Tuesday, June 03, 2008

11,105 Pharmacies Gone?!? Just More AMP Hype

A new report prepared by PriceWaterhouseCoopers (PWC) claims that 11,105 pharmacies will close due to the Average Manufacturer Price (AMP) provisions in the Deficit Reduction Act of 2005 (DRA).

However, as I explain below, this report is fundamentally flawed in a way that will be immediately apparent to anyone familiar with pharmacy economics. In my opinion, the “findings” are not a reliable or accurate prediction of the actual outcome of AMP on the pharmacy industry. No one in the channel – manufacturers, PBMs, wholesalers, pharmacies, and payors – should use this report to plan business strategy.


The centerpiece of the report is a state-by-state estimate of the number of pharmacies that will close if AMP is used to compute the FUL. (See The AMP Saga Goes On and On and On for background.) There are many questionable methodological aspects behind these estimates, but the most significant assumption in PWC’s model derives from the variation in the 2001 average pharmacy net profit.

The average Net Profit reported in 2001 was 3.5% (as reported in the 2002 NCPA-Pharmacia Digest.) However, according to the self-reported data from the report: 13% of independent pharmacies had a net loss in 2001; 28% had a net profit of less than 2% in 2001; 33% had a net profit between 2% and 5% in 2002; and 26% had a net profit of 5% or more.

PWC’s model assumes that AMP would cause all pharmacies with negative net profits, i.e., a net loss, to close and also cause some percentage of pharmacies with “low” net profits to close.

BTW, Dr. Schondelmeyer’s November 2007 report from the AMP lawsuit used a similar approach to come up with the “loss of 10,000-12,000 pharmacies” guesstimate that has been cited up until now.


Understanding the flaw in the report’s method requires a quick review of a retail pharmacy’s income statement:

  • Gross Profit = Revenues minus Cost of Goods Sold (COGS)
  • Net Profit = Gross Profit minus Operating Expenses
  • Operating Expenses = Owner compensation + Payroll Expenses (excluding owner’s comp) + Other Expenses (rent, utilities, etc.)
  • Owner's Discretionary Profit Before Tax = Net Profit + Owner Compensation

Key insight: A reduction in reimbursement has no direct effect on a pharmacy’s Net Profit.

A reduction in reimbursement, such as the use of AMP for FUL computations, lowers Gross Profit by reducing Revenues (assuming no change in COGS, among other things). However, the impact on net profit depends on whether a pharmacy can alter its operating expenses in response to a decline in Gross Profit.

If a pharmacy’s costs are entirely fixed regardless of changes in reimbursement, then a reduction in reimbursement translates directly into a loss of net profit. However, the impact on net profit would be less significant if a pharmacy can adjust its expenses in response to a change in reimbursement levels.


A private business may report an “net loss” for many reasons that do not relate to the true financial health of the business. For example, there could be tax minimization benefits for a business owner from reporting a low or negative net profit while generating high personal income for the owner.

Thus, the “average” pharmacy could have reported an “net loss” if the average pharmacy owner had chosen to pay himself or herself a larger bonus of instead reporting a positive net profit on the NCPA survey. In other words, a decline in Gross Profit could be offset by a reduction in profits to the owner without causing the business to shut down.

I’m no accountant, but a “global market leader for tax services” such as PWC should have considered these financial issues in their computations. If you understand these matters, then you too will question the core assumption that 13% of pharmacies with a “negative net profit” will automatically close.

So here’s another way to think through the math.
  • PWC estimates that average pharmacy net profits drop by $23,300 due to DRA.
  • The most recent data reported (2003) put Owner's Discretionary Profit Before Tax at 8.1% of revenues.
  • Using the most recent average revenue data of $3.6 million per independent pharmacy implies that Owner's Discretionary Profits were about $293,000.

Unfortunately for owners of independent pharmacies, the most obvious way to stay in business would be to reduce average pharmacy owner compensation by $23,300 to about $270,000 per year.

Personally painful? Yes. So the real (and still unanswered) question becomes: At what point will an independent pharmacy owner decide that the Owner's Discretionary Profit is too low and shut down or sell the business?


Look, I understand what’s going on. Pharmacists want to be compensated appropriately for the value that they contribute to U.S. health care. I fully support pharmacists’ First Amendment rights to advocate on behalf of their own interests. See In Defense of Lobbyists from Friday’s Wall Street Journal for a spirited POV on this subject.

