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The Drug Industry’s Profits and R&D Investment
By standard accounting measures, the pharmaceutical industry consistently ranks as one of the most profitable industries in the United States. Those measures, however, treat most R&D outlays as expenditures rather than as investments that add to the value of a firm. Thus, they omit from a firm’s asset base the value of its accumulated stock of knowledge. For R&D-intensive industries, such as pharmaceuticals, that omission can significantly over-state profitability. Adjusted for the value of its R&D assets, the drug industry’s actual profitability still appears to be somewhat higher than the average for all U.S. industries, but not two to three times higher, as standard measures of profitability indicate. The notion that pharmaceutical companies enjoy extra-ordinary profits is reinforced by the relationship between prices and costs in the drug industry. The industry’s high R&D spending and relatively low manufacturing costs create a cost structure similar to that of, for example, the software industry. Both industries have high fixed costs (for research and development) and low variable costs (to put a software application onto a CD-ROM or to produce a bottle of prescription medication). Consequently, prices in those industries are usually much higher than the cost of providing an additional unit of the product, because revenue from sales of the product must ultimately cover those fixed costs. Even though conventional accounting measures overstate the profitability of the drug industry, strong growth in the industry’s R&D spending over many years suggests that the returns on pharmaceutical R&D have been attractive. Ultimately, how adequately prices and profits indicate the kinds of drugs that consumers want to buy determines the extent to which the pace and direction of drug innovation are themselves adequate. High prices on new drugs encourage continued innovation. But because health insurance (private plans as well as Medicaid and Medicare) keeps consumers from bearing the full weight of those prices, the demand for new drugs is higher than it otherwise would be at any given price. That effect is magnified because employment-based health insurance benefits are not subject to income or payroll taxes, which reduces their cost to consumers. As a result, more people have health insurance, and many have higher levels of coverage, than would be the case otherwise. Strictly speaking, a product’s fixed development costs are not relevant to how it is priced because they are sunk (already incurred and not recoverable) before the product reaches the market. But a company incurs R&D costs in expectation of a product’s likely price, and on average, it must cover those fixed costs if it is to continue to develop new products. The effect of health insurance on drug companies’ revenues—combined with strong patent protection that helps firms maintain higher prices—may sometimes create incentives to invest too much in R&D (from the stand-point of the amount of investment that is optimal for society). The role of health insurance can be tempered in several ways, however. Insurers and other large buyers of drugs may be able to exercise more power to negotiate lower prices, and insurers can give patients and doctors stronger incentives to consider price differences between drugs. The more accurately a drug’s price reflects its value to consumers, the more effective the market system will be at directing R&D investment toward socially valuable new drugs. However, prices can only serve that directing role to the extent that good information exists about the comparative qualities of different drugs and that consumers and health care providers use that information.
The pharmaceutical industry spends more on research and development, relative to its sales revenue, than almost any other industry in the United States. According to various estimates, the industry’s real (inflation-adjusted) spending on drug R&D has grown between threefold and sixfold over the past 25 years— and that rise has been closely matched by growth in drug sales. Despite those increases, there has been little change in the number of innovative new drugs approved for use each year, even though the federal government has streamlined its drug-approval process. Only about one-third of the drugs approved annually in the United States are new compounds; the rest represent modified forms of—or new uses for—existing drugs. Firms develop new drug products in response to various factors. Those factors relate not only to likely demand in a given drug market—which is influenced by available health insurance coverage, doctors’ prescribing practices, and demographic changes—but also to government pol-icy toward drug safety and innovation and to the pace of scientific advances in the understanding and treatment of disease.
Spending for Research and Development
In 1980, U.S. companies spent a total of $5.5 billion (in 2005 dollars) on research and development of pharma-ceuticals and medicines, according to the National Science Foundation (NSF). By 2003, that figure had grown to more than $17 billion—an average increase of 5 per-cent per year in real terms. The pharmaceutical industry’s trade association, Pharmaceutical Research and Manufacturers of America (PhRMA), reported even larger expenditures and faster growth. Spending by its member organizations rose more than sixfold between 1980 and 2004, from about $6 billion (in 2005 dollars) to $39 billion. Those figures represent a real growth rate of about 8 percent a year, on average. By comparison, drug firms’ gross margins—sales revenue minus costs and income taxes—have been increasing more slowly, by about 4 percent annually. The differences between NSF’s and PhRMA’s estimates of R&D spending stem largely from differences in which drug companies are included in the samples and which expenditures are counted. PhRMA’s totals include all R&D spending in the United States by the association’s members (foreign and domestic) as well as expenditures abroad by U.S. firms and U.S. divisions of foreign firms. Spending by foreign companies that occurs outside the United States is excluded. NSF’s totals cover only domes-tic R&D spending by firms “engaged in for-profit activity in the United States.” They exclude all research and development not conducted in the United States, including that performed by foreign subsidiaries of U.S. firms or by other foreign organizations.
1. For comparison with NSF’s numbers, total R&D spending by PhRMA members in 2003 was $37.6 billion in 2005 dollars (including $29.6 billion for domestic R&D by U.S. firms). PhRMA estimates that total R&D spending by the drug industry, including nonmember firms, was $49 billion in 2004, the first year the association estimated that total. Overall R&D spending by PhRMA members has grown even though the number of members has fallen by more than half since the early 1990s (to 34 organizations in 2004). Mergers account for some of that decline.
2. F.M. Scherer, “The Link Between Gross Profitability and Pharmaceutical R&D Spending,” Health Affairs, vol. 20, no. 5 (September/October 2001), pp. 216-220.
3. National Science Foundation table, “Company and Other (Except Federal) Funds for Industrial R&D Performance, by Industry and by Size of Company: 1953–98,” notes section, and “Technical Notes for 1998,” available at www.nsf.gov/statistics/iris/excel-files/ NSF%2001-305/tn.doc. Note: Spending was adjusted for inflation using the biomedical research and development price index from the Bureau of Economic Analysis.
a. Expenditures reported by members of the Pharmaceutical Research and Manufacturers of America (PhRMA). Unlike the National Science Foundation data, PhRMA’s estimates include research and development performed outside the United States by U.S. companies (or U.S. divisions of foreign companies) as well as further research and development that occurs after a drug has gone on the market. The data come from Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 2006 (Washington, D.C.: PhRMA, March 2006).