Contract Manufacturing of Complex Medical Devices

As Co-founder and former CEO of Source Scientific, a contract developer and manufacturer of clinical diagnostic and therapeutic devices, I spent over 33 years in the Medical Device Development and Contract Manufacturing industry. Since then, I have spent the last 10 years working with other companies to develop and commercialize new products.

Who Actually Manufactures Complex Medical Devices?

Many products that are marketed and sold in medical device markets are not actually manufactured by the companies (Brands) who name, sell, and support them. Typically known as outsourcing, this is where Contract Manufacturers (CM’s) enter the picture. CM’s are independent companies who provide economies of scale by aggregating the specialized production of multiple products from multiple companies. These products are produced under the Brand client’s name. These CM’s typically have no branding of their own nor do they market, sell, or otherwise compete with their own client companies. Instead, they add value by supplying critical, dedicated production resources on a fractional basis; all in a fully qualified and regulated environment. This allows their Brand clients to focus on their core businesses. These clients can be small, medium, and Fortune 500 size companies.

Why do companies use Contract Manufacturing?

CMs typically provide production capabilities on a private label basis to Brands that lack them or need additional capacity. Many of these Brands are focused on the ideation, sales and marketing of their own proprietary products and leave the actual production to CM’s that do it on a more cost-efficient basis. This allows the Brand to focus on developing its products within its core markets.

Brand’s use CM’s for a number of reasons. Shorter time to market can be one important factor. Many Brands lack the expertise, proper production facilities, and assets and thereby avoid the capital investment and setup time required. For some, it is a matter of the capital required to expand existing facilities to accommodate new products or growth of existing ones. Sometimes it is a matter of bottom-line cost when the CM’s facilities and expertise result in a lower COGS.

The Brand’s other consumable products can then be sold in high volumes once there is a companion product that enables it. The classic example of this is Gillette’s famous creation of the safety razor which allowed it to sell millions of razor blades.

The low end of the CM spectrum includes high-volume, low complexity, easy to produce products that are likely to renew and grow year after year. Most CM’s happily take on this business at extremely low profit margins; typically in the low teens to single digits.

At the other end of the spectrum are high complexity instruments that are expensive and complicated to produce. These devices command very high profit margins, but the demand simply does not compare to high-volume consumables. Unlike other types of mass-production contract manufacturing, HCLV products present a unique set of business challenges.

In the medical diagnostics world, this includes complex instruments that analyze specially developed blood chemistries. These instruments enable developers to sell billions of dollars of single-use chemistries. In these cases, the chemistry producers outsourced the development and production of complex, dedicated instrumentation. They sell the instrument once and then sell high-margin consumable chemistries for life.

Once a relationship has been established between a Brand Client and a Contract Manufacturer, it is very difficult and costly for the Brand to terminate or switch to an alternate. Therefore, it is critical to the success of the product that the relationship be carefully considered prior to full engagement. In some cases, a milestone process is considered before the final signoff of a long-term production agreement. For high volume, low complexity products, Brand’s may seek a backup producer from the very start. This is almost impossible, however, for High Complexity projects.

Overview of High Complexity, Low Volume Contract Manufacturing (HCLV/CM) of medical devices.

The remainder of this article focuses on HCLV products that are typically diagnostic or therapeutic devices considered as capital goods, not consumables. They include imaging, treatment, ophthalmic, laboratory analyzers, certain portable equipment, etc. They are big budget items that are sold as capital assets and used on a repetitive basis. End users may lease them or acquire them for thousands (or perhaps tens of thousands) of dollars. User revenue is typically on a per-use basis.

Often, employing a CM can be a matter of professional competence where the Brand Client must focus its expertise on its high-volume consumables or therapies instead of a new instrument.

Since CM’s are dependent on their client’s ability to market and sell the products, they typically seek projects that will run as long as possible. They rarely seek out one-time projects without some form of ancillary benefit. They look for projects that will reward the up-front investment with a predictable stream of long-term profitable business.

