Experts in the global services terrain

Novartis on April 22, 2014, announced a succession of deals in a sweeping restructuring. It agreed to buy GlaxoSmithKline’s (GSK) oncology products unit for US$14.5 billion, plus another US$1.5 billion subject to certain milestones. In turn, it divested its vaccines business to GSK for US$7.1 billion, plus royalties. The two companies also announced the creation of a new consumer healthcare business through a joint venture, in effect combining Novartis’ OTC drug business with GSK’s consumer business, with nearly US$10 billion in annual sales. In a separate deal, it hived off its animal health business to Eli Lilly for US$5.4 billion.

The deals – given their scale and impact – principally reshape Novartis, which has been evaluating its businesses since last year. The move reflects a strategic imperative to focus on higher margin products, such as cancer drugs, and let go of low margin ones, which rely on scale and volume. This signals a momentous shift for the firm, which under its previous chief executive transformed into an expansive healthcare behemoth, fueled primarily by M&As. The deals have substantial implications for GSK as well, reorienting its business across respiratory, HIV, vaccines, and consumer health products – together accounting for nearly roughly 70 percent of its sales. It also consolidates its position as the leading global vaccine player.

These changes reflect an important inflection point for the pharmaceutical industry. The industry is coming to terms with multi-faceted challenges arising out of patent cliff implications, middling R&D productivity, and rising consolidation, leading to a rethink of business models.

Life sciences M&A bandwagon

Life Sciences Mergers and Acquisition Bandwagon

Bigger is not always better

Consolidation has been a standard practice adopted by Big Pharma to tide over industry challenges, maintain growth momentum, diversify into emerging geographical and product markets, beef up R&D efforts, and boost sagging drug pipelines.

However, with middling R&D productivity, patent cliff losses, and expansion into newer product/service lines, pharma companies are reconsidering the conventional paradigm to factor in these multi-pronged challenges. Incessant consolidation has had a detrimental impact on many companies with decreasing post-merger productivity, culture mismatch, integration challenges, and declining agility.

That has resulted in firms such as Novartis refocusing their priorities to focus on core competencies instead of having its fingers in too many pies. These restructuring efforts call for a carefully thought-out technology strategy that encompasses organization-specific challenges and hurdles. The roadmap for pharmaceutical firms must be evaluated on a profitability-productivity matrix to test for efficacy. The imperatives brought by wholesale value chain digitization in the pharmaceutical industry entail a re-examination of the organizational structure and resource allocation/rationalization required for driving top line and bottom line growth. Technology will serve as a key enabler to free up resources and ensure optimal utilization levels.

The profitability-productivity matrix of pharmaceutical firms

Profitability-productivity Matrix of Pharmaceutical Firms

Big Pharma will continue to take the acquisitions route as new drug development becomes more expensive and exhibits declining productivity. But companies need to take a more balanced and individualized approach as they assess their unique value proposition and go-to-market strategies in order to thrive in the new world order.

Have you ever spoken to a “digital transformation” enthusiast? The first thing you will notice is the person cannot exactly define digital in any meaningful way. The second thing is that the discussion will invariably include citation of popular consumer mobile apps, portals, and other things such as Facebook, Google Glass, the Internet of Things, PayPal, Pinterest, TripAdvisor, and Uber.

The third, and perhaps the most intriguing, is their obsession with customer engagement. The focus is so extreme that it pretty much excludes anything that is perceived not to be glaringly customer-related. This fixation, which means a sole focus on the front-end sales and marketing engine, fails to take into account that a digital strategy must pervade the entire value chain – customer engagement, business processes, technology operations, and organizational policies – and that a success requisite is transformation of the less attractive, unseen back-end.

Unfortunately, buyers have limited spending appetite and budget, and CIOs coming under intense pressure to add business value are vigorously channelizing these budgets into development of front-end-centric digital initiatives. I believe this myopic strategy is flawed, and will show its glaring weakness in the coming years.

