To Trim or Not to Trim: That is the Question — issue had come again and various management meetings company seminars Novartis too

The issue had come up again and again in various management meetings and company seminars. Novartis had too many products and needed to reduce the product proliferation that had occurred. Thomas Ebeling, Chief Operating Officer, Novartis Pharmaceuticals, wondered what he should do.

The merger of Ciba- Geigy and Sandoz to form Novartis on December 20, 1996 had resulted in a significant increase in the pharmaceutical product portfolio of Novartis’s Pharma Sector. Combining the pharmaceutical product lines of Ciba- Geigy and Sandoz had given Novartis a leadership position in several therapeutic areas, including immunology and inflammatory dis-eases, as well as strong positions in central nervous system disorders, cardiovascular diseases, oncology, dermatology, and asthma. Novartis now had approximately 250 product brands (such as Sandimmun, Voltaren, Lamisil, and Foradil). The sales volumes of each of the different brands, however, were very different. In 1999, the top 20 brands accounted for 79% of pharmaceutical revenues while the remaining brands yielded 21% of revenues.

Novartis Exhibit 1 presents sales, anticipated sales growth rates, cost and other data for the 50 smallest global base business brands that account for CHF 422 million in sales (or approximately 2.7% of pharmaceutical product sales) in 1998. In addition to the base business brands listed in Novartis Exhibit 1, 15 other product brands contributed an additional CHF 2.4 million in revenues. Although these products generated very small revenues, they satisfied some important medical needs. For example, Visken had sales of CHF 114,000 in South Africa but it was unique among betablockers regarding the effect on serotonin 1a receptors for the onset of antidepressant action.

Required

1. Please refer to the data on Pertofran and Visergil in Novartis Exhibit 1. Would you recom-mend that Novartis drop these products because the total cost of these products exceeds the total revenues?

2. What strategic factors would you consider in deciding whether to drop all 50 products shown in Novartis Exhibit 1 and the 15 other product brands described in paragraph 3 of the case?

3. Would you recommend that Novartis drop all the 50 products shown in Novartis Exhibit 1? What is the net present value gained or lost from dropping all these 50 products? Assume a discount rate of 12%. What are the factors that go into determining this rate?

4. Suppose Novartis was able to find a buyer for all the 50 products shown in Novartis Exhibit 1. What price should Novartis charge the buyer?

5. Comment on the incentive issues described in the last paragraph of the case. What, if any-thing, would you do to address these issues?

6. What would you recommend Thomas Ebeling should do with respect to the 50 products shown in Novartis Exhibit 1 and the 15 product brands described in paragraph 3 of the case?

SOLUTION

To Trim or Not to Trim: That is the Question

This case gives students the opportunity to apply the concepts they have learned in Chapter 9 in the context of a real decision faced by Novartis about whether to trim their pharmaceutical product portfolio. Students must think through the decisions from a financial point of view but they must also think about the strategic, reputational, and ethical implications of the various alternative plans of action. Thus the case gives students the opportunity to consider and weigh nonfinancial considerations that managers often face when making decisions.

Assignment questions 3, 4, and 6 require net present value (NPV) calculations. If students are unfamiliar with NPV calculations, instructors may choose to assign only questions 1, 2, and 5 or wait till they have completed Chapter 11 on Capital Budgeting to assign the remaining questions. Yet another alternative is to only drop assignment question 3 and indicate that the value to Novartis of continuing to sell the 50 products is CHF 1,654.6 million before tax.

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			Pertofran	Pertofran	Pertofran	Pertofran	Pertofran	Visergil	Visergil	Visergil
Sales	Sales	Sales	1.0	1.0				1.0	1.0	1.0
Variable costs	Variable costs	Variable costs		5.9	5.9	5.9		0.9	0.9	0.9
Contribution margin	Contribution margin	Contribution margin	(4.9)	(4.9)	(4.9)	(4.9)	(4.9)	0.1	0.1	0.1
Fixed costs	Fixed costs	Fixed costs		0.0	0.0			0.2	0.2	0.2
Operating margin	Operating margin	Operating margin	( 4.9)	( 4.9)	( 4.9)	( 4.9)	( 4.9)	(0.1)	(0.1)	(0.1)
			Drop because	Drop because	Drop because	Drop because	Drop because	Keep because contribution	Keep because contribution	Keep because contribution
			contribution margin	contribution margin	contribution margin	contribution margin	contribution margin	margin is positive and	margin is positive and	margin is positive and
			is negative	is negative	is negative	is negative	is negative	contributes towards	contributes towards	contributes towards
								recovering fixed costs	recovering fixed costs	recovering fixed costs

