At the Intersection of Health, Health Care and Policy

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Cite this article as:
F.M. Scherer
The Link Between Gross Profitability And Pharmaceutical
R&D Spending
Health Affairs 20, no.5 (2001):216-220
doi: 10.1377/hlthaff.20.5.216

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 H E A L T H T R A C K I N G : T R E N D S

The Link Between Gross

Profitability And

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Pharmaceutical R&D Spending
An analysis that answers the question: What does the pharmaceutical
industry really do with its profits?
b y F. M . S c h e r e r

S
i n c e t h e l a t e 1 9 5 0 s , when the
Kefauver Committee investigated the
business practices of U.S. pharmaceuti-
cal companies, representatives of that indus-
try have argued that its profits are an impor-
tant stimulus to, and source of funding for,
research and development (R&D)which in
turn leads to a stream of health-enhancing
216 new products. Although the argument is
plausible on its face, quantitative evidence on
the robustness of the linkage has been scarce.
This paper reports the results of a simple data
analysis yielding surprising new insights.
Profitability and investments in R&D can,
in principle, be linked in three rather different
ways. First, successful R&D leads, with long
and variable lags, to new products, which, de-
pending upon their reception in the market,
can add greatly to company profits. The dis-
tribution of profit outcomes, as research by
Henry Grabowski and John Vernon has
shown, is highly skewed.1 A minority of new
products confer blockbuster profits, while the
majority return less than the capitalized cost
of R&D, including the cost of failed projects.
Second, the profits earned by a company
serve as a source of funds to support R&D
investments, and some managers are known
to set R&D budgets using rules of thumb em-
phasizing an indicator of current cash flow or
sales. To be sure, as recent experience in
biotechnology shows, funds for R&D can also
be raised through new capital issues. Prior
tests of the hypothesis of internally generated
funds have yielded mixed results. For most
well-established corporations, R&D spend-
ing is not greatly dependent upon internal
cash flow, but small high-tech enterprises
before the 1990s venture capital boomand
the research-intensive pharmaceutical indus-
try were probable exceptions.2 Third, manag-
ers expectations of future profit opportuni-
ties, which are tempered, inter alia, by
contemporary market conditions, can exert a
demand-pull influence on R&D investments.3
Testing how well these relationships hold
for investments in pharmaceutical R&D is
rendered difficult by the complex structure of
the leading pharmaceutical companies. They
operate within a wide variety of fields in addi-
tion to ethical drugsfor example, pharmacy
benefit management, herbicides and pesti-
cides, medical instruments and supplies,
prosthetics, hair care products, dental prod-
ucts, and nutritional products. The more di-
versified companies almost never publish
R&D outlay breakdowns subdivided among
these fields, and they seldom report their op-
erating margin results in enough detail to re-
late R&D indices with any precision to meas-
ures of profitability.
An alternative approach, and the one used
here, is to analyze data on R&D investment
and profits at the aggregated industry level.

F.M. Scherer is Aetna Professor of Public Policy Emeritus at Harvard Universitys Kennedy School of
Government and a lecturer in public affairs at Princeton University.

