How Wholesalers Profit from Brand-Name Drug Inflation (But Perhaps Not As Much As You Think)

Since pharmaceutical pricing is in the news, let’s take a look at how pharmaceutical wholesalers benefit from inflation in brand-name drugs.

Growing drug prices are boosting wholesalers’ top-line revenues. We estimate that in the twelve months ending June 30, 2015, U.S. drug distribution revenues at the Big Three public wholesalers—AmerisourceBergen, Cardinal Health, and McKesson—reached a record $353 billion.

And as I explain in the excerpt below from our new 2015-16 Economic Report on Pharmaceutical Wholesalers and Specialty Distributors, wholesalers also generate substantial gross profits as prices increase. Their agreements with manufacturer and negotiations with customers, however, reduce wholesalers’ ability to retain the full benefit.

P.S. Friendly reminder: Special discount pricing on our new report ends this Saturday!

INFLATION GIVETH

Through distribution service agreements (DSA), brand-name manufacturers compensate wholesalers for having achieved negotiated performance goals. These agreements may also be called “fee-for-service agreements,” “inventory management agreements,” and “distribution performance agreements.” The specific services and performance criteria in any agreement will depend on the business needs of a manufacturer.

DSA fees are generally computed as a percentage of a brand-name drug’s list price. Therefore, the dollar value of a wholesaler’s fee payment from the manufacturer rises whenever a manufacturer increases a drug’s list price—the Wholesale Acquisition Cost (WAC). Gross profits increase, because the wholesaler’s fees are computed based on the new, higher price. The wholesaler could also benefit by selling inventory purchased at the older price at the new higher price.

Consider a pharmaceutical product with a $250 WAC list price that a manufacturer increases by 11% annually. We assume that price increases do not affect unit volume. As the numerical example illustrates in the exhibit below, the wholesaler’s total compensation per unit distributed would grow by 37% by the fourth year.

[Click to Enlarge]

Note that the illustration omits the benefit of payment discounts offered by manufacturers. These discounts, which average 2%, are an important component of wholesalers' gross profits and cash flow.

THE MARKET TAKETH

There are at least four important reasons that wholesalers do not retain all of the incremental profits from brand-name price increases:

1) Sell-side discounts. Manufacturer price inflation encourages large customers to renegotiate their wholesaler contracts every few years. Since contracts are often linked to WAC, customers renegotiate sell-side discounts to recapture a portion of these incremental profits. Similarly, pharmaceutical manufacturers can renegotiate buy-side fees to re-index the fees back to an appropriate value.

2) Increased capital costs. After a price increase, a wholesaler faces a countervailing financial impact on its balance sheet. Inventory and accounts receivables are the two biggest current assets on a wholesaler’s balance sheet. Higher drug prices increase a wholesaler’s cost for purchasing inventory and the value of credit extended to customers. However, these balance sheet costs are typically smaller than the extra fees illustrated above.

3) Manufacturers’ recapture of inventory profits. In recent years, nearly all larger manufacturers have negotiated agreements that recapture the value of price appreciation on inventory held in wholesalers’ warehouses and on order with the manufacturer. If a manufacturer recaptures the full inventory appreciation value, then a wholesaler earns only the buy-side fees and does not benefit from taking inventory purchased at the old price and then selling it at the new higher price. DSAs with major manufacturers typically include recapture and revaluation clauses.

4) Inflation in operating costs. Like other businesses, wholesalers face general inflation in the operating costs of distributing products. These costs are attributed to warehousing, transportation, technology, and other operating expenses. From 2010 to 2015, the price index for the wholesaling of non-durable goods (including pharmaceuticals) has increased at an average rate of 2.4% per year.

A wholesaler’s basic business model remains straightforward: Buy low, sell high, collect early, and pay late. These four offsets highlight how wholesalers should never promise what they can’t deliver.