Issues Brand Clients should consider when identifying and selecting a Contract Manufacturer

There are dozens of CMs in the US and elsewhere. The challenge is finding a qualified one that meets specific needs and is willing to work with its Brand clients. Issues include:

• What is their reputation within the relevant industry? Are there references from other clients as well as vendors used by the CM.
• How big are they – overall revenue, staffing?
• What products do they focus on?
• How well do they protect the Client’s intellectual property?
• Does the CM’s location make it easy to distribute the manufactured product?
• Are they easy to access, especially during the production transfer phase? Are they across town or
• across the country?
• Are they ISO 13485 certified and FDA registered to the proper level? Any history of non-compliance?
• Track record and relevant expertise and experience with the technology to be produced
• How long will the production transfer process take?
• Is final production domestic or outside the US?
• International support for product sold outside the US
• Long term commitment for production and delivery
• Responsiveness to short and long term adjustments in product delivery demand
• Is the product within the CM’s current experience or will it have to develop new capabilities?

Typical terms of a Brand/CM agreement

• What are the upfront payments to cover fixed costs such as tooling, fixtures, setup, training, lack of credit.
• In addition to the upfront fixed cost, what deposit(s) are necessary to cover vendor deposits and pre-payments.
• What are the Brand Client obligations to take ownership and delivery of the product including volumes and delivery rates.
• Inspection, acceptance, and certification requirements prior to and after receipt of shipments.
• How advance deposits are credited to deliveries. How much of a deposit is allocated to each delivery?
• Invoicing and payment terms on delivered product
• Where will the finished goods inventory be held – Brand Client, CM, third party?
• Is the Client charged for storing finished goods inventory?

Issues a Contract Manufacturer may consider when quoting a project to a Brand Client

Here is a summary of things a Contract Manufacturer will evaluate when taking on a HCLV client. In the end, they must determine if it is profitable and has acceptable and controllable risks. There are a variety of upfront costs, deposits, and delivery terms to be assessed and negotiated. A new HCLV project can take a considerable amount of integration time, effort, and expense before recurring production can begin.

Client relationship

To accept a new project from an existing or prospective client, the CM first evaluates it on a strategic basis. The technology must fit it’s capabilities and resources. It must determine if the project poses a resource or confidentiality conflict with current client projects. To decide if it will take on a new Brand client, it may consider the following:

• Client reliability – Time in business, credit worthiness, and prior history of working with CM’s
• Assessment of target market of client’s product. Is this a known, well understood market or is the Brand client entering a new market with few predicate examples of success?
• What is the client’s potential profit margin when reselling the delivered product? A thin selling margin may mean future cash flow issues.
• Client order demand flexibility – How reliable will the Client’s delivery demands be?

Product considerations:

• Required safety protocols for handling material and operating the equipment
• Post-market surveillance and compliance requirements
• Product lifecycle maintenance
• Special skills, certifications for production staff
• Special proprietary processes and production equipment required for production

Other issues:

• Scalability of product
• Understanding of target market
• Probability of follow-on projects
• Internal product technology competence

In the end, CM’s of high-complexity medical devices typically negotiate 40% to 60% profit margin on transfer price. However, the difficult questions are “what is total cost, what is transfer price, and how is it calculated?” Simply put, cost is the sum of direct material, labor processes, and allocated overhead. Calculating this can be a formidable task as the product complexity rises.

Profit margin is the ratio of profit/price (not profit/cost). In other words, a selling margin of 60% is the same as 2.5 times the loaded BOM cost ($40 cost x 2.5 = $100.00 with $60 profit)

Ultimately, there are two main funding requirements that the Brand Client must cover – prepayments and payments for delivered product.

For the upfront prepayments, there can be multiple components:

• Technology transfer and production setup costs including assembly and test fixtures, process development and validation, documentation, etc.
• Advance deposits, prepayments, and minimum purchases required by vendors and passed through to the Brand client.
• Additional security deposits required by the Contract Manufacturer.

Delivered product costs are typically the sum of:

• Bill Of Materials (less any adjustments for prepaid vendor deposits)
• Direct labor for assembly, test, and handling
• Allocated overhead for production equipment and processes

These components are subject to negotiation and will depend on the size and nature of the project, Brand Client’s creditworthiness, history of relationship between the Brand Client and CM, and the anticipated market for the product.