I’m just bothered that pharmacists are making the case using misleading analyses rather than explaining their true value to the health care system or confronting the cross-subsidies of the pharmacy economic model. I’m disturbed to think that this report might be used by outside parties to predict the actual impact of DRA. I also suspect that many independent pharmacists may begin to believe (falsely) that AMP is the single biggest threat to their collective survival.

Just to be clear, I have no stake in the outcome of the AMP battle. I’m not being paid to write this blog nor do I get paid for advocating any particular position regarding AMP. I don't have a grudge against retail pharmacists - honest!

But I do believe strongly in the value of independent expert analyses. Unfortunately, the latest AMP report appears to be political theater designed to influence policy makers rather than a genuine attempt to quantify the impact of AMP. Too bad.


  1. AnonymousJune 03, 2008

    I hate to admit it but you make a very good point. I did not read the report but it sounds like they overestimated the closure rate. Thanks for pointing it out.

  2. AnonymousJune 03, 2008

    The challenge your comments don't address is the high rate of fixed costs in running a pharmacy. If operating expenses were truly variable your logic would be sound but we all know that is not true. The impact of margin compression like that caused by AMP is that the threshold for a financial breakeven number of prescriptions continues to rise. It continues to remove the stores servicing the smaller communities where prescription volumes are fixed by population size. If you are going to claim to take the high ground then you should also recognize that a $290K NI is at best a skewed number and there is likely a bimodal distribution with a large number of stores struggling to keep above water. Opinion blogs are great but your bias in this area is no less damaging than the overstatements of the lobbyists!!

  3. Thanks for your comment. However, I believe that my critique holds even if we assume all other costs except Owner's Discretionary Profit are fixed.

    You are correct that the average may not reflect the underlying distribution. Here are the median values of "Owner's Discretionary Profit Dollars Before Taxes" by Sales Size of Pharmacy (as reported in The 2004 NCPA-Pfizer Digest):

    Under $1.5M: $97,216
    $1.5M to $2.5M: $161,364
    $2.5M to $4M: $250,465
    Over $4M: $359,935


  4. AnonymousJune 03, 2008

    Adam, I'll take a 130,000 annual salary at 38 hrs per wk w zero stress and high benes anytime over the future AMP driven retail pharmacy reimbursement program. It's no secret that the big 3 PBM's are all keenly watching what will happen when the Fed's launch this program....as this will ultimately help the PBM industry increase their spread pricing.

    It's sad to say, but those providers which have been saving the system money via therapeutic subbing and high generic fill rates (above market) are to be penalized the most.

    And yes, the blogger b4 me was correct in saying that most retail pharmacies labor expenses are indeed fixed and held down to the bone.

    It's all about the margin erosion.....and those that can grow in the 4 buck environment to cover the margin shrink will survive.

    I guess it boils down to what level shall we throw in the towel and go work for a W.

  5. AnonymousJune 03, 2008

    You're right. You're no accountant. Nor are you a pharmacy owner. I am (or was) both, but I sold my stores and got the heck out because I saw the writing on the wall. Since then the current owner of those stores has shuttered a third of them. According to the figures you cite on "owners discretionary income" I should have been pulling down a cool million plus. Can you hear my cynical snicker? Look, pharmacies are an easy target. They take the heat for a health system that tolerates the abuses of PBM middlemen and insurance oligarchies. Take a hint from the trenches: cut revenues to pharmacies and they WILL close, cut revenues more, and MORE will close. Oh, and what "cross-subsidies" are you talking about? I'm interested because I'm considering farming so I can get "cross-subsidized" to grow corn to fuel our SUVs and watch food prices soar.

  6. AnonymousJune 03, 2008

    Surely, you are not going to rely on 2004 Net Income Levels to argue that pharmacies have lots of room for margin compression! Post 2004 there has been compression as seniors moved to Medicare Part D; managed care has continued to press on margins and don't forget that although margin % is better with generics, margin dollars have continued to drop as we have moved to 70% generic fills in many communities. Argue with accurate and current facts if your goal is to take the argumant away from emotions to business principles!!

  7. AnonymousJune 03, 2008

    I think the last two comments missed your point. You are saying that pharmacies showing net losses will not necessarily close because part of the profit is being paid to the owner/pharmacist. And you say that the estimates of pharmacies closing in the NACDS report closing is based on 2001 data. So your points are technically right and maybe not all of the 11000 will really close.

    But as a pharmacist, I can tell you that it is getting harder to make a good living. I don't know how many will close, but I'm almost ready to sell our 2 (profitable) stores and retire.

  8. AnonymousJune 03, 2008

    This blog is great for its topicality, its plain language, its references, and its disclaimers, but I want to point out that the "key insight" is flawed (as the accompanying text allows).

