Dynamic Dual Capacity Sourcing for New Ethical Drugs

Abstract

Capacity management for new ethical drugs is one of the most challenging tasks facing pharmaceutical manufacturers due to long lead times to acquire capacity, significant risks in product launching failure, volatile and growing demand and costs, and extremely high service level requirement. Motivated by the growing practice of dual capacity sourcing strategies in the pharmaceutical industry, we introduce a finite period, dual capacity sourcing model with lost sales where a manufacturer uses two capacity sources to meet demand: in-house capacity that has a longer (two periods) construction lead time but once built can be used throughout the remaining periods, and outsourcing capacity that has a shorter (one period) reservation lead time but can only be used for the next period. We capture three uncertainties frequently observed in practice: product launching risks, and temporally dependent and growing demand and capacity costs. We show that the optimal total (in-house plus outsourcing) capacity is characterized by state-dependent basecapacity levels. However, the structure of the in-house capacity policy is intractable because the optimal value function is neither convex nor quasi-convex. Accordingly, we develop two approximate in-house basecapacity policies: the myopic solution and the convex value function approximation. Our extensive numerical study investigates, among other things, the strategic roles played by each capacity source and their dynamic interactions over the drug’s patent protection years. We find the following guiding principles for effective dual capacity sourcing: (1) largely postpone long-term investment before product launch and rely primarily on short-term outsourcing to meet demand in the early years; (2) quickly expand in-house capacity up to a modestly overage level soon after product launch and rely primarily on in-house capacity to meet demand in the intermediate years; and (3) use both the already built in-house capacity and outsourcing to meet demand in the late years. We also obtain other managerial and operational insights detailed in the paper.