The Los Angeles Times’s Michael Hiltzik finds a study that questions the drug lobby’s line on how much it costs to develop medicines:
The statistic that may be most hazardous to your health is one pegging the research and development cost of bringing a new drug to market at $1.3 billion. Its purveyor is the Pharmaceutical Research and Manufacturers of America (PhRMA), which exploits the number’s shock value to secure its lobbying agenda on Capitol Hill….
The industry’s R&D claim has been questioned for years, but seldom as thoroughly as in a recently published paper that calculates the true mean R&D cost as less than $60 million per drug in 2000 dollars ($76 million today).
The study’s authors, Donald W. Light of the University of Medicine and Dentistry of New Jersey and Rebecca Warburton of the University of Victoria in Canada, systematically dismantle what they call “the wholly artificial ‘fact’ of average R&D costs per new drug” by removing inflated multipliers and calculating the tax breaks drug companies get for their R&D, among many other steps.
The author of the original study defends himself, of course, and a lesser columnist would have left us hanging at the he said/she said stage. But Hiltzik shows that the $1.3 billion figure—or at least how the industry uses it— is seriously phony. Besides not revealing the data it’s based upon, which means it can’t be verified, there’s this:
Another issue is that the cost figure produced by DiMasi and his team includes “opportunity costs” — that is, the potential income the drug companies might have made on other investments, such as equity securities, if they hadn’t bothered to tie their money up for years developing drugs and getting them to market. The authors essentially doubled their calculations of out-of-pocket spending to accommodate these speculative lost profits. By financial alchemy, in other words, they made $403 million in tangible spending look like $802 million.
Excellent.
— The Wall Street Journal would like you to know, in an A4 headline, that:
Public-College Presidents Score Raises
An outrage! This is a time of belt-tightening for everybody else, except for top executives. Like ConocoPhillips’s CEO, whose paycheck jumped a quarter to $18 million. Or Ford’s CEO, whose takehome soared by half to $27 million. As the Journal itself reported a couple of weeks ago:
CEO bonuses at 50 major corporations jumped a median of 30.5%, the biggest gain in at least three years, according to a study of the first batch of corporate CEO pay disclosures by consulting firm Hay Group for The Wall Street Journal.
So how big a raise did these public-college presidents “score”?
One percent. To a median $444,000 among 185 “large public universities.”
— Vivian Schiller, the recently deposed CEO of NPR and self-described “antipay wall zealot” is changing her tune on charging for news. Romenesko has her speech:
The conditions are finally right to give newspaper pay walls a fair shake
This is the first time I’ve felt this way, and possibly the first time I’ve said this in a public setting. Back In 2007, that’s a generation ago in internet time, I was at NYTimes.com and a free content absolutist. That was the year my colleagues and I led the effort to end Times Select. (You may recall that Times Select completely locked out the columnists and the archive to all but paying subs. It was not the metered model The Times is launching now. Then, you were a home delivery subscriber, a paying digital subscriber - the no Tom Friedman for you) I was an antipay wall zealot, and for good reason…..based on the conditions of that time. But times have changed:
Ryan Says "Another issue is that the cost figure produced by DiMasi and his team includes “opportunity costs” — that is, the potential income the drug companies might have made on other investments, such as equity securities, if they hadn’t bothered to tie their money up for years developing drugs and getting them to market. The authors essentially doubled their calculations of out-of-pocket spending to accommodate these speculative lost profits. By financial alchemy, in other words, they made $403 million in tangible spending look like $802 million."
Grrrr. I hate to defend big pharma, but this is basic finance 101 stuff and really shows the blind spot that so many journalists have with numbers (as do the so-called economists who did the study).
The cost of financing any long-term capital investment is always a substantial part of its overall cost and drug research is no different. Financing costs are not "opportunity costs," they're actual costs of financing a risky project.
Consider a project to build a house that takes a year. You can't live in the house until it's done, but the interest on the money you borrow to built it starts accumulating right away.
Now imagine if the same house took 10 years to build. Those financing costs would sure add up.
Any time an investment project drags out for many years, such as drug research, a lot of money is spent years before any revenue rolls in. No matter what your capital structure (equity vs debt), using money today that doesn't generate a return for several years into the future is very expensive.
Typically, companies use their weighted average cost of capital to set the discount rate to analyze investment projects. Again, this is finance 101 and the same approach is used to analyze costs and benefits for any capital project in any industry. The idea that pharma is doing something unusual here is silly.
The important distinction is that the discount rate that's used in these calculations isn't an "opportunity cost," it's the firm's actual cost of capital. The study's authors make it sound like this is some weird financial alchemy that drug companies just made up, but this is the predominant model used worldwide for capital budgeting.
For a real-world example of another industry that does this in a similar way, take a look at power plant projects. They have a very similar front-loaded capital spending model, so cost of capital is a big deal. In the case of regulated monopoly power plant projects, the entire financial analysis including the discount rate is usually publicly available.
Jim
#1 Posted by Jim, CJR on Mon 4 Apr 2011 at 09:57 PM
+1 Jim,
"Excellent."? Seriously? More like borderline financially illiterate. The cost of capital is not "financial alchemy."
Elsewhere in the same LA Times article, the author uses another favorite of mine, referring to the billions in profits at the major companies as evidence that these costs must be overstated. I'm sure, however, that those profits are not net of the capital completely lost on investments in small drug biotech companies that spent millions to develop one drug, failed, and went under. Just totalling up the profits of the successful companies effectively amounts to cherry-picking. Taken as a whole, biotech does not perform particularly better or worse than other industries, it just has big winners and big losers. That's part of the reason the cost of capital is so high - in order to get people to lend you money, you need to provide them with a substantial return, because the risk that your drug will just fail and they will lose everything is also high.
Ryan, it's tough for me to believe you don't know this stuff. I don't like Big Pharm either, but that wouldn't inspire me to dub ignorant reporting like this "Excellent." Quite the opposite.
#2 Posted by Steve, CJR on Wed 6 Apr 2011 at 05:48 AM
Jim, Steve,
I understand opportunity costs. The question is whether they deserve to be included in this study. Here's what Hiltzik said in the following graph:
That all seems about right to me.
And Steve, Hiltzik didn't use high profit margins as evidence that the costs are overstated. He was talking about them to show how the opportunity-cost thing was fallacious:
"In any case, the profit margins of major drug companies have been running as high as 49%, which suggests that the industry makes a lot more from developing and selling drugs than it could in the stock market. A Big Pharma CEO who earns even 10% on stocks and bonds while his rivals earn 49% by hawking painkillers and sedatives will become an ex-CEO faster than you can say "9 out of 10 doctors recommend."
#3 Posted by Ryan Chittum, CJR on Fri 8 Apr 2011 at 05:41 PM