In this blog we discuss issues that drive the bio-pharmaceutical innovation cycle.
We intend to explain the high cost-high risk value of pharmaceutical research and the impact it has on growth strategies and on the size and structure of the organization of the bio- pharmaceutical research.
Success and failure of bio-pharmaceutical innovation cycle
One way to look at success or failure of the bio-pharmaceutical innovation cycle is by looking at the probability of a drug reaching the market. The table below shows the low probability of a drug in the early stage of the research process to reach the market.
Industry average success rate: Probability of reaching market from start of each phase
Another way to look at results of drug research is to look at the profitability of that drug that reached the market. According to a net present value analysis by (Grabowski and Vernon, 1994, 2001), one out of ten drugs makes it to the market with a return five times their costs. On the contrary three out of five drugs making it to the market failed to return the risk-adjusted cost of capital. These numbers support the findings in an industry reports (Adv Pharm Technol Res. 2012 Oct-Dec; 3(4): 200–201), showing that despite the synthesitation of many compounds very few actually become new products. Even before these drugs entered clinical testing, large numbers have been screened and eliminated in laboratory and animal studies. The table below shows the number of drugs that dropped out in each stage of the research process.
Percentage of medicines dropped at each stage of development from 2007-2011
At the same time more than 75% of the cost of producing new drugs have been attributed to previous development failures. It is believed that for every new drug that reaches the market about 10.000 compounds were prepared and dropped out somewhere during the process.
In 2013, for example only 7% of the drugs that originally entered clinical testing were ultimately approved by the EMA & FDA. While the low success rate may be partially responsible for the high cost of drug research, new and increased regulations from Board Of Health (BOD’s) also require more extensive pre-clinical and clinical studies to not only confirm efficacy and safety but also through pharmaco-economic and cost benefit studies prove that the new drug is more efficient and cost beneficial than the present drugs in use. A new report published by the Tufts Center for the Study of Drug Development (CSDD) estimated the cost of developing a prescription drug that gains market approval at $2.6 billion, a 145% increase, correcting for inflation, over the estimate the center made in 2003. CSDD’s finding, are based on an average out-of-pocket cost of $1.4 billion and an estimate of $1.2 billion in returns that investors forego on that money during the 10-plus years a drug candidate spends in development.
The center’s analysis drew from information provided by 10 pharmaceutical companies on 106 randomly selected drugs first tested in humans between 1995 and 2007.
The cost of developing a new drug has sky rocketed since the 1970s
Does size & structure of the research organization impacts innovative output?
In the previous section we have argued that success and failure of the drug research process can be measured by looking at the probability of a drug reaching the market and the profitability it generates after it reached the market. There is however some other parameters that have a significant impact on the success or failure of the bio-pharmaceutical innovation cycle?
For example, what is the best size for the bio-pharmaceutical research process? Is small beautiful and lonely or is big powerful and impersonal? Looking at size of companies, actual day to day practice shows that across all major industries larger firms generally support more innovative activity because of their greater market power, established product distribution systems and more rapid market penetration and higher profits margins. With this advantage of size, larger companies may profitably undertake R&D ventures that are not possible fore smaller competitors. On the other hand larger companies also suffer disadvantages.
For one thing there is evidence that smaller firms may be more cost conscious, so that the same project could be explored with less waste in a smaller firm (See Kamien and Schwartz, 1982). Large companies are also burdened with more administrative bureaucracy, so that communication and coordination are more complex and this may discourage creativity and innovation. Smookler has suggested that “these disincentives to creativity result in a higher average technical competence in smaller companies, while in contrast, large companies offer "a haven for the mediocre in search” of anonymity" (1972: 43). In their study of innovative output of 16 pharmaceutical companies over a 19-year period Graves and Langowitz concluded that…. “Innovative productivity declines with increasing company size”.
Another explanation for decreasing profits to scale for large companies can be the hypothesis that large firms may undertake more risky research, in line with Schumpeter's notion that “Size allows for greater technological progress”. Yet Manfield (1981) provides evidence against this assertion, he finds no statistically significant relationship between large companies and risky R&D. Adams and Brock (1986) called this the "creative backwardness of bigness." One factor may be the administrative bureaucracy of large organizations, or what Downs (1967) describes as the "ossification of operations" in large organizations. Another factor may be the generally conservative nature of large organizations that may make it difficult for creative and innovative ideas to be heard and noticed.
