Wednesday, October 10, 2012

CMS Pulls NADAC/NARP Data; Plus, Pharmacy Economics 101

Yesterday's article (Transparency is Here! CMS Exposes Pharmacy Prescription Profit Margins) was one of the most viewed articles in Drug Channels's 6 year history. Thank you, faithful readers!

Alas, pharmacy data nerds got a rude surprise when they looked for the data, because CMS PULLED THE NADAC AND NARP DATA FROM THEIR WEB SITE! CMS also removed the June and July FUL/AMP data, along with the 3-month rolling averages. (UPDATE: Data are back online. See this post.)

I have no idea what what happened. A quick injunction? Big Bird blowback? Government goof-up? I'll let you know when (if?) the data reappear.

In the meantime, many pharmacy owners wrote to me with a similar lament: "My average cost of dispensing is about $10 per prescription. If my gross profit is less than $10, then I lose money." While this sounds logical, it is actually not true. Below, I explain why.

COST OF DISPENSING

To explain what's wrong with the pharmacy owners' complaint, we need to look at the difference between a pharmacy's AVERAGE and its MARGINAL Cost of Dispensing (COD).

The AVERAGE cost of dispensing divides:
1) Total annual costs allocated to the prescription department
by
2) Total annual prescriptions dispensed

Total annual prescription-related costs include personnel costs (salary and benefits for pharmacists) and an allocated prescription-related portion of such overhead costs as rent, utilities, insurance, advertising, computer systems, etc.

For example, if:
  • Total annual costs allocated to the prescription department = $640,000
  • Total annual prescriptions = 64,000
Then, the average cost of dispensing = $10.00

MARGINAL COSTS

Now, how much EXTRA does it cost the pharmacy to fill one more script each day? In other words, what is the incremental increase in total annual costs for filling 365 more prescription per year?

If you only look at the average COD, you may conclude that total annual costs would increase by $3,650 (=365*$10). But this is inaccurate.

Instead, the MARGINAL (incremental) cost of dispensing one extra script is close to $0.00, because the total annual costs must be incurred whether the pharmacy fills 64,000 prescriptions or 64,365 prescriptions. For a typical pharmacy, total costs do not vary based on small differences in the number of prescriptions. The pharmacist is still standing behind the counter and the electric bill is already paid.

Put another way, a retail pharmacy has relatively fixed costs—expenses that are not dependent on the number of prescriptions dispensed. These costs aren't fixed forever, because enough extra volume will require a larger pharmacy or an extra pharmacist. However, we can treat them as fixed for small changes in prescriptions dispensed.

PROFIT MAXIMIZATION

For a pharmacy owner, it's sensible to fill one more prescription, if the prescription's revenues exceed the marginal COD. The average COD doesn't factor into the decision for this extra prescription.

Consider a generic drug that can be purchased for $0.02 per pill, or $0.60 for a 30-day supply. If the pharmacy sets a price of $4.00, then gross profit is $3.40 (=$4.00 - 30*$0.02). In this example, the gross profit of $3.40 is below the average COD of $10.00, but above the marginal COD of $0.60. The extra $3.40 in gross profit will drop right to the pharmacy's bottom line.

Is it better to dispense a prescription with a $10 gross profit? Absolutely. But given its fixed costs, the pharmacy is better off making $3.40 than not filling the prescription, and making $0.00.

Two more observations:
  • The pharmacy industry's generic prescription price war will continue. Super-low generic drug acquisition costs, combined with low/zero marginal COD, encourage price competition. With its $4 program, Walmart fills a few incremental scripts at each of its pharmacies, with limited incremental costs. (As a bonus, people transfer other, higher-profit prescriptions to Walmart.) The pharmacy industry's marketing is making generic drugs look more like every other consumer product. Savvy pharmacy owners have already figured out this cash-pay math, and are competing successfully with chains.
  • Average acquisition cost reimbursement models will be increasingly attractive to pharmacies. With traditional reimbursement models, a pharmacy can sometimes earn a very high gross profit on a prescription, but it can sometimes earn a low profit or even lose money. Cost-plus trades this volatility for a stable average margin. Medicaid programs in Alabama and Oregon are making the dispensing fee equal to the average COD, which is typically greater than the marginal COD. (As a bonus, the AAC may be inflated, per my comments on NADAC.)
Still confused? Watch Khan Academy's microeconomics course, especially the video on Marginal Revenue and Marginal Cost.

