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14 Changing the Economic Image of the

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Pharmaceutical Industry FRANCIS J. B L E E Beach, W i d m a n n & Co., T w o Decker Square, B a l a - C y n w y d , P a . 19004

The

key

industry innovation and

economic

Research

as an investment

all published

figures.

ized, the return reduced

distinguishing

is the heavy

development

and capitalized

If research

that a

Comparison

6-9%

reduction

prices would reduce the industry's level equal to the electric utility

drug

on

on

research

should

be

by the industry

in

expenditures

on shareholders' equity

from 19% to 15%.

ties demonstrates

and

the

dependence

and the high level of expenditures

development.

viewed

characteristic

from other industries

are

capital-

of the industry with electric in drug

is utili-

industry

return on investment

to a

industry.

T n d i s c u s s i n g t h e e c o n o m i c i m a g e of the p h a r m a c e u t i c a l i n d u s t r y there A

is a l a c k of g o o d e c o n o m i c

data on the pharmaceutical

industry i n

g e n e r a l a n d o n t h e e c o n o m i c s of p h a r m a c e u t i c a l i n n o v a t i o n specifically. T h i s is a f r u i t f u l area, h o w e v e r , a n d deserves greater e c o n o m i c r e s e a r c h efforts. T h e d r u g i n d u s t r y c a n b e v i e w e d as the creator a n d d e l i v e r e r o f a n i n n o v a t i v e service, the most significant of w h i c h is d i s c o v e r y .

The

a c t u a l p r o d u c t i o n , m a r k e t i n g , a n d d i s t r i b u t i o n of d r u g s , w h i l e a v a l u a b l e a n d h i g h l y efficient o p e r a t i o n , is n o t m u c h different f r o m d r u g s or several other c o n s u m e r industries.

proprietary

H e n c e , the p r o d u c t i o n , m a r -

k e t i n g , a n d d i s t r i b u t i o n c y c l e c o u l d b e p e r f o r m e d b y m a n y other i n d u s tries l a c k i n g i n the c r e a t i v i t y w h i c h is so essential to the p h a r m a c e u t i c a l industry.

I b e l i e v e that t h e i n d u s t r y has m i s u n d e r s t o o d

its o w n role,

o v e r e m p h a s i z i n g p r o d u c t i o n a n d d i s t r i b u t i o n a n d u n d e r p l a y i n g its m o s t d i s t i n c t i v e e c o n o m i c characteristic—i.e., the creative process of d i s c o v ering and developing new pharmaceutical

products.

257

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.

258

DRUG DISCOVERY

Pharmaceutical Research T h e economics of a n i n n o v a t i v e p h a r m a c e u t i c a l i n d u s t r y h a v e b e e n c h a n g i n g d r a m a t i c a l l y over the a l t h o u g h precise

measurements

last s e v e r a l decades.

I n the

1950's,

are not a v a i l a b l e , p h a r m a c e u t i c a l

search was h i g h l y p r o d u c t i v e a n d a p p a r e n t l y q u i t e p r o f i t a b l e .

re-

Broad

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generalizations c a n b e m a d e , c e n t e r i n g a r o u n d the f a c t that l a r g e n u m bers of n e w c h e m i c a l s

entities,

combination products, and duplicate

p r o d u c t s w e r e i n t r o d u c e d i n the d e c a d e of the 1950's o n research b u d g e t s w h i c h b y today's standards a p p e a r to be q u i t e modest.

F o r example, i n

the seven-year p e r i o d 1956-1962, p r i o r to the n e w d r u g r e g u l a t i o n s of 1962, the i n d u s t r y i n t r o d u c e d a n average of 44 n e w c h e m i c a l entities p e r year. T h i s w a s i n a n era w h e n one or t w o years seemed l i k e a l o n g t i m e f o r d e v e l o p m e n t of a n e w d r u g p r o d u c t . T h e t i m e s p a n f o r d e v e l o p i n g a n e w d r u g p r o d u c t has i n c r e a s e d t r e m e n d o u s l y since the e a r l y 1960s w i t h estimates c u r r e n t l y r a n g i n g f r o m 7 - 1 0

years or m o r e .

