Impact of Profitability, R&D Intensity, and Cash Flow on

R&D Expenditure in Pharmaceutical Companies

Destrina Grace Simanjuntak

Department of Business Development
Dexa Medica Group
Jakarta, 15224

Raymond R. Tjandrawinata*
Department of Business Development
Dexa Medica Group
Jakarta, 15224

Abstract
This paper empirically examines the influence of the determinants of R&D
expenditure, such as firm’s lagged profitability, R&D intensity, and cash flow on R&D
expenditure of the pharmaceutical companies. All of them have an important roles in
determining the steps of the corporate strategy to investing in R&D activities. The data
used in this study was gathered from six large pharmaceutical companies in the U.S., in
the period of 2003 to 2010. The result shows that firm’s lag profitability, R&D
intensity, and cash flow have the positive influence and affect significantly the firms
amount R&D expenditure in the pharmaceutical companies. Thus, enhancement in the
firm’s one-year lagged profitability, R&D intensity, and cash flow can increase firm’s
amount of R&D expenditure.

Keywords: Research and Development Expenditure; Profitability; R&D Intensity; Cash

Flow

Date: April 29, 2011

* Corresponding Author: Department of Business and Development, Dexa Medica Group, Jakarta, 15224,
Indonesia. Phone: (62)(21)7451777. Fax: (62)(21)7452573. Email: raymond@dexa-medica.com

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1. Introduction

This study was performed to investigate the determining factors for research and
development expenditure in the pharmaceutical industry, and also the factors that
influence it. Research and development expenditure plays an important role in a
pharmaceutical company’s decision to develop drugs, both new drugs and those with
modification of existing drugs. Companies maintain market share and building barrier
via R&D to develop new products and technologies (Breitzman, Thomas, & Cheney,
2002). When companies develop a new drug, the cost is usually large and is time-
consuming, before it is able to finally sell in the market. Cost to develop a specific
medicine vary widely from approximately one million dollars (or even less) for
obtaining case studies to nearly 1 billion dollars (Adams and Brantner, 2010). Every
year, R&D spending has grown faster, because nowadays many companies choose to
invest their money on R&D activity, to gain future revenue in appropriate with their
expectations. The amount of R&D spending that a company spends, depends on highly
creative and fast-moving industries (Kennon). Based on Schumpeter’s (1934) view that
R&D effort and innovation activities open the opportunity of making larger profits.
Chen, Chang, and Lin empirical studies, found that larger firms must increase their
profitability, in order to invest more in R&D resources, and then increase their
innovation performance. Vernon (2006), found empirically that profitability has a
positive influence and is statistically significant to R&D expenditure. The consistency in
R&D spending within an industry is a well documented phenomenon (Cohen and
Klepper 1992, 1996).
The level of R&D activity contributes significantly to productivity growth in larger
U.S. manufacturing company (Grilches, 1979). The pharmaceutical industry spends
more on research and development, relative to its sales revenue, than almost any other
industry in United States (A Congressional Budget Office Study, 2006). Chao and
Kavadias (2009) found that a key metric for the assessment of innovative activity at the
firm level is research and development intensity, defined as the ratio of a firm’s R&D
investment to its revenue. This is because when there was an increase in R&D spending,
the increase was always associated with an increase in sales revenue. Changes in the
price level of drugs can affect firms’ expectations about profit (A Congressional Budget
Office Study, 2006). Because the level of profits which obtained by companies can

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affect the level of investment in R&D, when there is a change in the profit gained,
change also occurs at R&D spending. Price level of drugs can also affect a firms’s cash
flow. Hall et al (1999), found a significant positive impact for cash flow measured gross
of R&D expenses for the US and France. Giacotto et al. (2005) found that past cash
flow had a significant impact on R&D expenditures. Based on Bond et al. (2003) studies
found that either in UK or in Germany, cash flow is not sensitive to R&D investment.
The purpose of this study is to discuss the influences of profitability, R&D intensity,
and cash flow on R&D expenditures in the pharmaceutical industry of US. The structure
of this paper is as follows: Section 2 would outline the literature review; section 3
described the methodology and measurement of this study; section 4 would discuss the
empirical results; the final section was conclusions of this study.

