Brandweek – VNU Business Media, Inc.

Last year, Merck CEO Raymond Gilmartin gave two public policy speeches in which he displayed copies of Time magazine from 1952 and 2004. The older edition featured a photo of company founder George Merck and the quote, “Medicine is for people, not for profits.” (Gilmartin keeps a copy in his office in a glass case.) The more recent issue carried the headline: “Why Your Drugs Cost So Much: Who’s to Blame; What We Can Do About It.”

“Today,” said the CEO, “the pharmaceutical industry is far too often seen as a vehicle for greed, putting profits over patients.”

Though he’s been hit especially hard–the withdrawal of Merck’s pain reliever Vioxx has already cost the company $1.3 billion in lost revenue and legal expenses–Gilmartin is not alone. Recently, several Big Pharma CEOs lamented that their companies are being bashed on the issues of drug pricing and marketing.

Last September, for instance, Novartis urged its employees to use generic prescription drugs to cut its healthcare costs, according to trade publication Generic Line. The magazine raised the question of whether drug prices have gotten so high that “one of the world’s largest drugmakers no longer can pay for Rx medicines for employees.”

The public’s distrust of the pharmaceutical industry is “deeply troubling,” AstraZeneca CEO Tom McKillop told the Pharmaceutical Leadership Forum on Nov. 16. His company has been sued over the marketing for its prescription heartburn medication Nexium; suits allege the drug is not significantly more effective than its less expensive OTC remedy Prilosec, even though the marketing claimed it was.

What is missing from this picture, however, is a detailed look at marketing expenditures and an analysis of the impact of such spending on the price of drugs.

A close inspection of financial reports reveals that the top 10 drug companies spend between two and three times on marketing what they spend on research (see chart, page 26). Marketing at those companies accounted for anywhere from 26% to 33% of sales. (In other industries, a more typical sales to marketing ratio would be 5-15%.) Put another way, for every dollar drug companies make in sales, the first 26 cents, at least, goes to marketing. For some drug companies, such as Pfizer, the cost of marketing is the single biggest corporate expense, greater than either research or manufacturing.

It is statistics like that which have kept the public’s attention on the rising cost of drugs and on the cost of the advertising that promotes them.

According to a study by the U.S. Government Accountability Office, drug prices jumped 21.8% between 2000 and 2004, or three to four times the rate of inflation. A similar study, published by the policy research group Families USA in June 2004, found a 22% price increase in the most commonly used remedies among the elderly since 2001. The price of asthma treatment Combivent, for example, increased 56% during the period, per the study.

At the same time, spending on direct-to-consumer advertising surpassed $3.8 billion in 2004, per Nielsen Monitor-Plus. Industry critics claim that increasing expenditures on drug advertising and promotion are fueling rising prices, which are in turn passed down to patients in the form of higher bills.

“The industry average for research and development is about 15% [of sales],” said Jerry Flanagan, healthcare policy director at the Foundation for Taxpayer and Consumer Rights. “Profit is twice R&D and marketing is two to three times as much. Every dollar spent on marketing means the price of drugs will be more expensive.”

In their defense, pharmaceutical firms often cite the exorbitant costs of research and development, which average more than $800 million per new remedy, according to the lobbying group Pharmaceutical Research and Manufacturers of America.

“R&D is risky, time-consuming and very costly. The drug approval process spans 12 to 15 years,” said PhRMA spokesman Jeff Trewhitt. “On average four out of every five potential new medicines going into testing fail, generally for toxicity reasons… Companies lose millions of dollars on a single failed research project.”

Who is right?

Consider the companies’ own figures: The top 10 drug companies took in a total of $293 billion in global sales in 2003, the last year for which complete figures are available. (Comparable numbers, available in the next few weeks, are expected for 2004.) During the period, those companies spent $37.9 billion on research and development, or about 13% of sales. The
companies’ costs for marketing and administration far exceeded research at $96.4 billion, or about 33% of sales.

In typical annual reports, “marketing and administration” are recorded as one item, and most companies do not delineate between promotional activity and routine office bills. Only three of the top 10 firms–Bayer Group, Roche Group and Novartis–actually itemize the two expenses. In these cases, administration is a small minority of the total, between 13.8% and 20.6%.

It is not clear whether that range is a rough industry standard. Some corporations have large non-drug businesses, like Johnson & Johnson, and their cost ratios are likely to be different than Merck’s, whose entire business is drugs. Even so, administration is expected to be a minority of the total, said David Moskowitz, managing director for healthcare at investment bank Friedman Billings Ramsey, Arlington, Va.

Taking the conservative end of the range, one can extrapolate that the top 10 companies spend $76.5 billion on marketing, or about 26% of sales. That’s still twice what those companies spend on research.

The way drug companies delineate their expenditures can become slippery. In an October conference call to analysts, AstraZeneca “reclassified” $460 million out of “research” and into “marketing.” The move did not go unnoticed.

