The Effect of Research and Development Costs on the Profitability of. Pharmaceutical Companies

Transcription

1 The Effect of Research and Development Costs on the Profitability of Pharmaceutical Companies Abdellah Hajiheydari (Corresponding author) School of Accounting, Mobarakeh University Iran-Isfahan Dr. Mohsen Dastgir School of Accounting, Isfahan University Dr. Asghar Soltani School of Accounting, Isfahan University Abstract The pharmaceutical industry is rapidly expanding and research and development undoubtedly are required to ensure its prosperity in international markets. Since the cost of research and development studies for large and multinational pharmaceutical companies is very high and sometimes reaches up to 24% of their annual income, many managers consider research and development as a waste of resources and are unaware of their usefulness and benefits. This study is intended to examine the effectiveness of R & D costs on the profitability of 20 large and multinational worldwide pharmaceutical companies, based on these companies' sale. The results of the study indicated a strong and positive relationship between R & D costs and the profitability of pharmaceutical companies. Keywords: Research And Development, Profitability, Sales, Pharmaceutical Companies Introduction From December 2000 to February 2008, the top 15 companies in the pharmaceutical industry lost roughly $850 billion of their stock market values. Although a number of factors including the increase in the price of raw materials, the introduction of generic medicines, pricing pressures, inflation and legal entanglements are to blame, Garnier, the CEO of GlaxoSmithKline, believes that the decrease in R&D is the primary reason. The way to solve it, he says, is to return power to the scientists by reorganizing R&D. When the GSK began to reengineer its R&D, it had only two products in the late-stage development. Today it has 34, the most in the industry, and thus could increase their sales by about 10 thousand million dollars. The importance of research and development is so great that countries are divided to developed and undeveloped countries based on the fund devoted to R&D. Research and development costs in addition to stimulating economic growth and social development,enhance a firm's profits (Abdi, 2007). In this study the efficacy of research and development costs on the profitability of 20 major multinational pharmaceutical companies in the world are explored. First, a general definition for research and development costs is provided, and then the theoretical principles and the relationship between profitability and R & D spending will be checked. Research and Development costs Research and development (R & D) costs include all the resources spent for the activities that are particularly suitable for the production of the planned products. These activities can be outsourced by a single organization or an independent unit within the organization (Britt, 2007). In another definition, Vinod Kumar defines research and development as a way of discovering new knowledge about products, processes and services and applying that knowledge to create products, processes and services that meet the new and increasing needs of the market (Vinod Kumar, 2007). 914

2 The relationship between R & D costs and profitability In many studies, particularly in the area of pharmaceutical, research and development expenses are linked to critical factors including the profitability of the company and different opinions about this relation are presented. Mansfield (1968) and Grobowskey and Muller (1978) examined the relationship between profits and research and development and found significant relation between profitability and R&D. Lev and Sougiannis (1996) presented the following equation for profitability: Earning = 0 + 1ATGassets + 2RD + 3AD + In the above equation, the physical and non-physical assets of the company are shown by ATGassets, spending on research and development by RD, and the costs of advertisements by AD. In the above equation, operating income is calculated before the deduction of depreciation, advertising expenses and research and development costs.results indicate a significant relation between profitability and operating assets and between spending on research and development and the profitability. History of research Franzan and Radhakrishnan (2009) evaluated the relationship between R&D costs and the profitability or loss. They applied the residual earnings model to illustrate that the multiplier for R&D costs would probably be negative (positive) for profit (loss) generating firms. This is due to the fact that the dynamics of linear information in the residual earnings model is mostly appropriate for profit generating firms rather than loss generating ones. The income statement for income generating firms includes information on future benefits of R&D; while no such information is presented in the income statement of loss generating firms. Empirical evidence approves predictions made by researchers for loss generating firms. Rockoff (2009) believes that the high value for a product is not necessarily due to the traditional strategies of high risk R&D activities, however, concentration on activities with economic merits and the control of the cost of production and assets would not be possible without the application of R&D strategies. Sharad and Zhang (2006) applied the Olson evaluation model to examine the relationship between R&D costs and the persistence of abnormal earnings. According to their research which was carried out from 1982 to 2001 contrary to previous studies which considered the industry as an R&D index, R&D costs were divided into two categories. The first category included average industry R&D costs (industry influenced) and the second involved companies focused on R&D costs (company influenced). Ultimately the effects of both categories on the persistence of abnormal earnings were studied. They realized that both categories have a positive relationship with abnormal earnings. Moreover the positive effect of the efficiency of R&D costs on earnings persistence and the creation of a competitive merit are quite more significant than the negative effects of R&D project risks. Also it is not only the industry which plays a role in predicting earnings persistence but rather it is the investment of the owners in R&D costs that is indicative of the firm s efforts in producing diverse and different products and the measurement of earnings persistence. Nvark (2001) investigated the relationship between growth, profitability and costs of research and development using simultaneous equations model. In this study the relationship between firm size and R & D and other factors affecting research and development in its various forms has been investigated. The results show a significant and positive effect on research and development, and mutual profitability and growth on profitability is significant. Jones (2000) looked at the effect of profit and other information in assessing the companies that have research and development costs. The sample included 144 companies in four industries in Market value by the variable operating profit, operating assets, book value, profit sharing and other data were considered. The results showed that operating profit and the persistence of abnormal profit of firms with research and development expenses are to companies that lack such expenses are less. Perry and Grinaker (1994) studied profitability expectations and discretionary research and development costs in America. In this study, he investigated the ratio between R & D and profitability of 90 major USA companies. Results showed that the profitability of research and development is effective. This effect was more than a quarter of the total impact on profitability. Also, research and development has been associated with an increase in prosperity, but in times of recession, it has been reduced. 915