    Gross Profit = Rev minus COGS
    Net Profit = GP minus Op Exp
    Using my 7th grade math, I substitute "Rev minus COGS" for GP in the NP formula, and I get:
    NP = Rev - COGS - Op Exp

    Ceteris paribus, a reduction in reimbursement DOES have a direct (negative) effect on net profits.

    I only comment because you generally hold yourself and others to a higher level of rigor. Your point can be made without an oversimplified (and bolded) conclusion.


  9. AnonymousJune 04, 2008

    So, I wonder if the dues revenue for the national organizations will drop dramatically once 11,000 of their members learn that they are going out of business?

  10. Thank you all for the feedback.

    To Michael:
    Thank you for the kind words about the blog. Yes, your math is correct, but my point is still accurate. A decline in revenues only reduces net profits if there are no offsetting changes in Op Ex. In other words, the relationship between Reimbursement and Net Profits is mediated by Op Ex and Owner's Compensation.

    A pharmacist/owner generally does not control the revenue or COGS from a script (given the role of 3rd party payers), whereas owner's comp and (to a lesser extent) all other expenses are more variable and partially under the control of the business owner. I highlighted the "key insight" in bold in order to expose this important assumption buried within the PWC methodology.

    The 4th comment (anonymous) and Bill's comment points to the real issue: At what point does a pharmacy owner decide to shut down b/c the financial returns are either too small or just not worth the headaches? As I have pointed out on the blog for some time, AMP will not be good for independents. However, the PWC estimates are illogical and needlessly fear-inducing.

    The other comments should take note of the fact that the PWC estimate applied the *2001* distribution of net profits for independent pharmacies to all pharmacies: chains, mass merchants, supermarkets, & independents. Two more dubious, but subtle, assumptions, IMHO.

    I used the most current data available to me because Owner's Discretionary Profit is no longer reported by NCPA in the Digest available to non-members. However, the average over 1994 to 2003 was 8.0% (range 7.6% to 8.5%). I'd welcome more current information.

    Perhaps comment #5 (anonymous) may have the right idea: demolish your pharmacy and plant corn for ethanol! :-)


  11. AnonymousJune 04, 2008


    There is a reason why most in the retail pharmacy industry truly feel the sky is falling....and has for the past 3 yrs.....and before.

    When one does not control their own destiny, the future is shaky.

    It's not just the indy's and small chains who are worried, but you can believe the guys with the top 5 chains and mass/grocery are petrified as well.

    The only diff: we count on our income to put our kids thru top colleges and take care of our wives.

    That ain't easy on evey 200M per year.....and yes, that's a pit and a reflection on our society.

    Lastly, ever wonder why so many of us blog via anonymous?

    Ya think the Gov or PBM's monitor this site?

    Thx for your ongoing insight. (Ur great to visit with and follow).

  12. AnonymousJune 04, 2008

    I'm with a PBM and take great pleasure in saying that I do visit this site very frequently. No other motive than to just get pretty consistent and accurate insight from an intelligent Adam Fein. You have fans everywhere....

  13. AnonymousJune 11, 2008

    "However, the impact on net profit depends on whether a pharmacy can alter its operating expenses in response to a decline in Gross Profit.

    If a pharmacy’s costs are entirely fixed regardless of changes in reimbursement, then a reduction in reimbursement translates directly into a loss of net profit. However, the impact on net profit would be less significant if a pharmacy can adjust its expenses in response to a change in reimbursement levels."

    Am I losing my mind, or did you just state that a pharmacy will not lose any money as long as they can figure out another way to make money?!?!? You call this analysis? This is the insight that your advanced degrees have provided you? The ultimate in doublespeak, a perfect statement for today's times.

  14. AnonymousJune 23, 2008

    Greetings, I am a health-system pharmacy administrator and PharmD who is responsible for a small system of community pharmacies. We have a very similar business model to an independent pharmacy because our pharmacies do not qualify for disproportionate care drug pricing despite our affiliation with our health system.

    I understand your key point to be: A reduction in reimbursement has no direct effect on a pharmacy's Net Profit.

    I understand your logic for this to be: Pharmacies experiencing reduced revenues due to a reduction in reimbursement can compensate through reducing operating expenses.

    In your article you state that operating expenses consist of three main components: Owner compensation, Payroll Expenses (excluding owner's comp), Other Expenses (rent, utilities, etc.).

    I would argue that these pharmacies do not have the ability to reduce operating expenses. There are several reason for this.

