New Pharmacy Math – Holding Gains

As independent pharmacy owners and members of chain pharmacy management, how many of you are trying to improve your “efficiency” by increasing your inventory turns?  PHSI took the time to calculate what a pharmacy can gain by increasing their turns and found some surprising results.

Lower inventory is not always better!  The current economic down turn and reduced brand pharmaceutical innovations have impacted two key inputs to this question:

  • Reduced cost of money (low interest rates on business loans)
  • Increased brand drug price inflation

While it may seem counter intuitive, if the cost of money is less than the brand drug inflation rate, you will experience holding gains by increasing your inventory and reducing your turns.

The prime interest rate is 3.25% so most pharmacies should be able to borrow money at least at 4.25%.  According the Medco Drug Trend report, inflation of brand drug prices set a record high at 9.4% for 2010. 

So let’s consider the calculations:

NCPA Digest reports that the average independent pharmacy had sales of $3.6 million dollars in 2010.  Let’s assume that 80% of pharmacy revenue is brand sales, which is roughly $3 million, and the gross margin on brand drugs is approximately 7%.  Using the brand profit margin, we can calculate acquisition cost of brand drugs sold.

Brand Cost of Goods Sold             = Brand revenue – (Brand Revenue x Gross Margin)

                                                      = $3.0m – $0.21M

Brand Cost of Goods Sold             = $2.79M

The NCPA Digest also reports that the median pharmacy had 12.4 prescription inventory turns per year.  Using Turns and Brand COGs, we can estimate the average brand inventory.

Turns*                         = Brand COGS / Brand Inventory

12.4 turns                     = $2.79M / Brand Inventory

Brand Inventory            = $225,000

If 80% of inventory is brand, then the pharmacy has $281,250 in total inventory
(*Assumes that both brand and generic inventory are turned at the same rate.)

The next step is to compare the interest expense of your inventory, with the conservative assumption that you are borrowing money to fund inventory rather than using your cash flow.  If you borrow $225,000 at 4.25%, it would cost approximately $9,500 in annual interest.  This can be compared to the following holding gains calculations:

Days on Hand          = 365 days / turns

                                = 365 days / 12.4 turns

                                = 29.4 days on hand

Holding Gains          = Revenue per day x Days on hand x Brand inflation rate

                                = $3M / 365 days x 29.4 days x 9.4%

                                = $22,714

The interest expense on $225,000 of brand inventory is $9,500 annually, but in the course of the year brand price increases will generate an extra $22,714 resulting in over $13,000 of incremental benefit.  Since the brand inflation rate is greater than interest rate, this incremental benefit will only increase with more brand inventory.   Using cash flow and not borrowed money to purchase inventory further increases the incremental benefit.

Are we saying that you should borrow money to hold brand drugs on your shelf?  Of course not.  There are several natural limitations to holding gains.  Drugs expire and a savvy businessman must be able to invest money that will generate more than the bank’s loan rate.  However, if cash flow is available and there are not major capital investment projects that you are missing out on, it may not hurt to allow a little extra brand inventory on the shelf.  In addition to providing extra profits, it can improve customer service by reducing out-of-stock situations.  Finally, remember that generic drugs generally deflate in price so be sure to continue to tightly manage generic inventory.  As a matter of fact, it may be helpful to estimate brand and generic turns separately. 

We look forward to seeing your comments.  Does this “new math” work for your business?  Will you begin to measure brand and generic turns separately?

Comments are closed.