3 Lewis and Bohumir (1993) believe that various attempts have been made to measure the profitability of research and development. The most important of these activities are: 1 To use cost analysis - for the benefit of an individual patent 2 To consider research and development activities as a measure of economic activities or cost of production 3 To use market value to assess the impact of regular research and development activities on company value. Grobowskey and Muller (1978) based on the results of a cross-sectional analysis concluded that investment on research and development leads to an increase in the profitability of firms. Hypothesis testing and estimation model The results obtained from this study can be used in financial decision-making process. The researcher in this study is seeking to assess the relationship between two or more variables. It, therefore, uses single-variable regression model to analyze the results and to test the hypothesis.as the effects of R&D projects and investments will be determined after four years, the correlation between R&D spending and the operating income of the four years later will be assessed. The following single-variable regression model was used: Y = x + The value of 0 and 1 are given by solving In the above equation, X = is the summation of independent variable, Y = is the summation of dependent variables such as Sale, XY = is the summation of the product of dependent and independent variable, N = is the summation of the product of dependent and independent variable, X is the independent variable and R & D costs in the base year (t) and Y is the dependent variable and sale in the fourth year (t +3). In order to test the relationship between research and development costs and profits of pharmaceutical companies, the Financial Information of 20 major worldwide pharmaceutical companies from 2006 to 2010 in terms of their sales in 2010 was used. The amounts used in this study are in dollars. The records of the companies which were recorded in other currencies like British pound, Japanese yen were converted to dollar using the exchange rate of December 31, Regression linear equation, regarding R & D costs (independent variable) and companies sales (dependent variable) Determinate coefficient is the rate of variability in the dependent variable, which could be described by regression. The difference of the determinant coefficient and the justified determinant coefficient could be in the volume of samples and the No of variables. If the sample is small, the justified determinant coefficient is more appropriate for interpretations, but by growing of the samples volume, the two coefficients get closer to each other. Hence, the researcher uses the justified determinant coefficient. It means that the.856 of dependent variable can be explained by the regression. Then, the regression analysis significance is considered, and the certainty of the existence of the linear relations between two dependent and independent variables will be analyzed. The statistical hypotheses for the significance of the regression model are as follows: H0: There is no linear relation between two variables. H1: There is a linear relation between two variables. Since the significant value is less than 5%, the linearity of the relation between the two variables is approved. Regression line indicates the changing rate of dependent variable, expressed by independent variable, expressed by other random elements. In column in this table the constant value and the independent variable coefficient in the regression equation are shown, respectively. Therefore the regression equation is obtained as follows: 916

4 Y= (X) Column shows non-standardized coefficients and column shows standardized coefficients. The variable scales in non-standardized coefficient. (B) are not similar to each other, while the scales in standardized coefficient are homogenized and therefore the variables could be compared with each other. Hence, standard coefficient () are used for comparing the effects of some independent variables on the dependent variable, but it is not the case here, with only one independent variable. If we name the constant value and the coefficient of independent variable as and, their significant values consider the test assuming zero, i.e.: H0: = 0 H1: 0 H0: = 0 H1: 0 Since the significant value of the independent variable coefficient is less than 5%, the assumption for the coefficient to be equal to zero is refused. Conclusion This study aimed to investigate the effects of research and development costs on the profitability of pharmaceutical companies. Based on the results of this study, research and development leads to an increase sales of these companies. Accordingly, the information to pharmaceutical companies that increase market share, sales and profitability through increased spending on research and development is beneficial. The government can also support job creation in the private sector and facilitating conditions, as for the potential exists between professionals and young people in the country and it also costs less than Western countries, to develop research and development departments of pharmaceutical companies, even so, such as India, can absorb the world's drug research and development corporations. Also the government should be like Australia's government, deduct a series of tax exemption incentives for research and development activities that companies encouraged for investing in these activities. 917

5 References - Franzen-Laurel-Radhakrishnan-Suresh-The value relevance of R&D across profit and loss firms - Journal accounting (Vol 28) Grobowskey-H.G & Muller-D.C - Industrial Research and Development, Intangible Capital Stocks, and Firm Profit Rates - Bell Journal of Economics 1978 Autumn - ( ) - Jones- Denise - The relative importance of earnings and other information in the valuation of R&D intensive firms - Doctoral Dissertations - The University of Chicago K wak - Young Hoon - Risk management framework for pharmaceutical research and development projects - International Journal of Managing Projects in Business Vol 1 ( ) - Lev-B and Sougiannis-T - The Capitalization, Amortization, and Value-Relevance of R&D - Journal of Accounting and Economics vol. 21 February - ( ) - Lewis - D Johnson & Bohumir - Pazderka - Firm Value and investment in R&D - Managerial and Decision Economics Vol 14 (15-24) - Mansfield - E - Industrial Research and Technological Innovation - W.W.Norton - New York Newark-L - Further Evidence of the Determinants of Industrial Research and Development using Single and Simultaneous Equation Models ( ) - Perry-S & Grinaker-R - Earnings Expections and Discretionary Research and Development Spending Vol 8 - No. 4 - (43-51) - Rockoff -Jonatha - Drug Firm Leaves R&D to Others Valeant Pharmaceuticals Prefers to Forgo the Risk, Grow Through Acquisitions - Wall Street Journal B. 6 - Sharad-Asthana & Zhang- Yinqi - Effect of R&D investments on persistence of abnormal earnings - Review of Accounting and Finance Vol 5 ( ) - Xu- Bixia - R&D strategy and stock price volatility in the biotechnology industry - Review of Accounting and Finance Vol 5 (59-71) 918