The True Economics of Pharmacy Ownership

Hooray! It’s time for my annual disambiguation of independent pharmacy owners’ true economics, courtesy of the new 2011 NCPA Digest sponsored by Cardinal Health.

You may believe that independent pharmacies are unprofitable and pharmacy ownership is a bad deal. However, data from the NCPA’s latest Digest show otherwise. Here are four fun economic observations about pharmacy ownership:

• Pharmacy profit margins remain stable.

• An independent pharmacy’s profits from prescriptions are increasing, not decreasing.

• The average pharmacist owning a single pharmacy earned over $250,000 in 2010, but 7% less than 2009.

• The average pharmacist owning multiple pharmacies earned over $1 million, up 17% vs. 2009.

These data have some limitations, but are certainly fair game for analysis.

Curiously, the NCPA Digest no longer reports profitability by payer. Those data have historically shown extraordinarily high margins for uninsured, cash-pay consumers at independent pharmacies. Hmmm...

THE DATA

The NCPA Digest is based on self-reported financial and demographic information from an unknown number of independent pharmacy owners with at least one year of operations. Here are some of the limitations to the data:

• The NCPA data come from a self-selected sample. Pharmacies doing better or worse than average may not have returned the survey in equal proportions.
• Year-over-year differences may not be statistically significant. NCPA does not release information on samples size or provide confidence intervals around the point estimates in the Digest.
• The data were self-reported, not based on audited financial statements. Respondents could have made their profit data look better or worse than reality.
• The average respondent reported revenues of $4.0 million per pharmacy location vs. only $2.1 million per location in the IMS/NACDS data (as shown in The Pharmacy Industry's Evolution: 2000 to 2010).
  
• Many items on the survey instrument were not defined and therefore may have been interpreted differently by respondents.

Here are my two previous analyses of the NCPA Digest data:

• Shhhh! Owning a Pharmacy is Very Profitable (2008 data)
• Owning a Pharmacy: Still Pretty Profitable (2009 data)

These data are fair game for analysis. The NCPA digest data are used for Congressional briefings and testimony, have been analyzed in peer-reviewed academic articles, and featured prominently in an expert report written on behalf of NACDS and NCPA in their lawsuit over Average Manufacturer Price (AMP).

As an aside, NCPA uses the survey results to compute the $92.8 billion size of the independent marketplace as: Average revenues from Digest respondents ($4,022,455) X NCPA's estimate of independent pharmacy locations (23,064). If you think the survey undercounts smaller pharmacies, then you also think that the independent marketplace is smaller.

As always, I welcome your comments on the computations below.

PHARMACY PROFIT PRIMER

Here are some basic definitions to clarify the pharmacy profit story.

Gross Profit is the difference between the revenues received by a pharmacy minus the costs of products sold by the pharmacy. Gross profit measures the portion of revenues available to cover the operating expenses and operating profit of a pharmacy. Think of gross profit as Earnings Before Expenses (EBE). Gross Margin expresses gross profit as a percentage of revenues.

A pharmacy’s gross profit dollars can be spent in three primary ways:

• Non-Owner Operating Expenses: Everything needed to operate the pharmacy—payroll, rent, licenses, insurance—except the salary and benefits of the owner
• Owner Compensation: Pre-tax salary and benefits of the working pharmacy owner
• Net Operating Income: The so-called “bottom line”

This is a zero-sum formula. Increasing one part will decrease another. For example, increasing Owner Compensation will decrease Net Operating Income. A pharmacy could report a “net loss” if the pharmacy owner chooses to pay himself or herself a larger bonus instead of reporting a positive net profit.

The NCPA Digest reports the sum of Owner Compensation and Net Operating Income as Owner's Discretionary Profit (ODP). Thus, ODP represents 2 of the 3 ways a pharmacy's gross profit can be spent.

OBSERVATION 1: Pharmacy profit margins remain stable.

In 2010, gross margins for independent pharmacies increased slightly to 24.0%, up 120 basis points from 2006’s 22.8% gross margin. Total pharmacy gross margin is at its highest level since 2003.

The Digest notes that gross margin “…remained in the 22–24 percent range seen over the last 10 years.” This survey finding is consistent with the U.S. Census Bureau’s data, which show remarkably stable drugstore gross margins for at least the past 17 years. See Drugstore Margins Jump in New Gov’t Data.

