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Merck Business Strategy

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Expanding Through Open Innovation Case Report

MGT 6125 Strategic Managment Spring 2010

Stanislav Komsky

The ability to remain innovative is what makes companies rise and fall... All our ideas have one thing in common: They not only safeguard the future of Merck, but above all that of our customers says Dr. Plaumann, a Merck project manager. Merck, or Merck Sharp & Dohme, is the 9th largest pharmaceutical company in the world by revenue. Merck, headquartered in New Jersey, has recently been in the news for its merger with Schering-Plough in a $41 billion deal. Although the two companies have had a strong partnership in the past, it is believed that this merger will create a truly global company with a stronger research and development pipeline. The pharmaceutical industry currently ranks 3rd in the fortune 500 list of most profitable industries with 19.3% of 2008 revenues counting as profits. Historically, the pharmaceutical industry is known for blockbuster drugs and high margins. The competitive environment in the pharmaceutical industry began changing in the late 1980 s due to a decrease in sales volume, a decrease in innovation, and an increase in drug-specific industry competition. The market began a decline in annual growth rate and had dropped 10% between the 80 s and 90 s, but manufacturers fought the 15% drop in sales volume by increasing prices 132%. Starting in 1987, the cost of a new drug had risen $250 million because of increasing regulatory procedures and complexity of the compounds developed. In the United States, rigorous product quality regulations by the FDA compelled drug companies to invest in more advanced production technology to guarantee untainted drug manufacturing. Also, the EPA began a more stringent supervision on manufacturing emissions, requiring expensive pollution control and waste treatment equipment, as well as containment facilities for more complex drug production. Regardless of government regulations, there were internal factors affecting the conditions of pharmaceutical production stemming from competition within the industry. Exhibit 1 shows the difference that regulations created on the pharmaceutical value chain. Drug exclusivity was in rapid decline because more companies were developing similar products. Companies are quicker to develop competitive product lines, and this change has led to lower sales of novel drugs. This competition within drug classes takes a heavy toll on pharmaceutical companies profit margin, especially considering that the peak of drug sales comes around the fifth year of commercial production due to a continual increased in customer demand after product launch, and competitive products are being launched after two or three years. Most new drugs that are released are not able to reap the benefits of the fifth year of sales because similar drugs are being distributed after two or three years. Alongside large company competition of drug classes were the steadily increasing generic substitutes. By 1993, approximately 50% of all prescriptions were filled with generic products of brand name drugs, and by 2008, this number was increased to about 72%. These generics were generally 30% to 60% lower priced because the generic companies had no need to recoup R&D or marketing costs. Also, it only took a single generic alternative to subject an entire drug class to price reduction equaling the generic price, crippling multiple drug companies simultaneously. Since all of these new pressures were taking such a large toll on major pharmaceutical companies and their production, the industry began to reconsider its development and innovation strategies. Alongside the increased regulations, research costs, and pressures from generic drugs comes increased competition. Although any high profit industry attracts strong competition, the pharmaceutical industry has an especially competitive landscape. Exhibit 2 displays the increased growth of players in the pharmaceutical industry, along with the total number of drugs released for commercial production per year. Exhibit 3 shows the cost to develop a new drug over time, which includes the costs of the tens of thousands of drugs that never make it to market for every 1 that does. In 2006, the cost per new drug

was 1.318 billion and takes between 10 to 15 years. Exhibit 4 shows a drug development timeline, including FDA approval and clinical trials. Through this increasingly harsh environment, Merck has kept profits up or something. Merck s main core competency is its employees competence and skills, as Merck hires top of the line researchers. Another core competency is its research and development pipelines. Although Merck can gain a competitive advantage with the intellectual property that comes with the patent, any competitive advantage of this nature will go away with the expiration of the patent and the introduction into the market of generic substitutes. With an inflation of competitors on the market and a much tougher path of research and development to create a drug, a competitive advantage in the pharmaceutical industry cannot be sustained beyond a patent lifeline. In 2008, Merck spent $4.8 billion in research and development, filed 216 patents and only had 1 product approved by the FDA as shown in exhibit 6. Merck estimates that 1 out of every 5000-10,000 compounds screened becomes an approved drug and that it takes an average of 10 to 15 years at an average cost of more than US$1 billion to develop a successful medicine. There is no question that Merck s research and development and innovation engine needs a boost, and this boost can come from open innovation. Exhibt 5 shows Business Weeks top 50 most innovative companies of 2007 of which Merck is ranked 46th. It is important to note that 31 of the 50 use an open innovation strategy. Open Innovation is a new paradigm which assumes that in order to gain a competitive advantage, firms should use external ideas in addition to internal ideas. This treats a research and development pipeline as an open and global system, rather than a closed in-house system. Henry Chesbrough, a professor at Haas School of Business, states that open innovation is the use of purposive inflows and outflows of knowledge to accelerate innovation. With knowledge now widely distributed, companies cannot rely entirely on their own research, but should acquire inventions or intellectual property from other companies when it advances the business model. This business model, in the words of Chesbrough, can create value by leveraging many more ideas, due to their inclusion of a variety of external concepts, and can also enable greater value capture, by using a key asset, resource, or position not only in the company's own business model but also in other companies' businesses. This business model has taken effect in the United States leading companies, including Google, Apple, and Microsoft. Merck claims in its annual report that to deliver important products to the people who need them, we need a global environment and that the sharing of ideas across scientific disciplines enables Merck to continue to build on our culture of innovation. Although, a pro-innovation and pro-global development culture exists at Merck, it has not yet taken? to be an open innovation company. Open Innovation can indeed help Merck meet the needs of its customers in creative and cost-effective ways that also bring value to its shareholders. Exhibit 7 shows the increase of alliances in the biopharmaceutical community. Companies are realizing that in order to survive and thrive in these harsher times, it is important to share and collaborate on ideas. Open innovation can let companies bring their individually unique strengths to research and development in the pharmaceutical industry, and can be mutually beneficial to the corroborators. For Merck, open innovation can increase its research and development pipelines. Merck would be able to take ideas from the outside scientific community for new innovative products.

