How to Prepare for New Pricing Rules and Consolidation in China's Medical Device Distribution System

Posted in China by Jamie Hartford on February 26, 2014

These changes will create an imperative for distributors to improve performance as well as bring new opportunities for device makers that can properly build and manage their commercial models and partnerships with the right channel partners.

By Kelly Wang


Multinational medical device companies have a long history of driving growth through patented products, strong brands, and direct sales force in the United States and Europe. In China, however, multinational medical device companies have not seen much success with the direct sales model and rely instead on distributors.

But changes afoot in the country will require many medical device producers to rethink their channel strategies in the country. New pricing rules for medical services are being imposed in the near-term, and in the longer term, consolidation is coming to the fragmented Chinese device distribution system. These changes will create an imperative for distributors to improve performance as well as bring new opportunities for device makers that can properly build and manage their commercial models and partnerships with the right channel partners.

Multinational medical device companies would do well to address the following action points for success:

1. Clarify Distributor Roles in a Fragmented Market

China is a hospital-based healthcare market, dominated by government-owned, public hospitals. To break in, manufacturers need the help of distributors that have good relationships with hospitals, which account for the bulk of device purchasing. Attempts to sell directly to hospitals have not worked out well, and clarifying distributors’ roles and responsibilities by customer segments will be critical in aligning channels and capturing opportunities for device companies in the future.

China’s medical device distribution base is intensely fragmented. At the end of 2011, there were more than 180,000 medical device distributors in China, compared with about 13,000 pharmaceutical distributors. Beijing alone has about 8000 medical device distributors, and Shanghai has about 6000.

Most medical device distributors are highly specialized in certain product categories and provide access only to a single local market or even one or two hospitals. The ratio between medical device distributors and manufacturer sales representatives is nearly 1 to 1—about four times the ratio for pharmaceutical manufacturers. For large equipment, the number of distributors can even exceed the number of sales representatives a manufacturer can deploy.

When most medical device manufacturers first entered China, they relied on distributors to develop the market. Multinational device companies needed distributors that could have a strong impact on their ability to drive sales, expand penetration, and defend against competitive and local products.

As these companies expanded, many built their own direct sales forces and transitioned to a hybrid go-to-market model with increased direct sales involvement and internalized local insights. In this model, direct sales forces focus on covering large hospitals and big cities, while distributors play more of a supporting role.

Today, companies struggle with issues such as which accounts to cover with a direct sales force and which ones require only distributors. Given that companies have a limited number of direct sales representatives, which accounts should be the initial focus? In different account segments, what roles should the distributors play? As companies institute standardized processes for this kind of decision-making, outcomes will improve.

2. Revisit Distributor Trade Term and Channel Margin

Medical device distributors in China preserve high margins of 30%–60%—significantly higher than the Chinese pharmaceutical distribution sector, whose gross profit margin was 6.9 percent in 2012, according to the Ministry of Commerce.

Eager to cut healthcare costs, the Chinese government is expected pressure medical device distributors to consolidate and reduce their margins much as it successfully did with pharmaceutical distributors in the past. To stay ahead of the game, manufacturers will need to reassess their channel strategies.

The channel’s high mark up is viewed as contributing to the high cost of medical devices and corruption within the system, and authorities have already taken action on some devices. The impact can be seen in cardiovascular stents, where the mandated central tendering that began in 2011 has forced prices down, squeezed the channel margin, and flattened the distribution channel.

In a recent manifestation of this intention, the Commerce Ministry's antimonopoly bureau sent a survey seeking extensive information about pricing to most of the companies involved in the medical devices industry. (reported in Reuters, August 21, 2013 ).

In May 2012, the National Pricing Guideline for Medical Services was coissued by the National Development Reform Commission (NDRC), Ministry of Health (MoH), and State Administration of Traditional Chinese Medicine (SATCM). Exact implementation details are still under consideration and will likely vary across provinces, but it is clear that stricter rules will be applied to medical service pricing—a change that will impact on manufacturers of innovative medical devices the most. In the face of price reduction, manufacturers will be obliged to reallocate profit along the value chain and rethink the conditions of generous distributor margins and the somewhat opaque hospital mark-up.

Compared with the stance it took with the pharmaceutical industry, where a fixed hospital markup of up to 15% was enforced and the channel margin was capped, the Chinese government has taken a more gradual approach to rationalize the channel margin in medical device industry. Still, MNCs should not underestimate the force of the government’s effort.

3. Upgrade Channel Management Capability Building

Within medical device companies, the commercial department, a kind of management department unique to companies in China, is responsible for managing distributors. The changing marketplace and increasingly complicated distribution channel management have required commercial departments to evolve from a more operational role to become a more strategic channel manager. But these departments lack the experience needed to rationalize distribution, and the sales force itself too often handles selection and management.

The need to work with large numbers of distributors places a strain on the commercial departments at some manufacturers. One manufacturer’s business team of more than 100 sales people currently coordinates more than 200 distributors of varying scale and capabilities. But with the increased capability of some visionary distributors, the manufacturer is running a pilot with a smaller number of directly managed (Tier 1) distributors and constructing a more structured tiered distribution channel, as is more common in the pharmaceutical industry.