2. Related Studies and Testing Hypothesis

2.1 R&D Expenditure and Profitability

A number of previous studies have examined the link between profitability and
R&D expenditures, but most of them only analyzes how the effects of R&D expenditure
to profitability, and only a few that analyzes how the effects of profitability on R&D
expenditure. According to Branch (1974) studied, he found that R&D expenditure and
profitability exist bilateral influence relationship, where there is a tendency for R&D to
influence future profitability, but only slightly influenced by past profitability.
According to Paiboon Archarungroj and Yasuo Hoshino (1999) studied, found positive
relationship between R&D expenditure and profitability. F.M. Scherer (2001) explained
that in principles, profitability and investment in R&D can be linked in three rather
different ways: 1) successful of R&D, can greatly to company profits; 2) The profit
earned by a company serve as a source of funds to support R&D investments; 3)
Managers’ expectations of future profit opportunities, can exert a demand-pull influence
on R&D investment.
In pharmaceutical company, profits are an important stimulus to, and source of
funding for, research and development (R&D), which in turn leads to a stream of health-
enhancing new products (F.M. Scherer, 2001). Research and development fund is like
an investment and are always associated with future revenue. Although average cost
suggest that new-drug discovery and development can be very expensive, it reflects the

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research strategies and drug-development choices that companies make on the basis of
their expectations about future revenue (A Congressional Budget Office Study, 2006).
So that, ultimately research and development activities will affect the profit they will
receive in the future. If companies expected to earn less revenue (means less profit)
from future drug sales, they would adjust their research strategies to reduce their
average R&D spending per drug, and vice versa, if companies expected to earn more
revenue from future drug sales, they would adjust their research strategies to increase
their average R&D spending per drug. And all of that, its depends on the profitability
they earn in the previous period, if the profit they earn on the previous period increases,
then they can invest more in R&D activities, and if the profit they earn on the previous
period decreases, then they can’t invest more in their R&D activities, and expectations
of profit that they earn in the future will be reduced.
Based on Schumpeter’s (1934) view is that larger profit is the main force to
stimulate R&D efforts and innovation activities. Firms with a value above normal
profits and relate such performance with the persistence of R&D efforts of the
individual firm (Eklund and Wiberg, 2007). So that, profits they earn will determine the
company’s strategy to invest in research and development.

2.2 R&D Expenditure and R&D Intensity

Research and development intensity, defined as the ratio of a firm’s R&D

investment to its revenue (Chao and Kavadias, 2009), thus R&D intensity in
pharmaceutical companies always related with how much companies will invest their
money to R&D, relative to their sales revenue. When the acquired company’s profit
increased by increasing the value of sales revenue, the company found that it is more
profitable for firms to invest their incremental dollars of sales revenue in their own drug
research (A Congressional Budget Office Study, 2006). Gee (1981), found that the
industries that devote a larger percent of sales to R&D are generally more profitable and
competitive. A Congressional Budget Office Study (2006) also proposed there is two
reason a relatively close relationship exist between drug firms’ current R&D
expenditure and current sales revenue: 1) Successful new drugs generate large cash flow
that can be invested in R&D (their manufacturing costs are usually very low relative to
their price); 2) Alternative sources of investment capital (such as bond and stock

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markets), are not perfect substitutes for cash flow financing, because they are more
expensive, because lenders and prospective new shareholders require compensation for
the additional risk they bear compared with the firm, which has more information about
the drug under development, its current status, and its ultimate chance of success (Uwe
Reinhardt, 2001).
Based on Archarungroj and Hoshino (1999) studied, they found that an increase in
R&D intensity leads to an increase in profitability, and when profitability increase, then
companies will invest more additional dollars of profitability to R&D expenditure, so
that R&D expenditure will increase. Another factor that can affect companies’ R&D
intensity or their propensity to invest in R&D from their revenue is changes in real
prices, because internally generated cash is relatively inexpensive as source of
investment capital (A Congressional Budget Office Study, 2006). Another factor that
can affect R&D intensity according to Chao and Kavadias (2009) studies are R&D
return, risk, and cost of sales, which lower R&D return, risk, and cost of sales drive
higher R&D intensity, and lower competition intensity drives lower R&D intensity
(consistent with the Schumpeterian Hypotheses).

2.3 R&D Expenditure and Cash Flow

Cash flow define as the movement of cash into or out of a business, project, or
financial product (Wikipedia). In this case, the movement of that cash into R&D
expenditure. Source of funds for research and development is favored from internal
funding, and several study has found the relationship between R&D expenditure and
past cash flow (Malmberg, 2008). Mulkay et al. (2001) found that internal funds are
important for physical and R&D investment in the USA. According to research by
Himmelberg and Petersen (1994) and Mulkay, Hall and Mairesse (1999) points out
there are significant positive relationship between R&D and cash flow. Rafferty and
Funk (2005) considers that if long-run productivity growth reduce because of recessions
since reduced cash flow reduces the pool of funds available for R&D, so that reduced
the R&D spending. They also suggested that the standard method for evaluating
investment project is by using discounted cash-flow analysis. That method inherently
puts projects with lots of initial costs and uncertain future rewards (like R&D) at a