For a company the size of Merck, any large change can be both time consuming and costly. Merck needs to keep on its current track of external research and development, but to compliment this track, needs people that are in charge of bringing in the outside technology and research. For Merck to change from its old innovation paradigm to the new open innovation paradigm, as shown in exhibit 9, it will need to begin sharing knowledge and research with the outside. Merck can do this by letting their unused pharmaceutical ideas be used by others and by making greater use of external ideas and developments. According to Chesbrough, this could include the greater use of purposive outbound knowledge flows by companies, the emergence of a secondary market for intellectual property, and the creation of new organization roles and practices for identifying, incorporating, and adding value to external knowledge sources. As exhibit 8 shows, the research and development funnel for the open innovation model has many more pathways for ideas to come in and more processes on the outside of the funnel when a product needs to be taken to market. Overcoming resistance to change and selling the new open model to Merck s employees could prove difficult. The first step would be to get research to give equal importance to both internal and external knowledge and begin to realize a competitive advantage from e. They also need to be more intone with the scientific community and create an outbound flow of knowledge, for example begin publishing more journals and studies with previously internalized Merck data. With this increased sharing of knowledge and data, Merck needs to step up its intellectual property management. Strategic partnerships need to be made and maintained carefully with universities, small pharmaceutical and biopharmaceutical startups, and the pharmaceutical research community. Merck should be careful not to begin engaging externally without a clear innovation strategy. With more industry experts recommending an open innovation strategy, it might be tempting for Merck executives to being its path into externality without first overlooking its goals and strategy. As large part of this is having a clear view of how to handle its intellectual property, it might be advisable to Merck to hire lawyers that are open innovation intellectual property experts. Another area that Merck should be careful in is its relationships with potential partners. Merck needs to make sure it clearly evaluates the needs and goals of potential outside partners as well as the values and opportunities created by working with them. The next steps for Merck to pursue in order to enter into the open innovation world include human resource spending. Not only should Merck hire intellectual property experts and lawyers to protect itself in the sharing and collaborative environment, it should hire project managers that research staff that can expose the company to outside opportunities. Merck needs to develop strong partnerships with the leading scientific universities, and create a mutually beneficial environed that includes learning and development on both sides. The first step, however, is to officially formulate its strategy of how to approach open innovation both internally and externally before opening its research gates to the outside world. Exhibit 10 shows a SWOT analysis of Merck. Although pharmaceutical companies are historically very profitable, increased laws and government regulations, an increased flood of generic drugs, and increased competition have all lowered the market potential. Merck needs to explore new strategy to widen its research and development strategy, and open innovation could be the answer. Open innovation, the new collaborative development concept that is being used by several of today s most innovative companies, can help Merck by exposing it to outside knowledge and resources. Taking on open innovation could be both timely and costly, but might be necessary for Merck to not get leapfrogged by the incoming dynamic generation of pharmaceutical copies.

Exhibit 1. The Pharmaceutical Value Chain After 1990.

RESULT HAS BEEN DECONSTRUCTION OF THE PHARMA VALUE CHAIN
1980¶s Early 1990¶s Research Development Trials Registration Manufacturing Sales & marketing

Increased development costs Role of global launches increasing Quality outsourcers leverage scale advantages in individual layers of value chain (specialized) Easier IT enabled coordination and knowledge management

Research

Development

Trials

Registration

Manufacturing CMOs

Sales & marketing PBMs HMOs JVs/ licensing

Academic labs Late 1990¶s Early 2000¶s Biotech firms

CSOs Contract research organizations
Note: PBM=Pharmaceutical benefit management, HMO=Health maintenance organization, CMO= Contract manufacturing organization, CSO=Contract sales organization Source: BCGanalysis

Exhibit 2. Number of drugs and companies per year in the pharmaceutical industry.

Exhibit 3. Cost to Develop a New Drug Over Time.

Exhibit 4. New Drug Development Timeline.

Exhibit 5. Business Week World s Most innovative Companies of 2007.

*Red Implies Practice of Open Innovation

Exhibit 6. Merck R&D Pipeline 2005-2008 Performance Data.

Exhibit 7 . Number of Biomedical Alliances 1990 to 2005.
Number of Bio Medical Alliances 1990 to 2005
2500

2000

1500

1000

500

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 Drug-Drug 1999 2000 2001 2002 2003 2004 2005

Drug-Biotech

Biotech-Biotech

Uni-Biotech

Uni-Drug

Exhibit 8. The Open and Closed Innovation Paradigms.

Closed Innovation

Open Innovation

Exhibit 10. SWOT Analysis.

Strengths y One of the largest players in a high profit industry y Strong Research and Development Pipeline with 200+ pharmaceutical patents a year y Temporary patented protection of intellectual property

Weaknesses y Currently using an old closed innovation methodology and missing outside opportunities. y Close expiration of patents of top selling drugs y Larger difficulty creating a competitive advantage from intellectual property because of increased government regulations Threats y Increasingly competitive market with many new players coming into the pharmaceutical industry every year y Generic drugs are becoming a large part of the market, with an estimated 72% of pharmaceutical sales y Increasingly more expensive and a longer time to market for newly developed drugs

Opportunities y An open innovation methodology with information sharing and increased use of outside resources y Larger collaboration with universities, pharmaceutical startups, and the pharmaceutical community

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