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1- NEW INITIATIVE IN PRIVATIZATION AND INVESTMENT
2- REVENUE COLLECTION FOR THE FIRST SIX MONTHS
3- PAKISTAN: THE BEST PERFORMING EQUITIES MARKET
4- NATIONAL SAVING SCHEMES
5- TRANSFER PRICING BY MNCS
6- NPV: METICULOUS MEASURE OF PROJECT EVALUATION?

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TRANSFER PRICING BY MNCS

 

A case study of pharmaceutical industry in Pakistan.

 

By Irfan Sattar, SZABIST
Jan 13 - 19, 2003
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Pharmaceutical industry is probably one of the most organized industries in Pakistan, employing a large number of qualified professionals, and utilizing huge economic resources.

For decades, Pakistan remained dependent on Multinational Pharmaceutical companies for fulfilling the needs of its market for medicines. Whenever, the business conduct of any MNC is questioned, transfer pricing is at the top of the agenda. This makes it a very important and interesting issue to investigate and learn from, as this issue is not confined only to pharmaceutical operations, but wherever a local subsidiary imports raw material from the parent company, there are strong chances of transfer pricing.

Every time, the issue of transfer pricing is touched upon at any forum. The discussions always end with the allegations and counter allegations by MNCs and local companies against each other, without arriving at any concrete conclusion. Looking at exorbitant selling prices of the products marketed by MNCs, and at the same time a negative profitability in their annual reports definitely indicate something seriously wrong in the whole process.

To investigate the problem, a random selection of products and companies will be made and the C&F prices at which they import their raw material will be taken into account. A comparison will be made between the prices they pay and the prices prevailing in the international market to know if the cost they claim is justifiable or inflated to meet their hidden agenda?

AN OVERVIEW OF TRANSFER PRICING:

Unlike consumer products, services and consumer durables, pharmaceutical companies are not allowed to use the mass media for advertising their products. Companies aim to make the cost appear as high as possible by buying the raw material at an inflated price, in most of the cases from their own parent companies. This phenomenon is termed as transfer pricing.

TRANSFER PRICING: What it is? Suppose the retail price of a product is Rs. 150 for a pack of 10 tablets, each containing 10 mg of active drug. The ex-factory price for the product will be calculated as per the following formula:

Retail price (Less) 15% retailer's margin (Less) 10% distributor's margin.

Now assume that the cost of raw material in the international market is US$ 100/kg. If we take US$ 1= Pak Rs. 60, the cost will come to Rs. 6,000 per kg. Add 10% duty to it and the landed cost for each kilogram of raw material will be Rs. 7,200. The raw material consumer per pack will be 100 mg, the cost of which will be 0.72. If we now put this figure in the cost structure given above, and take approximate costs of the remaining items, we can arrive at the total cost of each pack.

 

 

Cost of Active Raw Material (Drug itself)

0.72

 

+

Cost of excipients (Material used to give the medicine a particular form like tablets, syrups etc)

1.00

 

+

Cost of labor and other overheads

5.00

 

+

Packaging Material

5.00

 

=

In-Factory Cost of Product

11.72

If we take the above costs against the ex-factory price of Rs. 121.50 as calculated above, the profit margin comes to 90%.

The profit margin coming in the above example will make the firm liable to pay a handsome tax to the government, a reasonable dividend/return to the shareholders (in case of a public company), and finally bank charges to transfer the retained earnings to their parent company. In the example cited above, the company may decide to buy the raw material from the parent company at the rate of US$ 10,000 instead of US$ 100.

Cost of Active Raw Material (Drug itself)

72.00

 

+

Cost of excipients (Material used to give the medicine a particular

1.00

Cost of labour and other overheads

5.00

 

+

Packaging Material

5.00

 

=

In-Factory Cost of Product

83.00

Gross Margin

32%

 

 

Informed sources claim that the multinational pharmaceutical companies cause a loss of a staggering Rs. 4-5 billion per year to the national exchequer. The prices at which MNCs sell their products will leave them with at least 20% net profit. Pharmaceutical industry in Pakistan has a total estimated value of Rs. 45 billion, out of which 50% is MNC's share. Local companies also get a price which even being lower than MNCs, still give them extra-ordinary profits.

WHY MNCS INDULGE INTO TRANSFER PRICING?

As the first step, we need to understand a little about the costing and pricing structure of the industry. The cost structure in pharmaceutical industry goes somewhat as follows:

Cost of Active Raw Material (Drug itself) + Cost of excipients (Material used to give the medicine a particular form like tablets, syrups etc) + Applicable duties on import of material (Approximately 20% all inclusive) + Cost of labour and other overheads + Packaging Material = In-Factory Cost of Product

ARE LOCAL COMPANIES CLEAN?