H E A L T H A F F A I R S ~ V o l u m e 2 0 , N u m b e r 5
2001 Project HOPEThe People-to-People Health Foundation, Inc.
 H E A L T H
The principal industry trade association,
Pharmaceutical Research and Manufacturers
of America (PhRMA), conducts an annual
survey, from which one can obtain a continu-
ous data series on PhRMA members ethical
drug R&D outlays extending back to the
early 1960s (Exhibit 1).
n Time-series analysis. Examination of
Exhibit 1 reveals why the usual techniques of
time-series analysis used by economists work
poorly in ascertaining the links between
R&D and profitability. Those methods focus
on year-to-year changes in the variable of in-
terest. But there are few sharp changes in the
spending path from year to year and, accord-
ingly, few true degrees of freedom necessary
for a standard time series analysis.4 Rather,
one sees gradual swings in actual R&D
spending around a best-fitting long-term
R&D time trend, assuming steady exponen-
tial growth. The trend line implies growth in
inflation-adjusted spending at an average rate
of 7.5 percent per year.
The most closely comparable aggregate
time-series measure of industry profitability
is derived from Census of Manufactures and An-
nual Survey of Manufactures data from the U.S.
Census Bureau. It is computed as sales less
outside materials purchases, payroll outlays,
and employee fringe benefitsincluding
EXHI BIT 1
Pharmaceutical Industry Research And Development (R&D) Outlays Against Exponential
Time Trend, 19621996
Millions of 1992 dollars
16,000
12,000
8,000
4,000
0
1962 1970
SOURCES: Pharmaceutical Research and Manufacturers of America, Industry Profile: 1998 (Washington: PhRMA, July 1998); and
PhRMA, Annual Survey Report: 198385 (Washington: PhRMA, 1986).
NOTE: Outlays have been adjusted for inflation, using the deflator for U.S. gross domestic product, with 1992 as the base year.
H E A L T H A F F A I R S
T R A C K I N G : T R E N D S
those mandated by law along with voluntary
benefits. As such, it is best described as a
measure of pharmaceutical manufacturing
plants gross marginsthat is, the surplus of
revenues over in-plant production costs avail-
able to cover R&D costs along with deprecia-
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tion, marketing costs, central office costs,
debt service costs, income taxes, and net prof-
its. The coverage match between ethical drug
R&D outlays and this gross margin measure
is not perfect, as the census universe under
the Standard Industrial Classification (SIC)
code 2834Pharmaceutical Preparations
also includes less research-intensive over-the-
counter drugs, generic drugs, and some vita-
min formulations.5 Fringe benefit outlays,
amounting to 3.68 percent of gross margins in
1967, had to be estimated by extrapolation for
19621966, imparting possible inaccuracies in
the gross margin measure too small to affect
the results reported here.
n Gross margins versus R&D outlays.
The growth rate of deflated gross margins was
4.23 percent per yearmuch lower than the 217
7.51 percent growth rate found for R&D out-
lays (Exhibit 2). The disparity of growth rates
implies a likely slackening of R&D growth
rates in the future. If R&D were covered
solely by domestic gross margins, continu-
ation of growth trends experienced since 1962
R&D outlays
Time trend
1980 1990 1996
~ S e p t e m b e r / O c t o b e r 2 0 0 1
 H E A L T H T R A C K I N G :
EX HI BI T 2
Pharmaceutical Industry Gross Margins Against Exponential Time Trend, 19621996
Millions of 1992 dollars
40,000
30,000
20,000
10,000
0
1962 1970
SOURCES: U.S. Bureau of the Census, Census of Manufactures: 1992, and Annual Surveys of Manufactures, various years.
would mean that R&D outlays would exceed
gross margins in the year 2025. To be sure,
profits from overseas sales also help to repay
R&D costs, but since the United States is the
largest single market for U.S. drug companies
products, retardation of R&D growth rates
218 seems likely in the long run.
As in the R&D time series, pharmaceutical
industry gross margins exhibit long swings
around their exponential time trend. To some
extent, coincidence in the timing of the
swings can be seen by comparing Exhibits 1
and 2. However, the relationships are brought
into sharper focus by computing the percent-
age deviations of actual R&D outlays and
gross margins from their exponential time
trend values.6 The resulting trend deviation
series are juxtaposed in Exhibit 3.
The degree of coincidence was, at least to
this investigator, surprisingly close. The sim-
ple Pearsonian correlation between the two
time series is +0.92. Deviations from trend
values rise and fall in tandem. The swings are
so closely correlated that it would be implau-
sible to infer a chain of causation running
from R&D to profits, since lags of ten to fif-
teen years from peak R&D spending to peak
profitability for new products are typical.7 At
two of the three clear turning points, reversals
in the R&D spending series precede reversals
in the gross margin series by a year or two.
This is superficially inconsistent with a hy-
pothesis that changes in gross margins drive
H E A L T H A F F A I R S
T R E N D S
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Gross margins
Time trend
1980 1990 1996
changes in R&D spending. However, the
paradox diminishes if decisionmakers are able
to foresee changes in general industry condi-
tions two or more years into the futurefor
example, recognizing that the rational drug
design approaches, demonstrated by the in-
troduction of Tagamet in 1977, presaged in-
creasingly rich opportunities for profitable
new product development.
Sensitivity tests revealed that the patterns
observed in Exhibit 3 persist when domestic
R&D outlays, a time series available only be-
ginning in 1970, are substituted for worldwide
R&D outlays, and when fringe benefit out-
lays, reported by the Census Bureau only be-
ginning in 1967, are not deducted in calculat-
ing gross margins.
It is conceivable, as one referee suggested,
that the cycles observed here reflect spuri-
ously correlated changes in industry aggre-
gates, for example, as a result of differences in
sample coverage between the trade associa-
tion and Census Bureau universes. To test this
possibility, a further analysis correlated trend
deviations in variables defined as ratios, with
no intermingling of trade association and cen-
sus universe data for a given ratio. For R&D,
the relevant ratio was worldwide R&D out-
lays, divided by worldwide sales of trade asso-
ciation members in any given year. The
PhRMA sales variable was not used in the
previous analysis. For gross margins, the rele-
vant ratio was the gross margin, as defined for
~ V o l u m e 2 0 , N u m b e r 5
 H E A L T H T R A C K I N G : T R E N D S

EX HI BI T 3
Percentage Deviations From Trend For Pharmaceutical Industry Gross Margins And
Research And Development (R&D) Outlays, 19621996
Percent deviation
20

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Gross margins
10

R&D outlays
-10

-20

-30
1962 1970 1980 1990 1996
SOURCES: Pharmaceutical Research and Manufacturers of America, Industry Profile: 1998 (Washington: PhRMA, July 1998),
and Annual Survey Report: 198385 (Washington: PhRMA, 1986); and U.S. Bureau of the Census, Census of Manufactures:
1992, and Annual Surveys of Manufactures, various years.
NOTE: Percentages were figured using constant 1992 dollars.

