Simple Metrics Clinical Research Organizations Should Utilize - But Don't
Data is the primary output from a clinical trial required to get a new drug or device approved so that improved patient care can be achieved and companies can profit from their research investments. Data is used to make go-no go decisions, recruit patients and approve products. A core competence for a good clinical research organization is to capture, clean, analyze and interpret clinical trial data. Ironically, from my experience, many clinical research organizations do a very mediocre to poor job of collecting their own operating data and turning that data into information that can be used to improve their overall operations and profitability.
The focus of this blog is to identify, define and discuss the importance of a few easy to calculate clinical research organization operating metrics. I am going to use actual data reported by several public clinical research organizations throughout my blog.
Backlog Rollforward Schedule
A backlog rollforward is a standard schedule that should be utilized in all clinical research businesses. Backlog represents anticipated service revenue from work not yet completed or performed under signed contracts, letters of intent, and pre-contract commitments that are supported by written communications. A backlog rollforward lays out all of the elements making up backlog: New Awards, Cancellations, Net Awards, Revenue, FX Adjustments & Other Adjustments. Below is the calculation for ending backlog:
Here is a backlog rollforward for Parexel that I pulled together by using their public financial statements.
You can see that Parexel's backlog has grown from $4.879B to $5.943B over the last 10 quarters. Obviously, a backlog rollforward displays overall backlog value over time, but this simple schedule also provides the data required to calculate several other key metrics:
Gross and Net Book to Bill Ratios
Backlog Burn Ratio
Gross & Net Book to Bill Ratios
Book to Bill ratios are indicators of sales performance, demand for services and provide a general sense if the business is going to grow or contract in the future. The gross book to bill formula is new awards / revenue, while the net book to bill calculation is (new awards - cancellations) / revenue. Here are a couple examples:
A growing business will want to have a net book to bill greater than 1.0. A net book to bill less than 1.0 is typically a business in decline, equal to 1.0 is flat and greater than 1.0 is growing. Since gross book to bill is calculated before cancellations, it would be wise to at least have a gross ratio greater than 1.0 so that the ratio doesn't fall below 1.0 after cancellations. Fast growing small to mid-size CROs can generally achieve higher book to bills than the larger CROs as the denominator (revenue) in the formula is much lower. Let's make some observations using Parexel's actual detail.
A few items jump out:
Notice the large spread between the gross and net book to bill. The average gross book to bill for the time frame was 1.75, the net average was 1.23, a .52 spread on average. In order to maintain a 1.0 net book to bill, Parexel would have needed to average at least a 1.52 gross book to bill, or in other words sell 50% more business than is currently being recognized as revenue. Mission accomplished since the average gross book to bill was 1.75.
Parexel had a tough Q1 '15 - Gross was only 1.27 and net was .88. Likely not a coincidence that revenue growth was slow in Q2 & Q3 '15 - only 2% as revenue grew from $492M in Q1 '15 to $502M in Q3 '15. Typically the adverse impact for a low net book to bill will be felt in future quarters until a business gets net sales back on track. Both gross and net awards were strong in Q2 '15 and Q3 '15 and revenue increased accordingly up to $523M by Q4 '15 (a 5% growth rate from Q2 '15).
Cancellations can make net awards extremely lumpy, some of the spreads between gross and net awards are very large. Q1 '17 is a great example, gross was 1.87 and net was only 1.14 - a spread of .73. The sales organization had a great quarter, but unfortunately the impact was muted by high cancellations.
Backlog Burn Ratio
Backlog burn ratio shows the rate at which backlog is converting into revenue. The higher the percentage the faster that backlog is converted into revenue. Here is the formula:
Below are a couple of charts showing Parexel and PRA Health Science's backlog burn ratios.
You can see that PRA is converting backlog into revenue at a much faster rate than Parexel - 15.3% vs 9.6% on average. Additionally, PRA has grown their backlog 40% vs. 22% by Parexel over the same time period. Take a look at the revenue and backlog burn charts below for Parexel and PRA. PRA's backlog growth combined with a higher backlog burn has created a steady and impressive revenue growth. Parexel's has slower, choppier revenue growth can be attributed to a slowing backlog burn and cancellation impact.
How can the backlog burn ratio between two large CROs be so radically different?
Parexel has a couple differing businesses that may burn at different rates - particularly Parexel's Perceptive Informatics business.
Backlog make up - I've written in the past that understanding a CRO's backlog is critical. Trials will longer durations are by definition are going to have slower backlog burns.
Slow starting or delayed trials will contribute a backlog burn of 0% until they get started. A significant number of trials that aren't burning can adversely impact the backlog burn ratio.
