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This case describes the reorganization of drug discovery at GlaxoSmithKline (GSK) following the formation of GSK from the merger of Glaxo Wellcome and SmithKline Beecham. This reorganization placed nearly 2,000 research scientists into six centers of excellence in drug discovery (CEDD). Each CEDD focused on a small set of therapeutic areas and possessed decision rights over the progression of pharmaceutical compounds through the early stages of development. It addresses issues about the benefits of focus vs. iversification in R&D, the role of decentralized vs. coordinated decision making, and the importance of alignment between the structural and infrastructural (e. g. , performance incentives) aspects of an operating model. 4. Economies in drug R&D process In this session we have analyzed the economies of scale, scope and learning in the drug R&D process. The drug discovery process can be divided into several steps: Research activities (including Target biology, Chemical design & synthesis and Lead optimization), preclinical development and clinical development.

As shown in the figure below, this process takes several years and encompasses a wide range of expertise and skills. Economies of Scale: Among the factors we have identified to increase scale and reduce R&D average costs, the use of new technologies is at the top of the list. By investing in capital intensive technological advances screening rates are increased and unit costs lowered. All the R&D processes are today carried via personal computers and software developer skills are a key requirement for scientists.

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The improved efficiency is due to the use of computer based programming for target diseases that have speeds up use of existing “keys & locks” in database to find match. The increased scale of production is associated with innovative changes in the R&D. Large firms are using their capital to acquire small companies which have innovative ideas and interesting portfolios. Moreover larger firms have access to more capital to fund R&D; the bigger is the firm, the more they can invest in innovation at a lower cost than smaller firms.

For example, clinical trials are extremely expensive and consequently only larger firms could afford to take multiple products through the process. On the other hand, well established firms seek mergers and alliances with smaller specialist firms due to access to capital and sales resources and capabilities. Larger firms are attractive partners for alliances since they could provide smaller firms with resources and validation. They have better capabilities for running large clinical trials and they are better at managing the Food and Drug Administration (FDA) approval process.

Economies of Scope: Whereas economies of scale primarily refer to efficiencies associated with R&D changes, such as increasing or decreasing the scale of production, of a single product, economies of scope refer to efficiencies primarily associated with demand-side changes, such as increasing or decreasing the scope of distribution, of different types of products. Smaller firms have specialist competencies in new technology including genetics, molecular biology, chemistry and computer sciences. The shared knowledge in an alliance with a larger firm is economy of scope. It is found that larger research efforts are more productive, not only because they enjoy economies of scale, but also because they realize economies of scope by sustaining diverse portfolios of research projects that capture internal and external knowledge spillovers” When merger or alliances are made, the R&D process is boosted, the existing knowledge base is transferred between the companies, the research findings are shared and new compounds can be tested against larger library of existing keys. Screening technology and organizational processes can be used across multiple areas.

In the case of GSK, there are three new strategic priorities that aim to increase growth reduce risk and improve GSK’s long-term financial performance: 1. Grow a diversified global business 2. Deliver more products of value 3. Simplify GSK’s operating model Yamada strategy focused on diversification with the introduction of centers of excellence, merging together the strengths of large pharmaceutical firms with those of smaller biotechnology companies. Merger leads to combined decision making for developments in pipeline, which leads to faster process of drug discovery.

Alliances with smaller specialist companies, allowed GSK to be more “flexible and responsive” to discovery, avoiding bureaucracy and simplifying the operating model. The elimination of the dual reporting schema enhanced the communication and cross transfer of knowledge, which will result in enhancing productivity in R&D. Economies of Learning: Alliances with smaller specialized firms, allows large firms to learn about new drugs and new technologies. Bayer for example, started R&D collaboration with the American biotech firm Millennium to bring the “entrepreneurial spirit” and innovation in its development processes.

Large firms have a lot to learn from small about new development processes, and move the focus away from research and publishing papers. Specialist teams can be formed to carry out specific complex tasks which are common across various areas of the process. In such way communication is improved across organizations. 5. Incentives to innovate with new drugs and new processes to create drugs Starting from the last century we have seen large firms acquiring small biotech companies. Large firms like Bayer and GSK were experiencing a decline in terms of productivity of pharmaceutical R&D.

They were committed to a particular technology and resources capabilities were specific to that technology. Due to the large number of employees, swapping to a new technology resulted in extra spending. It was considered as high risk investments, since that technology might come obsolete by the time the firm acquired the necessary expertises. This phenomenon is called “sunk cost effect”; Bayer and GSK were not incentivized to innovate. Both established firms incurred in sunk costs (costs to commit to a particular technology), and they were tending to favor the current technology.

Biotech companies instead were smaller in size with less bureaucracy and an entrepreneur spirit and as soon as the opportunity to innovate arose they displaced the “monopolist” of those big pharmaceutical companies. This is called the “Replacement effect”. The process of discovering and developing new drugs took 10-15 years and required more than $200m in “out of pocket cost”. Biotech firms entered into the pharmaceutical market because they were able to process and produce target drugs much faster. Bayer decision was to reduce the budget in R&D and to invest in collaboration with Millennium.