Exhibit 2, divided by the total value of plant
shipments, a rough Census Bureau surrogate
for sales, which can double-count interplant
shipments. For the time series of each vari-
able, a best-fitting linear trend was estimated.
A linear trend was used because, as variables
with a distinct upper bound, the two ratios
could not plausibly sustain exponential 219
growth for any extended period. Percentage
deviations from these best-fitting linear
trends were computed (Exhibit 4). Except
during the early 1960s, their movements over

EXHI BI T 4
Percentage Deviations In Research And Development (R&D) As A Percentage Of Sales
And Price-Cost Margins As A Percentage Of Census Sales, 19621996
Percent deviation
20

10

0 Gross margins

-10

R&D outlays
-20

-30
1962 1970 1980 1990 1996
SOURCES: Pharmaceutical Research and Manufacturers of America, Industry Profile: 1998 (Washington: PhRMA, July 1998),
and Annual Survey Report: 198385 (Washington: PhRMA, 1986); and U.S. Bureau of the Census, Census of Manufactures:
1992, and Annual Surveys of Manufactures, various years.
NOTE: Percentages were figured using constant 1992 dollars.

H E A L T H A F F A I R S ~ S e p t e m b e r / O c t o b e r 2 0 0 1
 H E A L T H T R A C K I N G : T R E N D S

time are similar to and consistent with those classification, the North American Standard In-
of Exhibit 3. Their simple correlation is 0.863. dustrial Classification, was adopted by the U.S.
Census Bureau in that year. Using splice data
Given the internally consistent industry sam- provided by the Census Bureau for 1997, one
ple frames but different trend measurement finds that constant-dollar gross margins for the
assumptions used for Exhibit 4 compared industry, as defined in 1996, probably rose by
with Exhibit 3, the similarity of trend devia- approximately 11.9 percent relative to 1996. Con-
tion patterns suggests that there was indeed stant-dollar R&D outlays rose by 10.6 percent.
The census universe excludes production in
cyclical comovement in pharmaceutical in- Puerto Rico, which is an important source of
dustry gross margins and R&D outlays. U.S. pharmaceutical products.
n A virtuous rent-seeking model. Thus, 6. For example, for R&D, the calculation is
a robust pattern persists. Combined with evi- [(R&DTrend)/Trend] 100.
dence that profit rates of return on pharma- 7. See U.S. Congress, Office of Technology Assess-
ment, Pharmaceutical R&D: Costs, Risks, and Rewards,
ceutical industry R&D investments tend to Pub. no. OTA-H-522 (Washington: U.S. Gov-
exceed risk-adjusted capital costs by only ernment Printing Office, February 1993), 2022.
modest amounts, the pattern suggests that 8. Ibid., chap. 1. For the pioneering theoretical
pharmaceutical industry R&D is best de- analysis of such behavior, see Y. Barzel, Optimal
scribed by a virtuous rent-seeking model.8 Timing of Innovations, Review of Economics and
Statistics (August 1968): 348355. For an applica-
That is, as profit opportunities expand, firms tion to pharmaceuticals, which at the time of
compete to exploit them by increasing R&D writing was considered one of two plausible
investments, and perhaps also promotional theoretical alternatives, see Scherer, Industry
costs, until the increases in costs dissipate Structure, Strategy, and Public Policy, 365366.
most, if not all, supranormal profit returns. If
this is a correct interpretation of the indus-
220 trys behavior, it has self-evident implications
for policy interventions aimed at reducing in-
dustry prices and profits.
NOTES
1. H.G. Grabowski and J.M. Vernon, A New Look
at the Returns and Risks to Pharmaceutical
R&D, Management Science ( July 1990): 804821.
2. See C.P. Himmelberg and B.C. Petersen, R&D
and Internal Finance: A Panel Study of Small
Firms in High-Tech Industries, Review of Econom-
ics and Statistics (February 1994): 3851; W.W.
McCutchen Jr., Estimating the Impact of the
R&D Tax Credit on Strategic Groups in the
Pharmaceutical Industry, Research Policy (Au-
gust 1993): 337351; and H.G. Grabowski, The
Determinants of Industrial Research and Devel-
opment, Journal of Political Economy (March/April
1968): 292306.
3. See J. Schmookler, Innovation and Economic Growth
(Cambridge: Harvard University Press, 1966);
and F.M. Scherer, Demand-Pull and Techno-
logical Innovation: Schmookler Revisited, Jour-
nal of Industrial Economics (March 1982): 225238.
4. Despite that difficulty, the use of standard year-
to-year time series analysis yields results consis-
tent with those reported here. See F.M. Scherer,
Industry Structure, Strategy, and Public Policy (New
York: HarperCollins, 1996), 388.
5. Extending the analysis into 1997 and especially
beyond is problematic, since a new industry

H E A L T H A F F A I R S ~ V o l u m e 2 0 , N u m b e r 5