Moreover, owing

to the i n c r e a s i n g scientific c o m p l e x i t y of d i s c o v e r i n g a n d d e v e l o p i n g n e w d r u g c o m p o u n d s a n d a m o r e stringent r e g u l a t o r y c l i m a t e , the n u m b e r of n e w c h e m i c a l entities

i n t r o d u c e d b y the

i n d u s t r y i n the

seven-year

p e r i o d i m m e d i a t e l y f o l l o w i n g the n e w d r u g regulations of 1962 f e l l to a n average of 16 n e w c h e m i c a l entities p e r year. T h e other p a r t of the e q u a t i o n is the a m o u n t e x p e n d e d o n research i n these c o m p a r a b l e p e r i o d s . B e t w e e n 1956 a n d 1962 the i n d u s t r y spent a p p r o x i m a t e l y $1.3 b i l l i o n o n research,

whereas

(R&D)

expenditures w e r e a p p r o x i m a t e l y $2.6

i n the

1963-69 p e r i o d research

and

billion.

development The

changing

e c o n o m i c c l i m a t e r e f l e c t i n g r i s i n g research costs a n d f e w e r n e w p r o d u c t s is o b v i o u s . U s i n g a v e r y s i m p l e f o r m u l a of d i v i d i n g the n u m b e r of n e w entities i n t o the research costs f o r each of these seven-year p e r i o d s p r o duces a cost p e r n e w c h e m i c a l entity of a p p r o x i m a t e l y $4 m i l l i o n i n the 1956-62 p e r i o d a n d $23 m i l l i o n i n the 1963-69 t i m e s p a n ( T a b l e Table I.

Average R & D Investment per N e w Chemical Entity" R&D Investment, Millions

Period 1956-62 1963-69

I).

$1,270 2,605

Total Number of New Entities 0

311 113

R&D Investment per Entity, Millions

Average Number of Entities per Year

$ 4.1 23.1

44 16

° Source: R & D investment: Pharmaceutical Manufacturers Association. New chemical entities: (9). T h i s c o m p a r i s o n is subject to o v e r s i m p l i f i c a t i o n ; f o r e x a m p l e , h o w m u c h of the R & D is i n d e e d a quest f o r c o m p l e t e l y n e w c o m p o u n d s , a n d is a n e w c h e m i c a l entity a c t u a l l y a reasonable b a r o m e t e r of R & D

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.

14.

BLEE

Economic

259

Image

p r o d u c t i v i t y ? W i t h o u t a t t e m p t i n g to j u s t i f y these figures or debate

the

a c c u r a c y of specific n u m b e r s , i t is o b v i o u s that there has b e e n t r e m e n dous increase i n the cost of d i s c o v e r i n g a n d d e v e l o p i n g a n e w product (I, 2).

drug

It is also o b v i o u s that the n i n e n e w c h e m i c a l entities

i n t r o d u c e d b y the i n d u s t r y i n 1969 w i l l h a v e to a c h i e v e t r u l y significant sales levels to justify a l e v e l of a p p r o x i m a t e l y $500 m i l l i o n a n n u a l l y b e i n g Downloaded by UNIV OF CALIFORNIA SANTA BARBARA on March 30, 2018 | https://pubs.acs.org Publication Date: June 1, 1971 | doi: 10.1021/ba-1971-0108.ch014

spent o n h u m a n e t h i c a l research a n d d e v e l o p m e n t i n the 1968-69 p e r i o d (3). E r r o n e o u s conclusions often seem to h a v e b e e n d r a w n r e g a r d i n g the i n d u s t r y ' s true p r o f i t a b i l i t y . It is true that the d r u g i n d u s t r y has g e n e r a l l y r a n k e d h i g h a m o n g A m e r i c a n industries i n terms of r e t u r n o n sales a n d r e t u r n o n investment.

H o w e v e r , I b e l i e v e that the i n v e s t m e n t

as stated i n the a n n u a l r e p o r t of the t y p i c a l d r u g c o m p a n y

understates

the a c t u a l investment since research a n d d e v e l o p m e n t costs h a v e syst e m a t i c a l l y b e e n w r i t t e n off against profit a n d do n o t a p p e a r i n the i n v e s t m e n t p o r t i o n of the b a l a n c e

sheet.

The

technique

of a n n u a l l y

a m o r t i z i n g research a n d d e v e l o p m e n t expenditures m a y b e r e l e v a n t f o r other i n d u s t r i e s a n d is also consistent w i t h conservative a c c o u n t i n g p r a c tices.

H o w e v e r , the resultant b a l a n c e sheet i n v e s t m e n t fails to r e c o g n i z e

the t r u l y u n i q u e d e p e n d e n c e of the p h a r m a c e u t i c a l i n d u s t r y o n research a n d d e v e l o p m e n t a n d the f a c t that as a percentage of sales the i n d u s t r y ' s research i n v e s t m e n t is larger t h a n a n y major i n d u s t r y .

