Gross profit and net income are both critical metrics when it comes to measuring the financial health of your pharmacy. Both give important insights into your pharmacy’s profitability and long-term sustainability — but these metrics are not interchangeable.
Each metric can be found on your pharmacy’s income statement, but they indicate different things about your business’s financial health.
Gross profit is primarily a measure of efficiency. It lets you (and your investors) know if the amount of revenue you are bringing in through the sale of prescription drugs and over-the-counter items is enough to cover your cost of goods. Because inventory is your pharmacy’s biggest expense, staying in tune with your gross profit is crucial in ensuring you are bringing in enough revenue to cover your inventory expenses.
Net income is a more holistic view of your pharmacy finances. In addition to accounting for the cost of your inventory, the net income metric accounts for all other pharmacy expenses. Because of this, it can be a better litmus test for whether your pharmacy is succeeding or failing. When people talk about their business “making a profit,” what they really mean is that they have a positive net income.
How and why to use gross profit
Gross profit, which is sometimes called gross income, is the money that your pharmacy makes after you’ve accounted for all the costs associated with selling your products.
You can typically find your gross profit on your income statement, but here’s the formula you can use to calculate it yourself:
Gross Profit = Revenue – Cost of Goods Sold
So, if your pharmacy made $100,000 in sales revenue in the first quarter of the year and your cost of goods sold was $75,000, your gross profit would be $25,000. After calculating your gross profit, you can find your gross profit margin, which is your gross profit displayed as a percentage, and uses this formula:
Gross Profit Margin = (Gross Profit / Revenue) x 100
In the case above, your gross profit margin would be 25 percent.
Your pharmacy’s gross profit and gross profit margin give you insight into how efficient your pharmacy is. Your gross margin tells you the percentage of every dollar you bring in that is available to cover fixed costs, operating expenses, and taxes.
The higher your gross profit margin is, the easier it will be for you to keep your business running and invest in new opportunities that will help you grow your pharmacy. But if your gross profit margin is too low, it means you might not be able to pay for all your operating expenses.
What’s considered a good gross profit margin varies widely by industry, but according to the 2020 NCPA Digest, the average gross profit margin for an independent pharmacy is 22 percent. If your pharmacy has a gross profit margin higher than 22 percent, that means you are running more efficiently than most of your peers in independent pharmacy.
To improve your gross profit, you have two choices: either lower your cost of goods or increase your revenue.
Because you have very little control over reimbursements from PBMs, increasing revenue is a tall task, which means you should concentrate on getting a lower cost of goods by securing a better wholesaler contract.
However, using gross profit as a metric to measure your pharmacy’s financial health does have some limitations. Because it only takes into account your revenue and cost of goods sold, it paints an incomplete picture.
You may have a good gross profit margin on paper, but if your fixed costs or operating costs are extremely high, that good-on-paper gross profit margin still won’t be enough to pay the bills.
How and why to use net income
Net income, sometimes known as net earnings or net profit, is similar to gross profit, but instead of subtracting only your cost of goods sold from revenue, you account for all expenses. When business owners talk about their “bottom line,” they are typically referring to net income because it appears at the bottom of the business’s income statement.
Your net income can be calculated using this formula:
Net Income = Revenue – Cost of Goods Sold – Expenses
That “expenses” category is all-inclusive and should account for your items like:
- Operating expenses
- Interest on debt
- Fixed costs related to overhead
- Income taxes
You can also add back in any non-sales income your pharmacy may receive, like income from investments.
Because net income is more inclusive, it can be a better measure of your pharmacy’s financial health than gross profit. It is even possible for a company to have a positive gross profit but a net loss.
Drawing from the previous example, a gross profit of $25,000 and a gross profit margin of 25% would seem to indicate that a pharmacy is performing well. But that pharmacy could also have monthly expenses of $40,000, leaving them $15,000 in the hole every month.
This is clearly an unsustainable way to run a business, but you would only have a clue that something isn’t right if you looked at net income instead of gross profit.
The most common reason for a discrepancy between net income and gross profit is that a business has taken on too much debt, and the cost of servicing that debt every month can’t be covered with the gross profit despite high sales.
If you are seeking additional financing or trying to attract investors, a bank or investor will want to take a look at your net income. Unlike your gross profit, your net income is a strong indicator of whether you will be able to pay back a loan or provide a return on investment.
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This blog series is all about learning the essentials of pharmacy financials. Follow along as we discuss the ins and outs of the financial aspects of running a business.
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