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What does a new drug cost?

Despite the variety of health systems across hundreds of different countries, one feature is near-universal: We all depend on private industry to commercialize and market drug products. And because drugs are such an integral part of our health care system, that industry is generally heavily regulated. Yet despite this regulation, little is publicly known about drug development costs. But aggregate research and development (R&D) data are available, and the pharmaceutical industry spends billions per year.

A huge challenge facing consumers, insurers, and governments worldwide are the acquisition costs of drugs. On this point, the pharmaceutical industry makes a consistent argument: This is a risky business, and it costs a lot to bring a new drug to market. According to PhRMA, the U.S. pharmaceutical industry’s advocacy group, it cost $1.3 billion (in 2005 dollars) to bring a new drug to market. The industry argues that high acquisition costs are necessary to support the multi-year R&D investment, and considerable risks, in to meet the regulatory requirements demanded for new drugs.

But what goes into this $1.3 billion figure? To understand the cost of a new drug, we need to consider both the cost of drugs that were marketed, but also factor in the costs of the failures – those discontinued during development. While most pharmaceutical companies are publicly held, no company produces detailed breakdowns of “per marketed drug” R&D costs, or the specific amounts spent on drugs that were later abandoned. Yet there have been attempts to estimate these values. The most detailed and perhaps controversial paper is a 2003 paper from DiMasi et al, entitled, The Price of Innovation: New Estimates of Drug Development Costs.[Light and Warburton, entitled Demythologizing the high costs of pharmaceutical research. They claim the median R&D cost is a fraction of DiMasi’s estimate: Just $43.4 million. “Big Pharma lies about R&D to justify illicit profits” shouted Natural News. Who’s right?

Drug Development
Drugs can be developed in different ways, but the usual model used describes a series of phases. The pre-clinical development stage constitutes preliminary studies of chemicals that have been synthesized or isolated, and are then screened. This process can take years: Identifying promising leads, validating them, tweaking with their chemical structures, and conducting endless in vitro studies. Only a fraction of drugs that show promise in pre-clinical studies will every progress to clinical trials. Clinical trials are generally grouped into three stages, each one representing an important milestone in a drug’s development. Phase I studies are small studies in healthy volunteers designed to help understand the basic pharmacology and pharmacokinetics in humans: how a drug is absorbed, distributed, metabolized, and eliminated. It’s in Phase II that the drug is tested in groups with the condition of interest. These trials are larger, and may be randomized, with multiple arms, possibly evaluating different dosing regimens. Endpoints are usually related to basic efficacy and safety parameters. Phase III studies are the largest studies, that may be randomized and double-blind, in order to establish a drug’s efficacy against a given condition. Regulators like the FDA will usually require one or more Phase III trials to support an approval to market a drug. In cases where real outcomes need to be measured (like mortality or morbidity), phase III studies can be massive. (Like this one, with over 18,000 participants!).

While the trial pathway is usually illustrated as a straight-line path, that’s a post hoc view: A tree may be a more appropriate model. Clinical trials may be conducted in different doses, treating different patient groups, using different protocols, in order to understand a drug’s effectiveness.

At any one time, multiple drugs may be in development, so only the most promising products may move forward in the development pathway, as subsequent phases of development mean a significant increase in costs. A drug’s development can be discontinued at any point along the path. Developers may identify toxicity issues, or lack of effectiveness issues. Or clinical practice may change, and all of a sudden, the clinical trials are measuring the wrong endpoints in the wrong patients. Decisions are always made in the face of uncertain evidence about efficacy and toxicity, and for every drug that moves forward that is eventually found to fail, it could be that there is an effective drug that didn’t reveal itself as promising, and went back on the shelf.

The development process is laborious and typically takes several years from discovery to clinical trials. The pharmaceutical industry estimates that it takes 10,000 molecules developed to bring a single drug to market. Without validating that number (a whole other post), it’s fair to say that the number of drugs that make it to market is a tiny fraction of the number of products identified or synthesized that enter initial screening. So there will be a substantial investment into drugs that never make it to market. Without including the cost of abandoned drugs into the costs of drugs that are marketed, we’d be underestimating the investment incurred. So any analysis needs to consider this cost, too.

The DiMasi Paper

The DiMasi paper, from the Tufts Center for the Study of Drug Development is the most widely cited paper on drug development costs. While the methodology they use is described in detail, some  essential information is unfortunately (though perhaps understandably) opaque. The authors used a sample of drug costs drawn from ten companies that volunteered (out of 24 that were asked) that were willing to provide R&D data on a per-chemical basis. Data were collected, and stratified by development phase. Only the costs of self-originated drugs (i.e., they developed the drug themselves) were included. In total, data on 68 products were collected, and the sample consisted of mostly small-molecule drugs, but also included four recombinant proteins, two monoclonal antibodies, and one vaccine. No further information is provided, so there’s no way to know just how representative this sample is.

