Contractors vs. Employees: When CROs Outsource
I wanted to write one more blog before the end of 2017 so I thought I'd address a question often get asked: “What percentage of a CRO’s billable labor costs should come from contractors?” The answer is it depends. It may be a surprising question if you haven’t worked with or for a CRO. Why would a business (CRO) which functions as an outsourced provider subsequently outsource work to another provider? Let’s take a look at the answers to that question and the economic impact when a CRO utilizes contractors to execute billable work.
Why Do CROs Utilize Contractors?
Let's take a look at some public statements used by INC Research in regards to their use of contractors.
First, a statement from INC's 2016 Annual Report (Management's Discussion and Analysis of Financial Condition and Results of Operations):
"Contract labor cost increased by $18.0 million for the year ended December 31, 2016, compared to the prior year due to the need to hire temporary labor in order to accelerate the timeline on a significant set of studies for the benefit of our customer. We use temporary contract labor or third-party contractors, which is more expensive than our own employees, to supplement our workforce for short-term demand needs such as these. We anticipate that we will reduce the mix of contract labor as these studies wind down."
Second, an article published by The News & Observer after interviewing Greg Rush (INC's CFO) after INC's Q1 2016 earnings became public:
"At the same time, the company has increased its use of higher-cost contractors this year, partially in response to a customer that wanted it to accelerate its work. By using contractors, even though it costs the company more money, it will avoid “another one of these restructurings” when that work winds down towards the end of the year, Rush said."
"INC also is relying on contractors to address an industry-wide shortage of qualified clinical research associates that do the heavy lifting on clinical trials. Contractors can make more money than employees, especially if they have a working spouse who can cover their health insurance costs, Rush said."
Based on the INC info above, its safe to say that CROs utilize contractors for the following reasons:
1) Supporting short-term labor challenges due to growth
2) Satisfying unique customer needs
3) Filling labor/talent gaps
I would also add that many small and mid-size CROs also utilize contractors in countries where they do not have a legal entity presence (Clinipace utilizes that strategy quite often).
The use of contractors by CROs is not shocking as rapid growth can require short-term labor needs. Recruiting and training new employees in a timely manner to support immediate client needs can be difficult. Having a short-term labor strategy supplemented by experienced contractors is a necessity for most CROs. Per Entrepreneur Magazine we can expect contractor use to increase as the contingent workforce in the U.S. was 17 percent in 1989 and is forecast to reach 43 percent by 2020. The challenge comes with managing the overall use and cost of contractors.
The Economic Impact of Using Contractors
Let's take a look at a few examples. First a couple basic assumptions:
1) A internal (i.e. employee) CRA's annual cost is $144,000 ($120,000 base + $24,000 for taxes/benefits). An article on Outsourcing-Pharma references experienced CRA salaries being between $100,000-$130,000 - so $120,000 should be a reasonable figure for our examples.
2) Let's assume an experienced contract CRA is roughly 25% more expensive than a internal CRA.
3) Assume 1 CRA working full time would generate $288,000 of annual revenue (which would be 50% gross margin % from an internal CRA)
4) SG&A expenses are 30% of revenue
Scenario #1 - Difference Between one internal CRA and one contract CRA
You can see below that there is a substantial profitability difference between using an internal CRA vs a contractor. Gross margin % with an internal CRA is 50% while the contractor is 37.5%, overall profit difference is 20% vs. 7.5%. The profit dollar amount difference is $36,000 - not an extreme amount if a small portion of your workforce are contractors.
Scenario #2 - Difference Between one hundred internal CRAs and one hundred contract CRAs
Let's blow this out an use the extreme scenario of 100 CRAs. The gross margin and profit % stay the same, however the profit dollar amount is a lot bigger. Using all contractors would result in $3.6M of lost profit or 62.5% overall profit. that's a big difference considering the CRO would still be responsible for managing CRA performance and quality.
Scenario #3 - Multiple Ratios
Below are 5 different scenarios - as you can see (and would expect) the profitability improves when more internal CRAs are used. The right mix to maximize profitability (using our assumptions) is likely somewhere between the 75-25 split more internal) and all internal staff.
Other Things to Consider
A possible and strong strategy that some drug development firms may utilize is outsourcing all of facets of a function where they do not have a great deal of expertise. They may not have an interest in turning a true profit on one function as long as they are turning a reasonable profit on their key expertise. Additionally, some firms may need to outsource all functions in countries where they do not have a presence - it could be the difference between winning a study (and gaining profit) or passing on an opportunity (and getting zero profit). The scenario I see quite often is that a quickly starting study is won and it would take too long to recruit, train and hire staff so a CRO utilizes contractors to quickly fill the void and satisfy client needs.
Contractors and contracting firms play a significant role for Clinical Research Organizations and should be viewed as valued partners. The right ratio of internal employees vs contractors depends on company strategy and profitability goals. However, its pretty clear that understanding your company's cost structure, pricing and profitability targets is critical to optimizing internal vs contractor ratios. Quite often, I've seen CROs get this mix incorrect and come to realize that they have a profitability issue that could have been easily avoided with a bit more oversight.
Wishing everyone a great 2018 and thanks to everyone who has read my blogs over the past year! Happy New Year!
Jason Monteleone is CEO of Clinipace Worldwide & President at Pivotal Financial Consulting, LLC. Clinipace is a global mid-size CRO with operations in the Americas, Europe and Asia-Pac serving the small pharma and biotech market. Pivotal provides Divestiture Assistance, Acquisition Advisory Services and Strategic Planning to the Pharmaceutical Outsourcing Industry. Jason can be reached at firstname.lastname@example.org. Follow me on Twitter @JMPivotal. Sign up for Jason's latest blogs and updates at my www.pivotalfinancialconsulting.com.