Is R&D the Next Sacrificial Lamb?

For the better part of two years, medtech executives waged a crusade against a 2.3 percent excise tax contained within the landmark Affordable Care Act. Their battle plan consisted of—but was not limited to—lobbying, tax repeal legislation, commissioned reports, outright threats (moving business overseas), and Chicken Little-esque caveats about the imminent demise of American innovation and global competitiveness. It was a well-fought conflict on many levels, but one the industry was likely to lose.

Now, almost quarter of a year past the official implementation of the tax, executives must concede defeat and figure out how they’re going to cover the additional outlay. Device companies are being taxed on gross revenue rather than profit, which means they’ll be giving a bigger piece of the pie to Uncle Sam going forward. Zimmer Holdings Inc., for instance, will slice a $50 million wedge this year for Washington while Cook Medical, the world’s largest privately owned medical device company, expects to surrender 15 percent of its earnings to the government. “…that’s an estimated $20 million that is taken away from re-investment in jobs, in innovation, in clinical studies,” Kem Hawkins, president of Cook Group Inc. and president /CEO of Cook Incorporated and Cook Medical, told The Times Argus of Barre and Montpelier, Vt., late last year.

Cook is not the first company to offer up personnel and product development resources to the device tax god. Last year, while the industry was still engaged in combat, manufacturing behemoths like Stryker Corp., St. Jude Medical Inc., Covidien plc, Smith & Nephew, Abbott Laboratories and Hill Rom instituted layoffs to soften the anticipated blow of the tax (in the event they lost the war). A Reuters report estimated that publicly traded device firms shed a total of 7,000 jobs in 2012, representing 1.6 percent of the industry’s U.S. jobs base.

And that’s just a taste of the kind of bloodletting anticipated in the industry: Economists at the Manhattan Institute estimate the tax could eliminate as many as 43,000 jobs and more than $3.5 billion in employee compensation. A good number of those cuts could occur this year, too—a survey conducted in late 2012 by the Medical Imaging and Technology Alliance (MITA) found that 40 percent of medtech executives intend to trim their payrolls over the next 12 months to offset the new levy (Accuray Inc. and Hologic Inc. already have announced layoffs, though neither company attributes the cuts to the tax. At the very least, such announcements boost the credibility of surveys and economists projecting the tariff’s potential impact).

MITA’s poll also discovered that three in 10 device executives plan to reduce research and development (R&D) spending this year. The finding is consistent with a MassMEDIC survey that put the number of research-busting executives at 50 percent, and a Pacific Research Institute report that predicts an annual $2 billion decrease in medtech R&D investment. “[The tax] is a cost that companies cannot pass on to their customers, so at the end of the day it’s going to affect their bottom line. Usually, the biggest cost for companies is people,” noted Kenneth Fine, president and co-founder of Mansfield, Mass.-based Proven Process Medical Devices Inc., a designer, developer and provider of validation services for Class II and Class III therapeutic and diagnostic devices. “When the economy is tight for whatever reasons, it’s usually R&D that gets cut. It’s certainly short-term thinking, but historically it seems to always be the case in almost every industry. Companies are certainly not going to reduce their product output expenditure, they’re not going to reduce manufacturing [costs] and they’re probably not going to reduce sales and marketing because that affects their ability to sell the product. The only thing left is R&D.”

Not necessarily. Some industry experts contend that all corporate “line item” expenses are potential sacrificial lambs; research only would be vulnerable if a company’s accounting system considers it a line item expense rather than an investment.

“The tax is an instant expense to every medical device company,” explained Jim Rancourt, Ph.D., founder and CEO of Polymer Solutions, a Blacksburg, Va.-based independent testing and materials analysis laboratory for the medical, consumer products, pharmaceutical, aerospace, defense and manufacturing industries. “Basically, companies will have to decide whether to reduce their profit, reduce their expenses or go somewhere in between. So all the expense line items that companies typically have will need to be looked at. [The tax] could affect the structuring of companies a bit. I expect the big ones already have a formal structure or accounting separation of R&D from production and manufacturing, so the tax may not directly affect R&D. The way it could affect research is if R&D is a line item expense and in an attempt to recover the 2.3 percent, a company makes the decision to reduce R&D.”

Those reductions, however, could be a blessing in disguise. The pruning of jobs and research dollars at the expense of the excise tax may force companies to outsource more of their R&D. 

“So many device companies have had layoffs in the last few months because they wanted to make their workforce as thin as possible to prepare for the tax,” said Jahnavi Lokre, vice president of strategy and software engineering director for Irvine, Calif.-based consulting firm Aubrey Group Inc., which specializes in design and development, contract manufacturing and quality systems. “Now that companies have made their staffs as thin as possible, there is a limited amount of resources and talent available for R&D, so companies might consider outsourcing it. There are many advantages to doing so—there are the cost advantages, for one. Companies that outsource R&D don’t have to go through the process of finding and retaining talent and they can use the outsourcing firm in whatever capacity they see fit. Even though the available money for research might be reduced, I think the tax may end up being beneficial for companies that outsource R&D.”