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The role of R & D in the modern pharmaceutical industry-challenges and

benefits

Technical Report · December 2018

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 The role of R & D in the modern pharmaceutical
industry – challenges and benefits
The pharmaceutical industry can be described as a high-fixed low-cost marginal cost industry.
This is based on the fact that introducing a new drug to the market is not only a complicated
issue, but also an expensive and risky process. It is more cost-effective to produce an extra
unit of an already approved and on the market drug, which is often referred to as ‘pennies a
pill’. [1]
One of the most important sectors of the pharmaceutical industry is research and
development (R&D), which amounted to a worldwide spending of $141 billion in 2006,
increased by 40% in 2015 and is projected to show a substantial growth of 60% in 2020.
Following these numbers, it is reasonable that there are expectations for a high return on
investment (ROI). However, the extremely low rate of introduction of new molecular entities
(NMEs) and their commercialization do not correspond to the soaring R&D expenditures and
in turn lead to failure of accomplishing growth objectives set by the industry. This puts the
sustainability of the current R&D model in question and forces pharmaceutical companies to
review the challenges they are facing as well as explore other growth options. [2] One key
challenge is improving R&D productivity, which could possibly provide sufficient innovation
to substitute revenue losses stemming from a variety of reasons such as patent expirations
and high late-stage attrition rate during drug development. [3]
R&D productivity can be characterized as the relationship between the value an NME creates
in terms of commercial and medical sales and the investments required to produce this entity.
It is a two-dimensional parameter with inputs (R&D investments) leading to outputs (NMEs)
and outputs leading to outcomes (value for patients). A schematic representation of the
interpretation of the term R&D productivity can be seen in Figure 1. [3]

Figure 1: Key components of R&D productivity. [3]