“The size of the reclassification I think is quite substantial,” said London ‘s Redburn Partners analyst Paul Major, who followed with the question, “I was wondering if you could flesh out a little bit [why] you think what you have done is in line with industry practice?”

AZ CFO Jon Symonds replied that it didn’t make much difference. “There is a degree of discretion as to whether you do a local clinical Phase IV trial, or you do a different form of local product promotion,” he said.

Symonds’ implication–that certain clinical trials and local promotions are interchangeable–cuts to the heart of one of the main criticisms of the way the industry touts its commitment to research as a driver of prices. Drug companies have long paid hundreds of doctors to monitor their patients in massive tests of drugs that are already approved and on the market. In return, the company gets a little bit of post-market information about the drug’s performance.

The main function of these trials is to get doctors into the habit of prescribing the drug being tested, critics contend, which is why Symonds was able to shift a sum larger than the entire ad budget of Verizon Wireless from “research” to “marketing.”

“It’s a major way to seed the market,” explained Donald Light, a professor of comparative healthcare systems at Princeton University. “They plant the seeds for growing the market by paying physicians… a lot of money to recruit patients.”

Such efforts also contradict the popular notion that companies overspend on DTC advertising. As the financial statements confirm, DTC spending is a tiny fraction (about 2%) of average drug marketing activity. The real money–around $76.5 billion–is spent marketing drugs to doctors via ads in medical journals, free drug samples, office visits and entertainment at thousands of annual drug education seminars, dinners and lectures.

On paper, spiraling DTC spending is a red herring in the debate over drug pricing, a point on which even tight-lipped pharmaceutical firms are willing to speak out. “Our spending on direct-to-consumer advertising does not impact the price of drugs,” said Michal Fishman, a Pfizer rep. “It’s so minimal compared to the amount we spend on research and development. We spend more than 10 times on research and development what we do on [DTC] advertising.”

While that is true, it is not the whole picture. The TV ads may draw the most scrutiny, but the real money gets spent on the sales reps, aka “detailers.” Detailers visit doctors offices carrying free samples of new pills they hope doctors will prescribe to their patients–the same way salesmen used to go door to door to selling vacuum cleaners.

From 1996 to 2001, industry-wide spending on detailing rose from $4.9 billion to $9 billion, according to the Blue Cross/Blue Shield Assn. In a similar period, the number of sales reps more than doubled, from about 42,000 to 90,000. Currently, there are between 80,000 and 100,000 detailers in the U.S., and about 500,000 doctors. Doctors can get five or six visits per day from sales reps. “Those ratios are pretty scary,” said a pharma ad agency exec. “The average [salary] cost of a sales rep is about $100,000 a year… The fully loaded cost with benefits and cars goes far beyond that.”

The retail value of the “free” samples is also enormous: $13.1 billion in the 12 months ending in September 2003, according to IMS Health, and another $15.4 billion in the same period for 2004.

Those are some pretty big numbers, and experts say they do, in fact, impact drug prices. Even John Calfee, a resident scholar at the conservative think tank American Enterprise Institute, admits that marketing “is certainly not irrelevant” to pricing. But most industry executives stick to the official line–that prices are driven by research.

“As much as people don’t want to hear it, what drives the cost of drugs is how much it costs [in research] to get the damn drugs to market,” said the pharma agency exec. “The number of years, the number of people, the number of clinical trials.”

That argument may be wearing thin in Washington. Lawmakers are so concerned about the rising cost of drugs that several senators are urging bills that would allow U.S. citizens to buy prescriptions in Canada, where the government wields firm control over pricing. If such a reform were passed, drug marketers would find themselves in a price war with their own products, which are currently sold more cheaply across the border.

One bill is supported by John McCain (R-Ariz.), Trent Lott (R-Miss.) and Edward Kennedy (D-Mass.), a bipartisan coalition that may be enough to pass the legislation. “If [they] can get a clean floor vote they might have as many as 75 votes,” predicted Bill Vaughan, director of government relations at Families USA. “That would send this issue back to the House, which has twice indicated over its leadership’s opposition that they want to do something in this area.”

The stakes in the debate go beyond what consumers will end up paying for their medications. “Policy makers are literally debating the future of the industry and how it’s going to work in the next decade, and they’re saying something has got to give,” said Matt Giegerich, CEO of CommonHealth, a Parsippany, N.J., agency that counts several of the top drug companies as clients. “It could be the pricing model, it could be the role of the government, it could be the marketing.”

However, is it fair to make a direct correlation between marketing costs and higher drug prices? At a basic level, the answer is yes. For most pharma companies, marketing is a major cost that companies need to cover in order to stay in business. But there are other schools of thought.

The industry’s official line, as previously stated, is that the cost of research and development, not marketing, hikes the price of drugs.

