On the profit and loss statement (P&L), there are two main drivers of profitability for a veterinary practice: Cost of Goods Sold and Labor. These two categories make up the vast majority of your expenses. This series from Vetcelerator will feature how to think about the challenges of managing the cost of goods sold (COGS) at your veterinary clinic.
The table of contents for what’s to come is as follows:
- Understanding Cost of Goods Sold: Misnomers and Measurement
- Benchmarking, Ratio Analysis, Pricing
- Ordering Strategy to Increase Cash Flow and Lower COGS
- Red Flags in your Cost of Goods
- Buying Groups
Note from the Author
I came into the industry from a background in financial analysis, modeling, and investment management. When I first joined the veterinary industry in 2021, I was asked to work with some vet practices on growth in both revenue and profitability. I visited the practices on-site so I could learn a bit faster. I was given access to the practice finances and their PIMS systems ahead of time so I could prepare.
What I saw at first glance was that the veterinary clinics’ income statements and balance sheets didn’t really tell you what the Cost of Goods was. The inventory values were static on the balance sheet, and the resulting inventory turnover was meaningless as the numerator (COGS) was moving, but the denominator (Inventory) was apparently static.
Then, I learned that the practice managers and the veterinary clinic owners didn’t really know these numbers either, nor how they were derived. They said, “You have to ask our bookkeeper how that number is calculated.”
Their accountant or bookkeeper also didn’t fully know because they didn’t work in the clinic. They received monthly invoices and tried the best they could to put the pieces of the IS/BS together. They could articulate their process, but let’s say assumptions were often made.
So, what’s the biggest problem with managing your Cost of Goods Sold? The first problem and one of the biggest challenges is: well…what is it? What number are you looking for?
We are trying to lower a number without any understanding of what that number is. Really tough for a veterinary practice manager who is told by the hospital owner to “Go! Lower that number!” and then look around and have no confidence in how that number is created and whether it is a true reflection of the vet clinic.
What Goes Into Cost of Goods Sold at a Veterinary Practice?
Cost of Goods Sold is the direct costs associated with providing a product or service. Direct costs here mean that there is an input into delivering the product or service that is necessary or there would not be revenue for that one unit. For example, I can not generate revenue from the sale of a medication without the medication. Medical supplies, pharmaceuticals, surgical materials, laboratory, and anesthesia are some common items to include as COGS in an animal hospital.
What about the veterinarian’s time needed to prescribe the medication, the vet tech’s time to count out the exact number of tablets, and the merchant’s cost to collect money from the customer to get the revenue? Good question.
People’s Time (Labor Cost): Excluded from COGS. In some industries, this is actually included in the Cost of Goods Sold, but it is not a generally accepted accounting principle for vet med. To be sure, there is a logical argument here as well. The two main controllable elements of a veterinarian’s P&L are the cost of products and labor. Combining these two numbers, however, will make both of them more unmanageable.
Credit Card Fees (Merchant Fees): Excluded from COGS. This is a cost of operating your veterinary practice, but it is not a direct cost of providing the service or product. Instead, it is a function of the payment method applied to pay for the service.
Online Pharmacy Revenue and Cost in COGS
This one is complicated as it’s problematic for vet practices no matter what. Some online pharmacies make it difficult to track the cost of medication dispensed through the pharmacy, and they only send you the net revenue of the transaction, so there is no COGS component to a sale. This doesn’t make sense. For others that have an appropriate flow of funds, COGS is problematic as online pharmacy sales at veterinary practices have low margins, and clinics may be doing the right thing by pushing items to an online pharmacy only to see, on paper, their COGS increase.
To combat the reporting issue, make sure you get a statement to record revenue and cost in your P&L. The bank statement can be used to match the net amount to the statement. If you’re not reporting the cost of your online pharmacy on your P&L, I bet you don’t know what it is, so you are likely mismanaging this product. Very important!