For

example,

since i n d u s t r y figures o n c a p i t a l expenditures are n o t a v a i l a b l e , w e c a n cite a n i n d u s t r y leader, M e r c k , a n d p o i n t out that i n the three year p e r i o d 1967-69 M e r c k spent $163 m i l l i o n o n research a n d d e v e l o p m e n t c o m p a r e d w i t h $118 m i l l i o n o n c a p i t a l expenditures f o r p l a n t a n d e q u i p m e n t . I suggest that it is a t r u l y u n i q u e r e l a t i o n s h i p f o r a firm i n a n y i n d u s t r y to have spent 3 8 % m o r e o n research a n d d e v e l o p m e n t t h a n o n p l a n t a n d e q u i p m e n t expenditures, a n d I suggest that this is f a i r l y t y p i c a l f o r m o s t research o r i e n t e d firms i n the d r u g i n d u s t r y . A c c o r d i n g to U . S . g o v e r n ment figures, the p h a r m a c e u t i c a l i n d u s t r y i n 1969 h a d a r e t u r n o n investm e n t of a p p r o x i m a t e l y 1 9 % .

T h e significance of c a p i t a l i z i n g research

a n d d e v e l o p m e n t c a n be i l l u s t r a t e d b y the f a c t that the industry's r e t u r n o n i n v e s t m e n t c a n be r e d u c e d to 1 5 % u s i n g a n a r b i t r a r y 5-year a m o r t i z a t i o n of R & D expenditures ( T a b l e I I ) ( 4 ). H a v i n g d i s c u s s e d r e t u r n o n investment, I s h o u l d c o n s i d e r the risks associated

w i t h the

anticipated return on pharmaceutical

investment.

A g a i n because of a l a c k of a v a i l a b l e d a t a , w e m u s t s u b j e c t i v e l y observe that the research i n v e s t m e n t b e i n g m a d e b y the i n d u s t r y carries a h i g h degree of risk o w i n g to the degree of u n c e r t a i n t y i n v o l v e d i n n e w p r o d u c t research.

I b e l i e v e a l l w o u l d agree that n e w p r o d u c t research is i n h e r -

e n t l y m o r e r i s k y t h a n the process i m p r o v e m e n t or cost r e d u c t i o n t y p e research i n d i c a t i v e of m a n y other industries. A t t e m p t s h a v e b e e n m a d e

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.

260

DRUG DISCOVERY

Table II."

Begin­ ning Equity

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Year

D r u g Industry Return on Shareholder's E q u i t y Assuming Capitalization of R & D

R&D Invest­ ment

R&D Write-

Off

R&D Write­

Ending Equity

Profit Before R&D

$49.62

$14.10

$4.50

off

A

$49.62

$4.50

1 2 3 4 5

49.62 54.12 57.72 60.42 62.22

4.50 4.50 4.50 4.50 4.50

0 .90 1.80 2.70 3.60

54.12 57.72 60.42 62.22 63.12

14.10 14.10 14.10 14.10 14.10

0 .90 1.80 2.70 3.60

Β

$63.12

$4.50

$4.50

$63.12

$14.10

$4.50

$

0

Profit After R&D $

9.60 14.10 13.20 12.30 11.40 10.50

$

%

Return On Equity

9.60

19.3% 26.1 22.9 20.4 18.3 16.6 15.2%

Assumptions (1) (2) (3) (4) (5) (6) α

Sales are $100.00 per y e a r P r e - t a x R & D = 9 % of g l o b a l sales 5 0 % t a x rate, after t a x R & D = 4 . 5 % of sales P r o f i t after t a x = 9 . 6 % of sales U n a d j u s t e d e q u i t y = 4 9 . 6 % of sales F i v e y e a r w r i t e - o f f of R & D

Source of ratios: (10, 1 1 ) .

to measure the r i s k of the i n d u s t r y , w i t h n o a p p a r e n t c o n c l u s i o n h a v i n g b e e n r e a c h e d (5,6,7).

T h e q u e s t i o n is w h e t h e r or n o t the r i s k is increas­

i n g . A s the p r e v i o u s figures i n d i c a t e d , m o r e dollars m u s t be i n v e s t e d i n e a c h research project w i t h a consequent l a r g e r loss i f the p r o j e c t

does

not c o m e to f r u i t i o n . I n a d d i t i o n , the degree of c e r t a i n t y i n a c h i e v i n g a m a r k e t a b l e p r o d u c t w o u l d also a p p e a r to be less t h a n i n the past because the scientific obstacles

have become

more formidable.

Since w e

are

d e a l i n g w i t h research i n v o l v i n g the h i g h l y v a r i a b l e h u m a n b e i n g , there are o b v i o u s l y a t r e m e n d o u s n u m b e r of u n k n o w n s i n v o l v e d i n the r e a c t i o n to v a r i o u s d r u g s . P e r h a p s the reason that attempts to measure r i s k h a v e b e e n u n s u c c e s s f u l is the fact that w e m a y b e d e a l i n g w i t h u n c e r t a i n t y rather t h a n risk, a n d the c o n c e p t of u n c e r t a i n t y m a y n o t be susceptible to statistical m e a s u r e m e n t .