“What’s driving up the price of drugs? At the end of the day it really is the cost of innovation,” agreed Giegerich.

The other is a more complicated explanation, which argues that the fluctuations of the market dictate prices and companies simply tailor their expenses to stay competitive within that changing framework.

Research costs aren’t a driving factor any more than marketing, said AEI’s Calfee. “I know they sometimes say that but I think it’s a mistake.

Calfee insists that drug prices are set by the market. Pharma companies work “backwards,” he said, when considering whether to launch a new product. They try to estimate how many people might need the new drug, the prices of rival drugs and then they select the price. Only then do they factor in the cost of marketing and development.

The backwards calculation, experts say, is a nebulous one. Supply and demand are regulated by doctors and patients who don’t know the real price of the drugs, and by pharmacies and benefit managers who can negotiate bulk prices downward but can’t control what patients want or what doctors prescribe.

Thus, the drug companies are engaged in the equivalent of a series of boxing matches in which half the fighters are blindfolded and the rest have one hand tied behind their backs.

“The biggest challenge in the system is the transparency of prices,” said one major drug company executive who asked not to be named. “What’s wrong with it is nobody really knows what anything costs at the time they buy it… From the patient’s perspective all medicines cost the same because they’re paying the same co-pay.”

In this school of thought, what consumers are actually complaining about is not the price of individual drugs but the total cost of their drug bills. Those bills have been rising because consumers are simply taking more drugs, not because each individual drug is getting more expensive. Blue Cross recorded that there were 7.8 prescriptions issued per capita in 1993. By
2001, it was 10.9.

The only flaw in this argument is the reason consumers are taking more drugs, which goes back to marketing. A study by Harvard University’s schools of medicine and public health, published in 2003, found that for every 10% increase in DTC advertising, drug sales rose 1%.

That does not sound too impressive until it is translated into hard cash: Every additional dollar spent on DTC yielded an average of $4.20 in sales.

The bottom line? Americans’ drug bills are going up because we’re taking more drugs. And we’re taking more drugs because the marketing works.

Drug companies seem to realize they have marketed themselves into the center of a storm, from which the escape route is not clear. Executives have retrenched even further in their public discussions of marketing and pricing ever since Congress started drafting the Canadian drug legislation. None of the top drug companies agreed to speak to Brandweek at any length regarding prices and the impact of marketing.

In the courts, Merck has been hit with hundreds of suits over Vioxx, a once heavily marketed pain reliever that may increase the risk of heart attacks. The Food and Drug Administration cited five of the top 10 drug companies for misleading advertising last year. Pfizer and Abbott Laboratories were warned twice. In recent weeks the FDA has highlighted misleading ads for pain relievers Celebrex, Crestor and Bextra.

Chastened, some industry insiders hope to see Big Pharma tone down their ads and lower their prices.

“Once a drug has been on the market for a number of years and it’s a monstrous success, like Lipitor, for those drugs to take price increases, I don’t know how the companies can justify that,” said the ad agency exec, who asked not to be identified. “The price initially is reasonable, it’s
priced to recoup what’s in development and marketing… But by year three, four or five, that ‘s where you have to wonder about the sanity of some companies.”

Still, there are also true believers, like CommonHealth’s Giegerich. “I don’t think it’s gone too far. Consumers need to know about their choices,” he said. “It’s going to be an interesting year.”

At Merck’s headquarters in Whitehouse Station, N.J, CEO Gilmartin still has both copies of Time. He might not like the more recent cover, with its cynical take on drug industry profits, but it gave him an idea of how consumers see his company.

“Not only is this [magazine] cover not hanging in my office,” he said during one of his speeches, “the mail room wasn’t even sure they should deliver it.”

Not every media outlet has blamed Big Pharma and its marketing for the high cost of drugs. One of the more sympathetic articles, published last October by The New Yorker, was penned by Malcolm Gladwell, author of The Tipping Point.

The piece did not mention, however, that Gladwell has been paid by pharmaceutical companies on numerous occasions in recent years to give speeches on his marketing theories. Gladwell denied a conflict of interest. He says he has previously disclosed giving the speeches, and has not advocated a position that supports Big Pharma’s interests.

“Did [my actions] create a bias in favor of the pharmaceutical industry?” he writes on his Web site, gladwell.com – “The evidence is for all to see.”

In the piece, “High Prices,” Gladwell argues that drug companies are not primarily to blame for increasing healthcare costs. Rather, he implies, the fault lies with lazy doctors who keep prescribing heavily advertised drugs like Nexium when cheaper generics are just as effective–and because Americans are simply taking more drugs. The increased costs were a function of volume, not price, he concluded.

Should drug companies follow his opinions, they’d urge doctors to try generics first and help introduce a Canadian-style healthcare system in the U.S. “That would cut the sales of Pfizer and AstraZeneca, and everyone else in the brand-name pharmaceutical business, by tens of billions of dollars,” he states.