Outsourcing on the Rise

A worker loads SMT parts for a new medical device.

Gaet Tyranski

August 5, 2010

12 Min Read
Outsourcing on the Rise

A worker loads SMT parts for a new medical device.

The medical device industry has historically maintained a low level of outsourcing activity, estimated to be only about 10% of cost of goods sold in 2010.1 There are several reasons for this, which can be summarized as perceived concerns about quality control, regulatory compliance, competitive pressures, and, in general, a traditionally simpler market with less regulation and a tighter geographical focus compared with current globalization. 


Today, the medical device manufacturing landscape has interesting new contours that require new ways of doing business. Companies are facing tougher competitive and regulatory challenges, which make outsourcing an increasingly attractive option. At the same time, many of the traditional barriers to outsourcing have lessened or disappeared. Contract manufacturers (CMs) have also diversified and significantly expanded their capabilities. All of these factors have converged, fueling a growing trend toward the use of third-party resources to design, engineer, manufacture, package, and distribute a wide range of medical devices—from diagnostic equipment and single-use devices (SUDs) to combination products.


Outsourcing Heats Up

Ten to 15 years ago, medical device OEMs were not much interested in outsourcing because they did not feel the pressures of cost control and speed to market that now drive product development and manufacturing. These companies enjoyed strong profit margins and ample cash flow, providing plenty of resources to invest in facility infrastructure and the equipment necessary to perform their own manufacturing. Another factor that supported in-house manufacturing was the simplicity of the market. The bulk of demand for medical devices came from the United States, Europe, and Japan, making it easy for companies to acquire the regulatory expertise and establish the plants, supply chains, and distribution systems needed to support these regions.


OEMs also had concerns about entrusting design and manufacturing tasks to outsourcing companies. Loss of direct control raised questions about the suppliers’ ability and commitment to deliver the requisite high quality and to meet regulatory requirements. OEMs were also concerned about protecting their brands and avoiding infringement of their intellectual property. These reservations were exacerbated by fears related to offshoring, e.g., cultural differences and adherence to in-country regulations and systems.


However, outsourcing is becoming a more attractive path for medical device OEMs for two main reasons: changes in the market and vast improvements to CM offerings.

Figure 1. A comparison of EMS revenue segmentation in 2008 and 2015 (projected). Source: Frost & Sullivan.


The Market Is Changing

Globalization. A number of important trends in the medical device market underscore the benefits of outsourcing. First is globalization. Demand for diagnostic equipment and other devices is growing in emerging markets such as Brazil, Russia, India, and China (the so-called BRIC nations), where the expanding middle class can afford more and better medical services. Findings from Millennium Research Group reveal that the BRIC economies will fuel much of the growth of the global market for diagnostic imaging systems through the current recession and beyond.2


At the same time, price points for devices tend to be much lower in these markets than in the United States and Europe. OEMs may find it difficult to compete for business in these markets by simply importing their products or transferring the manufacture of traditional models without local features, thereby ignoring glocalization, the act of thinking globally and acting locally.3 Manufacturers face differences in regulations, clinician and consumer preferences, and marketing strategies that can place them at a disadvantage. In response, manufacturers are starting to do the opposite—locally design and manufacture products targeted to the developing markets.


Margins. Another change is margin pressure. As other nations increase their production of medical devices for in-country sale as well as export to the West, OEMs face increasing competition, such as from Mindray Medical International Ltd., in China in the imaging field. Also, government healthcare legislation, especially in the United States, is seeking to tax OEMs more heavily. An example is the Healthcare Reform Act signed into law by President Obama on March 23, 2010, which imposes a 2.3% excise tax on most device manufacturers, producers, and importers (allocated based on sales volume) starting in 2012.


 

Contract manufacturers are diversifying their offerings beyond the production line to include packaging and a multitude of other services.

In the United States, more-stringent reimbursement requirements, such as the equalizing of outpatient and hospital reimbursements by the Deficit Reduction Act of 2005, and a recent proposal to increase the utilization percentage of imaging centers to meet Medicare reimbursement requirements, could dramatically affect the bottom line. A harder line on reimbursement means hospitals receive less reimbursement per procedure, thus requiring more procedures to justify new equipment purchases. In turn, OEMs face pressure to reduce costs per unit to keep sales up, often driving the need to outsource.