To combat the latter problem, veterinary clinics should separate online sales from in-clinic sales so that the numbers can be tracked independently. When reporting COGS and measuring progress to your goal, measure the sub-categories of COGS as well as the total so you understand how online sales are affecting your overall profitability (hint: they are probably helping).
For more information on what goes into COGS and inventory management, there are a ton of great resources. Nicole Clausen has been writing and speaking on this topic for years. Go listen to this, this, and this (features Vetcelerator!). The American Animal Hospital Association also has a standardized chart of accounts with definitions to help veterinary practice owners bring standardization into their practice.
Timing and Mismatch Error in Veterinary COGS
In a perfect world, the Cost of Goods Sold should be recorded against the revenue it created at the time it was created regardless of whether money changes hands. This is called accrual vs. cash accounting. Cash accounting is the process of recording when money changes hands regardless of when the transaction occurs.
To illustrate, let’s take the parasiticide order you placed on March 31st to prepare for the spring season and sell all ten doses in April. We will use simple numbers to avoid decimal points – the cost is $450, and you sell it for $900.
This is boring accounting stuff, but you can see that the practice is all expense in March and all revenue in April if they use cash accounting. So their COGS is 0 or infinity based on what month they are looking at.
Financial Insights: Breaking Down the Veterinary Clinic P&L
In Cash accounting, this scenario leads to errors in reporting your COGS. However, look at all the great data you get from accrual accounting. You can calculate your current inventory, your Cost of Goods Sold ratio, and your inventory turnover. Valuable insights!
Unfortunately, accrual accounting is out of reach for a lot of practices. There are a few reasons. Most practice management software lacks the sophistication to do this well. There is a lot of manual configuration and administrative time required to do this manually. Also, at the end of the day, it might not be worth the cost to do so for many practices. That said, our friends at VetBooks are solving this very problem for the veterinary practices that want accrual accounting and have also written on the accrual accounting topic.
Tips for Reducing Time and Errors in Inventory Management
For the rest of us, Cost of Goods Sold is generally recorded at the time of purchase, and clinics do quarterly or annual inventory counts to adjust their cost of goods expense on a regular basis. Imperfect systems are not bad as long as they are consistent, understood, documented, and made transparent. Veterinary clinics can make the measurement issues created by timing differences less pronounced by following some simple rules.
Buy Only for the Month Ahead (if you can): Less inventory means less lag between the purchase of inventory and sale. A very simple rule of thumb for inventory management within a veterinary practice is that anything bought should be used within a month. Of course, this is not possible with much of your pharmacy. However, the items that contribute most to your revenue (and likely cost), like commonly prescribed medications, can follow this rule and save you in the long run. The higher-level version of this is knowing cycle counts, reorder points, and utilizing your PIMS to track inventory.
Have an Accounts Payable Process: Many clinics utilize a bookkeeper but may still have poor processes for recording bills in the financial statements. Creating an email account for all bills to point to, for example, [email protected], is a good way for bills to be tracked and recorded in a timely manner.
Be Comfortable with Special Orders: Items with infrequent sales (low turnover) should be examined to determine if a special order is appropriate going forward. There is a lot of empirical research on this topic. Items with low turnover better be massively profitable. For a benchmark, if you don’t plan on ordering this item at least two times a year – move it to special order.
Measure Over Longer Periods: One-month periods need to be measured but may present more noise than signal with respect to how you are managing your Cost of Goods Sold. Consider evaluating quarterly or taking rolling three-month averages to smooth out timing differences.
Conclusion
Vetcelerator doesn’t perform bookkeeping or accounting services on behalf of clients, but we do help them get control of their cost of goods, and to do so, we need the numbers to make sense! In future articles, we will go through how we can use that data to improve clinic performance and how we can improve cash flow and lower the cost of goods through better inventory ordering processes and our buying group. Need guidance on inventory management for your vet clinic or looking for veterinary GPO discounts? Contact us at Vetcelerator.
