced (in 1989) a export distribution in Scandinavia growth hormone pen, Nordiject, which approximately 16%, Europe 54.1%, Japan 3%, considerably boosted its sales. _________ Post-Merger Organization 2The US dollar to Danish kroner exchange rate has fluctuated over the last decade. During the mid-eighties the dollar was Despite the historical animosity weak and the exchange rate was between US $1: DKK 7 and between the companies, the transition after the US $1: DKK 10. In recent years the rate has been more merger was smooth. With approval from stable, approximately US $1: DKK 6.5. On December 31 1993, the exchange rate was US $1: DKK 6.7725. shareholders to merge the companies in April 14
  • 15. Novo-Nordisk (A) S-SM-22 1989, Novo Nordisk would achieve a engaged in research and development combined sales increase of 16% and a pre-tax activities, including approximately 200 income increase of 10%. scientists with advanced academic degrees. Following the merger, 1,935 of the new Following the merger the combined company's 8,094 people (24%) were involved management wanted to make the new in research and development and 13.5% of company stronger, especially in marketing and Novo Nordisk's net sales of DKK 7.3 billion research and development, and chose to were allocated to R&D activities. With these decentralize the new company into divisions. commitments, management reasoned that they Under the new structure, two core businesses could constantly offer new products and were established -- Health Care Group (HCG), processes to customers. Meanwhile, the which developed, produced, and sold company divested non-core businesses like the pharmaceutical products, and Bioindustrial combined Novo Ferrosan veterinary business Group (BIG) which developed, produced, and and Alfred Jørgensen Laboratories. The sold industrial enzymes and bioherbicides and company also decided to put the Novo Nordisk pesticides -- supplemented by a few smaller, Diagnostic business up for sale. related companies. After 1989, Novo Nordisk's The Health Care Group consisted of management commitment to high quality five divisions: Diabetic Care, production and innovation translated into Biopharmaceuticals, Pharmaceuticals, Medical extensive capital expenditures. Between 1989 Systems, and Central Nervous System (CNS). and 1993 the company would spend close to The combined knowledge and experience in DKK 7 billion on new plants, laboratories, and sophisticated fermentation, biotechnology, and facilities throughout the world. With enzyme technology allowed the company to expenditures between 14% and 20% of sales, continue the diversification of its Health Care the company has had negative cash flow in group into new products in biopharmaceuticals recent years. In addition, cost increases from and pharmaceuticals and lower its financial hiring new personnel for production, sales and dependence on insulin. The Bioindustrial marketing, and commissioning new plants Group consisted of four divisions: Detergent have put pressure on the company's margin. Enzymes, Enzyme Process, Wine & Juice, and At times the cost increases have even Biochemicals. The divisions were fully exceeded the sales growth. integrated to serve its markets. Each division had its own R&D, production, marketing, and The company's expanded efforts in administrative functions with close links to pharmaceuticals are in the areas of hormone International Operations, the company's joint replacement therapy products and central sales and international marketing organization. nervous system (CNS) products. The hormonal preparations developed by Novo Another Era of Expansion: 1989-1994 Nordisk are for the treatment of climacteric disorders in women and for the prevention and The strong tradition in R&D of both treatment of osteoporosis. Trisequens and companies would continue after the merger Kliogest, which counterbalance decreased (see exhibits 4 and 5). In 1981 research and amounts of natural estrogen, are the company's development costs were below 10% of Novo's biggest selling hormone replacement therapies. net sales of DKK 2.2 billion. Approximately In addition, in 1990 Novo Nordisk developed 600 of Novo's 3,300 employees (18%) were Vagifem, a female hormone product that 15