That scientific creativity is not necessarily correlated with the scale of laboratories & research was found in a cross-industry study of “large and small company’s behavior” by Acs and Audretsch (1990) They concluded “small firms tend to be more efficient concerning innovation in industries characterized by high levels of innovation, and intense use of skilled labor”.
In conclusion, size of an organization has an impact on research output, despite their use of more resources, large organizations can be less efficient and their size can sometimes negatively impact their innovative results. On the other hand small companies can have more dedicated and highly skilled scientist, resulting in higher quality of research output
Small companies and Innovative output
Flexible and informal organizations, even relatively small, are often conducive to the production of ideas of great originality. It implies that companies have to pay considerable attention to organizing and structuring their R&D and encourage creativity because highly creative individuals may become discouraged in large R&D operations. While "creative thinking power is a scarce resource, it comes in fairly inexpensive person-sized lumps" so that all of the advantages are not the large laboratory (Scherer, 1980: 416). Small laboratories with creative researchers are crucial for the innovative output and success rate of R&D projects. A key element for pharmaceutical creativity seems to be the routine personal interest and enthusiasm of the researcher, combined with a mind prepared to observe what happens
Size and R&D investments and Innovative output
Based on the assumption that increasing R&D budgets are associated with decreasing R&D productivity it is suggested that merger or acquisition can be harmful to a company’s future innovative productivity. This is supported by the findings in the literature that the number of innovations in an industry increases with R&D expenditures, but at a decreasing rate (Acs and Audretsch 1987, 1988). This means there are decreasing returns to scale with respect to the size of the R&D effort. If one considers increasing R&D expenditures as a reference for firm size, the earlier mentioned findings of Acs and Audretsch confirm Scherer's conclusion that increasing size results in declining innovative productivity. Further more R&D returns, measured as new chemical entities (NCEs), decrease when levels of R&D spending increase and that is counterproductive in terms of innovative output. The study further shows a positive relationship between R&D expenditures and the number of NCEs produced and the proportion of returns decreases as R&D expenditures; generally related to firm size, increase. In other words, innovative effectiveness decreases with increasing R&D efforts (budgets) and by association, with firm size.
My analysis suggests a relation between the scale of the company's research facility and the possibility to pursue enough leads, but there is less relation with innovative productivity of the value chain. Further more, the size of an organization has an impact on research output, despite their use of more resources, large organizations can be less efficient and their size can sometimes negatively impact their innovative results. On the other hand small companies can have more dedicated and highly skilled scientist, resulting in higher quality of research output.
It seems like both large and small companies have their pros and cons in relation to organization of R&D and innovative output. Other findings are that large companies presumably can afford the large laboratories specialized equipment to investigate in diverse therapeutic disciplines but with a tendency to low return on R&D investment. On the other hand small companies may be able to participate in basic-research, but their inadequate R&D facilities and R&D portfolio will result in substantial financial risk or bankruptcy.
Lower innovative productivity and lower profitability are responsible for the consolidation wave in the bio-pharmacutical industry over the past ten to fifteen years. This wave is driven by a need to gain new promising products and to sustain long-term growth. If increasing R&D expenditures tend to yield decreasing returns this trend may have implications for the many small to midsize pharmaceutical companies. Other identified key drivers for innovative output are; the scale of the research, size of the laboratories (at least in part) the organization of the research process (focused and dedicated research groups and last but not the least percentage of money invested in R&D. What we can certainly conclude is that there is a strong relationship between R&D spend and long-term growth of Pharmaceutical companies.
In case of merger or acquisition, in particular, it can be argued that this "bigness complex" may have sprung from Joseph Schumpeter's (1942) assertion that "monopoly firms" would have greater innovative productivity. Schumpeter argued that monopolistic companies might be better for society because of their superior ability to generate long-run technological progress. However, this argument has been misconstrued to mean that "bigger, is better," and has thus served to strengthen a resolve to increase company size in the expectation of higher innovative output. As pointed out this conventional interpretation of the Schumpeterian hypothesis is incorrect. However it appears that managers may have acted upon this incorrect interpretation and thus may have inappropriately pursued policies to increase company size through mergers and acquisitions. The need for large pharmaceutical companies to constantly replenish the supply of potential blockbusters will continue and it requires a consistent and dedicated approach to drug R&D. If in-house research expertise is not sufficient to provide this flow of blockbusters, companies will ultimately need to make a strategic shift. Food for thought to be covered in my next blog.