Information Technology (IT). The increasing sophistication of IT is another major trend. As devices become more complex and dependent on state-of-the-art electronics, OEMs may lack the internal resources to develop and produce the necessary software and hardware. For low-volume devices in particular, manufacturers may find it cost-prohibitive to hire the experts and purchase the technologies that are required. Constant changes in IT add to the challenge.
Resources. Similarly, OEMs interested in the growing market for combination products, such as drug-electronic device or plastic device-biologic combinations, may not be set up to handle all of these components. Although the combination product market is experiencing double-digit growth and has high potential outside traditional markets that make it very attractive, companies may encounter roadblocks due to their inexperience with pharmaceutical formulation, fluid engineering, nanotechnology, and other specialty areas.


Even if manufacturers possess the resources to develop sophisticated electronics or complex combination products internally, competitive pressures may require their engineers and designers to start working on the next product immediately, instead of spending the time needed to optimize a current device’s design and manufacturing process. For example, when the European Union’s (EU) Restriction of Hazardous Substances (RoHS) Directive required conversion of the bill of materials for legacy products, OEM engineers were focused on next-generation products and did not have time to work on the conversions. As a result, this value-added service was outsourced in many cases.
Internally, OEMs are seeing evidence from device recalls—such as the recall of Guidant cardiac defibrillators in 2007—that in-house quality control measures are not necessarily superior to those of contract partners.


Accelerated Capabilities Development

At the same time that market forces are orienting OEMs toward outsourcing, CMs have been adding sophisticated services, facilities, and capabilities that make partnership much more attractive. Although CMs have traditionally offered high-volume production of consumer electronics, they are transitioning to meet the specific needs of medical device manufacturers. First, they are diversifying their services beyond the production line to include design and development, testing, assembly, packaging, logistics, order fulfillment, and other aftermarket services. This broad offering gives OEMs greater flexibility to tailor an outsourcing arrangement to meet specific requirements. Some CMs, anticipating a brighter future for medical outsourcing, have built or upgraded cleanrooms, centers of excellence, and other specialized facilities; undergone certification to ISO 13485; and incorporated current good manufacturing practices (CGMPs) into their operations.


While they are adding new services, CMs are also seeing greater value placed on their traditional expertise in electronics. As medical equipment and devices become more technologically complex, a partner’s knowledge of and ongoing work with the latest electronics technologies can be a tremendous help to OEMs that face high costs in implementing new capabilities. The growing trends toward miniaturization, nonsurgical or minimally invasive surgical devices, and home healthcare delivery all demand more-sophisticated and smaller electronics, which may not be a core competency of a device OEM.


 

A Jabil engineer molds liquid silicone rubber device components at the company's Taiwan R&D facility.

CMs are able to leverage broad electronics expertise from work in other sectors to benefit the medical device industry. Technology transfer—from consumer electronics, for example, with its relentless drive toward miniaturization—spares OEMs the risk and expense of investing in these new breakthroughs. Likewise, the automotive industry has elements such as ISO/TS 16949 standards and the Production Part Approval Process (PPAP) that are very similar to medical quality requirements; the automotive industry—like medical—is a <50-ppm business. The fact that these other industries demand high-quality standards ensures that CMs already have appropriate quality control systems in place for medical device customers.


Large CMs often have global reach paired with local presence in key regions such as the BRIC nations. Knowledge of the local area and its regulations, previously built and scalable manufacturing infrastructure, and a network of established suppliers enable fast in-country turnarounds of new projects. Replicating such an infrastructure in a new region would require an OEM to invest enormous resources and 12–18 months of activity including identifying the site, registering the firm, building the facility, and hiring and training employees. Large CMs also offer business continuity through their ability to transfer a project to a sister facility and to tap alternative suppliers.


Benefits to the OEM

As OEMs take a fresh look at outsourcing to CMs, they are recognizing the strategic and tactical benefits that the right partner can provide. In one case, a global manufacturer of noninvasive patient-monitoring devices and sensors made the decision to partner with a single, large CM to achieve specific goals: faster time to market, greater flexibility to accommodate changes in volume and timelines, and reduced costs. By working with the CM, which prototypes and manufactures the OEM’s electronic subassemblies, the OEM reduced its prototype build cycle to 1–2 weeks; achieved 98% acceptance rates for quality, and gained the flexibility to respond immediately to unexpected surges in orders.
Although cost reduction is a common reason for outsourcing, typically saving 10–30% on product development and production costs, there are many other advantages to this model.