  • 16. Novo-Nordisk (A) S-SM-22 alleviates some problems associated with The company has also expanded its estrogen deficiency. Nevertheless, the efforts as a provider of biological plant company remains a relatively small player in protection agents (bioinsecticides) for this market relative to companies such as agriculture and forestry. In 1990, the company Wyeth, Schering AG and Ciba-Geigy. inaugurated a new biopesticide research and development company, Entotech, in the US to In central nervous system drugs, the develop new insecticides. The new company company's primary and first product was is situated in Davis, California, and works Seroxat (Paxil in the US), for the treatment of closely with U.C. Davis, which is one of the depression. This product was developed in country's top agricultural universities. In collaboration with Smithkline Beecham, which biochemicals the company markets owns the marketing rights outside the Nordic pharmaceutical intermediates, primarily countries, and was marketed in the UK in 1990 penicillin V and 6-APA, a building block for and the US in 1993. In 1993, Novo Nordisk most semi-synthetic penicillins. marketed the product in Norway, Iceland, and Denmark, and it continues to receive royalty Future Outlook and Challenges payments from Smithkline Beecham from sales in the rest of the world. The company is Novo Nordisk remains a world leader also collaborating with Abbott Laboratories in insulin and diabetes-care products. for the development of Tiagabine for the Although it shares 90% of the world market treatment of epilepsy. equally with Eli Lilly, the company dominates virtually every regional insulin market in the Although the company's Bioindustrial world with the exception of the US market. Group contributed only 28% of consolidated Almost every major breakthrough in insulin sales in 1993, compared to 30% in 1989, the treatment and delivery systems has originated group has undergone considerable growth and in Novo Nordisk laboratories. expansion. The group's primary focus is on enzymes, although it also has a plant Although diabetic care represents only protection division and a biochemical division. about 11% of Eli Lilly's consolidated sales, To maintain its growth rate in enzyme sales, Lilly is committed to the business and sees it Novo maintained its strong commitment to as an important component in its corporate expanding the market by the development of strategy. The next major innovation in insulin enzymes and enzymatic processes for new technology is insulin analogues, which offer applications. New product developments have improved control of metabolism and faster included Resinase, an enzyme for the paper "onset" and "offset," which means insulin can and pulp industry capable of removing pitch be administered at mealtimes and not the usual from paper production machinery, and 30-40 minutes beforehand. When this Durazym, a stain-removing enzyme and the becomes reality it will significantly improve first industrial enzyme produced as a result of the quality of life for diabetics. Although molecular modeling. To further innovation in Novo Nordisk is aggressively pursuing the the Bioindustrial Group, the company development of insulin analogues, it is behind inaugurated Novo Nordisk Biotech in 1992 in Eli Lilly, which will come to market first. Davis, California, mainly specializing in molecular biology, protein chemistry, and One potential challenge to Novo microbiology for the development of enzymes. Nordisk is the recent acquisitions of PBMs by several pharmaceutical companies. Between 16
  • 17. Novo-Nordisk (A) S-SM-22 November 1993 and the end of 1994, PBMs and the speed of its research and development were acquired by Merck, Smithkline Beecham, efforts. and Eli Lilly. Most troublesome to Novo Nordisk is Eli Lilly's acquisition of PCS Novo Nordisk is hoping to derive Health Systems, one of the largest PBMs in considerable future growth from its non- the US, for $4 billion (130 times PCS's annual diabetic products and developments, in earnings). Some estimate that putting Eli particular, human growth hormones and Lilly's drugs on these formularies could boost female hormone therapies. The company its sales by up to 15%. anticipates future growth to come in the US market with the entry of Norditropin and its In 1994, Novo Nordisk also faced female hormone therapy products. problems with supplying sufficient insulin for the US market and experienced unanticipated Strategic Options problems with the FDA, which resulted in a substantial decline in the company's share Among the largest pharmaceutical price. Meanwhile, the company is nearing firms several distinct strategies have emerged, completion of a state-of-the-art insulin largely as a reaction to developments in the manufacturing facility in Clayton, NC. When US market. Some companies are playing the it is fully operational, genetically engineered traditional role of an innovation-based human insulin preparations will be formulated, pharmaceutical firm. Companies like Glaxo filled, and packaged in the US. The new plant are focusing on increasing their research and will focus on supplying insulin to the US development performances. They believe they diabetes market. can succeed by compressing development times, pursuing novel therapies addressing The company hopes to benefit from the unmet