OBSERVATION 2: An independent pharmacy’s profits from prescriptions are increasing, not decreasing.

Here’s a shocker: independent pharmacy profit margins on prescriptions have been increasing, not declining, over the past five years. Gross margins on prescription sales were 23.3% in 2010 vs. 21.5% in 2006. And as the chart below shows, prescriptions margins have increased consistently since the launch of Medicare Part D, although there was a slight decline of 10 basis points from 2009 to 2010.

Average prescription prices have been flat due to increasing generic substitution rates. Nevertheless, gross profit dollars per prescription grew from $12.59 in 2006 to $13.43 in 2010.

Another surprise: margins on front-end (non-prescription) sales have dropped sharply, from 38.2% in 2006 to 31.8% in 2010. I speculate that consumers are more price-sensitive given overall economic conditions, so they are shopping more carefully.

OBSERVATION 3: The average pharmacist owning a single pharmacy earned over $250,000 in 2010, but 7% less than 2009.

As in previous years, I compute the Owner’s Discretionary Profit by multiplying the median ODP by average revenues.¹ On a per pharmacy basis, this figure fell again, from $274K in 2009 to $253K in 2010 (-7%).

In 2010, 74% of independent owners had ownership in a single pharmacy. Thus, the majority of pharmacy owners saw a decline in personal earnings. Put another way, pharmacy owners have not been immune to broader U.S. economic problems.

OBSERVATION 4: The average pharmacist owning multiple pharmacies earned over $1 million, up 17% vs. 2009.

Intriguingly, the NCPA Digest reports that the average pharmacy owner now has ownership in more pharmacies—1.89 pharmacies in 2010 vs. 1.69 in 2009 and 1.49 in 2008.

Mathematically, the 2010 figure implies that 26% of independent owners had ownership in an average of 4.4 pharmacies. (Algebraically: [74%*1] + [26%*4.4] = 1.89) In the 2009 sample, 27% of independent owners had ownership in 3.5 pharmacies. These owners must be pharmacists to meet the NCPA’s definition of “independent pharmacy.”

Put another way, the NCPA Digest imply that the owner of multiple pharmacies saw average earnings grow from 2009’s $958K (=$274*3.5) to 2010’s $1.1 million (=$253K*4.4)—an increase of $164K (17%).

It should be apparent that these changes could reflect differences in the sample over time, but there’s no way to figure it out from the Digest information. If NCPA is willing, I’d be pleased to re-analyze the raw data.

WHAT HAPPENED TO MARGINS BY PAYER?

In previous years, the NCPA Digest has reported the average gross margins and percentage of total prescriptions for third-party payers—Medicare Part D, Medicaid, and other third-party programs. A little math can provide the missing average gross margin figure for cash-pay customers.

Here are the data reported in the 2010 Digest. (This chart appears as Exhibit 33 in The 2010-11 Economic Report on Retail and Specialty Pharmacies.) A pharmacy’s gross profit margin from uninsured prescriptions was about three times as high as the profit from a third-party paid prescription.

Oddly, these data have mysteriously vanished from the 2011 Digest. NCPA told me that the survey instrument was “streamlined” and 20 out of 130 questions were cut. Average gross margin by payer was omitted, although the share of prescriptions by payer type was collected and reported.

Perhaps I'm being overly suspicious, but I imagine that it’s hard to lobby for more money or special breaks when the association’s own data show a “soak-the-uninsured” pricing strategy. See Pharmacy Profits and the Uninsured for more on this topic.

LET THE DATA TELL THE STORY

Some of you will not agree with the numbers above. Some may feel that the limitations overwhelm our ability to interpret the information. About half of the pharmacy owners will surely grumble that they are below average (except in Lake Wobegon, of course).

Please feel free to leave me your thoughts below. Just don’t forget that the digest data are frequently and authoritatively cited as a valid representation of the independent pharmacy industry. I am merely computing and presenting the information in a novel way, despite the acknowledged shortcomings of the data.

¹ Math geeks should not fret that I am multiplying an average by a median. the distribution of Owner’s Discretionary Profit Percentage in the 2010 Digest has a very slight negative Bowley skewness (-0.03), i.e., the average is less than the median. However, this figure is not statistically significantly different from skew=0, i.e., symmetry, so the average and the median are pretty close. See “Bonus Comment For Math Geeks” at the bottom of 2009’s NCPA Responds to Drug Channels.