Investments in R&D play a pivotal role in the constantly increasing healthcare costs and the
advancement in medical technology, which affects drug discovery and development that has
become a very costly and complicated process. Therefore, any decisions made in R&D have
long-term consequences and direct ramifications on the market and even public policy. For
example, estimating the cost for a new drug has bearing on the pharmaceutical industry and
can affect the market positively or negatively, while knowing the precise cost of R&D that
produced that specific drug enables the analysis of ROI and conclude if the investment was
worth or not. [4] It should also be noted, that according to the law of diminishing returns,
more innovation does not always yield positive outcome. Therefore, allocating sometimes
additional resources into R&D is not justified and will not translate to more potential
breakthroughs. [1]
Although, R&D has experienced a surge in investment the last two decades, pharma
productivity faces challenges, mainly due to its decreased output regarding the approval of
new drugs. This can be partially explained by the fact that R&D investments are becoming
more focused on areas associated with high risk of failure, where new clinical and therapeutic
needs must be met as well as new biological mechanisms must be discovered. This can be
characterized as a high risk/high reward situation, coupled with a lot uncertainties and
complexities due to the pursuit of innovation in the field of molecular biology. Moreover,
three factors must be taken into account when addressing the issues with pharma
productivity in R&D, namely development timeframe, number of successful NMEs approved
and attrition rate (failure rate in terms of drug development, as compounds do not advance
to the next clinical phase). Therefore, it is clear that there are a lot of challenges to overcome
in the pharmaceutical industry and the current business format needs to undergo structural
reorganization, as it already demonstrates that the R&D model shows signs of limitations. [5]
The development of new drugs requires a longer period of R&D, because science and
technological advancement have progressed to a state where there are no more easy targets
to identify and increased competition to exploit new opportunities in the market leads to a
decline in pharma productivity. [5] This leads to not only higher costs of developing a drug
but also increased total R&D expenses, which have experienced a yearly steady rise of 13%
since 1970. At the same time, the rate of approval of NMEs has remained unchanged in recent
years, resulting in more R&D spend per one NME approved by the FDA. However, this
measurement should be taken into account with caution, because it does not necessarily
reflect variations in the quality of output. On average, a company produces one NME every 6
years, when two or even three are needed per year for the ROI to make some sense. [6, 7]
The major cause for the decline of pharma productivity lies in the attrition rate, particularly
in Phase II trials, where the survivability rate has shown a substantial decline of 20%. It is
poignant to note, that attrition rates can act as indicators of how efficient pharmaceutical
companies allocate their R&D resources and constitutes an important parameter for the
effectiveness of clinical drug development. There are several reasons that can be attributed
to high attrition rates, mainly absence of reliable published data, preclinical models with low
predictive accuracy, complexity surrounding clinical trial for treatment of chronic diseases
and stringent regulatory guidelines. An extensive review of FDA approvals in 2012 led to the
conclusion that the top reasons for failures in phase II as well as phase III are directly
associated with lack of efficacy (56%) and varying strategies (7%), while safety issues (28%)
are responsible for failures in phase I. In addition, commercial reasons (5%) play also a critical
role in decision-making during the clinical phase and often lead to higher type II errors. This
means the acceptance of the hypothesis that a new drug will not meet safety and regulatory
standards, thus not resulting in a satisfactory ROI when in reality it would have done so if the
project was continued further. [2, 8]
The R&D landscape, which has been under constant cost pressure, has been slowly changing
due to the plethora of issues it has already created for the pharmaceutical industry and its
stakeholders. One form of solution can be found on virtualized R&D models that are becoming
more acceptable, as cooperation with external partners enables additional access to
specialized expertise and infrastructure, leading to less reliance on utilizing or even expanding
in-house capabilities. Moreover, the regulatory field has shifted from imposing strict
protocols regarding drug discovery and development to be inclined for a faster review process
of new drug approval, even when limited data is available. An example is Tagrisso
(osimertinib), which was approved less than three years after it was introduced into the clinic
phase. [9]
Although a general concept to improve R&D efficiency does not yet exist, it is safe to state
that its low value could be compensated by increased profits from each generated NME.
Despite tough market competition, bringing more blockbuster drugs that would guarantee
commercial success into the market would not only appease investors but also recoup the
majority of R&D expenses. Furthermore, merger and acquisitions (M&A) could
counterbalance patent expirations of these drugs, provide access to intellectual property and
potentially benefit the R&D pipeline. A less popular solution to increase R&D efficiency would
be to reduce operational costs by outsourcing certain activities and services to low-cost
countries. The outsourcing market value has been estimated to double by 2020, reaching
$35.8 billion. [2]
As previously mentioned, attrition rates are considered one of the key determinants of R&D
efficiency that can address some of the challenges to pharma productivity. The lower the
attrition rate, the lower the cost to produce one approved NME. One approach to reduce
attrition rates, particularly in late stages of the clinical phase, phase II and III, is to select better
validated targets by disqualifying compounds that are associated with mechanism-based
toxicity. There are several techniques that can be utilized to eliminate them like for example
RNA interference or gene knockouts. Another approach takes place during preclinical studies
with the use of more applicable and predictive animal models that can directly affect efficacy
testing of a new drug. It is paramount to start working with appropriate models, such as gene
knockout animals due to them being more compatible pathophysiologically. One last area
that could also substantially reduce attrition rates and R&D expenditure is by making better
decisions early in the process of drug discovery and development and discontinuing research
for a new compound when necessary. [10]
An increased R&D productivity under a new econometric model is central to the future
growth of the pharmaceutical industry. Companies should acknowledge that there needs to
be sustainable and reasonable investment into the R&D sector in order to generate an
acceptable and steady flow of new drugs. Allocating greater resources should be done under
better management and focused on the long-term perspectives. This means that more effort
should be done for the discovery of cost-effective medicine through innovative drug pipelines
in order to maximize ROI as well as contribute to the society. [11, 12]
In conclusion, the future outlook for the various pharmaceutical companies looks interesting
to say the least. As the demand for new therapies will steadily grow, the industry needs to
change its strategy and adjust to the challenges it faces. Apart from R&D productivity, there
are additional concerns with patent expirations, intellectual property and regulatory
problems. The industry has already started to divulge into two big groups: pure
pharmaceutical companies that focus only on developing new drugs and pharmaceutical firms
with diversified portfolio and different business interests in areas such as medical devices and
healthcare products. The key goal for the next decade will be affordability. This will be
possible through identifying innovation, new cost-effective techniques for drug discovery and
a better regulated environment. [13]