It is true that as m e a s u r e d b y c o n t i n u e d

p r o f i t a b i l i t y one w o u l d h a v e to say that the risks of research h a v e not y e t b e e n reflected i n g r e a t l y r e d u c e d p r o f i t a b i l i t y or p r o d u c e d a n y

finan­

c i a l crises l i k e that of P e n n C e n t r a l . N e v e r t h e l e s s , w e see other i n d i c a ­ tions of i n t e n s i f i e d r i s k ; f o r e x a m p l e , the effects of i n c r e a s i n g R & D u n c e r t a i n t y m a y h a v e c o n t r i b u t e d t o w a r d the p r o p o s e d c o m b i n a t i o n of Schering and Plough.

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.

14.

BLEE

Economic

261

Image

Role of Patents T o offset the d e a r t h of n e w p r o d u c t i n t r o d u c t i o n s , the i n d u s t r y has generally

been

compensated

through

greater

l o n g e v i t y of

products

a l r e a d y o n the m a r k e t . A l s o , the a b i l i t y to i n t r o d u c e n e w p r o d u c t s a b r o a d i n a d v a n c e of U . S . clearance has e n a b l e d the i n d u s t r y to sustain a faster Downloaded by UNIV OF CALIFORNIA SANTA BARBARA on March 30, 2018 | https://pubs.acs.org Publication Date: June 1, 1971 | doi: 10.1021/ba-1971-0108.ch014

g r o w t h rate i n f o r e i g n countries t h a n here. H o w e v e r , d u r i n g the 1970's, as patents e x p i r e o n the " w o n d e r d r u g s " of the 1950's, the p r o f i t a b i l i t y of the i n d u s t r y w i l l b e u n d e r i n c r e a s i n g pressure. H e n c e , w e m u s t c o n c l u d e that d r u g i n d u s t r y r i s k w i l l increase f u r t h e r i n the f u t u r e because

of

(1)

p a t e n t expirations, ( 2 )

generic

c o m p e t i t i o n , a n d ( 3 ) the greater threat of p r o d u c t w i t h d r a w a l s i n h e r e n t i n a c l i m a t e of stringent e n f o r c e m e n t b y the F D A a n d c o n s u m e r p r o tection b y all governmental bodies. A n essential p a r t of the economics of i n n o v a t i o n i n the U n i t e d States has b e e n the patent system. Patents h a v e b e e n v i e w e d t r a d i t i o n a l l y as a r e w a r d f o r c r e a t i v i t y . R e c e n t l y , d r u g patents i n the U n i t e d States h a v e c o m e u n d e r fire as r e p r e s e n t i n g a m e c h a n i s m w h i c h tends to create a n a r t i f i c i a l l y h i g h p r i c i n g structure b y r e d u c i n g c o m p e t i t i o n ( 8 ) .

I n de-

fense of the patent system w i t h r e g a r d to p h a r m a c e u t i c a l p r o d u c t s , w e can

cite the U . S. d r u g i n d u s t r y ' s h i g h l e v e l of i n n o v a t i o n o v e r t h e last

several decades, w h e r e a s i n other areas of the w o r l d w h e r e patents h a v e not existed (the I r o n C u r t a i n countries a n d I t a l y ) i n n o v a t i o n has gene r a l l y n o t b e e n at a v e r y h i g h l e v e l i n the d r u g

field.

T h e l a c k of d a t a

makes it difficult to a n a l y z e p r e c i s e l y the effect of patents o n the d r u g i n d u s t r y i n the U n i t e d States except i n v e r y g e n e r a l a n d s o m e w h a t subjective terms.

It w o u l d a p p e a r that a p r i v a t e enterprise i n d u s t r y c o u l d

not a f f o r d to s p e n d the sums p r e s e n t l y b e i n g spent o n p h a r m a c e u t i c a l research w i t h o u t some h o p e of r e c o u p i n g this i n v e s t m e n t a n d also e a r n i n g a n a d e q u a t e r e t u r n at least e q u a l to alternative f o r m s of i n v e s t m e n t . It is also o b v i o u s to m e that f r o m a p u b l i c p o l i c y s t a n d p o i n t the e c o n o m i c effect of e l i m i n a t i n g d r u g patents or r e d u c i n g the p a t e n t l i f e m u s t b e a n a l y z e d w i t h respect to e x p e c t e d f u t u r e r e t u r n o n the present l e v e l of research i n v e s t m e n t a n d not b a s e d o n the s i t u a t i o n i n the late 1950's or e a r l y 1960's w h e r e returns m a y h a v e b e e n u n u s u a l l y h i g h . Regardless of one's p o s i t i o n o n d r u g patents

it appears that

the

e c o n o m i c s of the research o r i e n t e d d r u g i n d u s t r y , w i t h resultant p a t e n t p r o t e c t i o n , has c r e a t e d a c l i m a t e of p r o d u c t c o m p e t i t i o n rather

than

p r i c e c o m p e t i t i o n . T h e relative r i g i d i t y of d r u g prices has p e r h a p s e n g e n d e r e d as m u c h c r i t i c i s m as the l e v e l of prices. If the i n d u s t r y is to a n s w e r to charges of excessively h i g h prices, objective e c o n o m i c analysis in depth w i l l be required.

