Saturday, January 16, 2010

The Economics of Pharmacy

Imagine you are a furniture maker. You possess skills that takes many years to learn and have knowledge that few laymen possess. Because of this, you operate your own furniture store to sell your work to local consumers and businesses. You have to compete with the big box retailers, but because all of your furniture is hand made, and made quite well, you have a loyal customer base. You generally manage to keep your prices competitive and, at times, you can match prices of the larger retailers.

In essence you are a respected member of the community providing needed goods and services to the area.

For humor's sake, lets look at the actual cost of materials of the building of a rocking chair.
Wood for Chair - $150
Hardware - $20
Time & Labor - $30
Total Cost - $200
Thus you need to sell this particular chair for over $200 to procure a profit. Being a fiscally responsible businessman, you decide to sell the chair for $250, a 25% markup. This is generally in line with the pricing of similar items at other retailers. As the years go by, you enjoy modest success with this pricing method and remain able to compete with the big box retailers.

Suddenly one day, Walmart attempts to under cut you. They start selling identical chairs for $210. Knowing both you and Walmart have roughly the same cost involved in procuring the chairs, you realize that there is only a very marginal profit made.

Customers start complaining about your now 'over priced' chairs and you are forced to price your chairs at the $210 price point. It doesn't appear to matter that you offer services that Walmart can in no way compete with. You are now making only 5% on this chair, but this pricing method begins to spread to other items in your.

When you voice your displeasure with the situation, the majority of the replies are:
"Well you drive a nice car, live in a nice house and have a stable job, you don't need to be making that much on your products."
Because not all of your customers are demanding meeting this price point, you are able to stay afloat. Your cash flows are altered, but big orders from regional hotels and businesses are supplementing the lost income.

One day you are approached by one of your largest hotel clients. They want one of your rocking chairs in everyone of their thousands of hotel rooms. Naturally, you are excited at this proposal until they start listing their contract demands.

Namely they will pay you $150 for each chair.

"That is unfair," you state. "The cost for each chair alone is $200 and I have to be able to make some kind of profit on it in order to pay my employees and my bills."

"Ah," starts the hotel representative, "but you have operated successfully selling your chairs at $210 and we know the cost of wood in each of these chairs is only $150. Thus you can absorb another reduction in price. So we're willing to pay that amount, and that amount only."

"But you're misunderstanding the situation," you cry back. "The only reason my prices are so low is because I have to compete with the likes of Walmart and other retailers. I'm barely making a profit as it is. And the cost of each chair is not $150, but $200. Your missing the associated costs of actually constructing each chair!"

"Irrelevant!" replies the representative. "The cost of the wood is $150, so that must be the cost of the chair. We will not pay you a dime more for your chairs. Either you accept this agreement or we will take all of our business elsewhere."

Reluctantly you agree. You cannot afford to lose such a large client, even if the deal is rubbish. So you go along, making all of these chairs but never seeing any profit come from it.

Then another of your clients hears of the deal you signed and wants the same pricing. And then another. And then another. Soon a large percentage of your big buyers are purchasing your goods at cost. Tie in the purchases by single consumers for a price barely above cost, and you find yourself leaking money in multiple directions.

Finally, after decades of loyal service to your community, you are forced to close your business. The big box retailers and greedy large clients have bled you dry.

This is exactly how the economics of pharmacy work today. Walmart prices its $4 generics to the point where there is virtually no money made on it (actually the average cost of a prescription, before adding the drug cost, is around $10 per prescription). The large buyers in the story are the PBMs of the nation. Too many of these actually expect us to fill prescriptions for cost.

It is a sad sad fact that very few people are actively aware of. No one seems to care that pharmacies, specifically independent pharmacies, find themselves scrambling for other sources of income. It is the sort of thing that would have its own Dateline special if it were more well known. I highly doubt the public would stand for this type of thing if the majority were aware of it.

Of course this example is overly simplified and there are several other factors that contribute to this problem. I've thought for the last several years that pharmacies and PBMs are going to reach a breaking point some day soon. With two more prominent insurances this year telling us that they will not pay over cost, I feel that day is creeping ever closer.

And it's gonna be one helluva fight.


Grumpy, M.D. said...

This is one of many reasons I don't spend a dime at Walmart. They are malignant scum.

I believe in capitalism. But anything, taken to an extreme, is bad.

Damn good post, Phat.

Anonymous said...

Already, independents closed shop when Medicare lowered reimbursement rates years ago.

griffin3 said...

Although, you did choose to take the deal, making all those chairs for a loss. You could have lost the big customer, and continued to make fewer chairs, at a good profit, for appreciative customers.

It's not like the government is forcing the price on you, at gunpoint. Yet.

Anonymous said...

I am an RPh and agree with all said except one thing 50+150+20= 220 not 200

WarmSocks said...

It sounds like signing that first insurance contract was a bad business decision for pharmacies. I still think insurance companies should be prosecuted under RICO.

Thank you for the explanation.

Phathead said...

@Anon - Fixed, thank you

@Warm Socks - The example I just provided is how the state Medicaid systems work. In most instances you simply cannot choose to not sign the contract. You'll lose droves of patients because you do not accept the plan they are on.

That's part of the reason they get away with contracts like this, a lot of the time we do not have any choice in the manner. It's in some ways similar to sharecropping if you will.

Anonymous said...

"Already, independents closed shop when Medicare lowered reimbursement rates years ago."

It didn't help that they apparently took forever (as in a month plus) to pay the pharmacies, but then the pharmacies did not have money to pay their suppliers for the drugs. So they were unable to buy drugs; and a pharmacy cannot run for long on no drugs.