Recently, local companies have given rise to a new phenomenon taking leads from MNCs.

THE DEBATE ON TRANSFER PRICING

The main bodies involved in these discussions are Pharma Bureau, a representative body of all multinational pharmaceutical companies operating in Pakistan, PPMA (Pakistan Pharmaceutical Manufacturer's Association, The Ministry of Health (The supreme regulating body in the country) and The Network (A consumer rights organization).

THE MNC'S STANCE

The stance adopted by MNCs is very clear: There is no element of transfer pricing whatsoever! They claim that the allegations of transfer pricing are all fabricated and carry no substance whatsoever. In response to the question that why do they insist on buying from the parent companies when the same raw materials are available from other suppliers at a fraction of prices that they pay to their parent companies, their plea is always the quality. They claim that they manufacture the products of the highest quality and that cannot ensure if the material is bought from other sources. Recently, several local companies like 'PharmEvo' and 'Hilton' have sponsored large scale clinical trials on their products which are manufactured using the raw material from other sources and the results have found to be comparable to international reference data. Laboratory analysis has also proven that the raw material from reputable companies besides the originator is of excellent quality.

It is true, that they are not allowed by the international law to buy from any other company except the originator in case of products having valid patents, but most of the products for which MNCs import the material from parent companies are off-patent and can be bought freely in the international market. Even for patented products, the cost they pay is not justified on the ground that R&D for pharmaceutical drugs are extremely expensive. The drug MNCs' claim that their huge investments in R&D warrant the high prices for their products is debatable in another respect.

It is not sufficient reason for pharmaceutical companies to justify high drug prices in developing countries as an incentive for R&D on new drugs. The small markets in developing countries will not significantly affect the R&D costs. The profits of the pharmaceutical industry will also be little affected by weaker patent protection in developing countries, which would enable the latter to manufacture and market medicines at lower prices.

A few years back, the Government of Pakistan started paying some attention to the development of local raw material manufacturing. This clearly shows the intentions of MNCs contrary to their claims of ensuring quality and importing material from their parent companies just because they don't have an option.

IS THERE EVIDENCE AVAILABLE AGAINST MNCS?

The following table will give the company name, raw material, import price from the parent company, international market price and the price difference between the two sources. The invoices scrutinized were for 2001-02, and the alternate source considered was a company of comparable stature and quality.

(Table 1)
EXAMPLES OF TRANSFER PRICING

Name of material

Company

Import Price US$

Alternate Source Price US$

*% Difference

Ofloxacin

Aventis

1,900

66

2,878%

Amlodipine Besylate

Pfizer

30,000

500

6,000%

Simvastatin

MSD

25,000

2,000

1,250%

Captopril

Brsitol Myers Squibb

1,400

55

2,545%

Ciprofloxacin

Bayer

900

90

1,000%

Pizotfen

Novartis

60,000

20,000

300%

Pindolol

Novartis

9,500

1,800

525%

Piroxicam

Pfizer

8,750

125

7,000%

Famotodine

MSD

8,000

150

5,333%

Diclofenac Sodium

Novartis

1,600

30

5,333%

Losartan Potassium

MSD

7,700

550

1,400%

Roxithromycin

Aventis

1,350

450

300%

Ceftriaxone

Roche

700

550

200%

Doxicycllin

Pfizer

700

60

1,166%

Atenolol

ICI

620

130

476%

Nifedipine

Bayer

3,000

85

3,529%

Cimetidine

Glaxo SK

95

30

316%

Omeprazole

Searle (National Co.)

440

50

880%

Fluoxetin HCl

Pharmatec (National Co.)

155

50

310%

Fluoxetin HCl

Zafa (National)

190

50

380%

The data presented above presents a shocking picture about the state of affairs. Considering the fact that the table covers just 8 MNCs and 17 products, we can have a fair idea of what magnitude of financial bungling we are looking at. It would be very interesting to workout the cost of each pack of these products and compare it with the selling price to know what sort of margins they are left with, and what margins they may have if they use the raw material from the alternative sources. Following table [table -2] works that out:

Table -2

Product

Company

Pack Size

Selling Price

Cost at Current

% Margin

Cost at Alternate

% Margin

Ofloxacin

Aventis

10

225.00

285.00

(26%)

20.50

487%

Amlodipine Besylate

Pfizer

20

180.00

227.00

(26%)