This results in developing 80 drugs in 18 months. GSK incumbent to innovate was the idea of improving efficiency. Yamada innovation was made in house and not bought in (as Bayer did). His idea was to restructure the R&D process using six “centers of excellence in drug discovery (CEDD)” each focused on one to three therapeutic area. The objective was to create an organizational structure for R&D that combined the strength of bigger pharmaceutical firms with those of smaller biotechnology companies. In the case of GSK we see the “Efficiency effect”.

The monopolist firms that want anticipate the entrant. GSK get the opportunity to innovate, promising to improve the research productivity by leveraging the benefit of scale in certain areas and focus in other. Sunk cost, replacement and efficiency effects all work simultaneously to determine if the incumbent will innovate or not. Large firms are as rationale in their innovation choices as new entrants GSK incentive to innovate was to increase the number of “locks” and to found their respective “keys” faster than competitors.

Yamada identified several weaknesses in the old R&D process in GSK, like excessive bureaucracy, poor communication across functional areas and lack of entrepreneurial spirit. His strategies focused on resources and motivate them not only on finding new targets but on producing new medicines. Yamada understood that large pharmaceutical firms were very good at the front-end of drug discovery and at the later stages of drug development. They needed to improve the “middle ground” of the R&D process, where flexibility and responsiveness of small firms is essential. Biotech firms had the capabilities to alter the structures adopted by large firms.

Bayern acquired those skills while GSK chased the challenge, creating the beneficial characteristics of small biotech by reviewing the existing capabilities of the firm. CEDDs were small with low bureaucracy for daily interaction. Efficiency effects are altered where there is a market for new ideas. Incumbents may ‘purchase’ ideas from entrant. The Food and Drug administration (FDA) required three phases of clinical trials. In Phase I testing of investigational new drug (IND) the drug maker perform small scale testing on healthy subjects to learn about safety and dose/response ratios.

Phase II involves medium scale clinical trials to test for efficacy. The large Phase II trials are the final step before the drug company can submit its application to the FDA. There is a strong chance in each phase that IND will fail. Thanks to revolutionary in biotechnology, biotech firms with only one or two drugs attempt to bring a drug through the FDA review process, This require sufficient R&D to have sufficient absorptive capacities and to have a credible threat to keep down the price asked by entrants.

Early stage firms are more likely than mature firms to advance their drugs to Phase II, especially if they have large cash reserve. However they are less likely to progress to Phase III. The explanation for this is that managers of early firms are reluctant to acknowledge their failures and exploit asymmetric information since abandoning their R&D effort would mean closing down their companies. In contrast with this managers of larger firms can take drug’s failure in stride and reallocate funding to other projects. 6. Sustaining Competitive advantage

Isolating mechanisms are those that enable firms to protect the resources /capabilities that are the source of its competitive advantage from imitation, neutralization by rivals. In relation to GSK in the 21st Century, the mains innovation and competitive advantage are – 10% of sales due to go off patent within 3 years, – Considerable past & current scientific successes – Managerial re-organization of segment of R&D value chain to amplify wealth creation and capture From a legal prospective, GSK R&D could generate sustainable advantages by granting patents and trademarks for discovered drugs to avoid imitation.

The firm could look at a ten years protection through patents; this can bring financial strength pursuing those who infringe. Only big firms are allowed for capital investment in technologies since smaller firms could not afford. They can reach efficient economies of scale in R&D, production and distribution by alliances and acquisitions. To protect it competitive advantage GSK should effectively control the distribution channels for products either because they own them directly or they can use their power to control them indirectly – pressuring distributers not to distribute for other companies.

Rivals would step back from imitating since the time it takes to replicate the products and processes may be prohibitive because the incumbent may be well established in the marketplace. While a process can be copied, it is impossible to replicate the learning that went into the development of the process – this is important for the refinement and evolution of the process going forward. GSK should tight its intellectual property focusing on information asymmetries.

Economies of learning are very important in such environment; they refer to reductions in unit costs due to the accumulation of experience over time. R&D productivity would be positively impacted if researchers take part to the “patent race”. In such way Yamada could secure a larger market share. Finally GSK might build intangible barriers. Intellectual Property Rights may protect from imitation, enable replication. Even if the rivals understand the source of competitive advantage, they cannot replicate the complex social interactions.

Yamada strategy generated skepticism within and outside the organization, causing buyer uncertainty. Reputation is very important in experience good markets. Consumers who have positive experience with a brand are reluctant to switch where there is a high uncertainty that competing product may not work. GSK should work on the strength of brand and marketing ability since marketing costs are very high in pharmaceuticals. The success of GSK R&D restructuring will confer reputational effects in eyes of consumer.

Bibliography Besanko et al (2007). Chapter 13. The Origins of Competitive Advantage: Innovation, Evolution and the Environment Besanko et al (2007). Chapter 12. Sustaining Competitive Advantage (in particular pages 406 to 422) Grant (2008) Chapter 11 Technology Base-Industries and the Management of Innovation Pisano, G. (1997). The Development Factory: Unlocking the Potential of Process Innovation. Harvard Business School Press. Werth, B. (1994). The Billion-Dollar Molecule. New York: Touchstone Book, Simon & Schuster.

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