needs, managing product life cycles increasing awareness among diabetics of the more effectively, and pursuing product benefits of a more aggressive treatment licenses and alliances. Others, like Rhone- regimen and from opportunities in third world Poulenc Rorer, are looking for business system countries. Many third world countries now enhancements to improve their product lack the money, stability, and infrastructure to delivery. Some companies are focusing on support diabetes treatments. Since about 80% eliminating costs in their systems. These of the world's population resides in the third companies also are adopting new marketing world, that potential market is enormous. strategies to demonstrate the value of their products. The company's enzyme business has the potential to become more important to Some companies are vertically Novo Nordisk. In 1993 the global market for integrating, acquiring PBMs. This allows enzymes was over one billion dollars and, them to capitate drug costs and ensure although the detergent, starch, and textile formulary inclusion and appropriate drug industries constitute 65% of the market, the utilization (see appendix). This is clearly the rest is highly fragmented. Novo Nordisk is route Merck chose in 1993 with its acquisition relying on innovation as a platform for growth. of Medco, the number one PBM in the US. Like the health care business, success in the Companies pursuing this strategy hope that future will largely depend on the company's their core pharmaceutical business will benefit ability to find new applications for enzymes from information about customers, and they 17
  • 18. Novo-Nordisk (A) S-SM-22 believe they have the management capabilities required to operate PBMs. Other pharmaceutical companies are choosing to integrate horizontally by forging strategic alliances and pursuing mergers and acquisitions with other pharmaceutical companies. In the US this can provide leverage against PBMs and institutional customers. In addition, this M&A activity will yield increasingly comprehensive therapeutic portfolios and enable companies to compete for position on increasingly limited and tightly controlled drug formularies. No single pharmaceutical company offers a broad enough product line to meet a full range of needs in therapeutic categories that must be represented on drug formularies. Another alternative is to diversify by buying a generic drug company, as when Hoechst acquired Copley Pharmaceuticals, to increase participation in the over-the-counter market. Some firms have even purchased unrelated business (e.g. Sandoz acquiring Gerber). Mads Øvlisen and his management team must answer some difficult questions, such as: How can they penetrate more of the US insulin market, and what are the implications of managed care in the US? Should Novo Nordisk pursue further diversification? Is Novo 2000 a sustainable strategy? Should the company pursue vertical or horizontal integration or alliances? If so, with whom? 18
  • 19. Novo-Nordisk (A) S-SM-22 Appendix: Changing Health Care Environment and PBMs in the US 3 Spending on health care in the US has been growing faster than the GNP for at least thirty years. The government, employers, insurance companies, and individual patients have been taking action to change this trend. In 1983, the federal government instituted a policy of prospective payment of hospital charges, whereby hospital services were no longer reimbursed in full after they were rendered but were determined in advance on the basis of the diagnosis. This shift in reimbursement policy captured the spirit of "managed care," which is to set limits on cost and hold providers accountable for rendering care within those limits. In 1986, only 23% of the US population was enrolled in a managed care plan, such as an HMO, a preferred provider organization (PPO), or some form of managed indemnity (a traditional insurance plan with some utilization controls). It is estimated that by 1996 nearly 76% of the US population will be part of a managed care plan. In recent years the pharmaceutical industry in the US has witnessed enormous changes in the delivery of health care products. Pharmaceutical benefit managers (PBMs) have evolved in many respects as a "middle person" in the pharmaceutical industry. Supported by the growth of managed care organizations, PBMs have emerged as an alternative distribution channel offering specific expertise in the management of drug utilization and costs. A PBM is an organization that contracts and manages the pharmaceutical benefits for large customers or payers -- self- funded employers or major corporations, insurance companies, government agencies, PPOs, and HMOs -- to provide cost-effective pharmaceutical benefits that assure quality therapeutic care. Typically they act