Tricks of the Trade: The Reality of Drug Company Profits
Financial accounting is a tool capable of great insight or, in the wrong hands, abuse. Just ask the employees of former economic giants such as Enron, WorldCom, or Global Crossing. The lack of transparency in their accounting practices resulted in the harshest market discipline: bankruptcy.
A poor understanding of its uses, however, can also create problems where none exist. This may well be the case with the pharmaceutical industry. The industry has come under scrutiny both nationally and here in Ohio, where a recent petition drive seeks to pressure the legislature into enacting price caps on drugs. The idea that this industry is a profit-hungry beast that needs to be tamed through regulation is a persistent one, and the petition backers are not alone in their concerns.
Take a report issued last year by the “watchdog” group Public Citizen. The title seems to tell the tale: “Pharmaceuticals Rank as Most Profitable Industry, Again”. In reality, however, while drug companies are profitable, they aren’t nearly as successful as the report implies
Drug companies compete in a very dynamic and challenging economic environment. Uncertainty, long lead times, and dramatic swings in year-to-year revenues (and, hence, profits) wreak havoc on the drug industry’s balance sheet.
The process of developing new treatments can now reach 10 to 15 years, and few potential drugs survive the weeding out phase. Out of every 5,000 compounds screened for pre-clinical testing, only 20 enter human trials. A tortuous regulatory process compounds these uncertainties. Only one in five drugs surviving clinical trials will ever make it to market.
In an industry where less than 1 percent of all compounds will make it to market, and only a few of those become “blockbuster” drugs, looking at revenues over just a year or two can’t possible capture the health of the industry. Perhaps not surprisingly, no pharmaceutical company can claim more than 10 percent of the market, a fact ignored in many claims of persistent profitability in this industry.
Reports such as Public Citizen’s are used to raise the specter of a profit hungry industry willing to abuse consumers. Such concerns can then translate into legislation if political action is taken on issues such as the petition before Ohio policymakers. The results have implications for health care costs for all of us.
In reality, the true profits associated with the industry are lower than their claims while the costs of production are much greater. Profits are not inherently evil, and the mere existence of profits in one or two years should not be used as a smear tactic for short-term political gain. Moreover, even casual observers of the industry would recognize that a two-year revenue stream is a strikingly inadequate window for capturing a meaningful picture of the drug industry’s profitability.
Higher than average profits in one year are simply the payoff for enduring an uncertain, lengthy, and high risk activity that ultimately benefits society through better and cheaper health care. Ohio policymakers should use caution before putting the brakes on this process. Profits provide the incentive for pharmaceutical companies to invest in the next breakthrough drug. Everyone is better off when they do.
