Against a backdrop of declining productivity, pharmaceutical companies need to recalibrate their measurements of R&D investment if they are to generate real value through innovation, a new study argues.
In future, suggests the analysis conducted by Deloitte in conjunction with Thomson Reuters, industry will be setting performance targets and driving research and development strategy around output-based measures such as internal rate of return (IRR). Historically, pharmaceutical companies have used input-based measures for R&D investment, such as expenditure as a percentage of sales revenue.
Investment returns are usually expressed in terms of individual assets or a development portfolio, points out the study, R&D value measurement: is R&D earning its investment? According to Deloitte and Thomson Reuters, this is the first time the return from investment in innovation has been evaluated by examining pharmaceutical R&D at a ‘whole business’ level, rather than as a portfolio of assets.
Encouragingly, this assessment found that the top 12 research-based pharmaceutical companies by R&D investment should generate a positive IRR – ranging from 8.4% to 18.4% – from the investment required to develop each of their late-stage product portfolios. These returns were all above the estimated Weighted Average Cost of Capital of 7% for the group.
Tempered optimism
The findings give cause for “tempered optimism”, Deloitte and Thomson Reuters believe. At the same time, though, a tougher external environment that includes rising R&D costs, increasing regulatory requirements, more demanding reimbursement hurdles and austerity-related price cuts “could exert significant downward pressure on performance”, they warn.
In this context, Deloitte and Thomson Reuters assert, “an IRR-based management framework will equip life sciences companies to shape and execute the strategies necessary for R&D to demonstrate a sustained capability to earn its investment”.
Pharmaceutical innovation “is healthy”, comments Julian Remnant, head of R&D advisory in Deloitte’s life sciences and health card practice. However, research and development “will need to be fitter in future, given the strengthening headwind presented by the external environment”.
Performance factors
The study also looked at whether IRR performance correlates with other characteristics of a company’s R&D portfolio, namely average R&D inflow and outflow per late-stage asset; the proportion of biologics relative to small-molecule compounds in the late-stage portfolio; the ratio of new molecular entities to non-NMEs; the mix of asset origin (e.g., co-developed, in-licensed, originated in house) in the late-stage portfolio; and the distribution of therapeutic categories.
None of these factors in isolation stood out as a clear influence on IRR performance. “This is perhaps to be expected, as our approach looks at R&D performance and returns from a ‘whole R&D business’ perspective and hence portfolio attributes in their own right form only part of the performance picture alongside structural factors such as R&D cost profile, development cycle times and operating margin,” the study comments.
An IRR simulation on a mid-quartile company from the top 12 cohort assessed the relative influence of selected value levers on IRR performance. These were measured in terms of the change required to achieve a relative 10% change in IRR, all other factors being equal.
This analysis found that reducing R&D costs has the biggest impact on IRR, with an 11.0% cut in annual costs needed to boost IRR by 10%. To achieve the same effect, the simulation indicated, a mid-quartile company would have to increase its annual revenues by 12.3% and shorten its R&D cycle times by 28.0%.
“However, given the interdependency of cost, revenue and cycle time levers, a multifaceted approach is almost certainly the most effective means by which to increase IRR in the long term,” the study adds.
Late-stage success
Improving average late-stage success rates – for example, through earlier acceptance of attrition or adjusting the disease area footprint – was found to be the most effective way of boosting IRR across the whole cohort of 12 companies.
In the Deloitte-Thomson Reuters simulation, IRR was most sensitive to changes in success rates at Phase III of the drug development cycle and at the approval submission stage.
Just a 6-7% improvement in success rates at Phase III and submission is needed to achieve a 10% lift in IRR, the study concludes.
“This offers good guidance to heads of R&D at life sciences companies about the continued need to focus on high-quality decision-making when progressing R&D compounds from one development stage to the next,” comments Hans Poulsen, head of consulting at Thomson Reuters.