on behalf of payers to encourage the use of less expensive alternatives to branded drugs. They also provide many services designed to lower pharmaceutical costs for their clients, including claims processing, broad pharmacy networks, lowered pharmacy fees through negotiation, generic substitution programs, and outcome analysis. An outcome analysis or measurement is a refined and sophisticated cost benefit analysis of the clinical and economic impact of a certain health care procedure such as the prescribing of a particular drug or the use of a particular surgical procedure. PBMs also provide a formulary, a list of prescription drugs that are preferred for use by a health plan and that will be dispensed through contracted pharmacies to covered persons. By offering these services, a PBM will typically guarantee to save a customer up to 20% of its drug-related expenditures in return for charging a flat fee on the basis of "lives per month covered." In the process of providing their services, PBMs acquire a large amount of information regarding physician habits and patient histories regarding certain prescription drugs. These data can be valuable to pharmaceutical drug manufacturers in boosting their research and marketing productivity. PBMs have expanded five-fold since 1989, and by 1994 there were twenty-five PBMs operating independently in the US. These included Diversified Pharmaceutical Services, Medco Containment Services, Value Rx, Express Scripts, PCS Health Systems, and Caremark. _________ 3 The material contained in this section is largely based on literature from and discussion with Smithkline Beecham following their acquisition of DPS, another PBM in the US. 19
  • 20. Novo-Nordisk (A) S-SM-22 Formularies have traditionally been used by managed care organizations and hospitals to control drug costs. Formulary creation involves the recommendations of an independent panel, and the role of the PBM is to represent the needs of the payer or plan sponsor while ensuring the availability of high-quality pharmaceutical products. Pharmaceutical companies can influence the process through their traditionally strong relationships with the physician opinion leaders who make up the formulary advisory panel. Thus while the primary customer in the process of formulary creation is the payer, but physicians are influential in establishing clinical recommendations and parameters. Once in place, however, formularies have a great impact on the role of the individual physician in the process of drug selection. With increased emphasis on formularies as a means to control cost, modify physician prescribing behaviors, ensure appropriate utilization, and assure high quality standards of care, the importance of PBMs is likely to grow significantly. By controlling and limiting the number of prescription drugs on these formularies, PBMs affect the distribution of drugs. They also negotiate lower prices with manufacturers in exchange for the increased volume that results from formulary access. A PBM's revenues come from a percentage of pharmaceutical manufacturer rebates, administration fees from payers, and rebates from pharmacies. PBMs charge payers a small transaction fee per prescription for processing prescription claims. In addition, they collect manufacturers' rebates and pass most of these along to payers, retaining a portion for themselves. Finally, they collect and pass along all the savings generated by the pharmacy contract. After all expenses are subtracted, PBMs earn pre-tax income equivalent to about 2% of total drug spending (see exhibit 8). The PBMs dispense pharmaceuticals through a network of participating pharmacies. A PBM electronically links participating pharmacies and provides covered plan members with magnetically-coded cards that confirm membership and plan benefits. A plan member then goes to a participating pharmacy for all prescriptions. The pharmacist reads the member's card electronically and, through an on-line link with the PBM, accesses the PBM's lists of drugs on formulary and patient co-pays. (Co-pay is a cost-sharing arrangement in which a covered person pays a specified charge for a specific service or pharmaceutical product, such as $10 for an office visit or $2 for a filled prescription regardless of the actual cost.) After filling the prescription, the pharmacist sends an electronic message to the PBM that a specific pharmaceutical product has been dispensed. The PBM tracks the transaction as part of a database on the cost and clinical impact of the formulary which it shares with the payer. But a PBM's electronic network also incorporates other stakeholders in the formulary process. Through a link with the local physician and patients, PBMs influence and monitor prescribing habits, compliance, and appropriate utilization. 20