Core Competencies. Full CM services allow OEMs to concentrate on their core competencies by offloading most or all of a product’s development, production, and aftermarket functions, such as packaging and sterilization and even repairs. Turnkey manufacturing is a growing trend—OEMs that partner with a full-service CM can free up resources to concentrate on new products or business expansion and avoid the costs of building infrastructure and hiring specialists that may only be needed for one device.


At the same time, a full-service provider can streamline operations and logistics versus using an array of vendors that must be managed and coordinated. A single outsourcing company also helps to alleviate concerns about IP security by restricting access to sensitive information to a single third party.


Expertise. Complementary CM expertise in specialized technologies, particularly electronics, allows OEMs to leverage state-of-the-art IT without having to acquire facilities and people. Utilizing established expertise, centers of excellence, and dedicated manufacturing teams provided by the CM, a device manufacturer can significantly reduce time to market for a new product. This approach also provides a competitive advantage to OEMs by giving them a source of strong institutional knowledge for new technological possibilities for upcoming devices, such as wireless technology for blood glucose meters. Also, because commercial applications tend to drive technological innovation, a CM’s familiarity with commercial manufacturing technology can guide the medical device company toward standard components equivalent to custom designs, which can save time and money.


For example, a manufacturer of diagnostic equipment wanted to create a handheld version of a device by miniaturizing its existing laptop-size footprint. The company was under time pressure and lacked available engineering resources to design and test a suitable board. By partnering with a CM that had relevant experience from engineering, developing, and manufacturing the latest cell phones and consumer handheld devices, the OEM was able to accelerate time to market.


Geographical Reach. CMs can often offer a substantial presence in emerging markets and knowledge of local regulations and procedures. CMs that have ensured compliance with local, U.S., and EU regulations for their global facilities help to simplify the process of approval in target markets. Local manufacturing, particularly in Asia, can leverage lower labor costs compared with other regions. Most importantly, the fact that a product is manufactured domestically—i.e., employing local people and using local services—is often critical in the purchasing decisions made by government officials. As a result, CMs can make it easier to penetrate regional markets.


A robust supply chain established, qualified, and managed by the CM can also help OEMs simplify production and provide alternatives in the case of an interruption. Although device manufacturers have traditionally retained control of their supply chains due to liability issues, they are recognizing the value of transferring some of this responsibility to CMs, which are using sophisticated tools such as electronic data interchange (EDI) to reduce costs and accelerate the process. EDI is a business-to-business IT system that allows a CM and an OEM to exchange purchase orders, pricing, payments, revised orders, etc. without direct labor involvement. In many instances, with the advent of IT systems such as SAP (originally Systems Applications and Products), CMs can even ship to an OEM customer directly, invoice the OEM, and receive payment in a seamless transaction. CM partners with high purchase volumes, economies of scale, and global scope can often drive down costs and optimize supply-chain management more effectively than OEMs.


Moving from vertical to virtual assets through outsourcing can have great financial benefits for many types of companies—from start-ups that can only devote scarce capital for innovation and marketing instead of infrastructure to listed companies seeking greater liquidity. Financial efficiencies are greatly improved, for example, when returns are ratioed to lower asset bases stemming from the CM’s ownership of inventories as well as property, plant, and equipment (referred to as PP&E). Financial ratios such as return on invested capital and return on net assets are improved by virtue of the outsourced model. 


Conclusion

With rapid changes in the medical device industry, including increased government intervention, tightening global regulations, growing global competition, and new opportunities in unfamiliar emerging markets, manufacturers are outsourcing a range of critical operations to CMs. At a high level, strategic outsourcing allows an OEM to focus on innovation and other core competencies while delegating other critical areas to a CM partner with specialized knowledge, existing facilities and suppliers, and economies of scale. Speed, conservation of resources, and deeper market penetration—together with traditional cost savings—are invaluable advantages to be gained from choosing the right partner.


References

1.    B Dunn and J Finn, “A Strategic Review of Outsourced Manufacturing for Medical Devices,” (Covington Associates, 2007); available from Internet: http://endeprofab.com/Document/Strategic%20Review%20of%20Outsourced%20Manufacturing.pdf.
2.    “BRIC Nations Spend $500 Billion in 2009 for Health Care Despite the Economic Downturn,” The Medical News, October 14, 2009.
3.    J Immelt, V Govindarajan, and C Trimble, “How GE Is Disrupting Itself,” Harvard Business Review, October 2009; available from Internet: www.lombardglobal.com/attachments/hbr_how_ge_is_disrupting_itself.pdf.
 

Gaet Tyranski is business unit director of Jabil Healthcare & Life Sciences (St. Petersburg, FL).

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