[Ip-health] Reporting $802: Opportunity cost of capital as a drug development cost

[James Love]

Opportunity cost of capital as a drug development cost

The least understood component of the Tufts study on drug development
costs concerns the "opportunity cost of capital," an imputed cost that
the Tufts researchers included to account for the costs of financing R&D
investments.  The inclusion of financing costs is similar to including
interest payments on car loan when estimating the costs of a car
purchase, except that the researchers have a lot of latitude in picking
the relevant interest rate for investment costs.  

In one earlier study a rate of 14 percent plus inflation was used to
calculate the financing costs for pre-clinical investments, which had a
huge effect on the eventual cost estimate.  In yesterday's press
releases there was no information on what interest rate was used, but
Teresa Agovino from the AP managed to get Joe DiMasi to tell her that
$403 of the $802 million was financing costs.   The fact that the
financing costs is about half the total is pretty important, but was
only reported by the AP.   

In earlier Tufts estimates, the financing costs were anywhere from 51 to
69 percent, depending upon the interest rate (9 to 15).   The fact that
the financing costs in the latest report runs just over 50 percent
suggests that either the discount rate is close to 9 percent, or that
the Tufts researchers included a much larger component for clinical
costs, which require less financing (than pre-clinical costs).  It
would be nice if Joe could clarify this for the list, since he knows the
answer.

While economists and MBA students are generally familiar with the
concept of opportunity costs of capital as a cost, lots of people are
not.  Few of the news reports explored how unusual it was for industry
costs to be reported in this way in the financial press, which is an
issue, because most people do not understand what was done, and tend to
double count, thinking that the industry needs to recoup the financing
costs several times.   

In our opinion, every report should have broken the costs out into two
main categories -- the costs of pre-clinical and clinical research, with
the costs of financing reported as a separate item, if it is included at
all.   The more everything is lumped together, the easier it is for the
companies to make non-experts think that the $802 million represents out
of pocket costs of running a drug through the FDA, for example, once a
product is licensed from a University, government agency, or a Biotech
company.   This mistake is often made (recently in the New York Times in
the context of the costs of d4T development), and the Tufts researchers
refuse to offer corrections or clarifications.  Also, it would allow
people to break down the estimates and see how reasonable they really
are.  How much of the remaining $399 million in out-of-pocket expenses
was assigned to clinical trials, for example, and how does this compare
to observable data from truly independent sources?

Interestingly, the Boston Globe story provided a fair amount of
discussion of this issue, including quotes from the Boston Consulting
Group (another PhRMA workhorse) that its own estimates of the cost of
drug development were $880 million, without financing costs.  One
wonders what numbers they use for clinical trials costs.  

Here is how the various news reports treated the issue of opportunity
costs of capital in the news reports. 
   
  Jamie

http://www.nytimes.com/2001/12/01/business/01DRUG.html
NYTimes December 1, 2001
Research Cost For New Drugs Said to Soar
By ROBERT PEAR

Dr. DiMasi said the study also included some of the cost of capital -
what could have been earned if investors had put their money in
securities of equal risk, rather than in pharmaceutical research and
development.


http://www.washingtonpost.com/wp-dyn/articles/A42120-2001Nov30.html
Price Tag for a New Drug: $802 Million
Findings of Tufts University Study Are Disputed by Several Watchdog
Groups 
By Ceci Connolly
Washington Post Staff Writer
Saturday, December 1, 2001; Page A10 

  No mention of the inclusion of opportunity cost of capital


http://biz.yahoo.com/rf/011130/n30295250_1.html
Friday November 30, 6:19 pm Eastern Time
Drug development costs $802 mln on average--study
(UPDATE: adds consumer group, Merck comments paragraphs 14-15, 17)
By Lisa Richwine 
(Reuters)

The Tufts figure includes the cost of human clinical trials,
pre-clinical tests and product failures and the impact of long
development times on investment costs.
.....
But Bob Young, research director for Public Citizen's Congress Watch, a
consumer group, said the average for actual after-tax cash outlays was
probably 75 percent less than the Tufts figure.    He said Tufts'
researchers included expenses that are tax deductible and that more than
half of their figure was attributed to opportunity costs of investing in
a potential drug when the money could have been invested elsewhere.


http://dailynews.yahoo.com/h/ap/20011130/hl/drug_development_costs_1.html
Friday November 30 5:31 PM ET 
Activists Slam Drug Dev. Cost Study
By THERESA AGOVINO, AP Business Writer 

The $802 million average cost includes $403 million that a company
potentially loses by not having invested in something more reliable than
drug development, which is risky. Activist say that loss is theoretical
and should not be figured in. DiMasi says it is standard economic
practice. 

In contrast, Public Citizen's report includes tax rebates and excludes
opportunity costs. Public Citizen said it based some of its research on
an earlier DiMasi study, along with information from the Food and Drug
Administration (news - web sites) and the National Institutes of Health
(news - web sites). 


http://www.boston.com/dailyglobe2/335/business/R_D_costs_for_drugs_skyrocket_study_says+.shtml
R&D costs for drugs skyrocket, study says
Tufts Center estimates amount up threefold from a decade ago
By Naomi Aoki, Globe Staff, 12/1/2001


Tollman  (a vice president at the Boston Consulting Group), whose firm
issued the $880 million estimate, was not surprised by the Tufts figure,
though the two studies took vastly different approaches. Tufts collected
detailed information from drug companies about their research and
development expenses. The center tallied those out-of-pocket
expenditures as well as the cost of opportunities lost by tying up those
dollars for the 10 to 15 years it takes to bring a drug to market.

Both estimates wrap the cost of failed projects into the average.
Tollman's estimate, however, is not based on data collected from
pharmaceutical companies nor does it calculate the cost of tying up
capital. Instead, the BCG estimate simply walks through every step of
the research and development process, adding up the total costs. 
BCG's method circumvents many of the criticisms levied by consumer
groups and yet comes to a similar conclusion as the Tufts study, said
Tollman, underscoring the fact that drug discovery and development is an
expensive business.

Consumer groups, however, argue that the $500 million figure, never mind
the new $800 million estimate, is greatly exaggerated. Bob Young,
research director for Public Citizen's Congress Watch division, said
that in the earlier Tufts study, more than half the cost of developing a
new drug was the cost of tying up capital.

''They are calculating what kind of return they would have gotten if
they invested their money elsewhere,'' Young said. ''But if they were
investing this money elsewhere, they wouldn't be drug companies. And the
bottom line is that the drug industry is hugely profitable.''

If tax deductions and other credits are taken into account, Young said,
another third of the estimate could be lopped off. Young also takes
issue with the fact that the raw data are supplied by the drug
companies, giving the industry an opportunity to inflate the numbers and
the estimate to their benefit.