Consider the impact of a sole focus on front-end digital initiatives without augmenting business process or technology operations. For example, a bank’s mobile sales force can open a customer account in 10 minutes or sell financial products using a banking mobile app, However, as the back-end operations and other business processes needed to make the account functional are still the same, the customer does not get the true benefits of this banking mobility. Or, when an online retailer develops a mobile app where customers can place orders, but the back-end processes and technology operations are same as customers placing an order through the online portal, the availability of one more access point for customers does not fundamentally impact the business.

Enterprises need to go full hog to leverage the disruptive power of digital services. A piecemeal approach will eventually hit a wall, and business leaders’ frustration will grow. To ease this, business leaders must understand and collaborate with the operations department, and push the operations manager to introduce digital transformation within the core technology operations and business processes.

Customers have always been at the center of the universe for successful companies, and digital transformation will not change that. However, extreme customer-centricity without suitable investment in back-end operations or business processes that drive customer delight will result in a grand failure. Enterprise buyers need to judiciously invest in technology solutions across their business and internal processes to create a vibrant “digitally aware” organization that understands the impact of this transformation. The impact should be pervasive and touch upon each aspect of the business.

Digitization of business processes across an organization presents a tremendous opportunity to leap ahead of the competition. But make no mistake…it’s a high investment, high risk, and high return game. Organizations that have the required mettle to make technology pervasive in their front-, middle-, and back-end operations will not only survive, but thrive.

Comedian George Carlin commented that men are stupid and women are crazy — and that the reason that women are crazy is that men are stupid. My observation is that it’s a strikingly similar dynamic to what’s occurring in large enterprises’ spend decisions in the global services market today.

Business stakeholders are “stupid.” They’re off doing their own thing, making snap decisions, stringing together solutions with half-tested as-a-service offerings and believing those solutions will scale up to meet enterprise production needs.

CIOs are “crazy.” They’re tearing their hair out, so to speak, in frustration over the business stakeholders’ actions. They try to engage business stakeholders in conversations, but the biz folks don’t have time for that. Furthermore, the CIOs’ funding has been taken away and given to the business stakeholders.

There is no time to plan, so CIOs must show a complete offering rather than going through a meticulous planning process. And CIOs are told they are accountable for security and compliance, yet they are not given the ability to shape the new solutions going in place. The situation is turning them into crazy people.

Why they talk past each other

CIOs and business stakeholders march to different drums, thus frustrating each other to the point of being stupid or crazy.

But in a way it makes perfect sense since both operate in their own world. And neither perspective is irrelevant. It’s just that the perspectives and operational goals differ in those two worlds, so they misunderstand each other. The business units misunderstand the CIO, and the CIO misunderstands the business units. In the words of Winston Churchill, they are two nations divided by a single language. They both talk technology, but they talk past each other because they come from completely different places.

Carlin’s opinion is that as long as men are stupid, women will be crazy. My opinion: As long as business stakeholders focus on business needs that get met in immediate gratification through SaaS and proofs of concept, the CIOs will be crazy. Look out for some very complicated discussions when it comes to funding and scaling the SaaS and proofs of concept across the enterprise.

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A question we often receive from CFOs in the U.S. is how to treat the costs associated with outsourcing.

In 2007, Everest Group wrote a well-researched white paper on this topic, citing U.S. Generally Accepted Accounting Principles (GAAP). While seemingly a long time ago, the conclusions in the paper are still very true today, with minor updates.

Following are our suggestions on accounting treatment for four key categories of outsourcing costs:

#Cost CategoryAdvised Treatment*
1.Exit or restructuring costs: These are costs related to employee termination benefits, contract termination, employee relocation, and facilities consolidation. These may include, but are not limited to: costs incurred in selling or otherwise disposing of a part of the business; consolidating and/or closing selected sites; and relocating operations from one site to another. The key here is that the cost must be incremental to other costs incurred in the course of normal operations, or be associated with a contract that will either be terminated or completed.Expense: Outsourcing implementation costs almost always need to be included in results from continuing operations, but restructure costs can be disclosed on a line item basis within the income statement.
2.Asset impairments: These are costs related to asset retirement abandonment or sale (primarily related to the IT infrastructure); an asset becomes impaired when its carrying value exceeds its fair market value. This can also be classified as a restructure cost.Note: A sale of assets by a client to a service provider at a price above FMV does not eliminate the requirement to record an impairment.Expense: Should be included in the income statement in results from continuing operations.
3.Transition and transformation costs: These are costs related to assessment, process reengineering, solution design, workforce redesign, and parallel processing. These includes costs associated with the preparation and administration of the RFP process, current state assessment, recruiting, training, and internal-use software acquisition, development, and implementation.Note: A scenario in which the service provider initially incurs these costs and then either re-bills them to the buyer or bundles them with future service fees does not eliminate the requirement for the buyer to recognize an expense.Expense: Although transition and transformation costs are not recorded on a line item basis in the income statement, these costs need to be disclosed in the footnotes to the financial statements if they are material in amount.
4.Software implementation costs: These are costs strictly associated with the application development stage – acquisition license fees, configuration and integration, custom coding, installation to hardware, testing and parallel processing, and primary data conversion costs.Note: Most other software-related costs (implementation planning and evaluation, user training, and post-implementation operating) should be classified as transition or transformation costs, and must be expensed in the period they are incurred.Capitalize: Most of the costs associated with the application development stage may be capitalized.

 

As noted above, both exit and asset impairment costs should, in most instances, be disclosed in results from continuing operation, although they may qualify for disclosure as restructuring cost. However, if they are the results of an exit or disposal activity that involves a discontinued operation as defined in accounting standards codification section 205-20, they should be included within the results of discontinued operations.

For further information on the timing of expense recognition and the technical nature of the accounting treatments, readers should reference the following authoritative sources applicable in accounting standards codification section:

  • 205-20: Presentation of Financial Statements – Discounted Operations
  • 350-40: Intangibles–Goodwill and Other – Internal-use Software
  • 360-10: Property, Plant and Equipment
  • 420-10: Exit or Disposal Cost Obligations
  • 720-45: Other Expenses – Business and Technology Reengineering 

The U.S. Securities and Exchange Commission (SEC) recognizes the financial accounting and reporting standards of the Financial Accounting Standards Board (FASB) as “generally accepted” for purposes of the federal securities laws. The SEC is strongly committed to a single set of global standards, and recognizes that International Financial Reporting Standards (IFRS) is best-positioned to serve the role of that single set of global standards for the U.S. market and the ongoing convergence process between the FASB and the International Accounting Standards Board (IASB). The SEC does not permit its domestic issuers to use IFRSs in preparing their financial statements; rather, it requires them to use US GAAP. The SEC permits but does not require its foreign private issuers to use IFRSs as issued by the IASB in preparing the issuer’s financial statements.
* This guidance is based on Everest Group’s advice to its clients. In addition, the information is based on U.S. GAAP, and may not be in exact alignment with IFRS and IASB. Buyers should always consult with both their internal financial accounting staff and external auditors to determine how they should address the specifics of their situation.

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Recently I had a conversation with an executive at a large software house known for its ERP. One of many things that struck me in our conversation was the change in whom the sales team targets. Their primary target is no longer the CIO; now it’s the CFO.

Apparently, in today’s business outcomes-driven world, CIOs are no longer authorized to drive tech spend decisions of this type, nor do they have the ability to write the check.

As I reflect on this change in decision rights and executive focus, I don’t find it at all surprising; after all, it is consistent with what I’ve blogged about several times. As she put it, the reasons for buying technology today are driven much more by business need and the impact that the technology can drive; it’s increasingly less about the technology itself. In this shift in mindset, the CFO and senior business stakeholders have become more influential because they have the best understanding of the business impact needed from the technology.

The lesson for a global services business

If the technology players are shifting their focus to the CFO as the influencer of tech spend, I think this underlines the changing dynamics or decision rights for the global services industry and the imperative to engage with and serve others outside of the CIO.

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