Step 1 – Technology Transfer and Fixed cost analysis

The entire product design must be initially transferred to the CM. This includes documentation, production processes, creating production fixtures and software, establishing the component supply chain. This also includes validation of quality control and regulatory documentation.

Considerations include:

• Ease of transfer – Is the client (or the products original design and engineering firm) able to provide all necessary details, support and control of the design and engineering of the product? How will they respond with any necessary engineering changes to accommodate production issues?
• What outside tooling will be required for custom molded and machined parts.
• What assembly and test fixtures must be engineered, built, and validated to enable assembly line production of the product?
• What production and test software must be created to operate test fixtures and verify performance of the product in-process and completed?
• What production floor processes must be designed and documented?
• What training is required for production staff?
• Verification of any special handling requirements such as hazardous substances or restricted materials?
• Effort required to incorporate the new product into the Brand Client’s existing ISO and FDA regulatory processes.
• Calculation of factored overhead including general and applied fixed costs. (For example, If the new project occupies 10% of available production space, does that mean it requires 10% of rent, taxes and insurance?)

Once these costs are understood, will the Brand Client be asked to cover these costs up front, or will they be amortized for future deliveries or otherwise absorbed?

Step 2 – Material Supply Chain Issues

These are issues that must be researched and addressed to arrive at a fully costed Bill Of Materials (BOM). It should be researched using the client’s projection of total demand and anticipated delivery schedules.

• Are any of the components and materials designated to be provided by the Brand Client? Why?
• If so, will there be compliant QC controls in place?
• Which components are considered Critical To Quality (CTQ)?
• Are there clear acceptance criteria established for these components?
• What are the incoming quality control requirements for CTQ material?
• Will the vendors provide certifications for these components and materials?
• Must special processes be set up for incoming inspection and testing of these components and materials?
• Review of all specified vendors in the client supplied BOM. Have they all been pre-qualified by the Brand Client?
• Do any of them pose quality control or lead time issues?
• Are there any special cost issues (such as scheduled or bulk delivery) that improve cost?
• Are any of these components already used by the CM on other projects?
• If so, can this relationship improve the delivered cost and delivery terms?
• Will the CM reject any of the specified vendors for cost, quality, or business reasons?
• Is the finished product subject to any “Made in USA” or other content requirements?
• If so, what is the acceptable content allowance?
• Are the designated vendors able to meet the required delivery demand?
• What is their responsiveness to changes in deliveries or lead times?
• Have alternative vendors been designated?
• Do any vendors require advance payment or minimum bulk deliveries?
• Will advance payments to vendors be included in the deposit advance by the Brand Client?

Step 3 – Pilot Production and Process validation

Before continuous production can commence, a pilot production run must be performed using the newly created supply chain, processes, production and test fixtures. The Client then takes delivery and verifies that the finished product complies with all requirements. Any exceptions must be corrected by the CM or accepted by the Client. Upon acceptance, the CM can commence regular production and deliveries of the product.

Step 4 – Finished Goods Production and Transfer Pricing

Transfer pricing is the final amount billed to the client for each finished unit shipped under the agreement. It is based on the cost and volume of delivered products plus an agreed profit margin. Most CMs operate on a transparent, “Open Book” basis where the Brand Client can see actual vendor pricing.

It should include the following:

• Updated BOM cost
• Direct labor for assembly, calibration, burn-in, and testing
• Outside processes – molding, machining, anodizing, coating, sterilization. etc.
• Factored overhead
• Gross profit markup
• Billing and payment terms

Once the product is sold and delivered to a user, what are the demands for Field and Depot Servicing?

• Does the product require on-site installation, calibration, or maintenance?
• Will it need on-site servicing?
• Will the client handle service or rely on the CM?
• Who will perform the necessary servicing?
• Where will the servicing be performed?
• Will the product be returned to the CM for service or exchange?

Recommendations

Any Brand Client considering outsourcing a HCLV project to a Contract Manufacturer should develop a thorough review process of the necessary tasks and issues involved. An experienced manufacturing professional can help greatly in this regard.