Question 1

In deciding whether to drop or keep Pertofran and Visergil, we need to compare relevant revenues and relevant costs and not simply revenues and total costs of the products. For each product, relevant costs are expected future costs and relevant revenues are expected future revenues that differ if the product is dropped or kept. One way to get a better understanding of relevant revenues and relevant costs is to prepare a contribution margin income statement for each product as shown below:

Purpose of aiding classroom instructors in the use of “To Trim or Not to Trim: That is the Question,” HBS No. 100-105. It provides analysis and questions that are intended to present alternative approaches to deepening students’ comprehension of business issues and energizing classroom discussion. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

Fixed costs would be incurred and cannot be saved whether or not Pertofran or Visergil is dropped and hence these costs are irrelevant to the analysis. On the basis of financial considerations alone, Pertofran should be dropped because variable costs exceed sales—it has a negative contribution margin. Visergil should be kept because revenues exceed variable costs—it has a positive contribution margin.

An alternative way to see this is to analyze what revenues would be lost and what costs would be saved by dropping these products.

	Pertofran	Pertofran	Pertofran	Visergil	Visergil	Visergil
Revenues lost	(1.0)	(1.0)	(1.0)	(1.0)	(1.0)	(1.0)
Costs saved	5.9	5.9		0.9	0.9
Net benefit/(cost)	(4.9)	(4.9)	(4.9)	(0.1)	(0.1)	(0.1)

Some students might argue that some of the fixed costs will be saved if a product is dropped (if a student does not raise this point the instructor may want to bring it up on his or her own). The instructor might want to ask the student, how much of the fixed costs will be saved. The student will most likely say some fraction (or 100%) of the fixed cost presented in Exhibit 1. Following some discussion, the instructor will want the student to understand that the fixed costs shown in Exhibit 1 are allocated costs. The relevant fixed costs are the fixed costs that would actually be saved not the fixed cost that happens to be allocated to the product by the accounting system. That is, the allocated fixed costs recorded in the accounting system and presented in Exhibit 1 are irrelevant.

A final teaching point pertains to the opportunity cost of dropping Visergil. Our current assumption is that there is adequate capacity so that there is zero opportunity cost of producing Visergil. That is, by producing Visergil, Novartis is not forgoing the opportunity to produce any other product. The instructor could ask “What if the resources currently used by Visergil could be used to produce an alternative product that generates contribution margin of more than 0.1m CHF, say 0.6m CHF. Should Visergil be kept?” This statement means that there is an opportunity cost of using resources to produce Visegil of 0.6 m. These opportunity costs represent what might have been so they are never recorded in accounting system but they are relevant costs in the decision. As the following calculation shows, Novartis should drop Visergil and produce the alternative product:

	Visergil	Visergil	Visergil
Sales	1.0	1.0
Variable costs	0.9	0.9
Net benefit/(cost)	0.1	0.1
Less opportunity cost	0.6	0.6
Relevant cost	(0.5)	(0.5)	(0.5)
Or, alternatively, by dropping Visergil, Novartis will gain:
Savings in variable costs	(0.5)	(0.5)	(0.5)
Increase in contribution margin		0.6
Loss of revenue	(1.0)	(1.0)	(1.0)
Gain/(loss)	0.5	0.5

Some students may raise the question of the effect on patients if Visergil is dropped. I would defer this discussion to a later point in time when we will have the opportunity to discuss this issue.

Question 2

Recall from our discussion of assignment question 1 that Novartis should keep all products for which relevant revenues exceed relevant costs, that is where the loss in revenues from dropping a product is less than the savings in costs.

The goal of this question is to get students to think about strategic factors beyond these calculations that managers must consider when making decision about whether to drop any or all 50 the products in Exhibit 1 plus the 15 other product brands area as follows:

Strategic arguments for keeping the products:

Keep the products even if they are not profitable because they uniquely satisfy important medical needs. Discontinuing the products would have negative reputation effects on health maintenance organizations (HMOs), doctors and patients.

