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Cut Out the Middlemen to Make Room for US Pharmaceutical Manufacturers

January 20, 2021

By Jeff Ferry, CPA Chief Economist

Drug shortages are a widespread problem in the US today. The American Medical Association reported a spike in drug shortages in early 2020 as COVID cases required doctors to write prescriptions for patients afflicted with the virus. The shortage particularly affected “analgesics, sedatives, and paralytics,” the AMA said, because these were needed especially by patients who needed to go on ventilators.

Our analysis shows that the US can reshore a substantial amount of essential drug production for health security. And that health care costs paid by consumers would be affected very little. That is because the manufacturer share of the final consumer cost for drugs is very small. The cost problem is in the layers of middlemen, each of whom adds his own profit margin to the price of a drug before it reaches the consumer. Those middlemen impact all drug prices,  regardless of whether essential medicines are made in the US or China.

But the COVID crisis only exacerbated a problem that already existed. In 2019, according to the AMA, there were 166 reported drug shortages. The Food and Drug Administration’s page on drug shortages currently lists 179 drug shortages, only 60 of which have been resolved. That leaves 119 drugs still in shortage. The AMA called on the FDA to “provide greater transparency regarding the pharmaceutical product supply chain, including production locations of drugs.”

The migration of pharmaceutical production to foreign production sites creates increasing problems for the US medical system and consumers. The US pharmaceutical market is worth about $500 billion a year. According to the latest trade data, pharmaceutical imports totaled $136 billion, or 27 percent of the market as of October 31st. Despite drug shortages, imports are up 10 percent over the 2019 level. The problem of drug shortages is compounded by the increasing concentration of production in fewer sites. A key part of multinational corporations’ strategy is to achieve lower costs by concentrating production in few or even just one low-cost site. This lowers cost, but at the expense of resiliency. If that one site is temporarily shut down by an accident, or is overwhelmed by a spike in demand, the entire world can suffer from shortages for a protracted period.

Generic Pharmaceuticals

The problem of drug shortages is particularly acute in generic pharmaceuticals. Generics account for about 20 percent of pharmaceutical revenue, but around 85 percent of the prescriptions written each year in the US. Many of the staple drugs used regularly by consumers, such as antibiotics, painkillers, blood-thinners, or ulcer treatments are generic drugs. Because the prices of generics are much lower than branded drugs, drugmakers have been especially aggressive about moving generic production to low-cost locations. fig._2_Generic_Pharma_Cost.png

Often, these locations are India and China. According to congressional testimony by FDA official Dr. Janet Woodcock last year, only 28 percent of the facilities making active pharmaceutical ingredients (APIs) for the US market were in the US. The other 72 percent were outside the US. And 13 percent of the total were in China. The number of Chinese factories producing APIs has doubled since 2010, she said. Moreover, many of the drug companies making the final generic drugs purchased in the US are in India and many Indian drugmakers rely on APIs manufactured in China. The precise origin of the ingredients in the drugs we consume are unknown to the public, because the FDA keeps much of the information it receives confidential. In February 2020, Rajiv Malik, CEO of leading generic drugmaker Mylan, said: “Our whole industry is In one way or another connected with China.”

One danger is that an accident can create shortages of important drugs. For example, when the Qilu Pharmaceutical plant in Jinan, China, exploded in October 2016, that caused shortages of Piperacillin, a widely-used antibiotic.

Another danger is that foreign facilities are not as closely regulated as those in the US. In 2008, contaminated batches of heparin, a key ingredient in blood thinners led to 81 deaths in the US and many more cases of sickness and other side effects before the FDA pinpointed the problem. The heparin was made at Changzhou SPL Company. That plant was the source for 70 percent of the heparin used in the US. CPA recently reported that foreign drug manufacturing facilities consistently violate FDA rules, with no apparent fines or any costs at all. For example, Emcure Pharmaceuticals of India has received three FDA warning letters citing product quality issues due to poor manufacturing standards since 2015 yet still sells its cancer drugs in the US market.

