When Hard-Nosed Purchasing Does Not Work

In the July 6, 2011, issue of The Wall Street Journal, Roger Bate has written a column entitled “Beware the Risks of Generic Drugs.” He specifically zeroes in on drugs produced from ingredients sourced in China. Although this story is about the issues associated with generic drugs, the bigger question it raises is why pharmaceuticals would cut corners on such critical processes as the sources of ingredients for their drugs. At least one of the root causes is the relentless pressure governments, insurance companies, and employers feel to reduce costs by reducing the acquisition prices of drugs.

When governments, private insurers, and self-insured health plans try to drive drug prices down and, specifically, to convert patients from using generic drugs instead of branded drugs, there is a limit in terms of cost-saving opportunities available, without putting patients at risk. To push cost savings beyond that point inevitably raises a huge risk of acquiring generic drugs priced at a level that does not optimize patient safety.

We cannot solve our health care cost crisis entirely primarily by driving prices down for drugs, supplies, devices, and medical services. We have to reduce unnecessary usage of the health care system, and to drive the healthier behaviors that are the most sustainable way of reducing health care system usage.

Publicly held businesses and governments under stress for excessive costs often have the tendency to flex their muscles in procurement processes to demonstrate their ability to save money. The unit cost savings are visible, the savings opportunities are often immediate, and the purchasers can present themselves as fiscally responsible. Moreover, it is far more comfortable for payers to beat up on suppliers through the procurement process than to deal with the messy questions associated with inappropriate usage of the health care system, or driving people to engage in healthier behaviors.

There are two things wrong with relying on procurement strategies as the primary cost reduction tool:

• Unless there are tight controls on what is purchased, cost reductions are often covered by sellers cutting corners in what they are providing, or reserving the right to charge for what had been given away. Government contractors have mastered the process of low-balling initial contract price offers, and then making huge profits from “extras” which are inevitably required by the government at a later time. The so-called savings are phony; they are merely costs that are deferred to a later time and are often higher than a more comprehensive competitive bid.
• The sellers who agree to accept lower prices and try to honor them according to their terms often find themselves unable to perform profitably. Over time, the pool of sellers willing to bid on business that is consistently likely to be unprofitable shrinks. Eventually, the purchaser has no competitive options.

In the pharmaceuticals context, the corner cutting can be fatal to patients, as was the case with heparin. Although I obviously cannot know what happened in every health plan procurement negotiation, I would not be surprised that purchasers which drove a hard bargain on pricing for generic drugs created an environment in which the supply chain functions of pharmaceutical manufacturers attempted to acquire ingredients for the drug at a price that could not be supported with the extra cost of a tightly controlled supply system.

There are no “magic bullet” ways to take drug prices down beyond a certain point. Major drug manufacturers are administratively inefficient; they spend excessively on marketing and sales; and they may still have less efficient research and development processes. However, beyond a certain point, cost cutting will cause people in their organization to take actions that put processes at risk.

Employees of pharmaceutical companies are not excessively evil or reckless compared to other businesses or governments; this is true of every large organization. Employees under severe pressure anywhere to cut costs make stupid and reckless decisions to keep their jobs. They particularly cut costs in areas in which the consequences are less visible or more likely to appear at a later time, especially if they can transfer the risk to someone else. They are unlikely to go after the most sustainable cost reductions, which involve messy structural reform of their organizations.

In the health care marketplace, this was illustrated particularly with the Johnson & Johnson manufacturing safety problem in the last few years. Much of the publicity about that case demonstrated that the root cause was a culture that, over time, became excessively focused on cost cutting at the risk of patient safety.

Relative to other areas of health care, the same principle applies: there is no free lunch when costs are cut excessively in the procurement space. One major firm was very happy with the fact that its insurance plan administrator significantly reduced the payments due to physicians, hospitals, and other healthcare providers. The plan administrator secured a very good long-term contract because it presented itself as having a better ability than other administrators to negotiate prices with providers.

Unfortunately for the Company, the consequence of this hardball negotiation process was that many providers left the network and stopped treating patients with whom they had long-term relationships. As a result, the Company lost in two ways:

• Some patients stayed with these providers, who were now out of the network and were charging much higher prices. Even with lower reimbursement percentages for out-of-network care, the Company still paid more. Out-of-network costs shot up.
• Some patients changed providers, received disruptive and suboptimal care, and were very unhappy with the Company for causing this to happen.

As a CEO, I was never comfortable with strategies based predominantly on procurement-based price reductions. They tended to work for 2-3 years, and then fell apart. The better strategy was to work with vendor-partners to get better products and services through sustainable cost reductions. For example, I always liked solutions in which parts were re-engineered or packaging was reduced, or a less expensive, but equally reliable, way to ship the product was found. These kinds of cost reductions were more challenging, but they worked. Cost reductions based solely on price concessions struck me as a very lazy way to reduce costs. I supported them, but, to a limited degree and for a limited period of time.

Ultimately, the challenges of reducing health care costs will require us to make deep and broad structural changes on how we live our lives, and allocate societal resources. The move from branded to generic drugs is a small step in health care cost reduction, but, like every other, it has limited value and has to be managed with great care.