Four Gross-to-Net Pitfalls to Avoid
- Mar 27, 2018
- Phil Bergamo
Gross-to-net (GTN) revenue accounting permeates life sciences, especially the sale of pharmaceutical products. Many companies use third parties to commercialize their products by working with distributors in order to maximize distribution efficiencies and penetrate a large customer network. In exchange for services, distribution companies receive discounts (typically between 2% and 5% of list price) and rebates that reduce the gross selling price realization. Other pricing adjustments impact the gross selling price such as chargebacks, government rebates and sales returns.
GTN, the accounting for pricing adjustments, represents the difference between the gross price/wholesaler acquisition cost (WAC) and the net sale recognized. Pricing adjustments are a significant percentage of the WAC price and can reduce it by as much as 70%. The most prevalent pricing adjustments are:
Chargebacks – Distribution companies purchase drugs from a manufacturer at a gross price (the WAC) and sell them to consumers at a different contract price. When the consumer contract price is lower than the WAC price, the distributor minimizes losses by charging the manufacturer for the difference.
Rebates – Primarily relate to distribution fees paid to distributors and other service providers. The pricing adjustment can be a percentage of the selling price or a per-unit rebate (fixed dollar amount per product sold).
Medicaid Rebates – Discounts and rebates provided to governmental entities that are paid to the states by the manufacturer.
Returns – Manufacturers generally accept returns from six months before to 12 months after the products’ expiration date.
GAAP accounting requires that the selling price to the buyer is substantially fixed and determinable at the point of sale, and the amount of future returns can be estimated in order to recognize revenue. Pricing adjustments may not be deducted by customers for months, or even years, after the product is sold. The new revenue recognition standard—effective for public entities beginning after December 15, 2017, and one year later for all other entities—places a significant burden on companies to estimate all pricing adjustments when the product is sold. Thus, it becomes critical to develop systems and processes that can capture these deductions in detail and in a timely fashion. Pricing adjustments would be accounted for as contra-sales (sales deductions) and as reductions to accounts receivable or liabilities at the time the product is sold. Accounting for pricing adjustments should result in a value that closely resembles the amount that companies anticipate collecting from their customers. Some common challenges companies face with respect to accounting for pricing adjustments include:
1. Insufficient systems and procedures to account for pricing adjustments
The amount and form of data related to pricing adjustments is substantial. With possibly a tremendous amount of data, the pricing adjustments can be communicated via electronic transfer, paper documents, PDFs or Excel spreadsheets. Companies without adequate systems and processes to accumulate and process this data are at a significant disadvantage when it comes to understanding their products and profitability. Robust processes and systems give companies the appropriate and detailed information that can ultimately lead to better decisions regarding the viability and profitability of products, forecasting and budgeting, negotiation of the price of products with customers, and accounting for the transactions such as including the set up of appropriate accruals and processing transactions in the order-to-cash cycle.
2. Inability to verify pricing adjustments taken by customers
Recent consolidations in the pharmaceutical industry have resulted in a greater concentration of business with distributors—increasing the negotiating power that they have with manufacturers, and resulting in lower prices and more marketplace volatility. This volatility makes it paramount that companies understand the deductions their customers take so that they can manage their portfolios. Without the ability to accumulate pricing at the product level, manufacturers are vulnerable to not having the ability to verify and substantiate pricing adjustments taken by customers or identify market trends that directly affect product profitability.
3. Audit compliance and financial reporting
The inability to accumulate and process data related to pricing adjustments could also result in significant true-ups in estimates of pricing adjustments, delays in the ability to recognize revenue until pricing adjustments can be determined and properly supported, and the inability to properly substantiate revenue recognition estimates.
4. Profit-sharing arrangements
In product profit-sharing arrangements, poor accounting for pricing adjustments could result in inaccurate information provided to partners, difficulties in responding to partner inquiries regarding developments in the market and pricing for specific products, and loss of partner trust as it relates to reporting of results and sharing of profits.
In order to mitigate the aforementioned challenges, you must develop an efficient model to accumulate, monitor, account for and analyze pricing adjustment data. Companies should also develop detailed analytics to understand trends and the magnitude and appropriateness of customer pricing adjustments. The most successful companies use a combination of in-house technology (adequate ERP and general ledger systems) and third-party resources. Take seriously having adequate and clearly documented controls and procedures to validate pricing adjustments. An appropriately designed system facilitates the information needed to fully understand and analyze the market, profitability and trends in products so that you can make informed business decisions.
Catalyst - Spring 2018
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Phil Bergamo is a Managing Director overseeing engagement teams that perform financial due diligence on buy and sell-side transaction.
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