Yet another danger of growing dependency on China for key drugs or ingredients is the national security issue. Antibiotics remain an essential treatment for military personnel wounded in action. Given the still small but rising likelihood of some form of military encounter with China on land or sea, does it make sense to depend on China for these crucial supplies? The Chinese government made it very clear where it stood on its own national security early in the COVID pandemic, when it ordered Chinese companies not to export any personal protective equipment until the Chinese government was satisfied that all domestic demand was met.

The obvious solution to the problem of dangerous overconcentration of drug production outside the US and particularly in China is to incentivize drugmakers to rebuild their US production capability. The economics of generic drugs and branded drugs are very different. Branded drugs are priced high and often produced in Europe or the US. Generic drugs are the ones that have been offshored to China and India. Their prices have been pushed down relentlessly over the past ten years. Drugmakers say they cannot afford to move the manufacturing to the US because US costs are higher than Asia and the profit margins are too slim.

However, according to drugmakers, the main reason the profit margins are so slim on the manufacturing of generic drugs is that the markups by all the middlemen involved in the drug sales and marketing process are huge and leave no room for manufacturers to shift production to US locations. Ed Price founded pharmaceutical ingredient maker Seqens, built it into one of the few successful US makers of APIs, and sold it to a multinational pharmaceutical giant. He is still a consultant in the industry. He says that the typical profit margin for the manufacturer of a generic pharmaceutical is 30 percent. But once a generic drug leaves the manufacturers’ gates, its price goes up on average 14 times until it reaches the consumer. This is the consequence of the byzantine American system of drug distribution which involves many middlemen and many payments between them, mostly invisible to consumers. Because most of that cash comes from insurance companies or federal programs like Medicare, there is little pressure to rationalize the system.

Typical costs in the supply chain for generic pharmaceuticals.
Fig.1_Generic_Pharma_cost.png

Price provides an illustration from his years in the industry: a typical active ingredient for a generic drug can cost $10,000 a kilogram (one kilogram equals 2.2 pounds). The manufacturer buys other ingredients, pays for the cost of manufacturing the ingredients into the drug. The final cost might be $17,500 a kilogram. The manufacturer adds his typical profit of $7,500 and sells the finished drug, in pill form, to a drug company for $25,000.

But since each pill prescribed by your doctor has only a fraction of a gram of the drug in it, one kilogram of active ingredients can yield 40,000 pills. At the prices offered by services like Good.RX, Price says, these pills might cost around $9 each. So one kilogram of active ingredients yields a total revenue of $360,000, paid by the consumer, which is usually a combination of insurance company (or government agency like Medicare) and the patient. Of that $360,000 in total revenue, only $25,000 or 7 percent, goes to the manufacturer. The other 93 percent goes to a complicated network of middlemen, including drug wholesalers, pharmacy benefit managers (PBMs), and pharmacies. There is limited transparency in the pharmaceutical supply chain, so it’s hard for outsiders to figure out which of the middlemen benefits most. This distribution process adds a huge amount of cost but relatively little value.

The total manufacturing cost is just 7 percent and the manufacturer’s profit is just 2.1 percent of the total price paid for the finished drug. So if manufacturing were re-shored back to the US, the manufacturing cost might rise only a percentage point or two above the cost in Asia. US manufacturing is more capital intensive, using the latest machinery, than Asian manufacturing so although US labor cost is higher, total cost rises by much less due to more efficient methods. Further, new manufacturing techniques in pharmaceuticals now emerging in the US mean the manufacturing cost might be the same or even less. In short, cost increases that may occur, if any, would be invisible to the end-consumer. doubled and that additional cost was passed onto the final purchaser, the price would rise by just 7 percent.  The benefits on the other hand, in terms of self-sufficiency, resiliency, and higher, more consistent quality of the drugs, would be huge.

Furthermore, the re-shoring should be accompanied with measures to simplify the drug distribution supply chain and drive some cost out of it. The net result of re-shoring manufacturing and simplifying drug distribution could be a fall in drug prices paid by the final purchaser.

Pharmaceutical manufacturing supply chain

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