A Critical Cog in the Machine: Solving COGS
Cost of Goods Sold (COGS) is typically one of the largest expenses on any veterinary practice profit and loss statement, making it a powerful profitability lever for practices that are successful in minimizing COGS as a percentage of gross revenue. In order to appreciate the magnitude of COGS as a profitability lever, let’s compare the profitability and owner take-home for a 2 DVM, $1 million gross revenue ($600k by owner DVM) practice with either an above-average COGS of 30% or a competitive COGS of 20%:
Scenario 1 - COGS is 30% of Gross Revenue:
Gross revenue: $1,000k
(-) COGS (30% of Gross Revenue): $300k
Gross profit: $700k
(-) Owner clinical salary (20% of Gross Revenue): $120k
(-) All other expenses: $530k
EBITDA (profit): $50k
EBITDA margin: 5%
Owner take-home: $120k salary + $50k EBITDA = $170k
Clinic valuation at illustrative 6x EBITDA: $300k
Scenario 2 - COGS is 20% of Gross Revenue:
Gross revenue: $1,000k
(-) COGS (20% of Gross revenue): $200k
Gross profit: $800k
(-) Owner clinical salary (20% of Gross Revenue): $120k
(-) All other expenses: $530k
EBITDA (profit): $150k
EBITDA margin: 15%
Owner take-home: $120k salary + $150k EBITDA = $270k
Clinic valuation at illustrative 6x EBITDA: $900k
As we can see in these two scenarios, a clinic that is otherwise operating identically but in one scenario is able to be on the leading rather than the trailing edge of the industry in COGS results in a dramatic difference in profitability and equity value. In this blog we’ll be discussing five ways that a practice owner can improve the COGS line of their P&L.
1. Excessive COGS is often a revenue quality issue, not an expense issue
Not all revenue is the same! Margins on service revenue are significantly wider than those on inventory revenue. Inventory sales are largely “shoppable”, meaning that consumers will go elsewhere (namely to online pharmacies) if your pricing falls significantly out of range from their expectations. This issue is compounded by the fact that online pharmacies can leverage economies of scale and low overhead in order to achieve profitable pricing that may even be at or below your wholesale purchase price. Inventory sales can drive up your top line but contribute very little to your bottom line.
COGS is high on inventory revenue and low on service revenue, so many practices with above-average COGS% are actually suffering from a shortage of services revenue rather than truly excessive cost of goods. In order to drive more service revenue there’s two levers that can be pulled (ideally both):
1. Perform more services: Give your clients an opportunity to say yes to gold standard care! Veterinarians will sometimes incorrectly assume that a client will be unwilling to approve higher levels of care like inpatient management, additional diagnostics, or initiating care at the clinic via parenteral routes rather than only going home with oral medications. Clients can’t approve or decline care that was never offered to them.
2. Increase service prices: Services are significantly less “shoppable” than inventory sales, meaning that you have more flexibility to increase prices without concerns about elasticity of demand – especially if you’re starting out charging below the local market price for veterinary services.
2. Find power in numbers
Vendors and distributors see value in large/bulk purchases and offer better prices to larger businesses and groups of businesses than they do to small ones. This is one of the fundamental drivers for why COGS% is commonly above industry norms at small veterinary practices. With that being said, there are two levers that you can pull to get better pricing:
1. Join a group purchasing organization (GPO) or other purchasing group: Gathering smaller practices together, these groups can collectively bargain better prices on goods by simulating the purchasing power of a large group. Just make sure to read the fine print on any agreement you might sign with one of these groups – they may include restrictive covenants or long-term commitments that you’ll want to be aware of.
2. Consider partnering with a group that can bring group purchasing power to you: Partnership with a group like AVP means that we can flex our muscle on your behalf.
3. Only keep what you need on hand
COGS is driven not only by the base acquisition cost of goods, but also by the expense of managing inventory on hand and loss to spoilage. As a general rule of thumb you shouldn’t keep more than $10-15k of inventory on hand per full-time-equivalent veterinarian and target at least one inventory turn per month. You want to keep the minimum inventory on hand to ensure you’re equipped to perform proper care and provide clients with the convenience of being able to get common outpatient medications dispensed at the time of a sick visit (antibiotics, antidiarrheals, pain medications, etc.). However, too much inventory creates an administrative burden to track and stock and leads to significant expense due to spoilage. Here are two levers to help manage your inventory stocking:
1. Affiliate with an online pharmacy and use that to sell your low margin (preventatives) and infrequently used medications. You’ve already lost the war with Chewy, whether you realize it or not! You can’t compete with online pharmacies on price, and with most offering next day shipping you can’t compete with them on convenience anymore either. Rather than fight a losing battle with online pharmacies over pennies of profit, instead see yourself as being in the veterinary services industry. Be equipped to meet your clients’ basic expectations for what you should have in stock to go home with sick patients, but realize that those medications are there to facilitate your service sales. Your clients expect and will seek the price and convenience of online pharmacy regardless of whether you’re the one offering that service or not, so it is better to capture some of that money yourself with an affiliation rather than losing 100% of it to Chewy.
2. Track spoilage and adjust pricing and ordering accordingly. Even if a medication is inexpensive in base cost, if you’re throwing away half of every bottle that you buy then the true cost (and implied price to the client after markup) should be doubled. If you’re frequently throwing away a medication due to spoilage then you should make a decision as to whether it is necessary to keep that medication on hand, and if it is deemed necessary then you should adjust pricing to account for the cost of spoilage. Keeping too many infrequently used medications that occupy space on your shelves and eventually are lost to expiration means literally throwing away money!
4. Set a minimum dispensing price and/or general dispensing fee
Your pharmacy is a convenience that you’re providing to your clients and it carries significant costs (both direct expenses and indirect opportunity costs) so you should charge accordingly. Pulling a staff member away to fill a medication and call a client means taking them away from driving services, regardless of whether they’re counting out 10 pills or 100. Offsetting some of that cost directly by rolling them into your inventory sales as dispensing fees will help keep COGS% from ballooning while still reflecting competitive prices on the medications themselves on the invoice.
5. Systematize your inventory processes
Like every aspect of operations, inventory management benefits from creating streamlined processes. Refill requests should be delivered to the staff working in the pharmacy area in a consistent, clear manner in order to improve efficiency and decrease errors. The pharmacy area should be clean and organized. Clients should have options that enable them to submit refill requests that bypass the need for a phone call with a Client Service Representative, whether that is through a third-party app or a request form on your website. Reordering/restocking should have a set process for how and when items are reordered in order to minimize incidences of overstocking or gaps in availability.