The methodology for the different calculations is fairly well detailed, but as I noted, the underlying data are not provided. Whether this basket of drugs studied represents a fair measure of the market is impossible to determine. The authors compiled actual costs wherever possible, broken down by development phase. A notable exception is the “preclinical” development period where it’s difficult to draw a direct link between expenditures and a specific drug that ends up being commercialized. For this segment, they inferred, using their own database, costs of $121 million per approved new drug.

To account for the costs of drugs that were abandoned (for any reason) during development, the authors used their own database of investigational drugs to estimate the odds any given new drug would reach a particular development milestone. Setting aside a detailed analysis of the methodology, let’s look at the two biggest cost drivers of the final that have been subject to repeated criticism: Tax issues, and the cost of capital.

Tax Issues
A major criticism of the DiMasi paper has been that the preferential taxation provisions for R&D expenses have not been factored into the analysis. Essentially, if R&D costs are given preferential tax treatment, this should reduce the net cost of R&D to the company. I have no particular insight into this issue other than to flag it as one that has caused controversy. Given preferential treatment of R&D expenses isn’t unique to the pharmaceutical sector, the extent to which this biases the validity of this particular analysis isn’t clear to me.  But I’m a pharmacist, not a tax expert.

The Cost of Capital
Probably the biggest criticism of the DiMasi paper is that the authors factor in what’s called the cost of capital into the development cost. Looking at the calculations, DiMasi estimated the out-of-pocket costs per new drug at $403 million (2000 dollars). But this is then capitalized, based on the opportunity cost of that investment – at 11%, bringing the “total” cost up to $802 million. Adjusting this cost to 2005 dollars, and we’re at the $1.3 billion that PhRMA is calling “the average cost to develop one new drug.”

The cost of capital can be a bit baffling to understand. If I’m going to invest my money in something now, with a possible payoff down the road, I need to factor in the opportunity cost of something else I could have invested in – but decided not to. It is a true cost, because by choosing to invest in one thing, you’re forgoing the investment in another.

DiMasi uses a cost of capital of 11% – that is, they assumed that the drug developers, by moving forward with the development of a drug, where forgoing investments which would be expected to yield 11%. Is 11% valid? From a personal investment perspective, 11% seems rich. But the cost of capital that companies use is dependent on the risk involved. Different industries have different business risks.  The DiMasi paper bases the 11% estimate based (in part) on historic returns in the industry. Given that half of the reported “cost” of a new drug is based on the cost of capital, the value we use use has a massive influence on what the final “cost” of a new drug will be.  But is 11% appropriate? Many argue no – that current returns don’t match past returns, and therefore the CoC should be lower. I took a look at a cost of capital table created by Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York University. He calculates that pharma’s cost of capital is 8.59%. But there is no single “right” answer here. It’s an assumption that goes into our calculation.

 

Other Reviews
Other authors have made their own attempt at estimating the cost of a new drug. Paul Adams of the Federal Trade Commission, writing in Health Economics estimates that the DiMasi estimate is low, and the 2003 cost is closer to $1 billion per new drug, but noted there is significant variation between products. A 2006 Congressional Budget Office report on drug development [PDF] largely supports the DiMasi estimates. Most recently, Light and Warburton argued that, “based on independent sources and reasonable arguments, R&D costs companies a median of $43.4 million per new drug, just as company supported analysts can conclude they are over 18 times larger, or $802 million.” This figure seems implausibly small, given a single clinical trial can involve hundreds to thousands of patients. (For a more detailed critique of the Light and Warburton paper, I’ll refer the interested reader to Derek Lowe’s excellent In the Pipeline blog (and its comments) where it was dissected in detail here and here.) One of the best ways to contemplate the costs and calculations is to manipulate the numbers yourself: There’s a model developed by venture capitalist Bruce Booth, where you can enter your own estimates and see what cost it spits out. I tried working with the model for a while, and I couldn’t get it anywhere near $43 million – it was always in the hundreds of millions.