The products as a whole may not be profitable in the Novartis portfolio but they may constitute significant sales in some countries, where selling these products helps Novartis’s brand, reputation and image.

Keep because of ethical reasons. For example, Visergil is used to treat patients with schizophrenia and anxiety. What if Visergil was the only product that is effective on some patients whose treatment would suffer if it were not available? Should Novartis take this into account when making a decision? How? Is Novartis responsible for the health of citizens at the expense of its shareholders? There is no correct or wrong answer to these questions and the instructor should not aim to come to a definitive conclusion. It is important, however, for students to think about these issues.

My own view is that companies that are performing well, as Novartis is doing, should aim to be both great and good. There are clear long-term economic benefits of being seen as an ethical company by governments, customers, physicians, and employees. In many cases, it is also the “right” thing to do. But a company cannot do these things unless it is performing well and then only after fully disclosing its actions to its shareholders. Such disclosures help companies determine the extent of shareholder support for such actions.

Strategic arguments for dropping products:

Dropping these products might simplify manufacturing operations and so further reduce costs and improve the quality of other products because of greater focus. These savings would be relevant benefits and are often missed if the analysis focuses only on the revenues from and costs of the 50 products.

Focus organization and sales and distributions efforts on a few products in order to increase sales of and get the full potential benefits from these products. These would be relevant revenues and costs that are once again missed if the focus is only on the 50 products. Some students, might argue, however, that these products do not get much attention anyway so dropping them will not make much difference in the attention given to other products.

Question 3

The instructor should only assign this question if students are already familiar with Net Present Value (NPV) analysis for other courses. If this is not the case, the instructor can assign this case after completing Chapter 11 on Capital Budgeting decisions. Yet another alternative is to drop assignment question 3 and to simply indicate that the value to Novartis of continuing to sell these 50 products is CHF 1,654.6 million before tax.

Most students have had an introductory course in Finance at the time they do the Management Accounting class. If they have not had a Finance course or the instructor does not want students to spend time on net present value calculations, she or he could drop assignment 3 and simply

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The attached Excel spreadsheet shows that Novartis should not drop all 50 products because dropping the products has a negative net present value of CHF 1,654.6 before tax, CHF 1,323.7 after tax at 20% under the following assumptions:

Consider cash flows from products only through 2009 o Fixed cost savings of the same amount each year.

Growth (decline) rates as projected for 99–09 as in Exhibit 1.

Discount rate of 12%.

Some instructors may want to hand out the Excel spreadsheet with the numbers from Novartis Exhibit 1 filled out and have the students project the cash flows, put in the discount rates, and calculate the NPV. Other instructors may wish to give the completed spreadsheets to students and have them focus on interpreting the results and coming to conclusions.

Some students will do sensitivity analysis by assuming:

different growth rates

different discount rates

different sales-variable cost relationships

The spreadsheet assumes that as sales decrease, variable costs decrease in proportion but we could have revenues declining but variable costs not declining as fast, particularly if revenue declines due to prices but not units.

Change in fixed costs over time if Novartis drops all 50 products

Opportunity costs of alternate uses of capacity over time

The instructor should point out that students should always think carefully about and exercise thoughtful judgment about the assumptions underlying the NPV analysis. Sensitivity calculations help establish the range of possible NPVs that managers can then use to make decisions.

Question 4

The first point to clarify here is whether Novartis will ever sell below CHF 1,654.6, the net present value to Novartis of producing and selling the 50 products. One reason Novartis may be willing to do so is that the assumptions underlying the model are too aggressive. If the numbers assumed in the calculations are too high, they overestimate the value of these products. The sensitivity analysis should help managers judge this. For the rest of the discussion of this question, assume that the NPV of producing and selling the products is $1,654.6 million.

The instructor could then ask, “If the 50 products were sold, assume the contribution margin from greater managerial focus and attention on the remaining products is CHF 200 million?” From Novartis’s point of view, the additional CHF 200 million of contribution margin from more focus means that it could afford to sell the 50 products for CHF 1,654.6 – CHF 200 = CHF1,454.6 and still be as well off. But doing so would mean that Novartis would be giving away the CHF 200 million to the buyer of the 50 products rather than keeping these benefits for its own shareholders. So even in the presence of this benefit, Novartis may want to get a minimum of CHF 1,654.6m because this is what it is worth to the buyer. The principle here is that Novartis should not be willing to sell below the net present value amount of CHF1654.6 because the principle is that it must determine this price by

(1) Looking to the future

(2) Looking outside.

