The target audience of this blog is independent pharmacy owners. Many, perhaps most pharmacy owners have little to no formal education in business. Most of us learned on the job. In the coming weeks we will be hitting a core concept pretty hard. Gross Margin. Before I do that I wanted to spend a few moments discussion what Gross Margin (GM) is and why is it important.
Gross Margin is a measure designed to look at the core profitability of the business. It is simple to calculate from financial statements if it isn’t already explicitly there. GM is the net profit divided by the revenue. Let’s look at an example
An auto repair shop pays its mechanics $50/hr. When that mechanic works on a car, the customer is billed $100/hr. Likewise, the business uses a simple 50% markup on selling price: something that cost the business $10 is billed to the customer at $20. Let’s look at an invoice for repairing my car:
Labor: 2.5 hours.— $250.00
Parts:
Battery — $50
Zip ties — $1
Total: $301.00
In this simple example, the business has $125 invested in labor and $25.50 in the parts totaling $150.50. The Gross Margin is therefore 50% ($150.50/$301.00), Why is this important? GM is important because it represents the percent of total sales that remain to pay expenses.
If you run a business you already know that it cost the repair shop more than $150.50 to repair the vehicle. There are other costs like benefits paid to the employee and overhead including the building and utilities. Most importantly, after expenses are removed, there is the most important part: profit for the owner.
A low Gross Margin means that there is less to work with to pay expenses. This in turn means that given some level of expenses, the profit also goes down. The general rule in business when it comes to Gross Margin is that higher is better, and anything less than a GM of 20% is a serious problem for the business.
The GM equation is simple. We only have two ways we can improve GM—decrease our cost of goods (what we pay for parts and labor in the above example) or raise our prices. If our GM is low and we cannot do either of those, the business only left with cutting overhead to maintain profit. Being simple means that GM is powerful, but it also means that if you don’t have control over the limited variables you are in for a rough ride.
And this is where we are with pharmacy. Pharmacies that accept insurance have only one significant lever they can manipulate their Gross Margin: cost of goods. Pharmacies generally don’t have any control over their selling price: the insurance sets that for us. If a pharmacy has a poor GM it has to purchase pharmaceuticals for less and / or cut expenses. Too low of a GM usually means that the pharmacy at risk of having to close its doors permanently.
Soon, we will take a close look at early 2024 reimbursement numbers which reflect the significant changes that have taken effect as of Jan 1 of this year. With this information, we can discuss the ramifications of pharmacy reimbursement in the new year.
