Summer 2011
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The Impact of Wholesaler Source Contracting Programs on the Pharmaceutical Marketplace
Allen Dunehew, RPh, MPA
Vice President, Pharmacy
Amerinet

The evolution of the pharmaceutical distribution marketplace continues. For the past several months, some of the larger wholesalers have been negotiating with pharmaceutical manufacturers to stabilize the wholesaler revenue stream by converting to a new type of financial arrangement in return for providing specific services to the manufacturers. This arrangement is referred to as "fee-for-service" (FFS).

The primary reason behind this transition can be explained by an analysis of the change in the revenue sources for pharmaceutical wholesalers. Until recently, the speculative buying of additional inventory in anticipation of price increases was one of the primary revenue sources for wholesalers. In this scenario, wholesalers purchase incremental inventory in anticipation of a manufacturer price increase. Wholesalers implement the price increase when the manufacturer announces it and sell their lower- cost inventory at the higher price. A 5% price increase, for example, generates an additional 5% profit for the wholesaler on the excess inventory and essentially delays the financial benefit of the price increase for the manufacturer until such time that the excess wholesaler inventory is sold and the wholesaler replaces the stock at the new price. Other wholesaler revenue sources have included, but were not limited to, the purchase of products from secondary sources at reduced prices, supplier cash discounts, and incentives offered by some suppliers to accept additional inventory prior to the end of a fiscal year or quarter. This latter group is sometimes referred to as "channel stuffing." Channel stuffing has been used by manufacturers to inflate reported sales. Recent regulatory action to curtail this practice has caused many manufacturers to implement inventory management agreements (IMAs) to more closely control this practice, which has had a secondary effect of minimizing wholesaler opportunities to buy speculatively. Of the various types of wholesaler revenue sources described above, the cash discount is still viable. The loss of the speculative buying opportunity has had the most significant negative financial impact on those wholesalers who were most effective at this practice. This is true for two of the big three wholesalers, whereas the third has been much more active in relying on the source programs as a primary revenue source.

Two of the largest wholesalers have indicated that the FFS initiative is the key methodology to return stability to the wholesaler revenue stream. The stated goal for completion of the FFS initiative was the first quarter of 2005.1 Based upon informal discussions with several manufacturers, it appears that a majority, but not all, have reached agreement with wholesalers. The financial terms of the agreements are not public, but most appear to be in the 2% to 4% range for many suppliers rather than the 5% to 7% range as originally requested by some wholesalers. Several recent articles provide additional background on the dynamics behind this transition.2-7 What is unknown at this point is to what extent manufacturers will implement price increases to offset costs associated with the negotiated FFS payments.

The other key source of wholesaler revenue beyond FFS and cash discounts is from wholesaler source contracting programs. For the purposes of this article, "source" contracts are defined as wholesaler-based contracting initiatives, usually, but not limited to, generic pharmaceutical manufacturers. Source programs have been offered by wholesalers for several years and have had the most impact on the retail pharmacy sector. Each wholesaler has had a somewhat different strategy for marketing its source program. Two of the big three wholesalers have historically limited their efforts primarily to the retail market segment and have marketed source programs in the non-retail setting as a back-up strategy for use when the primary GPO contracted item is not available. The third has been more aggressive in this area and recently announced to manufacturers that their efforts are now targeted at all of the GPO generic contracted business. This article will focus on the wholesaler source contract programs including the contractual and financial relationships between supply chain participants, in an effort to increase awareness of the short- and long-term impact of these programs.

The typical contracting relationship between the manufacturer, provider, wholesaler and GPO is outlined in Figure 1. This model demonstrates a balance between all parties in such a way that the maximum long- term value is delivered to the customer. Figure 2 describes the various discounts, rebates and fees that flow between the parties. Understanding the money trail is necessary to understand the marketplace. In the current model, suppliers offer discounts on products to the provider through contracts negotiated primarily by GPOs or the provider for products delivered through a wholesaler. Manufacturers value inventory at cost, whereas wholesalers value inventory at wholesaler acquisition cost (WAC). Wholesalers adjust the inventory value between WAC and the actual selling price by processing a chargeback to the manufacturer for the difference between the two price points. In the FFS model, wholesalers earn revenue from cash discounts and receive a specific fee from suppliers, based upon the services provided. The wholesaler returns some of their revenue stream to their larger customers in the form of a "cost-minus" distribution fee, which results in the customer actually paying a lower price than the contract cost or WAC for a noncontracted item. GPOs receive administrative fees based upon purchases by members. Many arrangements between GPOs and their members return a portion of the administrative fee to the member in the form of shareback payments. GPO-contracted sales for brand-name products far exceed the sales volume for generic product sales. However, the average GPO administrative fee from generic product sales exceeds the average fee percentage earned from brand-name sales. This is an important factor as GPOs consider their response to aggressive competition by wholesaler source programs.