References
[1] R. Frank et al, Pharmaceutical industry profits and research and development, USC-
Brookings Schaeffer on Health Policy, 2017.
[2] A. Schuhmacher et al, Changing R&D models in research-based pharmaceutical
companies, J. Transl Med., Vol. 14, Issue 105, 2016.
[3] S. M. Paul et al, How to improve R&D productivity: the pharmaceutical industry’s grand
challenge, Nature Reviews Drug Discovery, Vol. 9, pp. 203-214, 2010.
[4] J. A. DiMasi et al, The price of innovation: new estimates of drug development costs,
Journal of Health Economics, Vol. 22, Issue 2, 2003.
[5] F. Pammolli et al, The productivity crisis in pharmaceutical R&D, Nature Reviews Drug
Discovery, Vol. 10, pp. 428-438, 2011.
[6] B. Booth et al, Prospects for productivity, Nature Reviews Drug Discovery, Vol. 3, pp. 451-
456, 2004.
[7] B. Munos, Lessons from 60 years of pharmaceutical innovation, Nature Reviews Drug
Discovery, Vol. 8, pp. 959-968, 2009.
[8] DiMassi, Risks in new drug development: approval success rates for investigational drugs,
Clinical Pharmacology&Therapeutics, Vol. 69, No. 5, pp. 297-307, 2001.
[9] R. Berggren et al, R&D in the age of agile, McKinsey&Company Pharmaceutical & Medical
Products, 2018.
[10] I. Kola et al, Can the pharmaceutical industry reduce attrition rates?, Nature Reviews Drug
Discovery, Vol. 3, pp. 711-716, 2004.
[11] F.H. Spiegel, The economics of Pharmaceutical Research and Development: An industry
perspective, Medical Innovation at the Crossroads, No. 2, 1991.
[12] M. Kessel, The problems with today’s pharmaceutical business-an outsider’s view, Nature
Biotechnology, Vol. 29, pp. 27-33, 2011.
[13] A. Gautam, The changing model of big pharma: impact of key trends, Drug Discovery
Today, Vol. 21, Issue 3, pp. 379-384, 2016.
 The Role of R&D in the Pharma Industry

Percentage of total revenue reinvested into R&D

30 between 1999-2015
PERCENTAGE REINVESTMENT (%)

25

20

15

10

0
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

YEAR
JJ NV PF RO MK

This graph illustrates the percentage of total business revenue that five pharmaceutical
companies Johnson and Johnson (JJ), Novartis (NV), Pfizer (PF), Roche (RO) and Merck (MK)
reinvested into the department of research and development (R&D) over a 17-year period,
from 1999 to 2015. All companies showed a general upward movement, which can be
explained with a direct comparison of percentage reinvestment into R&D in the years 1999
and 2015. JJ displayed the biggest increase with 6%, followed by RO with 5%, NV with 4.6%,
MK with 3.9% and finally PF with a slight growth of 0.7%.

There appear to be variable degrees of change in percentages between 2004 and 2014 with
several highs and lows, which can be attributed to a number of factors such as economic
instability, tighter regulations, and political climate. However, it is safe to state that high
business revenues are expected to lead to high investment into R&D, as there is a direct
correlation between these two variables. The lowest reinvestment of revenue can be
observed for JJ (15.7%) in 1999 and 2002, for MK (16%) in 1999, for NV (17.1%) and RO (11.6%)
in 2001, while for PF (12.9%) in 2013. This shows that apart from PF none of the other
companies decreased their investment into R&D at a level before the year 2002, but rather
demonstrated an almost steady pattern of increased financing of R&D.
In addition, it can be deducted from the graph, that out of the five pharmaceutical companies,
PF and RO display the biggest decrease of revenue reinvestment. RO contribution to the R&D
sector declined substantially by 7.2%, from 24.2% in 2010 (which represents almost double
the reinvestment compared to 1999) to 17% in 2013. PF reduced its investment by 5.1%, from
18% in 2008 to 12.9% in 2013. JJ, NV and MK do not show any steep decline in percentage of
revenue invested into R&D, although as previously mentioned there are some minimal
cutbacks.