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disadvantage relative to projects with relatively certain rewards in the near future (like
expanding current production capacity).
Bae and Noh (2001), found that for both domestic and multinational corporates
current-year R&D expenditures are significantly positively related to cash flow.
According to Rafferty and Fund (2005) studies, the cash flow and opportunity-cost
effect concern the ability and willingness of firm to engage in inventive activity (such as
R&D), and based on their empirical studies, they found the relationship between R&D
and cash flow, that an increase in cash flow stimulates R&D. Some managers are known
to set R&D budgets using rules of thumb emphasizing an indicator of current cash flow
or sales, although for most well-established corporations, R&D spending is not greatly
dependent upon internal cash flow, but small high-tech enterprises and the research
intensive pharmaceutical industry were probable exceptions (F.M. Scherer, 2001).
Achilladelis and Antonakis (2001) used sales and net profit as proxies for cash flow,
found significant correlations between R&D expenditures and cash flow.
Based on the literature review described above, then through our hypothesis, we
expect to observe that :
Hypothesis 1: Firm’s profitability is positively associated with firm’s amount of R&D
expenditure.
Hypothesis 2: Firm’s R&D intensity is positively associated with firm’s amount of
R&D expenditure.
Hypothesis 3: Firm’s cash flow is positively associated with firm’s amount of R&D
expenditure.

3. Data and Methodology

3.1 Samples and Data Collection

This research was conducted in the firms of the pharmaceutical industry in U.S.
Financial data used in this study, obtained from annual financial reports of each
pharmaceutical company. There are six large pharmaceutical companies in the U.S., that
is Pfizer, Abbott, Johnson & Johnson, Amgen, Merck, and Eli Lilly used as samples in
this study. Archarungroj and Hoshino (1999) found a significant relationship between
R&D and a firm size, impliying that larger firms spend more on R&D and are more

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R&D intensive than smaller firms, hence we choosed to use larger firms data’s for our
study. Data used in this study were taken from the period 2003 to 2010. Since there are
one-year lag in the variable profitability (t-1), then the whole panel data observations
become 42 observations, but our panel dataset was not balanced, bringing our sample
size to 41 observations. The definitions and measurements of these constructs were
further defined as follows:
1. R&D Expenditure
This study uses total R&D expenditure data as the dependent variable for our model.
Total research and development expenditure data is obtained from the income
statement contained in the annual financial statement of each pharmaceutical
company. According to Vernon (2005), it is reasonable to used total R&D
expenditure because pharmaceuticals are the most research intensive divisions these
companies have.
2. Profitability
The data used is the profit before tax as the proxy for profitability, which is obtained
from the income statement contained in the annual financial statements. In this
study, profitability variable uses the profitability data of each pharmaceutical
company, that is one-year lagged (t-1) profitability.
3. R&D Intensity
One of the factors that influence R&D expenditure is R&D intensity. R&D intensity
is the ratio of a company's investment in research and development compared to the
firm's sales. In this study, R&D intensity is derived as follows :

& 


& 
 
 

4. Cash Flow
The data serve as a proxy of cash flow in this study obtained from the:
    
   

    
&
Cash flow is used as an expected profit as the determination of R&D expenditures.

3.2 Methodology and Models

This study was conducted by using regression analysis method using random effect
model, with generalized least squares (GLS) method. In random effect model, it is

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assumed that the intercept of an individual unit is a random drawing from a much larger
population with a constant mean value. The individual intercept is then expressed as a
deviation from this constant mean value (Gujarati, 2003). GLS was necessary to correct
for within-group and contemporaneous serial correlation (Vernon, Golec, Lutter, and
Nardinelli, 2006). The purpose of this study is to examine that there is a positive
relationship between firm’s one-year lagged profitability (t-1), R&D intensity, and cash
flow to firm’s amount of R&D expenditure in pharmaceutical companies, in the period
2003 until 2010. The model equations used in this study is:

! "#$%  &'  &( ! )*+,$%$%-(  &. ! "#/$%  &0 ! 12$%  3$% (1)

Logarithmic transformation are used for all the variables in the model, because with
logarithmic value, elasticity value is obtained, making it easier for us to see clearly and
to interpret the relationship between the dependent and independent variables. In the
model described above, the coefficient of each independent variable (slope) shows the
elasticity of firm’s one-year lagged probability, R&D intensity, and cash flow to firm’s
R&D expenditure respectively. This shows the percentage change in R&D expenditure,
for a one percentage change in firm’s one-year lagged profitability, R&D intensity, and
cash flow.

4. Result

Table 1 reports the descriptive statistics of this study. Table 2 shows the empirical
result from model (1) of this study.

