A veterinary business usually has several objectives. Those objectives may be related to financial performance, animal health and welfare, social issues, community support, philanthropic causes, etc. Financial Friday topics are each crafted to give you a brief, high impact look at a topic that has the potential to impact the financial performance (Net profit) of a veterinary business.
As business people, we try to make decisions that improve profitability. Now is the perfect time for me to share a bit of wisdom that I learned from Walt Woodard, a two-time World Champion Rodeo Cowboy. Walt is something of a modern day Will Rodgers, philosopher, roper, cowboy and student of life. Walt shared this observation and strategy with me. “Although we usually associate goal setting with successful people, unsuccessful people also set goals. The difference in outcome is that successful people make better decisions than unsuccessful people. Every decision you make puts you closer to your goal or further from your goal and not deciding is a decision.”
Let’s look at the impact of a decision veterinarians commonly make and understand its unintended consequences. Drugs and supplies make up the lion’s share of Cost of Professional Services (COPS), one of the largest expense categories in our businesses. Every practice has a pricing strategy related to drugs and supplies.
We purchase drugs and supplies from distributors or manufacturers, then we apply a markup and then we sell the product to our clients either as part of our treatment of their animal or to take home and administer to the animal.
The objective of the markup is to recoup your costs of ordering & handling the product and to generate profit on the investment made in the product.
There are several formulas and a huge variance in the markup percentage that veterinarians may use. I’ll use an example of one set of circumstances.
Cost + (1.10 x Cost) = Price to Client
This formula includes a 10% markup to cover the cost of ordering & handling the product and an 100% markup to generate profit on the investment. Since it does not generate profit, I do not include the ordering and handling markup in the profit or profit margin calculation.
Keep in mind the key concept that a 100% markup yields a 50% profit margin.
Price to Client – Cost = Profit
If I buy something for $1 and mark it up 100%, the price to the client is $2. What is our profit on 100% markup?
$2 - $1 = $1
Profit Margin is the profit expressed as a percentage of the price to the client.
Profit/Cost (expressed as percentage) = Profit Margin
$1/$2 = .5 or 50%
Now that we have reviewed the formulas lets see what happenes if you receive a discount on a product from the distributor or manufacturer. In our example the profit is $1 and the price to the client is $2 so we are generating a 50% profit margin. Lets assume that, for some reason, we received a 25% discount on an order of a product that normally costs $10. That makes our cost $7.50 per unit. We decide to apply our standard 100% markup and calculate the price to the client of $15. We check our math and find that we generate a 50% profit margin on the discounted product.
All good so far but let’s look at dollars (profit) instead of percent (profit margin). At the standard, non discounted price we buy for $10 and sell for $20 yielding a $10 profit. At the discounted price, we buy for $7.50 and sell for $15 yielding a $7.50 profit. Both examples are 50% profit margins but we make more profit on the non-discounted cost.
Remember that every decision we make moves us closer to or farther from our objective and in this case our objective is profitability. The decision to mark up a discounted product using the same formula that we use for non-discounted products caused us to lose $2.50 profit per unit. That is a 25% loss in profit dollars! Is there a better profitability decision we can make on discounted products? Yes there is. First we have to distinguish between a price reduction due to market conditions and a discount. Supply and demand, market conditions sometimes yield a lower cost. That cost is considered to be a long term cost. In that case, in order to remain competitively priced to our clients, we must lower the price to the client.
In the discounted price situation, the vendor is giving us a discount on this particular order or group of orders but the cost will go back up to the original cost. The decision we made, to mark up the discounted price using the routine formula, caused the business to lose 25% of the profit we ordinarily make. From the point of view of generating profit, a better decision might be to use the routine formula (100%) applied to the routine cost ($10) yielding a price to client of ($20) and a profit of ($12.50) on the discounted product.
Discounted cost is a short term situation in which the vendor is rewarding the practice for some temporary reason. If you use the same markup strategy, you not only pass along the reward to the client but in our example, you subsidize the reward with a 25% decrease in profit. When you mark up the discounted price instead of the routine price, A VENDOR DISCOUNT IS BAD FOR YOUR PRACTICE!
Discounted cost is a bad thing if you mark up the discounted price is a relfection of a decision that did not consider the law of unintended consequences. The take home message is Make Better Profitability Decisions by thinking completely through the scenarios and evaluating the profitability results of the various decisions.