Review of Industrial Organization
14: 135–146, 1999.
1999 Kluwer Academic Publishers. Printed in the Netherlands.
The Cash Recovery Method of Calculating
Proﬁtability: An Application to Pharmaceutical
CHRISTOPHER T. TAYLOR
Ofﬁce of Economics, U.S. International Trade Commission, 500 E. Street SW, Washington, DC
Abstract. The problems with commonly used accounting proﬁt rates are well documented. In this
paper an alternative to accounting proﬁt rates, the cash recovery method is investigated and improved.
This improved method is used as a means to estimate proﬁtability in the pharmaceutical industry on
a ﬁrm level. The proﬁtability estimates give a similar rank order to the accounting proﬁtability rates,
but have different magnitudes.
Key words: Proﬁtability, market performance, pharmaceuticals.
The unadjusted accounting rate of proﬁt, as computed by the usual methods
from balance sheets and income statements, is prima facie an absolutely unre-
liable indicator of the presence or absence either of monopoly power or of
(Bain, 1941, p. 291)
There is a large literature concerning bias in accounting proﬁtability measures
whichculminates inFisherand McGowan (1983). In synthesizing and extending the
previous work on the subject, they reduce the problems with accounting measures
to two main concerns: (1) measuring ﬁrm assets and (2) the timing of cash ﬂows
generated by those assets. While researchers such as Long and Ravenscraft (1984)
have challenged Fisher and McGowan’s sweeping conclusion, “There is no way in
which one can look at accounting rates of return and infer anything about relative
economic proﬁtability” (Long and Ravenscraft, 1984, p. 90), the need to recognize
and adjust for accounting bias is now an accepted fact (Schmalensee, 1989). The
theoretically correct measure of the proﬁt rate is the internal rate of return (IRR),
This paper is drawn from my dissertation at Duke University. I am grateful to John Vernon, Henry
Grabowski, Bill Gentry, Frank Sloan, and Michael Meurer, the members of the U.S. International
Trade Commission research division workshop, and two anonymous referees for their input. The
author is responsible for any errors. The views and opinions expressed in this paper are solely those
of the author and should not be interpreted as reﬂecting the views of the U.S. International Trade
Commission, any of its individual commissioners, or other members of the staff.