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.

262

DRUG DISCOVERY

F u r t h e r , the effect of r i s i n g research costs a n d f e w e r n e w p r o d u c t i n t r o d u c t i o n s has g e n e r a l l y r e d u c e d the n u m b e r of firms w h i c h are able a n d w i l l i n g to enter the research o r i e n t e d p h a r m a c e u t i c a l i n d u s t r y . It is not possible to d e t e r m i n e h o w m a n y firms h a v e b e e n f o r e s t a l l e d f r o m e n t e r i n g the i n d u s t r y because of the h i g h t h r e s h o l d of research e x p e n d i tures; h o w e v e r , it is o b v i o u s that there h a v e b e e n v e r y f e w n e w entries Downloaded by UNIV OF CALIFORNIA SANTA BARBARA on March 30, 2018 | https://pubs.acs.org Publication Date: June 1, 1971 | doi: 10.1021/ba-1971-0108.ch014

into the research o r i e n t e d p a r t of the i n d u s t r y i n the last d e c a d e .

The

d i f f i c u l t y of e n t r y c a n also be u n d e r s c o r e d b y r e m e m b e r i n g the n u m b e r of large c h e m i c a l c o m p a n i e s w h i c h h a v e u n s u c c e s s f u l l y a t t e m p t e d

to

enter the d r u g i n d u s t r y i n the last f e w years. I n a d d i t i o n , p e r h a p s the most successful s m a l l c o m p a n y i n the i n d u s t r y , M a r i o n L a b s , r a t h e r t h a n a t t e m p t i n g to assume the b u r d e n of a l a r g e r e s e a r c h . o p e r a t i o n has a p p a r e n t l y chosen to d e v e l o p research contacts t h r o u g h l i c e n s i n g agreements rather

than incurring

the

large

fixed

costs associated

with

in-house

research.

Promotional Costs It seems that the i n d u s t r y s t i l l continues to suffer f r o m a p o o r econ o m i c i m a g e b r o u g h t o n b y charges of h i g h prices a n d a l a c k of m e a n i n g f u l p r i c e c o m p e t i t i o n . P e r h a p s the A c h i l l e s h e e l of the e c o n o m i c story at the m o m e n t is the l e v e l of p r o m o t i o n a l expenditures w h i c h at a p p r o x i m a t e l y 2 5 % of sales are m o r e t h a n t w i c e the i n d u s t r y ' s c o m m i t m e n t to research. A l t h o u g h the i n d u s t r y m u s t b e c o n v i n c e d that this p r o m o t i o n a l effort is necessary, this category of expenditures is the most difficult to d e f e n d . It also appears that the i n d u s t r y m a y be b u r d e n e d w i t h a somew h a t o u t m o d e d a n d expensive d i s t r i b u t i o n system. A l t h o u g h w e h a v e a l l h e a r d the arguments j u s t i f y i n g p h a r m a c e u t i c a l p r o m o t i o n a n d the present d i s t r i b u t i o n system, it appears that this p r o b l e m m u s t be a t t a c k e d o n t w o f r o n t s : ( 1 ) e v e r y effort m u s t be m a d e t h r o u g h c o o p e r a t i o n b e t w e e n m a n u f a c t u r e r s , wholesalers, a n d retailers to l o w e r the p r o m o t i o n a n d d i s t r i b u t i o n b i l l for the d r u g i n d u s t r y , a n d ( 2 )

in-depth economic sup-

p o r t m u s t be generated to demonstrate the benefits to the c o n s u m e r of the present m a r k e t i n g - d i s t r i b u t i o n c o m p l e x . R e t u r n i n g a g a i n to p h a r m a c e u t i c a l research, i t s h o u l d be a d d e d that the i n d u s t r y has also b e e n w i d e l y c r i t i c i z e d o n the g r o u n d s of m o l e c u l a r manipulation,

me-tooism,

and duplicative programs.

