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Financial and strategic framework for contract manufacturing decisions: evaluating incremental costs in the pharmaceutical industry
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This thesis develops a strategic and financial framework to help big pharmaceutical companies decide how to operate as contract manufacturers and to calculate a data-driven minimum price for contract manufacturing offers. Big pharmaceutical companies face substantial idle capacity in their production sites due to the growth of competitors in the price-competitive generic and contract manufacturing market. Research and development setbacks and patent expiration on previously high-volume products further reduce internal production demands. This results in higher per-unit costs and compressed margins as the fixed costs remain.
The recommended strategy is to monetize idle capacity as a premium contract manufacturer to produce for external clients. A big pharma company can highlight its competitive advantage which enables them to compete on customer value creation rather than on price alone. Moreover, the thesis emphasizes that a clear strategic position on the level of importance of contract manufacturing for the business is essential, because each option requires distinct governance, investment and client selection rules, plus an efficient inquiry assessment process.
To compete with the market and to know the minimum price, production costs for an offer need to be calculated. Therefore, product costs are defined from a traditional accounting perspective and contrasted with decision-relevant costing, which defines incremental costs as the additional costs occurring compared to an alternative decision. Methodologically, the financial framework follows three steps to classify production site costs in their cost categories, to define relevant incremental costs in comparison of a base case scenario and to construct incremental cash flows over the contract horizon. The cash flows are discounted to define the floor price and sensitivity analysis support to manage long-term prediction uncertainty. Any price above the floor price generates
positive contribution and dilutes fixed costs.
A worked example applies the method to a ten‑year offer with staged volumes and explicit assumptions on transfer costs, capital expenditures and materials. The example also classifies site costs into those relevant or irrelevant for the business case. The weighted average cost of capital of 4.54% is calculated based on peer analysis. With the discounted cash flow, the model sets the net present value to zero at a floor price of 335€ per kilogram active ingredient.
Practically, companies should benchmark the floor price against market offers to set a competitive price to the client. Second, they should favor shorter initial contract terms and careful contract drafting to avoid unexpected costs. Third, by maintaining a clear strategic vision for production sites and the importance of CMO activities, following the financial framework, companies ensure idle capacity is converted into value while sustaining strategic control and managing risk.