The instructor might then ask, “What arguments can be made to suggest that Novartis must negotiate an even higher price than CHF 1654.6?” Think of point 2 above that emphasized “looking outside” and think of this problem through the eyes of the buyer rather than the eyes of the seller. A little probing and reflection will lead the students to realize that this portfolio of products may be worth more to a buyer than Novartis because:

The buyer may have a lower cost structure than Novartis (perhaps because of lower overhead costs)..

The buyer could promote these products more aggressively (versus Novartis which has many other products to focus on).

The buyer could be more efficient.

The buyer may be able to raise prices (Novartis’s profile may make it more difficult to raise prices on older products).

This would argue that Novartis should try to negotiate a price that is even higher than the value that Novartis will give up from this portfolio. It also suggests the importance of researching and understanding the circumstances and advantages of the buyer.

Question 5

If products are dropped, the budgeted management results for the country sector organizations would need to be adjusted for the lost sales by reducing the targets management would need to reach to achieve bonus payments. Still, the lower levels of profits (sales minus local country costs) would mean lower compensation for the country sales organization. Under these circumstances, the country sector organizations (CSOs) would have no interest in even dropping Pertofran. Suppose the total variable marketing costs of Pertofran are CHF 0.2 million. From the point of view of the CSOs the product is still profitable (Revenues of CHF 1 million minus marketing costs of CHF 0.2 million equal to CHF 0.8 million).

Renegotiating targets is also complicated because the profit impact of dropping individual products is often not clear cut. For example, if Pertofran was dropped, how much lower profits would the management of Novartis be willing to accept? The answer would depend on how much of the marketing costs would be saved or how much additional revenues would be realized if the marketing costs incurred on Pertofran were spent on other products.

The instructor could close this part of the discussion by pointing out that the targets would need to be adjusted but that this adjustment is not straightforward and would need to be carefully considered and negotiated.

The instructor could also ask about how fixed costs are likely to change. These costs may be fixed in the short run but should decrease in the long run if multiple products are dropped. Reducing fixed costs would improve managers’ performance measures and bonus payments although the precise increase may be difficult to estimate.

Question 6

Students are likely to come up with several options for Ebeling. The instructor should focus the discussion on the 50 products. The instructor could then go back and ask how/why the recommendations would differ for the additional 15 product brands. Many of the same arguments apply but the data that is available in Exhibit 1 is not available for these other products.

Keep these products and promote them. This does not really seem reasonable given the limited growth potential for these mature products even after promotion. Moreover, promoting these products would take attention away from other more-promising products in Novartis’s portfolio.

Sell these products via third-party agreements or outright to companies with lower cost structures than Novartis and for whom these products constitute a meaningful part of their product portfolios. This requires finding buyers with global reach willing to take on these products. Otherwise, Novartis would have to do local deals in different countries with different companies.

Discontinue products. This is a negative NPV proposition. It is better to keep selling the products without promotion rather than discontinuing them because they are generating value.

Do “quid pro quo” dealsThat is, exchange products for growth products where Novartis has a comparative advantage in terms of promotion and distribution. The challenge is to find deals that are attractive to both parties.

The key lesson is to manage these products much earlier in the product life cycle.

Novartis should attempt to sell products to third parties when these products are still attractive and have some potential left in them  likely to generate higher NPV than by holding on to them till the products are in decline. Some students might argue that if the market prices the future potential in the products correctly, the NPV from selling earlier is equal to the NPV of selling later. But other students will point out that selling earlier will allow the buying firm to invest more aggressively in the product while it is still growing and thereby get more value from the product. Many acquiring firms see too much risk in products that are already in decline.

Some student s will point out that many managers do not prune their portfolios in time because they mistakenly believe that products will deliver value for a lot longer than they actually do. In other cases, as described in the chapter and in assignment question 5, there is a conflict between the decision model and the performance evaluation model.

Beyond these actions, the best alternative is to continue selling the products without much marketing support.

Drop products that have negative contributions margins provided they are not needed to satisfy an important unmet medical need.