Other considerations
One important factor that isn’t considered in any of these analyses (from what I can see) are the costs of new indications for existing chemical entities. Consider the case of cancer drugs, where drugs are often approved for the treatment of metastatic disease, and only after efficacy is demonstrated, is it studied as a potential “adjuvant” treatment for early stages of disease. Additionally, the DiMasi analysis only looked at drugs developed solely in-house. Given the growing role of smaller biotech companies that develop, and then sell, promising drugs to pharmaceutical companies, the impact on costs isn’t clear. In contrast, the cost of the “me-too” drugs that seem to fill the pharmaceutical marketplace aren’t discussed explicitly, either. When your new drug is a variation on a competitor’s (or your own) product, how does this influence overall R&D expense? Again, it’s not clear.

Conclusion
Is the $1.3 billion new drug a myth? New drugs could be hitting, or even exceeding this mark – it depends on what your assumptions are. When we try to summarize all the variables of drug development into a single number, accounting for the hits and the misses, we can end up with a number that sounds impressive. But is it meaningful? Without transparency, only the manufacturer will know what it cost for their own drugs. It’s probably more important to understand the key drivers of R&D costs, noting that there are a huge number of variables that may influence the final cost of bringing a new drug to market.

Posted in: Clinical Trials, Pharmaceuticals, Science and Medicine

Leave a Comment (19) ↓

19 thoughts on “What does a new drug cost?

  1. windriven says:

    Nice post, Mr. Gravura. Pharmaceuticals represent a growing chunk of health care costs and the business model deserves careful scrutiny. But it is important to point out that, regardless of the cause, pharmaceutical companies are not huge cash cows; if they were, we’d all be heavily invested in pharmaceuticals.

    This morning Pfizer (PFE) is trading at $20.38 a share. This is about its best performance in the last three years but it hits the $20 area about once a year and then droops into the mid-teens. Its price to earnings ratio (PE Ratio) is around 20:1. One isn’t going to earn much in dividends and one isn’t likely to see a large run-up in the price absent release of some blockbuster drug. This isn’t a horrible stock to have in one’s portfolio – but it isn’t an inspired choice either.

    But this doesn’t tell the whole story either. Are pharmaceutical companies well run? Are their management teams and boards overcompensated? Are marketing costs appropriate? One thing is certain: BigPharma’s revenues are huge. If those revenues aren’t going into R&D and they aren’t finding the way to investors pockets, where exactly is that money going?

  2. passionlessDrone says:

    Hello friends –

    Very nice article. I too, would recommend the In the Pipeline blog to anyone interested in learning about the pharmaceutical industry.

    Leaving out drugs that were developed, or partially developed by other, smaller companies, and then purchased by larger pharma companies for phase 2 trials and ongoing seems like a unknown to these numbers. In particular, there’s lots of consternation about the Sirtus / resverotal purchase, which ran around .75B, while a great many researchers have screamed for a long time that the findings used to justify the purchase are unlikely, and haven’t been replicated.

    The NIH has recently launched an initiative to try to jump start development of drugs to address perceived failings of the industry pipeline. We might get some transparency there, but with the hinderance of calculating out expenses due to government work.

    - pD

  3. windriven says:

    @daedalus2u

    “The major expense is marketing”

    Maybe. Maybe not. The two journal pieces cited by Wikipedia to substantiate that claim don’t seem at first glance to be all that compelling. But presuming it to be true that doesn’t necessarily make it wrong.

    One would like to believe that if you invent a better mousetrap the world will beat a path to your door. Unfortunately, it doesn’t work that way. I own a couple of small medical device companies and I can assure you that getting physicians and hospitals to evaluate a product is an expensive and time consuming undertaking. Meanwhile, the company has invested a significant amount of money in bringing the product to market. If there is no return on the investment companies will stop investing in new drugs and will look for other places to better use their assets. This is the opportunity cost that Mr. Gravura mentioned (though opportunity cost is a pretty loose concept; it’s a little like saying that if I hadn’t married my wife I could have married Elle McPherson – entirely, in my case wildly, speculative.)

  4. Scott says:

    Also note that the largest part of those marketing expenses was free samples. Relatively unobjectionable compared to the direct-to-consumer advertising.

  5. DarrenG says:

    Since Pfizer was brought up I think it’s useful to look at their 2010 income statement:

    http://finance.yahoo.com/q/is?s=pfe&annual

    Unfortunately marketing isn’t broken out as a separate entity, but is mixed into “cost of revenue” and SG&A. I think it’s safe to assume from a $16.3B cost of revenue and $24B SG&A expense that they’ve got quite a number of billions in marketing expense.

    A related point about marketing is that marketing costs are orders of magnitude higher for U.S. sales than foreign sales, so it might be nice to examine why that is, and possibly reduce them for our market.