15.00

92%

Simvastatin

MSD

10

257.00

191.00

26%

25.50

90%

Captopril

BMS

20

101.00

62.00

39%

13.00

87%

Ciprofloxacin

Bayer

10

385.00

335.00

13%

43.50

89%

Pizotfen

Novartis

60ml

37.00

24.00

35%

15.00

60%

Pindolol

Novartis

30

110.00

216.00

(96%)

49.00

55%

Piroxicam

Pfizer

10

44.50

74.00

(66%)

12.00

73%

Famotodine

MSD

10

201.00

241.00

(20%)

15.00

92%

Diclofenac Sodium

Novartis

30

72.00

97.00

(30%)

12.50

83%

Losartan Potassium

MSD

20

790.00

122.00

84%

20.00

97%

Roxithromycin

Aventis

10

195.00

157.00

19%

59.00

70%

Ceftriaxone

Roche

1

114.00

28.00

75%

24.00

79%

Doxicycllin

Pfizer

10

42.00

61.00

(45%)

15.00

65%

Atenolol

ICI

28

96.00

43.00

55%

17.50

82%

Nifedipine

Bayer

50

79.00

65.00

18%

12.50

84%

Cimetidine

Glaxo SK

20

63.50

38.00

40%

19.50

70%

Omeprazole

Searle (National)

14

Not yet launched

126.00

-

24.00

-

Fluoxetin HCl

Pharmatec (National)

14

96.00

18.00

81%

16.00

84%

Fluoxetin HCl

Zafa (National)

20

51.00

21.00

60%

17.00

67%

 

 

It can be safely assumed that after going through the above table, the situation will be crystal clear for the reader. It must be noted that in pharmaceutical industry, a profit margin of 60%+ on any product is considered to be reasonably good. We can imagine what level of profits these MNCs have on their products, and what is being actually reported?

It appears as if this is not an extraordinary situation for any MNC to have an "off-shore" margin on a particular product, but it is actually the way they conduct their business in the developing countries. Charging high price to rob the masses, evading taxes to rob the government, and on top of it, siphoning foreign exchange thus affecting the balance of payments to a huge extent.

CONCLUSIONS & RECOMMENDATIONS

It can be safely concluded that the multinational companies in Pakistan are robbing us to an extent, which is even hard to quantify and even to comprehend. The most disturbing fact is that the high prices and off-shore margins are not just confined to patented-products, but even for old and off-patent products, the same principles of pricing and costing are being applied.

There are no reasons, either technical or commercial to support this practice. The situation doesn't seems to be such that needs just a corrective measure, or adjustments through negotiations. It seems as if a large-scale operation has to be conducted with our government taking a tough stance against these corporate parasites.

On the one hand, this study reveals the malpractice of MNCs, and on other hand, it also exposes the incompetence of our Ministry of Health. No has ever asked these companies that why do they bother to sell a product which is giving them a negative profit margin? No one has ever bothered to compare the cost data submitted by the MNCs with those submitted by the local companies for the same brand, where the cost of raw material is shown as a fraction of what MNCs claim.

There is no denying the fact that quality is the primary concern for medicine. But quality has a premium, which is in line with the cost of alternative sources. It can never be hundreds of time more than the going market rate, which is exactly the situation emerging from this analytical study.

This study has also served the purpose of highlighting the complication involved in the area of international business. It is not just manufacturing a product and marketing it effectively and efficiently. It involves a lot more than that. It spreads right from small-time tax evasions to large-scale organized crimes across the geographical boundaries.

I sincerely hope that a large-scale study be carried out on the business conduct of multinational corporations operating in other industries as well. This is about time that we become aware of the intricacies involved in international business and take charge of the situation.

Following are the recommendation for amending the situation into our favour:

1. Ministry of Health should carry out a survey of all the products being marketed in Pakistan, and determine the realistic cost-component for the raw material.

2. All companies, whether MNCs or local selling at a price higher than the reasonable level should be issued notices and their prices shall be reduced. The quality element should of course be considered, and the patent status of the product has also to be taken into account.

3. All local companies with a sales base of more than Rs. 500 million should be asked to create a consortium and setup a large scale manufacturing facility for bulk raw material to cater for our needs. The technology is now freely available from India, China and Korea. Once the material being produced there is found to be of acceptable quality, protective duty should be imposed on the import of the raw material.

4. The Ministry of Health should take a tough stance and stopped being blackmailed by the MNCs. It is encouraging to note that the local pharmaceutical industry is now fully capable of fulfilling the needs of our people except for products like Insulin and Vaccines. These areas should be targeted for future growth and self-reliance.

5. A committee should be formed to assess each registration application in future with an objective to ensure that authentic costing data is being provided with no element of over-invoicing or inflated overheads. It is not a rocket-science that cannot be understood. All it needs is sincerity and a clear sense of purpose.