    First, a service oriented business such as a pharmacy must not only be conscious of financial performance (as is your ENTIRE focus). But they must also ensure that five other aspects of the business are thriving. These include:
    -- Market Position (i.e. ability to maintain adequate prescription volumes, which may not always be possible, and often requires operational expense)
    -- Operational Efficiency (may require capital investment to prepare for increased market capture, if it is available, or reduction in personnel)
    -- Employee growth and management (pharmacists are very hard to hire and retain due to the overwhelming salaries and sign on bonuses of the chain pharmacies)
    -- Clinical Effectiveness (pharmacotherapeutic intensity) Quality and Safety of Service (although I have not been reading your blog for long, I am very concerned about the evident lack of focus on the need to care for the patient)
    -- Customer Satisfaction (cost reduction in this area leads to immediate additional loss in revenue)

    If any of these areas suffer, the pharmacy will shut down. Costs cannot be cut continually and fast enough to keep up with the current steady reduction in reimbursement rates. I would ask, can you develop more than 3 effective strategies that could reduce operational expenses without negatively impacting the other aspects of business in such a way that would not threaten the business (via the other metrics)? You would definitely have to understand the intricacies of the business to do that.

    In addition, I would like to completely discount the ability of the independent owner to reduce their own take home pay. I can't imagine that it does very well for our economy for these middle class professionals to have to cut back on personal expenses, sell off their house for a smaller one, and stop purchasing all of the other economy stimulating services and products that they are accustomed to. I would imagine most would sell off the business before taking such steps. Not to mention, these thousands of business owners probably provide a significant amount of free will (tax deductible) donations to their communities (if they really are making as much as the estimates in the article said that they do. So in essence, the money goes from the dying rural communities to the corporate PBM headquarters, or into a fund distribution beauracracy (CMS).

    You should know better than anyone that a business that has to continually focus on cutting costs because of continually shrinking revenues is a failing business. Any independent pharmacy owner would be smart to get out of the business.

    However, these independent pharmacy owners do spend the time to increase revenues that are not associated with the prescription dispensing services. These services include demonstrating the real power and quality of the Doctorate degree in pharmacy to improve the health OUTCOMES of patients.

    I am going to bold the next statement: There is only one healthcare professional who is currently and consistently equipped to improve the health outcomes of the entire population of patients while simultaneously reducing the astronomical commodity costs associated with that care: The Pharmacist.

    The future of dispensing pharmacies is very different than it is today, and it is not so far away. This industry CANNOT sustain itself given its current trends (even the big chains). The nature of the business will have to change. That is not so hard to see if you can take into account the big picture.

    I would implore you in your future posts to step out of the financial analysis and understand how the pharmacy really operates and how pharmacists really practice.

  15. Wow, here you go again. Bashing retail pharmacy. Guess we know who pays your bills.

    Why don't you address the roll of Pbm's in the pharmacy market?

    I could close my pharmacy now and go to work for a chain, increasing my wages/benefits by 30%. But I prefer to know my customers and not work in a sweat shop.

    Pbm's are the bad guys here, they will get what is coming to them when the truth gets out, and it will.

    How do you justify the Pbm making more than the pharmacy when a prescription is filled? The rebates they get from manufactures on brands is greater the the pharmacy's margins and the price spread on generics is disgusting.

    I would guess you would not tackle that issue, dont bite the hand that feeds you.

  16. To the most recent commenter (4/22):

    The PWC study is fundamentally flawed, which has nothing whatsoever to do with me "bashing" anyone. Thus, you chose to attack me personally (and anonymously) rather than rebutting my analysis. Nonetheless, I do appreciate your participation in the dialogue.

    FYI, I'll be addressing the relative profitability of drug channels players in an upcoming post.


  17. Retail pharmacists have to post anonymously, or face the wrath of the pbm. They have absolute power over retail pharmacy.

    It just seems you are overly critical of retail (mainly independent) pharmacy.

    Its hard for me to stomach when I see the outragous practices of the pbm's. I see hard working self-insured groups getting ripped off by the pbm's. How can you justify the pbm's charging these plans way more then they pay the pharmacy.

    Could you imagine what the AMA would do if they found a large difference in what their doctors were paid by insurance companies and what those insurance companies billed these self-insured plans?

    Retail Pharmacy is too divided to stand up to the pbms, chains are willing to use the pharmacy as a lost-leader.

    I just want the truth.

  18. OK, I understand the anonymous part.

    Keep in mind that I'm only criticizing a highly partisan and misleading "study," not being critical of retail pharmacy. See question 9 of my Frequently Asked Questions (FAQs).


  19. ok, fair enough.

    Just spread some of that cynical hardass(ness) to the pbm's.