    Then there’s profit. Contra the above assertion that pharma isn’t a cash cow, Pfizer generated $51.5B gross profit, and $8.3B net profit on revenue of $67.8B and R&D of $9.4B. They also generated $11.5B net cash from operations last year. Those are very, very nice ratios.

  6. Merrill says:

    This was an objective overview of the standard discussion about the costs of new drug development. But it leaves out two critical issues: 1) the economic v. medical value of any particular new drug and whether the difference between those two values should be factored into R&D cost-accounting for the drug industry; and 2) the declining productivity of pharmaceutical R&D.

    As the author of a book on this subject (“The $800 Million Pill,” University of California Press, 2004), I’ve long wrestled with these issues. For a long discussion on the web on this subject, you can go to my website and read, “The Pharmaceutical Innovation Conundrum” here: http://gooznews.com/?p=1578.

    Long story brief, accurately calculating the answer to question #1 above would substantially reduce the cost of new drug development under traditional economic models like those used by DiMasi. The most costly new drugs are those that require the largest clinical trials precisely because they are of marginal medical utility. When it takes huge numbers to gain statistically significant improvement worthy of FDA approval, cost rise exponentially. Most fourth, fifth and nth drugs in a class where there are already large markets — statins, blood pressure lowering medications, blood sugar management medications, pain relievers, etc. — fall into this category. I estimate about half of industry R&D falls is on me-too drugs. Since most new me-too drugs are of little or no medical utility, a proper accounting for this would be “marketing,” not R&D. That’s why they’re called me-too drugs. They are for gaining a share of a preexisting market, and shouldn’t be categorized as R&D or innovative.

    The long story brief on question #2 is that drugs therapy as an approach to solving medical problems is a mature industry. The low-hanging fruit of the pharmaceutical revolution has been picked. Today, the most pressing medical problems are intractable diseases of aging (cancer, dementia) or societal pathologies (tobacco, obesity, diabetes, antibiotic resistance) needing public health approaches. On the first set of problems, the science simply hasn’t matured to the point where drug intervention is possible. These are the tough nuts of medical science, and no one has figured out how to crack them. Until basic science matures to the point where molecular pathways for intervention are validated, no amount of dollars poured into R&D will come up with successful new drugs. On the second set of problems, new drugs are at best a costly alternative to much cheaper, public health approaches.

    Anyway, hope that gives you something else to think about.

  7. nybgrus says:

    It is an old book and certainly a bit dated, but I highly recommend reading “The Billion Dollar Molecule” by Barry Werth about Joshua Boger’s attempt at rational drug design in the early-mid 80′s with his startup Vertex. While it doesn’t directly relate to drug costs in an already established company, it does give insight into just how much work, money, time, and uncertainty goes into making a drug. Hell, Merck almost went under in the 50′s when it bet the bank on cortisol as a blockbuster drug. The Americans were convinced the Germans were making “super-soldiers” because they had harnessed the power of cortisol and Merck spent a decade making it with the intent on everybody being on cortisol at all times. Then it was discoverd that is a really bad idea and Merck tanked. The point being that not only is the process extremely laborious and time intensive, not only are the up front costs extremely high, opportunity costs, clinical trial costs, etc, but patents run out and drugs end up getting recalled (think Vioxx) after being out for a year or two. Besides losing the additional revenue there, lawsuits, settlements, adverse reactions etc add to the cost of putting out drugs.

    My molecular pharm teacher turned PI post-grad stressed how these pressures are decreasing the innovation in drug production. She used to head R&D at Abbott and would tell us how the pressure was to re-formulate existing drugs since that would give you extra patent years without insanely costly trials. This is why you are seeing more “extended release” versions of the same drug instead of wholly new drugs.

  8. StandardCurve says:

    Merrill is right, the low hanging fruit is long gone. Now the big pharma companies have all slashed their research budgets. The strategy then shifted to snapping up small biotechs for their promising compounds. Unfortunately, there are less and less of these as the economy has dried up the venture capital that smaller companies run on.

    I don’t know the numbers, but the big pharmas have been more concerned with short term return on investment for a while now. The argument is that they make far more money now by spending on marketing then they could on research. Perhaps, but it seems short sighted to me.

    So where does that leave the pipeline for new drugs? Pretty empty, with no change likely any time soon.

    As an ex-Pfizer employee myself, it leaves me trying to change up my career. I wish there were more industries that would allow me to sling small-molecules down a mass-spec for a living.

  9. ConspicuousCarl says:

    The problem with saying that marketing is a/the major cost is that marketing, if it is working, causes a net increase in income, not a net decrease.