The commercial team must be able to create productive working relationships, manage complex coverage models, and implement targeted growth initiatives. This ensures targeted returns on distributors’ compensation and incentives will be achieved. Without strong channel management capabilities, multinational medical device companies are in danger of ceding initiative and control to distributors, which places sales and growth goals at risk.

The Chinese Ministry of Health’s newly revised Good Supply Practice of Pharmaceutical Products (GSP) went into effect June 1, 2013. The revised GSP standards set high requirements, and pharmaceutical distributors with an expired GSP certification or pharmaceutical distributor license will need to be inspected and recertified in accordance with the new provisions. This forces small and less qualified players to upgrade or drop out.

The timeline for pharmaceutical distributors to upgrade to new GSP requirements is five years. By then, it is expected that about 30–50% of pharmaceutical distributors will be forced out of business.

A similar scenario, albeit over a longer period, is expected to play out for device distributors. This will oblige multinational medical device companies to manage their distributors more efficiently.
Market conditions and distributor channel composition vary significantly across markets and cities, but this does not mean that multinational medical device companies should not use a disciplined, fact-based process to make channel decisions. In fact, outcomes will be stronger if standardized processes are used to help make local decisions. Using standardized processes also gives management improved visibility and performance measures.

Most medical device distributors in China lack the level of information technology practice to support distributor data interchange implementation. Some companies even struggle to have all their distributors place orders online through their distributor management system. As a result, medical device distributor sales and inventory data are still mostly manually collected using third-party data services or internal teams. One manufacturer maintains a team of about 30 people who manually check every invoice for hospital sales crediting. This limits manufacturers’ ability to plan efficiently and effectively for importation and promotional activities, as well as to control inventory and monitor performance.

Pharmaceutical manufacturers in China already have worked out a more integrated form of managing distributors. This starts with the identification and selection of the distributors the company wants to work with, so that they can enable, engage, retain, pay, and, of course, terminate the distributors.

As a result, the commercial departments of these pharmaceutical producers have taken on new strategic roles. Because they work closely with distributors, they are now also able to take responsibility for pricing and bidding, enhancing their companies’ abilities to react to healthcare reform. It is likely that medical device manufacturers will develop their commercial departments along the same pattern. Even so, there are clear differences between the pharmaceutical and medical devices sectors, which should lead to a slightly altered pattern of development.

4. Offer Differentiated Distributor Partnership Programs

Multinational medical device companies should react to inconsistent distributor performance and create performance and structure tiers while making some adjustments for local market conditions.

The medical device distribution base is far more fragmented than that of pharmaceuticals, and the market potential available to different distributors varies much more widely. Distributor performance gaps are much wider as well, and multinational medical device companes need to recognize that one size will not fit all.

Different manufacturers will naturally have different expectations, and only some distributors will have the capabilities to support a company’s current and future businesses. Device manufacturers need distributor segmentation and tiered partnership programs that allow manufacturers to optimize resource allocation.

If the model developed by the pharmaceutical industry indeed acts as a paradigm, there will be new partnership opportunities created for device makers as a result of this restructuring of distribution channels. We have seen that accelerated consolidation of pharmaceutical distributors and deteriorated channel margins have prompted several strong national and regional pharmaceuticals distributors to express interest in entering the medical device distribution business. This offers considerable new partnership opportunities for medical device companies.

Broad coverage, existing hospital relationship, strong logistics, and management capabilities make these pharmaceutical distributors perfect partners for medical device manufacturers. This is especially true for consumables and implantables, for which distributor roles are more like those in pharmaceuticals channels, and for which manufacturers will continue to face price pressure due to strengthened central tendering and price control regulations.

Pharmaceutical distributors also offer another model that medical device distributors are expected to adopt. Medical device distributors have not taken all the necessary steps to complement manufacturers’ own sales and services teams. In pharma, companies are moving toward pay-for-performance incentives for distributors that offer value-added services such as bidding/hospital listing assistance, broad market expansion, and information gathering, to name a few.

The Outlook

The process of channel structure reassessment will take longer in the medical device sector than it has taken in the pharmaceutical space. While pharma companies shorten the route-to-market, medical device manufacturers need to revisit the legacy practice and directly manage most of their distributors (large and small).

Multinational medical device companies should consider to what extent the medical service price will be adjusted as the regulatory measures are applied. They will have to give careful consideration to the effect on sales, and adjust for lower margins.

As the channel margin gets squeezed and larger medical device distributors emerge, device producers must forge closer strategic ties with the ones they choose to work with. Sales representatives should take over a large part of the distributor role, and they should increase their geographic and functional responsibilities. In another five to 10 years, a modern channel structure is likely to exist in China, thanks in part to government pressure and in part to change coming from the manufacturers themselves.

Kelly Wang is a manager at ZS Associates, based in the firm's Shanghai office. She leads ZS’s medical device practice area in China. Wang has worked with more than 20 medical device and pharma companies on more than 50 engagements on various sales and marketing issues, including channel strategy, sales force effectiveness, and opportunity assessment.

[image courtesy of OHMEGA1982/FREEDIGITALPHOTOS.NET]


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