Closing Case: The Pharmaceutical Industry
Historically, the pharmaceutical industry has been a profitable one. Between 2002 and 2006 the average rate of return on invested capital (ROIC) for firms in the industry was 16.45 percent. Put differently, for every dollar of capital invested in the industry, the average pharmaceutical firm generated 16.45 cents of profit. This compares with an average return on invested capital of 12.76 percent for firms in the computer hardware industry, 8.54 percent for grocers, and 3.88 percent for firms in the electronics industry. However, the average level of profitability in the pharmaceutical industry has been declining of late. In 2002, the average ROIC in the industry was 21.6 percent; by 2006 it had fallen to 14.5 percent.
The profitability of the pharmaceutical industry can be best understood by looking at several aspects of its underlying economic structure. First, demand for pharmaceuticals has been strong and has grown for decades. Between 1990 and 2003 there was a 12.5 percent annual increase in spending on prescription drugs in the United States. This growth was driven by favorable demographics. As people grow older, they tend to need and consume more prescription medicines, and the population in most advanced nations has been growing older as the post–World War II babyboom generation ages. Looking forward, projections suggest that spending on prescription drugs will increase at between 10 and 11% annually through till 2013.
Second, successful new prescription drugs can be extraordinarily profitable. Lipitor, the cholesterol-lowering drug sold by Pfizer, was introduced in 1997, and by 2006 this drug had generated a staggering $12.5 billion in annual sales for Pfizer. The costs of manufacturing, packing, and distributing Lipitor amounted to only about 10 percent of revenues. Pfizer spent close to $500 million on promoting Lipitor and perhaps as much again on maintaining a sales force to sell...
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