It's fun to bash the high cost of health care these days. Whether you take aim at doctors or health insurers or drug companies, they're all easy targets.

But I'm not sure lower costs are what patients really want. Sure, the rising cost of health care is unsustainable, but people's first priority is to live longer. In the long run, reducing the cost of drugs may hamper that priority.

Yes, drugs have very high gross margins: As little as $0.15 of every dollar spent by retailers or drug distributors like McKesson (NYSE:MCK) or Cardinal Health go toward the production of the tablet or vial.


Gross Margin (Trailing 12 Months)

Pfizer (NYSE:PFE)




Eli Lilly (NYSE:LLY)


Source: Capital IQ, a division of Standard & Poor's.

But drugs are also very expensive to develop. Clinical trials are costly to run, and consumers have to pay for the development of all the failures in addition to the ones that make it to the clinic. About 16% of every dollar that Pfizer brought in over the past 12 months went toward developing next-generation drugs.

After paying for everything else -- marketing, administrative costs, taxes, and so on -- drug companies have healthy but not overbearing net margins, especially considering that patents on many blockbusters are expiring soon, and the resulting reduced revenue will cut into margins. The companies have also offered to reduce prices of drugs for seniors in the Medicare doughnut.


Net Income Margin Over Trailing 12 Months





Eli Lilly


Source: Capital IQ, a division of Standard & Poor's.
*Adjusted for non-tax-deductible acquired in process R&D.

If customers expect drug companies to continue to innovate, they can't have their government forcing drug companies to charge less.

But Canada does it!
Through a combination of price controls instituted by the Patented Medicine Prices Review Board (PMPRB), and through government negotiations at the provincial level, Canada is able to keep its drug costs down for its citizens. But that doesn't make it right.

In fact, I'd argue that I'm supplementing Canadians' health-care costs. If drug companies were able to charge more in Canada, they could charge less in the U.S. and still make the same net profit.

As much as I'd love to blame Canada's altering of the free market as the sole cause of the difference in drug costs, there are a couple of things Canada does that probably keeps its costs lower than ours.

First, direct-to-consumer advertisements aren't allowed in Canada. It seems reasonable to assume that U.S. consumers are paying for the advertisements through higher drug costs. There's a reason Costco's (NASDAQ:COST) Kirkland store brand coffee is cheaper than the name brand, even though it's actually roasted by Starbucks (NASDAQ:SBUX). Of course, such advertising also drives up demand, which increases total dollars spent on health care.

There's also some evidence that lower legal liability limits in Canada may contribute to the lower cost of drugs. It's reasonable that companies should want to be paid more for taking on the risk of having to pay $4.85 billion settlements, as Merck (NYSE:MRK) did to settle Vioxx lawsuits. I know it's controversial, but tort reform could take care of that issue.

Because Congress seems as though it might be approaching a stalemate, the simple solution could be to export drugs from Canada and elsewhere. However, while that idea sounds good in practice, the reality is that drug companies would never let it happen in large numbers. They've attempted in the past to stop shipments to Canadian pharmacies that then import to the U.S., and I'm fairly certain drug companies would do so again if they thought they were going to lose large profits.

As with everything else in this debate, setting a cheaper price for drugs is not as simple as it seems on the surface. And as investors, we require the pharma companies to continue developing and selling new drugs.

What do you think? Does controlling health-care costs mean the demise of drug development as we know it? Do you have a better proposal? Let us know in the comments section below.

Costco, McKesson, and Starbucks are Motley Fool Stock Advisor recommendations. Costco, Pfizer, and Starbucks are Inside Value picks.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. The Fool owns shares of Costco and Starbucks and has a disclosure policy.