18 comments:

  1. First off I want to say that your provide a great service to the pharmacy world by publishing this blog.  Your explanation of Average vs. Marginal Cost of Dispensing makes sense.. sort of.  I would like to suggest an alternate way of doing the calculation.  I don't think it's fair to say that since the pharmacist is there and the electric bill is paid, then there's no additional cost.  Sometimes the cost of higher volume cannot be calculated by numbers.  Higher volume means more work, which means more stress, which can lead to errors. 
    My suggestion would be to calculate a fair number of prescriptions that can be processed by one pharmacist (and support staff) and calculate the cost per RX that way, and continue to count for every single RX.  For example, let's say one pharmacist alone has to fill 250 prescriptions per day, and we can't afford to add another pharmacist until the volume is up to 350 prescriptions.  I am saying rather that those additional 100 RX's still need to be calculated for somehow, because as the volume rises and the pressure goes up, the need for that second pharmacist becomes more urgent and you need to have the money set aside for that added high salaried employee.  So even though the prescriptions are still getting filled with one pharmacist, the money (at least a good portion of it) needs to be part of a separate budget so there are no cash flow issues when the new pharmacist is hired.  I don't think it's fair to count it as part of the profits if you can't use it for any other purpose than future planning.
    I hope I explained myself well enough.  I'm basically saying that every prescription has a cost, and you should not be saying that those RX's above a certain point are only incur acquisition costs.  They still need to be typed into the computer and have a label printed and be counted, verified, bagged, and put away.  There are label costs, bag costs, transmission fees from the software vendor, as well as the PBM, and again by the credit card processors at checkout (since most transactions are no longer cash). Please find another way to calculate for ALL prescription filling costs.

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  2. Incredibly clear explanation Dr Fein! Thanks.

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  3. Glad you enjoy the blog.

    1. As I note, no costs are fixed in the long run, especially for big volume increases. 
    2. Even if there are some additional marginal costs (bag, pill bottle, etc.), it doesn't change my fundamental point. 

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  4. "Savvy pharmacy owners have already figured out this cash-pay math, and are competing successfully with chains." -Adam Fein

    "The only rules that really matter are these: what a man can do and what a
    man can’t do.. And me, for example, I can
    let you drown, but I can’t bring this ship into Tortuga all by me
    onesies, savvy?"- Captain Jack Sparrow

    "A savvy store owner can either adjust with the changing economics (while exposing the crooks) and thrive, or whine about it and struggle, savvy?" -Dave Marley

    ReplyDelete
  5. Well, pierce my ears and call me drafty! It almost sounds like you gave me a compliment, Dave

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  6. Another fact to consider when "justifying" a lower margin on generics (e.g. the $4.00 generics) is that the cost to fill a generic is lower than the cost to fill a brand. 
     
    - Generic inventory carrying costs are much lower.
    - The average Receivables per Rx are lower for generics than for brands, improving cash flow.  Many generic prescriptions have no "balance due".  The full financial transaction is completed at the point-of-sale.
    - Also, and a very large factor, generics very seldom have a claim rejection issue compared to brand claims.  This results in a much lower average labor cost (time) to fill a generic vs a brand product, since the pharmacy personnel do not have to spend a lot of time tracking down formulary alternatives or prior authorizations.

    I understand that this segregation of expenses for brand vs generics results in a higher calculated average cost-to-fill for brands.  But, the brand margin dollars are much larger per Rx, even at a lower Margin %, due to the much greater dollar amounts for brands.

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  7. Hearing pharmacies talk about needing to cover a certain dispensing cost per Rx reminds me of how some home sellers tell their realtor that they need to get X dollars of profit from the sale of their home. In the case of real estate, it doesn't work this way - you get what the market will bear.  In the case of pharmacy, the consumer or payer is not exposed to the fact that a given pharmacy's cost of drugs or dispensing may be more or less than other pharmacies. By everyone in the dark about this variability in costs and not promoting competition on cost, pharmacies can continue to demand that they get "at least Y dollars" in average gross profit per Rx. Pharmacies need to realize they service payers, not the other way around.