Figures 3 and 4 describe the contracting model for the typical wholesaler source program and the flow of money. The contracting and money flow models described in Figures 1 and 2 still apply to brand-name contracts. A comparison of Figures 1 and 3 clearly identifies the change in the role of the GPO. The wholesaler source contracting model in Figure 3 excludes the GPO from the process and eliminates any manufacturer rebates and GPO shareback. Proponents of this model might point out that this strategy could reduce overall costs and streamline the supply chain, since the GPO and GPO administrative fees are replaced by the wholesaler as the "broker" for the manufacturer. However, that argument fails to recognize the other services that GPOs provide beyond price negotiation and their value as an independent representative of their members. The wholesaler, in this model, is placed in the unique role of controlling the final price to the customer. This significantly changes the equilibrium in the market and the consolidation of power should be of concern to the customer, particularly when combined with the significant consolidation within the wholesaler distribution market, where the big three wholesalers control greater than 90% of the distributor volume. Short-term, the customer may save a few pennies on a product price but pay a greater long-term price in the form of increased product costs and reduced GPO services.

In one wholesaler source program contracting scenario of which the author is aware, the total amount of these fees could exceed 15%. This would allow the wholesaler to move some of their fee into price reductions, to drive a source program price below a GPO- contracted price. Wholesalers are custodians of all contract pricing and have unique access to contract prices for every GPO. In wholesaler source contract programs, the wholesaler negotiates the contract price and then applies the cost plus or minus to arrive at the final selling price, thereby controlling two key factors in the price.

This dual role of negotiator and final price setter can create a potential conflict for the wholesaler, as to whether the wholesaler or customer interests take precedence. In one small study by the author, purchase information was reviewed for one facility for a one- week period. During that period, 43 items were purchased, where the same item was sold under a wholesaler source contract rather than the GPO contract. Each of these 43 items was priced in the wholesaler source program at exactly two cents below the GPO contract price for the exact same item. Prices for the 43 items ranged from $1.35 to $165.50. The wholesaler would make $16.50 on the $165.00 item, using a conservative example of total "fees" of 10% in the source program, while passing on only $0.02 to the customer. Because of the consistency of the two-cent variance across a broad array of products, it appeared that the wholesaler used the GPO contract price for each item as a benchmark and gave a very small portion (two cents) of the wholesaler source fees described above to lower the source contract price below the GPO price. In this study, the customer saved $120 on $47,000 (0.26%) in purchases for the products in the study period and lost any potential sharing by the GPO from earned administrative fee payments, along with any manufacturer rebates that might have been available had the item been purchased through the GPO contract.

In another recent example, a wholesaler announced a new source program targeted at the acute-care market. The wholesaler sent a letter to manufacturers listing the desired products and the target price that the wholesaler was expecting, which is much different than the GPO pharmacy model of competitive bidding. Based upon private conversations with a few manufacturers that were solicited for this program, it appears that there was a tremendous amount of pressure exerted by the wholesaler to gain manufacturers' participation in this new acute-care program. Several manufacturers indicated that one of the wholesaler's justifications as to why the manufacturer should participate in this new initiative was that the wholesaler has more control over which products are stocked by the wholesaler and, therefore, available for purchase.

Preservation of a competitive marketplace that rewards participants for embracing transparency and sound business practices to deliver the most appropriate value to the customer is paramount.