Although

these

charges m a y h a v e c o n t a i n e d some v a l i d i t y i n the late 1950s a n d e a r l y 1960s it seems that the p r o b l e m has b e e n c o r r e c t e d b y r i s i n g r e s e a r c h costs a n d the k n o w l e d g e that c l i n i c a l testing o n a me-too p r o d u c t t o d a y is just as expensive as o n a t r u l y u n i q u e c o m p o u n d . It also appears o b v i ous that the i n t r o d u c t i o n of a satisfactory n u m b e r of u n i q u e c o m p o u n d s w i l l b e necessary to justify the current l e v e l of research e x p e n d i t u r e s .

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.

14.

BLEE

Economic

263

Image

T h e i n d u s t r y has h a d a fine r e c o r d f r o m the s t a n d p o i n t of n e w p r o d u c t i n n o v a t i o n a n d a rather m i s e r a b l e r e c o r d i n e x p l a i n i n g t h e economics of the research

oriented pharmaceutical

firm.

I n short, i t has

spent

b i l l i o n s o n scientific research b u t a p i t i f u l a m o u n t o n e c o n o m i c research, a n d t o d a y it suffers g r e a t l y f r o m a l a c k of m e a n i n g f u l e c o n o m i c i n f o r m a tion, the t y p e of h a r d d a t a necessary to c o n v i n c e a g o v e r n m e n t agency. Downloaded by UNIV OF CALIFORNIA SANTA BARBARA on March 30, 2018 | https://pubs.acs.org Publication Date: June 1, 1971 | doi: 10.1021/ba-1971-0108.ch014

B e c a u s e of the g e n e r a l l y p o o r u n d e r s t a n d i n g of the i n d u s t r y ' s econ o m i c s a n d the s o c i a l overtones r e g a r d i n g a n y aspect of the h e a l t h i n d u s try, it is not s u r p r i s i n g that voices c a l l f o r either the g o v e r n m e n t

to

assume the entire b u r d e n of i n n o v a t i v e d r u g r e s e a r c h or for t h e i n d u s t r y to be treated as a p u b l i c u t i l i t y , r e g u l a t e d w i t h r e g a r d to p r o f i t a b i l i t y a n d r e t u r n o n investment. It w o u l d a p p e a r that there are s t r i k i n g e c o n o m i c differences b e t w e e n the n o r m a l c o n c e p t of a p u b l i c u t i l i t y a n d the d r u g i n d u s t r y as w e k n o w it t o d a y . T h e chief difference centers a r o u n d the t o p i c of this v o l u m e , a n d that is the f a c t that the d i s c o v e r y a n d d e v e l o p m e n t process is the most c r i t i c a l factor i n the p h a r m a c e u t i c a l i n d u s t r y b u t p l a y s a far less i m p o r t a n t r o l e i n p u b l i c u t i l i t i e s . A l s o , the m o n o p o l y v a l u e of a d r u g patent w h i c h c a n lose its e c o n o m i c v a l u e i n s t a n t l y u p o n the d e v e l o p m e n t of u n e x p e c t e d side effects, or t h r o u g h the i n t r o d u c t i o n of a s u p e r i o r p r o d u c t b y a c o m p e t i t o r , is c o n s i d e r a b l y different f r o m t h e r e l a t i v e l y absolute m o n o p o l y a c c o r d e d the t y p i c a l p u b l i c u t i l i t y .

W e m u s t also

w o n d e r w h e t h e r c a p i t a l c a n b e attracted i n t o the h i g h r i s k g a m e of n e w p r o d u c t research u n d e r c o n d i t i o n s of r e g u l a t e d p r o f i t a b i l i t y a n d r e t u r n o n investment. I n d e e d , even u n d e r present free enterprise c o n d i t i o n s , w e w o n d e r w h e t h e r the h i g h costs a n d risks of d o i n g n e w p r o d u c t research a n d the risks of i n c r e a s i n g g o v e r n m e n t i n t e r v e n t i o n h a v e not s u b s t a n t i a l sums to be

caused

a l l o c a t e d out of p h a r m a c e u t i c a l research

and

i n v e s t e d i n d i v e r s i f i c a t i o n o p p o r t u n i t i e s , s u c h as, cosmetics, c l i n i c a l l a b o ratories, a n d m e d i c a l instruments. T a b l e s I I I a n d I V estimate, i n a v e r y b r o a d sense, h o w m u c h of a p r i c e r e d u c t i o n it w o u l d take to l o w e r the d r u g i n d u s t r y ' s r e t u r n o n s h a r e h o l d e r s ' e q u i t y to e q u a l the electric u t i l i t y i n d u s t r y .

Using U.S.

g o v e r n m e n t figures f o r the d r u g i n d u s t r y a n d the E d i s o n E l e c t r i c Institute d a t a o n electric u t i l i t i e s , I h a v e d e v e l o p e d a statistical c o m p a r i s o n bet w e e n the t w o i n d u s t r i e s . T h e

financial

ratios are q u i t e different w i t h

respect to profit m a r g i n s a n d c a p i t a l r e q u i r e m e n t s .