    The only way that marketing could be a cost increase per pill is if it was causing a net loss (i.e., the resulting revenue increase was less than the cost of marketing activities). It is possible that the average pharmaceutical marketing budget is wasted and ineffective, but I would require a lot of convincing. Without such proof, marketing expenses are not relevant to the issue of development cost.

  10. daedalus2u says:

    Marketing is also expensed. Some aspects of drug development have to be depreciated.

  11. michaelangelica says:

    Some of the now 1.4 Bil$ used to bring a drug to market is in its marketing.
    Although you have to wonder about the “science”when these billion $ clinical trials designed to show a new dug is ‘safe and efficacious” results in 50% of them being withdrawn or banned after a mere 10 years because they aren’t either

  12. Jan Willem Nienhuys says:

    DarrenG on 14 Apr 2011 at 3:35 pm

    referred to

    http://finance.yahoo.com/q/is?s=pfe&annual

    I tried to understand that table, but for a drug you need first R&D, and I can understand the need for spending on marketing, but the drug has to be manufactured too. I assume that Gross Profit means sales minus production costs. I wonder what the total income from sales is.

  13. windriven says:

    @DarrenG

    “Then there’s profit. Contra the above assertion that pharma isn’t a cash cow, Pfizer generated $51.5B gross profit, and $8.3B net profit on revenue of $67.8B and R&D of $9.4B. They also generated $11.5B net cash from operations last year. Those are very, very nice ratios.”

    Big numbers are just that: big numbers. Pfizer generates revenues of $67.8 billion with a payroll of 110,600 employees – that breaks down to $61,310 of revenue generated per employee. I don’t know what your concept of good business is but $61k revenue per employee is laughable. Thoratec (THOR), is a maker of ventricular assist devices and vascular graft material. Thoratec generates better than half a million dollars in revenue per employee.

    Just sayin’. It isn’t what revenues a company earns. For the people who own it, value only comes through increasing share prices or dividends paid.

  14. Jan Willem Nienhuys says:

    @ windriven

    I think my earlier question is answered. My ignorance of economy is exposed. Revenue = all money received for their products. Cost of revenue = production cost (but apparently not salaries of some people).

    I, like DarrenG, still don’t quite understand where advertising is, in the “Cost of revenue” or in “Selling General and Administrative”. The 23B for this seems very high and I cannot quite imagine what’s in it, and http://en.wikipedia.org/wiki/SG%26A isn’t very helpful either.

    The total revnue of $67,809,000,000 divided by 110,600 employees equals $613,101 per employee, i.e. over half a million dollar per employee. I guess that windriven missed a zero.

  15. windriven says:

    @Jan Willem Niehuys

    My face is RED! Don’t know how I screwed that up. My only excuse is that it was 6AM. Guess I was still asleep. Thanks for the correction.

  16. windriven says:

    But my original contention remains: Pfizer is not a particularly attractive stock in that it offers neither strong appreciation of share price nor bountiful dividends.

    The point was and remains – if BigPharma is such a unrelenting profit machine, where’s the money and why aren’t we all carrying portfolios heavily laden with pharmaceutical stocks?

  17. qetzal says:

    @ Merrill,

    I agree that me-too drugs are not as innovative as a first-in-class, by definition. I’m also open to arguments that our current system overly-incentivizes development of me-toos. But it’s a bit ludicrous to claim that all development work on me-toos should be properly accounted as marketing. Me-too drugs have to go through all the same R&D steps as first-in-class drugs. They have to be created and tested preclinically and clinically before they can be marketed. You can’t just assume a me-too will have an acceptable risk/benefit profile, just because the first-in-class does. That has to be proven.

    Besides, it’s not so obvious that “most new me-too drugs are of little or no medical utility”. Even if we grant that they usually have less utility than a first-in-class, there are still plenty of reasons they may be useful. Not everyone can take a given drug, even if it works really well for most people. Some individuals will have poor results with one drug in a class, but better results using another drug in the same class. Some drugs will turn out to have unexpected toxicities that aren’t seen with others drugs in the class. You may think such drugs have little or no value, but others might disagree. And not just the folks selling them. :)

    I also agree that much of the low-hanging fruit in drug development has been harvested. However, I disagree that “no amount of dollars poured into R&D will come up with successful new drugs.” It’s trivially false in that successful new drugs are still being developed, albeit not at the pace we might wish for. More importantly however, no amount of basic science can validate a new pathway for human therapeutic intervention. That can only come from clinical R&D.

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