Drug development decisions of pharmaceutical companies are primarily based on business and economic factors--essentially whether a particular potential medication might be sufficiently profitable if it is successfully developed. Expected profitability of a particular product is determined by a combination of such factors as:
- development cost
- sales of the product
- cost of manufacturing, distributing and marketing the product
- duration of the development and product/sales life.
In order to analyze and better explain the development decisions of pharmaceutical companies, we developed a market analysis model that incorporates these factors. This model allows simulation of the economics driving a particular development decision and assessment of the sensitivity to various market and policy scenarios. The potential commercial attractiveness of a cocaine medication is assessed using this model, and selected values are believed to be plausible. In addition, the model is used to examine the sensitivity of conclusions to variation in particular factors The model was built on a spreadsheet, and has a user-friendly interface to enable determining how modification of inputs affects the two main output variables, PAR and NPV. Details about the model are given in the appendix.
For purposes of designing this model, it was assumed that a pharmaceutical company's assessment of the attractiveness of a potential medication/product can be based largely on certain financial indicators, e.g., product net present value (NPV) and peak annual revenue (PAR) of the product. Using information from other aspects of the project, various potential market conditions were translated into financial and other parameters that were fed into the model to generate NPV and PAR calculations. The input variables used in the model are shown in Figure 2.
|Uncapitalized R&D costs||Orphan drug (or similar) status|
|Stage of entry||Years of orphan drug extension|
|Discount rate||Orphan drug (or similar) tax advantage|
|Wholesale price||Years post-launch to competing drug|
|Peak market size||Years to replacement by competing drug|
|Weeks of prescription||First year MMDA* costs|
|Expected peak prescriptions||Duration of marketing campaign|
|Years post-launch to peak prescriptions||MMDA costs during marketing campaign|
|Years to patent expiration||MMDA costs after marketing campaign|
|*MMDA: manufacturing, marketing, distribution, administration|
A listing of terminology relevant to this report is provided below in Figure 3.
|Figure 3: Definitions of Selected Terms for Market Analysis|
Capitalized cost: The value of research and development expenditures plus the accrued interest costs on those outlays.
Discount rate: The interest rate used to convert future cash flows to their present value.
Expected return: Average of possible returns weighted by their probabilities.
Net present value (NPV): The difference between the present value of all cash inflows from a project and the present value of all cash outflows required for the investment, using the required rate of return to calculate present values. In general, investments are accepted that have positive NPVs.
Opportunity cost of capital: The expected return that is forgone by investing in a project rather than in comparable financial securities. Also known as hurdle rate or cost of capital.
Peak Annual Revenue (PAR): The highest annual revenue achieved by a product during its market life.
Present value: Discounted value of future cash flows
Required rate of return (RRR): The minimum acceptable rate of return on an investment. In general, investments are accepted that offer rates of return in excess of their discount rate or costs of capital.
Return on investment (ROI): Income divided by investment.
Brealey RA, Myers SC. Principles of Corporate Finance. Fourth Edition. New York: McGraw-Hill, 1991.
Horngren CT, Foster G. Cost Accounting. A Managerial Emphasis. Seventh Edition. Englewood Cliffs, N.J.: Prentice Hall, 1991.
U.S. Congress. Office of Technology Assessment. Pharmaceutical R&D: Costs, Risks and Rewards. Washington, DC: U.S. Government Printing Office, 1993.