NEW YORK (Money Magazne) -
Why do drugs cost so much? Drug companies say that their prices reflect the enormous cost of the research and testing required to develop new medications.
Last year, for example, they spent $32 billion on R&D -- an amount equal to about 70 percent of the industry's profits. Moreover, most R&D money is spent on drugs that never reach the market. The industry points out that for every 5,000 treatments tested, only five make it to clinical trials and only one ends up in drugstores. Last year, a mere 15 drugs won FDA approval.
As a result, in recent years drugmakers have come to rely heavily on just a handful of blockbuster drugs -- $1 billion-plus sellers. For example, 85 percent of Pfizer's $32.4 billion in sales last year came from its 10 best-selling drugs.
Once a drug is approved, the company has a limited time before the patent expires and others can copy the drug and compete on price, which inevitably decimates sales. Prozac sales slid 22 percent the year its patent expired, 63 percent the year after that. Although patents last 20 years, the clock starts running when the drug is first developed, not when it's approved, so the average sales period is just 11 years.
You might ask, why don't drug companies charge even more?
Because they aren't immune to market pressures. Insurers must first agree to cover the drug, and then they and other bulk purchasers negotiate discounts (only those without insurance pay full freight). And pricing depends in part on how many patients are likely to use the drug, how serious the condition it treats is (we'll pay more to tackle a life-threatening disease like cancer) and what else is available.
When a drug enters a crowded market, the company may discount to gain a foothold. AstraZeneca, for example, will likely price its new cholesterol-lowering drug an average of 12 percent below Pfizer's Lipitor, says health-care fund manager Tom Wald. On the other hand, if a drug is shown to be more effective and has fewer side effects than what's out there, insurers will pay a premium.
The other side of the pill
For consumer advocates, another set of numbers tell the story. Drugmakers' net profit margins averaged 19 percent last year vs. 7.5 percent for all the companies in the S&P 500. The seven largest U.S. drugmakers made $31.2 billion last year.
Simply put, critics say, the industry is greedy: They run billions of dollars' worth of ads a year to drum up demand, employ overly aggressive tactics to extend the life of their patents and exaggerate the cost of drug development by ignoring huge federal tax breaks for R&D and contributions from federally funded research.
Who's right? Your answer really comes down to philosophy.
We look at some of the issues.