Including contingent trials in total backlog. Contingent trials are opportunities that are contingent on the success of another trial. For example if a client has promises a CRO the Phase III trial if the Phase II study is successful. If a CRO includes the contingent Phase III trial in backlog, it will lower the backlog ratio as that backlog will not be converting into revenue.
I've written about cancellations in the past, so I won't go into too much detail. Cancellations tend to be between 4-6% of quarterly beginning backlog. As you can see below Parexel's cancellation rate falls within industry norms.
I believe that understanding why cancellations occurred - operational or drug related is important. Obviously if clients are cancelling studies because a CRO isn't fulfilling its obligations that's an issue that needs to be fixed. I also believe understanding the historical cancellation rate is important for forecasting purposes. CRO's should build a cancellation impact into their future revenue projections. Building in a low cancellation rate just because the previous quarter or year was low isn't a great strategy - if cancellations end up at or higher than industry norms, then there could be a large revenue hole to fill. As they say, "Hope" isn't a strategy.
Gross Margin Ratio
Gross margin ratio is a profitability ratio that compares the gross margin of a business to the net sales. This ratio primarily measures a CRO's profitability on services provided. Here is the formula:
Here is a simple example in practical terms - the CRO in this example makes 50% profit on the one CRA that is employed. The greater the gross margin ratio, the more profitable the business.
Below are the quarterly gross margin ratio trends for Parexel, PRA, Medpace and INC Research since the quarter ending December 31, 2014. You can see that Medpace is the high flier in the group with a gross margin ratio at or above 45%, INC Research is around 40%, while Parexel and PRA hover around 35%.
The following can impact a company's gross margin ratio:
Accounting differences - companies may report differently. For example, one company may put facility expenses into cost of goods sold, while another may report facilities in selling, general and administrative expenses. The result would be higher cost of good sold and a lower gross margin ratio.
Business Differences - My experience in the clinical research industry is that the gross margin on full service work is higher than functional staffing. A business with a higher ratio of functional staffing to full service work could have a lower gross margin ratio.
Pricing - A premium priced provider, assuming labor costs are equal, will have a higher gross margin ratio than a low cost provider.
Labor Costs - Higher labor costs, assuming pricing is equal, will result in a lower gross margin ratio. Companies that operate in low cost segments of the overall population can take advantage of lower costs of labor to improve profitability.
Labor Utilization - Utilization is a common clinical research metric that measures the efficiency of the workforce. A low utilization will likely result in a lower gross margin ratio.
Understanding the reasons for gross margin profitability success and challenges will enable a company to effectively manage their profitability drivers. Having the data is the first step in the process.
SG&A to Revenue Ratio
SG&A to Revenue Ratio is the ratio of selling, general and administrative costs to sales. I always track my SG&A to revenue ratio to determine how much leverage my company is achieving on administrative cost. Administrative costs should not grow as quickly as revenue, over time as long as a clinical research business is growing the SG&A ratio should decline. I like to split out my billable and non-billable expenses. Billable expenses being staff compensation working on the trials and non-billable are my administrative costs. Here is a simple example:
Revenue increases from $100 to $110, the gross margin ratio remains at 50% (due to my billable labor costs remaining at 50%) and non-billable SG&A remains flat at $25. The result of SG&A remaining flat is that my SG&A to Revenue ratio drops from 25% to 23%, resulting in an improvement of my overall profitability from 25% to 27%. Hence leverage is gained on non-billable SG&A since I was able to increase revenue without increasing SG&A. Clinical research organizations are highly leverageable businesses so managing non-billable expenses is a key activity to drive profitability.
Below is a trend of Parexel's SG&A to Revenue Ratio:
Parexel has been able to drive down its SG&A to Revenue Ratio down from 20.3% to around 18% as revenue has grown over time.
I chose the metrics above as they are some of the easiest metrics for a clinical research business to track, but are extremely effective in helping optimize your business. There are many other useful metrics including utilization %, variable margin %, project margin %, employee turnover %, etc... The list could go on and on. I recommend clients focus on the metrics they can track and will help them drive their business. Tracking a hundred metrics but not actively managing them doesn't do much good. Pick the 10-15 metrics that will best optimize your business and proactively manage those drivers for the greatest impact. I would love to write about more metrics in this blog, but one of my metrics is billable hours / total hours worked. My clients would prefer that I spend more time impacting their businesses and less time writing my blogs.
Jason Monteleone is President at Pivotal Financial Consulting, LLC. A Strategic Financial Consulting Firm serving the Clinical Research Industry. Jason can be reached at firstname.lastname@example.org. Follow me on Twitter @JMPivotal. Sign up for my latest blogs and updates at my website www.pivotalfinancialconsulting.com.