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Pharmaceutical outsourcing: How to negotiate payment terms with your vendor
For many pharmaceutical companies, cost-effective outsourcing is key to driving down operational costs, and ensuring core personnel can focus on research and development and other critical tasks. But as a category manager, how can you be sure you’re paying the fairest price for the labour you’re sourcing, and reduce the risk of shifting currency values?
Outsourcing is the lifeblood of many busy industries – and pharmaceutical development is no exception. But as a knowledge-based sector with a strong emphasis on data security and patent protection, you can find yourself paying a premium for the skilled staff, standard of equipment and level of security the work requires.
During the early years of outsourcing, the gains accrued from labour arbitrage alone were significant enough that any additional savings foregone from a lack of currency arbitrage was deemed insignificant.
Typically, today, you can expect to pay an offshore vendor in your own currency, while the vendor pays for its resources in its local currency. But as the value of the local currency drops, you can often end up paying more than the services actually cost in the offshore currency. With this in mind, companies across all industries are increasingly looking for opportunities to use exchange rates to drive down their costs.
So how can you guarantee you’re negotiating the fairest agreement with your vendor? Here are a few strategies that can help reduce the risks of currency exchange rate fluctuation and inflation when you’re outsourcing your pharmaceutical work.
Option 1: The vendor bears the risk
As vendors are generally more capable of absorbing currency shifts, you may be able to negotiate an agreement where your vendor handles the majority of the exchange rate risk.
In this kind of arrangement, the vendor bears the risk of currency fluctuations up to an agreed percentage above or below a baseline exchange rate – usually referred to as the ‘band’. If the exchange rate rises above the band, you’ll pay more, but if it sinks below the band, you’ll pay less. To make this work, you and your vendor should agree on how you track the currency, how often you’ll monitor fluctuations, and how you handle variances.
Option 2: Pay in dollars tied to foreign currencies
Under this agreement, you’ll pay your vendor in dollars, but the amount will vary based on the movement of the vendor’s local currency. If that local currency tends to devalue against the dollar, then you’ll wind up paying less – that saving might help you cover other financial risks, such as inflation.
You’ll also get more consistent service this way, as it tends to stabilise vendors’ profit margins – if the exchange rate favours the local currency, your vendor won’t be scrambling to cover previous losses.
Option 3: Hedge against fluctuations in exchange rates
You can also use the same hedging strategies as your vendors do. However, creating a dedicated team of financial analysts to develop and execute a hedging strategy would be a costly option if you don’t outsource a lot – and it’ll be risky if the analysts bet the wrong way on the future movement of the currency markets.
Option 4: Apply a ‘look-back’ average to future payments
With this approach, you’ll pay in dollars tied to local currency fluctuations, but not in real time. Your vendor takes the average currency fluctuation over a certain period – usually six months or a year – and applies that to the next period of payments. This is then repeated each year, throughout the contract term.
This provides stability for you both, unless the ‘look back’ period involves a major rate fluctuation, which you can’t rule out completely. Some outsourcing customers eventually may decide it is simpler to pay for services in fixed US dollars, even if that means some loss of savings – but it’s important to consider your options.
The changing impact of labour arbitrage
Labour arbitrage was a key factor that helped the outsourcing industry flourish, particularly in pharmaceuticals. Countries in South Asia for example, had an abundant supply of well-educated, English-speaking workers that helped these regions attract business.
Now the outsourcing industry has matured, labour arbitrage has lost some of its initial appeal – as rising inflation in these countries meant workforce salaries rose. But when you consider local currency depreciation, the effect of rising workforce wages is partially offset.
For example, the inflation growth rate in India has slowed more than in the US – during 2008–2013, the consumer price index hovered between 9.1% and 9.4%, while it ranged between 5.8% and 3.5% during 2014–2018. This lower wage inflation has reduced the pace of labour arbitrage shrinkage.
To look at this from a pharma perspective, the average salary for a US-based medical scientist is $84,810 (2018), while the average annual salary in India is closer to $15,450. The Indian rupee has experienced a significant decline against the US dollar over 2010–2018. This currency movement – a change from around 43 to 67 rupees to the dollar – created a large positive impact for US-based pharmaceutical companies buying outsourced services, offsetting inflation to a large extent.
Taking advantage of tax benefits
Often, outsourcing vendors are supported by tax breaks from their local government. For example, several outsourcing vendors in India operate in special economic zones, where they pay less tax than other businesses – or even none at all. Exemptions like these lower the cost of operations, and can therefore lower the service cost, so you should pay attention to these when you’re negotiating with vendors.
Why ‘cost of living adjustments’ don’t always work
Cost of living adjustments (COLA), an annual hike in the contract rates tied to wage inflation, are a common addition to outsourcing contracts to help guarantee talent retention. However, it might not work as well as you’d hope. Often, only a fraction of the inflation-adjusted increase actually makes it into the pockets of the employees – and in the pharma industry, keeping the right researchers and scientists on your team is vital. To make COLA effective, you should consider:
Building agreements into the contract: To help retain key team members, you can specifically include clauses in your contract to guarantee salary rises are actually given to your assigned team. While it’s easy to just track a 4% annual rise and be done with it, it’s not always effective – retention must become a part of the service level agreement structure.
Linking inflation to employee benefits: You can also tie the cost of living contract terms more directly to increased compensation and benefits for those staffing your accounts. You need to ensure that your longest-serving team members are getting the biggest bonuses.
In some cases, a simple raise can actually be counterproductive – a rise in compensation can be a trigger to job hunt because it makes the candidate appear more valuable.
Knowledge is power in negotiations
As the cost of developing drugs rises and margins shrink, it’s imperative for pharmaceutical companies to extract every ounce of savings possible. Knowing the risks and countering them will help you achieve major cost savings, get the best contract terms, and ensure your team is well-staffed with the right highly-skilled people.
At The Smart Cube, we empower Life Sciences organisations at every stage of the value chain by providing the insights needed to make rapid, informed decisions.
If you’d like to talk about how our market intelligence, research and analytics solutions can help back up your vendor negotiations with data-driven insights from the pharmaceutical industry, please get in touch.
And read our case study about how we provide connected intelligence to support a global biopharmaceutical company’s procurement programme.
Mayank has been in procurement research and strategic consulting for over a decade, half of which has been spent working for pharmaceutical clients. Having risen through the ranks at The Smart Cube, he is currently a manager in our Life Sciences sector, supporting multiple pharmaceutical clients across supply market intelligence, benchmarking and procurement consulting. In his free time, Mayank likes to read, write and watch sitcoms.