The wholesaler does have the power, if unchecked, to prove their level of control either by outright refusal to stock the product or, in more subtle ways, such as stocking the product at a low inventory level with substitution to the wholesaler source item if stock of the GPO-contracted item is not available. GPOs can measure this by calculating raw fill rates by manufacturer across all wholesalers. An unusually low fill rate for an item or a manufacturer, overall, at one wholesaler compared with fill rates for the market in general may be an indication that the wholesaler is intentionally maintaining a low stock to facilitate substitution to the wholesaler's own source-program contract item to deliver a higher revenue for the wholesaler. In other cases, a wholesaler may auto substitute the wholesaler source-contract product for the GPO-contract product. The long-term impact of these activities, if unchecked, will likely result in the decreased ability of any GPO to effectively contract for generic products. At some point, manufacturers will be forced to evaluate the relative value obtained from contracting through GPOs and the fees paid to the GPO if the wholesaler has the ultimate control over generic product selection. The long-term implications are too important to ignore.

Providers are encouraged to become more active as this market evolves. Short-term, the provider may save a few cents on items available through wholesaler source programs. Focusing on the long-term impact should create a concern for providers about the expansion of wholesaler source programs, including the impact on pharmaceutical costs and the types of services that a GPO can continue to provide. Providers have limited resources to monitor these issues. However, ignoring these issues may result in increased costs and additional shrinkage of resources. The following are some considerations for providers:

  • Closely review wholesaler purchases for unauthorized product substitutions
  • Educate pharmacy staff and hospital leadership regarding these issues
  • Support supply chain partners that demonstrate ethical business practices that focus on the best interests of the customer
  • Notify the GPO in cases where the variance in pricing for wholesaler source vs. GPO contracts appear to be artificially controlled, as in the two-cent example described above
  • Increase understanding of all parties regarding additional savings resulting from manufacturer rebates and GPO administrative fee sharing
  • Be prepared to pay an invoice price that is a few cents higher than a source contract in return for supporting a competitive marketplace for the long-term
  • Increase awareness of the value and role of the GPO for both contracting and value-added services
  • Monitor invoice pricing of products to determine if the base cost of non-contract items has been adjusted by the wholesaler
  • Continue to educate wholesalers on the potential impact on patient care resulting from product shortages and substitution

The long-term success of generic manufacturers is linked to this evolving marketplace. A well-balanced market is in their best interest, as opposed to a market where a wholesaler can select a subset of manufacturers and their products, which could be particularly damaging to manufacturers of sterile pharmaceuticals. The willingness of pharmaceutical manufacturers to participate in wholesaler source programs, including payment of significant fees and rebates to the wholesaler, is partially responsible for the renewed interest by wholesalers to utilize source programs as the latest method to shore up financial positions. More than one manufacturer has expressed concerns about the impact source programs can have on contract pull-through. However, upon loss of a large contract, some of these same manufacturers turn to the source programs to replace lost sales. Manufacturers should consider the following:

  • Continue to closely monitor chargeback reports from wholesalers to ensure that sales to GPO members are correctly attributed to GPO rather than to source contracts
  • Work with GPOs on any stocking problems or concerns regarding contract pull-through with a particular wholesaler, particularly if it varies significantly by wholesaler
  • Support a free-market system that includes adequate checks and balances, including a separation of roles, to minimize the ability of any one sector of the market to consolidate an excessive amount of influence
  • Be prepared to establish alternative efficient and effective distribution methods, if necessary

The penetration of the prime vendor distribution model has had a significant impact in improving efficiency in the pharmaceutical supply chain, which is proof of the value of wholesalers and the many services they provide beyond pure distribution. Not all wholesalers engage in the practices outlined above, nor is it appropriate to identify specific companies by name. In fact, one of the wholesalers engaged in the practice of using a two- cent variance to set preferential source prices indicated recently that this practice has stopped. Each wholesaler defines specific strategies for meeting operational and financial goals. Some have expressed concern about being disadvantaged in the marketplace by a competitor that elects to aggressively bid lower cost-minus offers with the intent of making it up after the contract is signed by diverting sales to more lucrative source programs. Some wholesalers have expressed a need to move aggressively into source contracting in the acute-care market in order to maintain a level playing field and prevent loss of business. As this market evolves, wholesalers are encouraged to:

Consider a strategy that supports a healthy and transparent marketplace

  • Clearly identify and communicate their strategy and engage GPOs in delivering the message that the cost-minus percentage is not the only parameter that needs to be considered when evaluating wholesalers and that a wholesaler can make up for a low cost-plus or cost-minus bid after the contract is signed
  • Insist upon being rewarded for support of a competitive marketplace
  • Educate current and potential customers regarding the impact of these activities on true cost, including the point that true cost is not measured solely by the wholesaler cost-minus bid
  • Explain the methodology and importance of evaluating prime vendor proposals over the entire term of the contract, rather than by the initial cost-minus offer
  • Work with GPOs to establish GPO and wholesaler goals that focus on the best interests of the customer
  • Support a uniform and transparent definition of "cost"
  • Establish secure firewalls to prevent access to confidential GPO pricing by wholesaler staff who are engaged in negotiating source contracts and setting final prices

Providers are encouraged to become more active at this market evolves.

Each GPO needs to clearly communicate these issues to their members and work with both manufacturers and wholesalers to develop strategies that provide value to all participants. A specific strategy should be developed by each GPO to educate the pharmacy buyer, director of pharmacy and hospital management on the complex dynamics involved in this marketplace. Other considerations for a GPO include:

  • Monitor wholesaler sales transaction data carefully for product and contract substitution
  • Educate GPO members on the short-and long-term impact
  • Work with manufacturers and wholesalers on initiatives as defined above
  • Assist members in evaluating the relative value of individual wholesalers to the provider
  • Advocate transparency in the marketplace by continuing to educate members on the fallacy of the cost-minus distribution pricing model
  • Increase data capabilities to facilitate invoice price checking
  • Stay vigilant regarding any additional horizontal or vertical consolidation in the pharmaceutical supply chain

Wholesaler source programs can undermine the value of the GPO services for the manufacturer if product purchases get diverted from the GPO contract to a source program. On the surface, this might appear to be self-serving for the GPO. There is no doubt that the long-term effectiveness of the GPO may be at risk if a wholesaler decides to actively pursue and is successful in converting sales from the GPO contract to the wholesaler source contract. In the author's opinion, the long-term impact of wholesaler source programs that divert purchases from GPO contracts is not in the best long-term interest of the customer.

There will be a variety of competing and aligned incentives between the participants in any industry as complex as the pharmaceutical marketplace. All participants in this industry are responsible, to some extent, for the current financial conditions of the pharmaceutical supply chain. Preservation of a competitive marketplace that rewards participants for embracing transparency and sound business practices to deliver the most appropriate value to the customer is paramount. The best resolution, overall, is full transparency and disclosure in the marketplace, as well as a uniform definition of "cost" for use by all wholesalers.

This evolutionary process will continue over the next few years, but the next 6 months will be critical in shaping the marketplace with respect to generic contracting practices. There is enough "chatter" in the marketplace to indicate that the concerns expressed herein are not just from one GPO or manufacturer and definitive steps will need to be taken in the very near term, if the open marketplace is to be preserved. Providers are encouraged to consult with their GPO for additional insight on this complex issue and for updates as these dynamics unfold.

References

  1. ABC Counsels Caution on Fee-For-Service Push by Wholesalers. The Pink Sheet. Sep. 20, 2004, p. 31.
  2. Wholesaler Distribution Fee Rates May Be Lower than Planned, Study Says. The Pink Sheet. Dec. 20, 2004, p. 33.
  3. Basta, Nick. Fee for Service Update. Pharmaceutical Commerce. 2005; pp.1-26.
  4. Dunehew, Allen. Changing Dynamics in the Pharmaceutical Supply Chain: A GPO Perspective. Am J Health-Syst Pharm. 2005; 62:527-29.
  5. Dunehew AR, Stokes H, Newberry J, et. al. Contract Pricing Integrity for Pharmaceuticals. Am J Health-Syst Pharm. 2005; 62:422-29.
  6. Yost, R. David. New Economics of the Pharmaceutical Supply Chain. Am J Health-Syst Pharm. 2005; 62:525-26.
  7. Cardinal to Restate Earnings; Urgency Behind Fee-For-Service. The Pink Sheet. Sep. 20, 2004, p. 30.
Volume 20
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