Five pharma company profiles between 1999-2015

1,000,000
900,000
800,000
700,000
US Millions ($)

600,000
500,000
400,000
300,000
200,000
100,000
0
JJ NV PF RO MK
Pharmaceutical Companies

Total R&D spend R&D/NME approved Total Revenue Revenue/NME approved

Figure 1: This is a graphical representation of the differences in R&D and total revenue as well
as the fractions of those values that are used to produce one approved NME for five different
pharmaceutical companies. It is evident that all firms spend only a small proportion of their
total revenue into the R&D sector and an even small percentage of that is needed for the
process to generate one NME approved by the FDA. There seems to be a correlation between
total revenue and total R&D spend. PF which has the biggest total revenue spends more for
its R&D department than JJ, which has not only the lowest total revenue but also allocates
the least for R&D. A more comprehensive analysis to understand the discrepancies can be
undertaken by representing the relationships of R&D and total revenue with NME, and
between R&D/NME and total revenue/NME. The calculated correlation coefficient will
determine the strength of this relationship.
 Relationship between R&D and NME approved
140,000
120,000
US Millions ($)

100,000
80,000
60,000
40,000
20,000
0
JJ NV PF RO MK
Pharmaceutical Companies

Total R&D spend R&D/NME approved

Figure 2: This graph depicts how much money is used from the R&D expenses to generate an
FDA approved NME in regards to the total finances available for R&D. The correlation
coefficient was calculated and is valued at 0.81, which indicates a strong correlation between
total R&D spend and R&D/NME approved. From the graph, it can be deducted that PF having
a lot of R&D resources, spent more for one NME, while JJ spent the least with less R&D money
at its disposal. However, JJ managed to produce 20 NME during a 16 year timeframe (1999-
2015) while PF only 18. On the other hand, NV which appears to have similar R&D expenses
was able to get 27 NME approved by the FDA. This clearly demonstrates the importance of
R&D efficiency and how different R&D ecosystems within each of these companies lead to
varying outcomes. Having more R&D resources does not always translate to more NME
approved or less expenses for the process to generate one NME.

Relationship between Total Revenue and NME

approved
900,000
800,000
700,000
US Millions ($)

600,000
500,000
400,000
300,000
200,000
100,000
0
JJ NV PF RO MK
Pharmaceutical Companies

Total Revenue Revenue/NME approved

Figure 3: This graph shows the fraction of total revenue that is used to successfully produce
one NME in relation to the corresponding total revenue for five different pharmaceutical
companies. The correlation coefficient was also calculated in this case and valued at 0.89,
which represents an even stronger relationship between total revenue and revenue/NME
approved compared to total R&D and R&D/NME approved. As in Figure 2, PF dispalys higher
earnings than the other four companies and thus a bigger fraction of it is allocated for the
approval of an NME. JJ having the least total revenue is spending less. Both in Figure 2 and 3,
RO and MK appear to have similar operational acitivity as despite their slight disparity in their
total R&D spend and total revenue, they managed to have analogous expenses for the
approval of an NME.