F o r example,

the

d r u g i n d u s t r y , often c r i t i c i z e d for h a v i n g h i g h profit m a r g i n s , realizes a b o u t $19 pre-tax profit o n e a c h $100 of sales, whereas the electric u t i l i t y i n d u s t r y realizes a b o u t $23 f o r e a c h $100 of sales.

O n the other h a n d ,

s h a r e h o l d e r s ' e q u i t y is $50 f o r the d r u g i n d u s t r y c o m p a r e d w i t h $120 f o r electric u t i l i t i e s o n e a c h $100 of sales.

C o m b i n i n g the p r o f i t a n d invest-

m e n t figures p r o d u c e s a r e t u r n o n shareholders e q u i t y , b e f o r e taxes, of

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.

264

DRUG DISCOVERY

a p p r o x i m a t e l y 3 7 % for the d r u g i n d u s t r y a n d 1 9 % f o r the electric u t i l i t y industry.

A l t h o u g h there

w o u l d appear

to b e

a considerable

spread

b e t w e e n the t w o rates of r e t u r n , i f the d r u g i n d u s t r y sales l e v e l w e r e r e d u c e d b y just 9 % , the r e s u l t i n g r e t u r n o n i n v e s t m e n t w o u l d b e e q u a l to the electric u t i l i t y i n d u s t r y , or a p p r o x i m a t e l y 1 9 %

before taxes

(see

Table III). Downloaded by UNIV OF CALIFORNIA SANTA BARBARA on March 30, 2018 | https://pubs.acs.org Publication Date: June 1, 1971 | doi: 10.1021/ba-1971-0108.ch014

Into the i n v e s t m e n t base for the d r u g i n d u s t r y s h o u l d b e i n c o r p o r a t e d the research a n d d e v e l o p m e n t investment.

U s i n g what I consider

to b e the m o r e r e a l i s t i c r e t u r n o n shareholders' e q u i t y f o r the d r u g i n d u s try, that is, w i t h R & D i n c l u d e d i n the i n v e s t m e n t base, i t w o u l d r e q u i r e only a 6.5%

r e d u c t i o n i n d r u g i n d u s t r y prices to l o w e r the r e t u r n o n

investment to the same l e v e l as the electric u t i l i t y i n d u s t r y — i . e . , T a b l e I V ) . W h e n i t is r e a l i z e d that out of the 9 % or 6 . 5 %

(see

d e p e n d i n g u p o n one's preference,

19%

savings,

that the g o v e r n m e n t takes a p p r o x i -

m a t e l y 5 0 - 5 2 % i n taxes, the a c t u a l s a v i n g to society is p r o b a b l y a b o u t h a l f of the pre-tax r e d u c t i o n or b e t w e e n 3 a n d 4 . 5 % . figures

A l t h o u g h these

are u s e d i n an i l l u s t r a t i v e sense, this c o m p a r i s o n underscores m y

b e l i e f that ( 1 ) r e t u r n o n i n v e s t m e n t is the v a l i d r a t i o w h e n c o n s i d e r i n g r e l a t i v e p r o f i t a b i l i t i e s of v a r i o u s i n d u s t r i e s , ( 2 ) w i t h R & D c o n s i d e r e d as Table III.

Adjustment of D r u g Industry Return on Equity to Equal Electric Utilities" Drug Industry

Electric

Utilities

Sales

$100.00

$100.00

Pre-tax profit

$ 18.60

$

Shareholder's e q u i t y per $100.00 sales

$ 50.00

$120.00

Pre-tax return on shareholder's i n v e s t m e n t

37.2%

Reduce drug industry sales b y 9 % = $9.00 adjusted sales

$ 91.00

$100.00

A d j u s t e d p r e - t a x profit

$

$

Adjusted pre-tax r e t u r n on e q u i t y

19.3%

9.60

23.10

19.3%

23.10

19.3%

Assumptions (1) (2)

Sales are $100.00 per y e a r . A l l costs r e m a i n c o n s t a n t ; therefore, a r e d u c t i o n i n sales produces an equivalent reduction i n pre-tax profit.

"Source: Drug industry ratios: ( 1 0 ) . Electric utility ratios: ( 1 2 ) .

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.

14.

BLEE

Economic Table IV.

