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COGS Myopia

Dollars and percentages can tell different stories about the cost of goods sold. Higher numbers aren’t necessarily bad.

COGS Myopia
COGS is expressed as a percentage of total gross income.

Nineteenth-century American humorist Josh Billings said, “It ain’t ignorance causes so much trouble; it’s folks knowing so much that ain’t so.” Three decades on, I’ve listened to practice owners, hospital managers, consultants and advisers bemoan a high cost of goods sold (COGS). Lower practice profitability is often attributed to a high COGS. But is a lower COGS always better? Could a higher COGS result in a more profitable and valuable practice? Will improved lab or pharmacy compliance (better medicine) result in a higher COGS, and if so, is good medicine bad business?

Simple Math?

COGS is expressed as a percentage of total gross income, and expressing numeric values in percentages is a simple way to compare and convey size, scale or value. However, the limitations of percentages and the mental errors we make with them are ignored or neglected at our peril. Percentages often dangerously mislead us.

Consider gross profit margins. According to Investopedia, “Gross profit margin is a measure of profitability that shows the percentage of revenue that exceeds the cost of goods sold. It is important to note the difference between gross profit margin and gross profit. Gross profit margin is shown as a percentage, while gross profit is an absolute dollar amount.”

Pop quiz: Would you rather own a business that has an 80% gross profit margin (COGS of 20%) or a 20% gross profit margin (COGS of 80%)? Rational folks prefer the 80% gross profit margin. Why? Because they made a common mental error by wrongly assuming the two companies have identical gross income.

Here’s an example:

COGS 1

By myopically focusing on the profit margin, your rational, impulsive, intuitive choice was dead wrong. Of course, we all prefer $3.2 million over $160,000, but as we’ll see, dollars and percentages tell contrasting stories.

The illustration above clarifies an ironic, odd and even uncomfortable truth: The gross profit margin tells us absolutely nothing about profits (at least as we think of them) in terms of dollars. Welcome to one critically significant shortcoming of percentages.

When dollars and percentages tell dissimilar stories, the percentages lie to you and the dollars tell the truth. You can’t make payroll with percentages. Vendors won’t take ratios. And very importantly, when it’s time to sell your practice, you’ll get a multiple of EBITDA dollars.

Good Medicine, Bad Business?

Conventional wisdom holds that COGS should be 22% to 24% of total gross income in a companion animal practice. Further, it dictates that a lower COGS (resulting in a higher gross profit margin) is better, while a higher COGS (resulting in a lower gross profit margin) is worse.

Tested at the margin, conventional wisdom fails completely. For example, a practice owner could quickly and easily drive COGS into the low single digits by divesting big profit centers. Divesting the in-house lab, reference lab, pharmacy and pet food would surely decrease COGS, but is that winning? Is this practice now healthier, more profitable or more valuable? Has pet care and client service improved or deteriorated? The owner with the lowest COGS has bragging rights, but the practice is now one-half its former size. Half of the total gross income just vaporized — poof, gone! Does anyone know a good bankruptcy attorney?

Next, consider this practice:

COGS 2

According to conventional wisdom, so far, so good. The COGS of 20% is comfortably below the accepted range of 22% to 24%. But let’s make one change. Five hundred 40-pound dogs start a 12-month supply of flea-tick and heartworm prevention.

COGS 3

Devotees of conventional wisdom will note that the COGS is now 26.6%, deteriorating from 20% and outside the accepted range of 22% to 24%. However, note the $68,100 in incremental gross profit. How is an extra $68,100 bad regardless of the percentages? At a multiple of 5, isn’t your clinic worth $340,500 more?

Once again, dollars and percentages tell different stories, and the percentages are lying. How? We instinctively know that 80% is more than 73.4%. Like before, the impulsive and subconscious mental error (a dangerous one) is to assume identical gross incomes wrongly. In this case, they’re $1,000,000 versus $1,183,470.

Second- or third-grade math, along with conservative real-world examples, clearly answer these questions:

  • Might improving compliance in the lab and pharmacy (better medicine) result in a higher COGS? Yes.
  • Is a lower COGS always better? No.
  • Could a higher COGS result in a more profitable and valuable practice? Yes. (Given the well-documented low compliance in the lab and pharmacy, determining a healthy COGS is difficult.)
  • Is good medicine bad business? No.
  • Is a colleague with a higher COGS — and higher profitability in dollars — running circles around you in the lab and pharmacy, practicing higher-quality medicine, and building a more valuable business? Yes.

On the other hand, an increasing COGS can signal trouble where trouble exists. High COGS is one of the most common reasons for lower profitability.

 

Most practices have extraordinary opportunities to manage and control their inventory better. I suggest limiting on-hand inventory to one or two preferred brands in each category and sending the rest to your online pharmacy. The inventory items held for resale should be added to the inventory module of your practice information management system, where you can systematically shorten reorder points and reorder quantities.

If you have good inventory control and your COGS is rising, perhaps compliance has improved. Maybe you deserve the praise, recognition and congratulations of your misled colleagues with lower COGS, not their scorn and condemnation.

Practice owners and managers slavishly worshipping at the altar of COGS are forgiven. Smart people make dumb mistakes. But you’ve overslept; it’s time to wake up. Pay much closer attention to what you pay attention to. And always exercise great caution in the presence of percentages. They lie!

Financial Wellness columnist Fritz Wood is a veterinary industry veteran with a special interest in finance.


TWO TIPS

Data show that, at the average practice, more than 8 in 10 dogs and virtually all cats are noncompliant with heartworm prevention over 12 months. Also, more than 9 in 10 pets are noncompliant with flea-tick preventives. As for buying and selling those medications, I suggest:

  • Purchasing through a buying group.
  • Matching or coming close to online prices. Otherwise, you risk client defections and losing a pet owner’s lifetime value, which is conservatively measured in the tens of thousands of dollars.

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