The current controversy about whether people should be able to buy imported drugs from Canada offers a useful lesson for entrepreneurs in determining true profits and evaluating risk.

The Canadian drug controversy stems from the fact that identical drugs in Canada sell for less - sometimes much less - than in the United States. These drugs are manufactured by the same companies selling in the United States and are identical in every way except the price.

So why would they sell for less in Canada?

It will be easiest to understand with a simple example that will illustrate both the difficulty of dealing with risky products and also the notion of full-cost pricing.

Suppose you have produced a new pill that will solve some major medical problem. To keep the numbers simple, suppose the cost to make the pills is 1 cent each and that you intend to sell 1 billion of them, so your total manufacturing cost is $10 million (for now I'm going to ignore the time value of money). How should you determine the price at which to sell them?

Here's where it gets complicated.

First you have to recover the costs required to research, test, produce and get FDA approval for the drug before you begin to sell it. For this example, let's suppose those costs are $1 billion. This would put the total revenue needs at $1.01 billion, or $1.01 per pill.

The real problem comes from the risk. Suppose that only one out of three of the drugs you research and test ever gets FDA approval. This means that successful drugs have to carry the cost of the unsuccessful drugs, which we will assume will cost the same $1 billion each.

Now, to cover the cost of the unsuccessful products, the revenue needs become $3.01 billion or $3.01 per pill. If you don't charge this much, you will not have enough money in the long run to stay in the drug business.

Now suppose the Canadian government comes to you and, through their national health care system, offers to buy one million pills, but they consider the price to be excessive and will not pay more than $2.01 per pill. Should you sell to them?

The first piece of logic is that, since all of the research and testing costs are fixed, the incremental pills will only cost $10,000, and so the extra $2.01 million will help cover $2 million of the research costs. That logic explains why the U.S. drug companies were willing to sell to Canada at lower prices. It makes economic sense but maybe not marketing sense.

Unfortunately, once the first set of customers discover that another set of customers have lower prices, they get upset. Now the drug companies are desperately trying to contain the damage. The media and politicians are screaming about obscene drug company profits. Of course, they are only looking at the one penny manufacturing costs for a drug that sells for $3.01 per pill. Some may look at the development costs for the pill, but ignore the costs of all the drugs that never get approval, and so still consider the profits obscene.

This example offers two cautionary lessons for entrepreneurs in highly risky businesses.

First, successful products have to be priced to cover the unsuccessful products or you will not cover costs in the long run. Salesmen know that their margin on the product actually sold has to cover all the visits to customers who do not buy.

Second, even though any price over the direct cost of the product will provide money to help cover fixed costs, there are potential market hazards if you offer multiple prices. Differential pricing can work if there is a clear difference in product or service. For example, airline business class seats and food are different than coach and, as a result, people are willing to pay higher prices. But if you have a product that is difficult to differentiate, the market will find a way to exploit the different prices. Instead of contributing additional money to cover overhead, the differential pricing may result in having to cut prices for everyone.