265

Image

Adjustment of D r u g Industry Return on Equity to Equal Electric Utilities"

D r u g Industry E q u i t y Adjusted for R and D

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Drug Industry

Electric

Utilities

Sales

$100.00

$100.00

Pre-tax profit

$ 18.60

$

Shareholder's e q u i t y per $100.00 sales ( adjusted for R&D)

$ 63.00

$120.00

Pre-tax return on C o m m o n e q u i t y

30.0%

23.10

19.3%

Reduce drug industry sales b y 6 . 5 % = $6.50 A d j u s t e d sales

$ 93.50

$100.00

A d j u s t e d p r e - t a x profit Adjusted pre-tax r e t u r n on e q u i t y

$ 12.10

$

19.3%

23.10

19.3%

Assumptions (1) (2) (3)

Sales are $100.00 per y e a r . A l l costs r e m a i n c o n s t a n t ; therefore, a r e d u c t i o n i n sales produces an e q u i v a l e n t r e d u c t i o n i n p r e - t a x p r o f i t . D r u g i n d u s t r y net r e t u r n on shareholder's e q u i t y = 15.2% = 3 0 . 0 % p r e - t a x r e t u r n , as adjusted for c a p i t a l i z a t i o n of R & D , per Table II.

"Source: Drug industry ratios: ( 1 0 ) . Electric utility ratios: (12). p a r t of the investment base, i t appears that o n l y a modest r e d u c t i o n i n the d r u g i n d u s t r y p r i c i n g l e v e l w i l l have a rather sharp effect o n r e t u r n o n investment, a n d ( 3 )

w h e n v i e w e d i n this l i g h t , it appears that

the

r e l a t i v e p r o f i t a b i l i t y of the d r u g i n d u s t r y is not n e a r l y as h i g h as other c o m p a r i s o n m a y h a v e suggested.

Summary I w o u l d u r g e the d e v e l o p m e n t of h a r d e c o n o m i c analysis, e x p l o r i n g i n d e p t h m a n y of the theories w h i c h are b e i n g a d v a n c e d w i t h r e g a r d to the economics of the d r u g i n d u s t r y today.

F u r t h e r , I b e l i e v e a sizeable

c r e d i b i l i t y gap exists t o d a y b e t w e e n the industry's c o n c e p t of its econ o m i c structure a n d the v i e w of the g o v e r n m e n t a n d the g e n e r a l p u b l i c . T h e i n d u s t r y has h e l p e d to create this gap b y f a i l i n g to u n d e r s t a n d its own

unique

economic

characteristics.

Industry

accounting

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.

practices

266

DRUG

DISCOVERY

w h i c h i m p r o p e r l y h a n d l e t h e s u b s t a n t i a l research a n d d e v e l o p m e n t i n vestment h a v e served to i n t e n s i f y the g a p b e t w e e n those i n t h e i n d u s t r y a n d t h e v i e w f r o m outside.

F u t u r e emphasis m u s t b e d i r e c t e d t o w a r d

c l o s i n g this c r e d i b i l i t y g a p a n d r e o r i e n t i n g e c o n o m i c t h i n k i n g t o w a r d the present a n d f u t u r e e c o n o m i c structure of p h a r m a c e u t i c a l i n n o v a t i o n ,

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r e l i e v i n g society f r o m o u t d a t e d concepts of the past.

Literature Cited (1) Clymer ,Harold, "The Changing Costs of Pharmaceutical Innovation," in "The Economics of Drug Innovation," Joseph Cooper, Ed., p. 109, The American University, Washington, D. C., 1969. (2) Mansfield, Edwin, "Discussion," in "The Economics of Drug Innovation," p. 149. (3) Mund, Vernon, "The Return on Investment of the Innovative Pharmaceutical Firm," in "The Economics of Drug Innovation," p. 125. (4) Schulman, Rosalind, "Discussion," in "The Economics of Drug Innovation," p. 213. (5) Fisher, I., Hall, G., "Risk and Corporate Rates of Return," The Congressional Record, U. S. Senate (90), Part 5, pp. 2120-2129. (6) Markham, Jesse, Conrad, Gordon, The Congressional Record, U. S. Senate (90), Part 5, pp. 1674-1678. (7) Mueller, Willard, The Congressional Record, U. S. Senate (90), Part 5, pp. 1809, 1816. (8) Task Force on Prescription Drugs, Second Interim Report and Recommendations, U. S. Department of Health, Education, and Welfare, Washington, D. C., 1968. (9) DeHaen, Paul, New Drug Parade, Paul DeHaen, New York, 1969. (10) "Quarterly Financial Report for Manufacturing Corporations," Federal Trade Commission-Securities and Exchange Commission, Washington, D. C., 1969. (11) "Annual Survey Report, 1968-69," Pharmaceutical Manufacturer's Association, Washington, D. C. (12) "Statistical Year Book of the Electrical Utility Industry," Edison Electric Institute, New York, 1969. RECEIVED November 5, 1970.

Bloom and Ullyot; Drug Discovery Advances in Chemistry; American Chemical Society: Washington, DC, 1971.