Relationship between Revenue/NME and R&D/NME

50,000
45,000
40,000
35,000
US Millions ($)

30,000
25,000
20,000
15,000
10,000
5,000
0
JJ NV PF RO MK
Pharmaceutical Companies

Revenue/NME approved R&D/NME approved

Figure 4: This graph presents the revenue per NME in relation to R&D for one NME. The value
of the correlation coefficient was calculated to be 0.95, which shows that there is a stong
positive correlation between these two factors. In most cases, like for JJ and PF, the more
revenue equals to more R&D expenditure for one NME. However, there are exceptions that
can be explained when comparing NV and RO for example. Although NV spent half of RO’s
R&D and revenue, it managed to generate 27 approved NMEs as compared to 15 NMEs for
RO. There are additional factors such as portfolio management and outsourcing that need to
be taken into consideration in order to fully understand this disparity.
 Total Revenue Percentage Reinvested into R&D in 2017
JOHNSON&JOHNSON 10.93
GSK 11.84
SANOFI 14.4
PFIZER 14.52
NOVARTIS 15.92
ROCHE 16
MERCK 18.85
ASTRAZENECA 24.08
0 5 10 15 20 25 30

Percentage of Reinvestment (%)

Figure 5

Percentage of Total Revenue Reinvested into

R&D 2015 and 2017
JOHNSON&JOHNSON 21.7
10.93

PFIZER 15.7
14.52

NOVARTIS 23.2
15.92

ROCHE 17
16

MERCK 19.9
18.85

0 5 10 15 20 25
Percentage of Reinvestment (%)

2015 2017

Figure 6
The percentage of reinvestment into R&D from their respective total revenue for the year
2017 can be seen in Figure 5. The values were calculated by dividing spend on R&D with the
total revenue in 2017. AstraZeneca (AZ) reinvests about one fourth of its total revenue into
R&D (24.08%) and leads by a margin of approximately 5% its nearest competitor Merck (MK).
There is a cluster of companies that display reinvestment percentages between 14-16%, while
Johnson and Johnson (JJ) and GSK have the lowest investments values amounting to about
11% and 12%. This is an interesting observation, because JJ with $76.5 billion had three times
more total revenue than AZ with $22.47 billion, but decided to invest the least amount to its
R&D sector. This leads to the conclusion that some big companies have a diversified portfolio
and interests in different scientific/technological areas and therefore are not only focused in
producing new drugs.
Figure 6 displays a good comparison of the differences in percentage of total revenue
reinvestment into R&D between five companies in the year 2015 and 2017. It is evident that
every single company invested less into R&D in 2017 than in 2015, which could be due to
either less revenue, stricter regulatory compliance or uncertain financial climate. The biggest
decline is observed with JJ with -10.77%, followed by Novartis with -7.25%.

FDA approved NME and Projected drugs in R&D

250

200
Number of drugs

150

100

50

0
Johnson & Johnson Novartis Pfizer Roche Merck

NME approvals by FDA Projected number of drugs in R & D pipeline in 2018

Figure 7

Total Revenue and Revenue from Prescription sales in 2017

$90.00
$80.00
$70.00
US Billions ($)

$60.00
$50.00
$40.00
$30.00
$20.00
$10.00
$0.00
Pfizer Novartis Roche Merck Johnson and Sanofi GSK AstraZenca
Johnson

Total Revenue Revenue from Prescription Sales

Figure 8

In Figure 7, the FDA approved NMEs from 2017 are compared with the projected number of
drugs in the R&D pipeline in 2018. It can be concluded that the majority of the drugs do not
get approved and ultimately fail during the clinical phase. The highest failure rates according
to literature are observed during phase II and III, which will be discussed in more detail in
section 4 of this coursework. Therefore for example it is safe to estimate that out of the 216
 drugs for JJ, around 20 or less will be finally approved by the FDA. This logic can be applied in
a similar fashion to the other companies.
Figure 8 depicts a representation of the prescription sales in regards to total revenue for each
pharmaceutical company. It appears that revenue from prescription sales corresponds to the
majority of the total revenue of these firms and plays a major role in the amount reinvested
into R&D. JJ seems to be an exception here, as revenue from prescription sales amounts to
less than half of its total revenue. This has been explained under Figure 6 and is due to the
fact that JJ derives more than half of its revenue from other sources rather than drugs or
prescription sales.

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