Table 1: Descriptive Statistics of the Key Variables Used

Variable Mean Std. Dev
LOG(PROFIT?(-1)) 8.723579 0.332239
-
LOG(RDI?) 0.100186667
1.879603833
LOG(CF?) 8.909126333 0.256978667

From descriptive statistics on Table 1 below, the average statistics value on firm’s
one-year lagged profitability is 8.723579 percent; the average statistics value on R&D

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intensity is -1.879603833 percent; and the average statistics value on cash flow is
8.909126333 percent. Standard deviation value from firm’s one-year lagged
profitability is 0.332239 percent; standard deviation value from R&D intensity is
0.100186667 percent; and standard deviation value from cash flow is 0.256978667
percent.
To test the hypothesis that firm one-year lagged profitability, R&D intensity, and
cash flow are positively associated with the firm’s R&D expenditure, we estimate the
equation in Model (1).
Through the estimates done using random effect model, the value of the coefficient
estimates was obtained and can be seen in Table 2. In this regard, the coefficient of
firm’s one-year lag profitability, current R&D intensity, and current cash flow are in
logarithmic transformations, so that we will interpreted the coefficient slopes as an
elasticity.

Table 2: Model (1) Result of Regression Analysis Based on a Panel of Six Large U.S.
Firms
Period 2003 – 2010
Dependent Variable: LOG(RD?)
Total observations: 41
Variable Coefficient Std. Error t-Statistic Prob.
C 5.470451 0.902113 6.064044*** 0
LOG(PROFIT?(-1)) 0.208991 0.071183 2.935986*** 0.0057
LOG(RDI?) 0.889397 0.199213 4.464544*** 0.0001
LOG(CF?) 0.307611 0.084524 3.639336*** 0.0008
R-squared 0.622348
Adjusted R-squared 0.591728
F-statistic 20.32462
Two-tail significance levels :
* Significant at level 10 %
** Significant at level 5 %
*** Significant at level 1 %

Based on our estimate is seen to occur in Table 2, the results indicate a positive and
statistically significant relationship between log(PROFIT?(-1)) and log(RD?). That
positive relationship between firm’s one-year lagged profitability and R&D expenditure
means enhancement in firm’s one-year lagged profitability can increase their R&D

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expenditure. Our elasticity estimates suggest that a one percent increase (decrease) in
firm’s one-year lagged profitability will be accompanied by 0.2 percent increase
(decrease) in firm’s amount of R&D expenditure. This is in line with the result of
previous study conducted by Vernon (2005), which showed that the elasticity of total
firm R&D with respect to pre-tax pharmaceutical profit margins was approximately 0.2.
According to Chen, Chang, and Lin (2006), pharmaceutical companies in U.S. should
raise their profitability, so that they can invest more R&D resources to increase their
innovation performance. This support the hypothesis that the firm’s profitability is
positively associated with the firm’s amount of R&D.
With regard to research and development intensity, similar results are obtained and
can be seen in Table 2. The results indicate a positive and statistically significant
relationship between log(RDI?) and log(RD?). The positive relationship between R&D
intensity and R&D expenditure means that enhancement in firm’s R&D intensity can
increase their R&D expenditure. Our elasticity estimates shows a number of 0.88
percent, which means that a one percent increase (decrease) in firm’s R&D intensity
will be accompanied by 0.88 percent increase (decrease) in firm’s amount of R&D
expenditure. In the U.S. manufacturing sector, pharmaceuticals ranked as the most R&D
intensive industry for most of the 1990s, according to NSF (in 2003, was taken by
communications equipment, 12.7 percent) (A Congressional Budget Office Study,
2006).
A positive and statistically significant relationship between log(CF?) and log(RD?)
has also seen in our calculation (Table 2). The positive relationship between cash flow
and R&D expenditure means enhancement in firm’s cash flow can increase their R&D
expenditure. Our elasticity estimates showed 0.3 percent, which means that a 1 percent
increase (decrease) in firm’s R&D intensity will be accompanied by 0.3 percent
increase (decrease) in firm’s amount of R&D expenditure. This result is appropriate
with previous empirical study conducted by Rafferty and Fund (2005), which showed
that an increase in cash flow stimulates R&D.

5. Conclusion

The purpose of this study was to examine the influence of the determinants of
research and development expenditure, such as firm’s lagged profitability, R&D

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intensity, and cash flow on R&D expenditure of the pharmaceutical companies.
Regression analysis has shown a positive and significant influence, thus, enhancement
in the firm’s one-year lag profitability, R&D intensity, and cash flow can increase
firm’s R&D expenditure. Hence, we conclude that profitability, R&D intensity, and
cash flow plays an important role to determine research and development expenditure.
But, in fact research and development expenditure is not only influenced by lagged
profitability, R&D intensity, and cash flow, but also influenced by another factor, such
as the firm’s performance, firm’s size, relevant policy, innovation performance, etc.

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