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  8. Im not exactly sure why a “cost-plus” model would be increasingly attractive.  To your point, it would provide more stable profits, however, with NADAC/NARP now offering better transparency into pharmacy profit margins, what’s to stop public and private payors from correcting the “plus” part of “cost plus” reimbursement downward to ensure that average margins are lower than today’s averages with traditional reimbursement? My guess is that pharmacies would prefer to tolerate the volatility if it meant that average margins were markedly higher than “cost-plus” average margins. My point is, while AAC’s may be inflated and DF’s higher than marginal CODs in today’s market, doesn’t the new insight into pharmacy’s actual profits set the stage for payors to simply correct these overages?

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  9. Yes, that is correct. Cost-plus is not a panacea. See "The Downsides of Cost-Plus Reimbursement for Pharmacies" starting on page 107 of the 2011-12 Economic Report on Retail and Specialty Pharmacies.

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  10. Adam, since you have covered your expenses with earlier sponsors on your blog we here at ApproRx would like to now become a sponsor on your blog at your new incremental cost, thank goodness, because your earlier fees when we inquired at Drug Channels were more than we could afford.
     I will assume your new rates are near zero( see Adam Fein Above) or perhaps now you will even need to send us money, since you may be a making a profit and you will need to send us this money as an offset to those earlier profits.
    How would this feel to you if the FTC, IRS, or even a private entity stepped in and mandated or predetermine what you can charge for your enterprise here on this blog based on your earlier successes.  The market should determine pricing not earlier efforts or profits…. all markets change and pricing will follow. The problem currently is not the market but the lack of clarity in the market and I blame the existing PBM business model for
    intentionally creating this lack of clarity.

    ReplyDelete
  11. Adam, since you have covered your expenses with earlier sponsors on your blog we here at ApproRx would like to now become a sponsor on your blog at your new incremental cost, thank goodness, because your earlier fees when we inquired at Drug Channels were more than we could afford.
     I will assume your new rates are near zero( see Adam Fein Above) or perhaps now you will even need to send us money, since you may be a making a profit and you will need to send us this money as an offset to those earlier profits.
    How would this feel to you if the FTC, IRS, or even a private entity stepped in and mandated or predetermine what you can charge for your enterprise here on this blog based on your earlier successes.  The market should determine pricing not earlier efforts or profits…. all markets change and pricing will follow. The problem currently is not the market but the lack of clarity in the market and I blame the existing PBM business model for
    intentionally creating this lack of clarity.

    ReplyDelete
  12. LOL! Your comment might make sense if I was competing against 60,000 other Drug Channels blogs. I suggest you spend some time with Khan Academy's micro course. 

    See also: Messenger, Don't Shoot the

    ReplyDelete
  13. This comment has been removed by the author.

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  14. While your marginal cost analysis makes sense for an existing concern, doesn't the pharmacy need to cover the average cost of dispensing for that to even become an issue?   I understand that you can fill a extra prescription for a profit so long as there is some minimal GM but if every rx only had that minimal GM you wouldn't have been in business to begin with since your average cost of dispensing must be covered before that marginal rx comes into play.  Basically pharmacy overhead, which is accounted for in the average COD, isn't addressed by the marginal COD analysis you provided since it is assuming that only that marginal prescriptions gross margin was decreased.  In reality, all prescriptions margins would have decreased. 

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  15. Adam - Great post as usual. In your costs explanation above, isn't it true that since marginal revenue > average variable cost (and >= marginal cost) and < average total cost, the result is positive economic profit, but negative accounting profit? Perhaps that distinction is a source of confusion on the issue. Best, Ryan

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  16. LOL! Your comment might make sense if I was competing against 60,000 other Drug Channels blogs. I suggest you spend some time with Khan Academy's micro course. 
    See also: Messenger, Don't Shoot the

    ReplyDelete
  17. Thanks for another amazing article. Where else could anyone
    get this kind of information in such a perfect way of presentation.

    ReplyDelete
  18. The biggest problem with marginal costs is that they are non-linear.  At the point where you have to add to the dispensing expenses, the marginal cost takes a big jump.  What if all those $3.40 margins now cost you $5.00 each?  

    ReplyDelete

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