FINANCIAL ASPECTS OF INVENTORY
MANAGEMENT
Learning
objectives
·
Describe the cash conversion cycle
and its importance to inventory management
·
Identify and understand the four
main costs of inventory, including purchase, ordering, carrying, and stock-out
costs
·
Understand the importance of
avoiding stock outs and maintaining safety stock
·
Describe and develop the economic
order quantity and reorder point, then understand their importance in
optimizing inventory control
·
List and explain inventory
management considerations
Introduction
Pharmacy
managers face unique challenges when it comes to the proper management of
inventory, with balancing inventory levels that satisfy patients’ needs while
minimizing costs the primary goal. This goal is not met when inventory is
managed without careful planning and analysis – for example, just ordering
substantial quantities of each formulary medication in an institutional setting.
While this method of controlling inventory may result in meeting the objective
of appropriate patient care, it will also result in excess levels of inventory
sitting on the shelves and represent a significant use of cash. The second
major consideration for pharmacy managers is to decide the appropriate
level
of resources (cash) to be committed to inventory. Recognizing that inventory is
included on the balance sheet as a current asset, it is less liquid given its little
value to the pharmacy operation until it is dispensed, billed for and payment/reimbursement
collected, which is known as the cash conversion cycle. Recently in large
chain/grocery chain/mass merchandise pharmacies, inventory control has become
automated using barcode technology to provide identification of inventory and
track transactions in real time as they occur.
Other
types of buying agreements can include competitive bidding or bundling the
purchase price of one product with the amount of an additional product’s purchase
quantity. In many institutional or large warehousing chain practices, market share
contracts are offered by various manufacturers. Under a market share contract,
additional discounts or rebates are awarded if the percentage market share of
all purchases within a certain category exceeds a contracted level. These contracts
recognize the importance of individual retailers’ professional purchasing
decisions on manufacturers’ market share.
However,
in most larger chain settings, pharmacy managers are not the individuals who
negotiate these more complicated purchasing contracts.
Pharmacy
managers may, however, be asked to contribute information to the contracting,
bidding or accounting department where these kinds of negotiations occur. The
next basic inventory cost is ordering costs, which are those costs associated
with placing an order and processing the corresponding payment. Any costs
associated with receiving the goods and getting them to the shelves for
dispensing can also be included. For simplicity’s sake, ordering costs are
usually not separately identified, as most pharmacy environments place daily
orders with their wholesalers and payment is made through the accounting
department. Putting the order on the shelves is also considered part of routine
daily duties of the pharmacy staff; although, if significant, these costs could
also be identified separately. Though, if an institution wishes to make bulk
purchases of intravenous supplies and these orders require additional outlays,
such as offsite storage and labor to unload and re-distribute when needed, these
costs should be added to the overall purchase price when placing orders.
Not
all items in inventory generate the same level of profits. Further, some items
require more inventory space than others. This is where the third basic
inventory cost, known as carrying costs, comes into focus. The capital
investment, or the inventory’s actual purchase price, is the major and most
easily identifiable component of carrying costs and the primary factor in
relation to the cash conversion cycle. Inventory service costs, such as
handling, insurance, and taxes are another component. Thirdly, storage costs
outside of the actual pharmacy contribute to carrying costs of inventory.
Finally, there are the risk costs, which are made up of obsolescence, damage,
and shrink.
Therefore,
good inventory management is often a trade-off between the costs associated
with keeping inventory on hand (e.g., carrying costs) and the benefits of
having the inventory in stock (ability to sell the inventory and convert it
into cash). In other words, the carrying costs of maintaining higher levels of
inventory must be balanced with the less easily measurable costs of stock outs,
lost sales, poor patient care/satisfaction and even the business’s or institution’s
reputation.
Case-in-point
6.3 Inventory loss
Product
obsolescence, theft (shrink), and natural disasters occur in all businesses.
The impact of these events is obvious. However, for most retailers, there are
more subtle risks that can impact inventories. For example, medications that
need to be refrigerated can be placed at risk when power outages occur.
Flooding and other types of water damage, such as that from a broken pipe or
water heater, can also create inventory losses. Losses can also occur as a
result of poor inventory storage, such as when inventory is improperly stored,
e.g., boxes stacked too high and they become unstable and there is breakage.
While some level of risk is inherent, proper management can reduce these kinds
of risks
to
a minimum. Considering all medications have an expiration date after which the
value
is
substantially reduced, obsolescence is a major consideration in inventory management.
Proper rotation of stock is essential, as is regular monitoring of expiration dates.
Many wholesalers allow for a return of inventory items based upon their
expiration dates, and effective pharmacy managers will keep a close eye on
individual inventory items and their expiration dates to take full advantage of
any return programs, given the magnitude of potential losses. Damage to inventory
is possible at any time, just by the existence of the inventory on the shelves.
Although damage is usually accidental, pharmacy managers should strive for
proper housekeeping of inventory to minimize such occurrences.
Case-in-point
6.4 Damages/damage reports
Throughout
the work day or week, medications are spilled, IV bags are broken or pills are
crushed, leading to damaged inventory. To handle these situations, managers can
keep an exact report/log of all damaged products and adjust the inventory accordingly,
or properly dispose of the damaged product and let it exist as shrink on the
year-end inventory. Either way, the inventory was purchased but not able to be
sold and, at the least, recoup the associated cost. Pharmacy managers must diligently
stress to the staff the negative impact damaged inventory can have on sales and
work to reduce damages and, therefore, maximize sales potential. The final risk
cost included in inventory carrying costs is shrinkage, or simply “shrink”.
When the final calculated inventory value in a company’s accounting records is
compared with the final valuation from the physical inventory, any shortage is
referred to as shrink. Inventory shrink is expressed in the actual dollar amount
difference, or as a percentage of the total inventory balance. Usually, theft
is attributed to the existence of shrink, both by customer shop lifting and employee
theft. Proper controls over access to inventory and good housekeeping by
pharmacy managers can contribute greatly to keeping inventory shrink to a
minimum.
Case-in-point
6.5 Employee theft
Theft
of inventory, also referred to as “shrink,” occurs across all industries. It
may be particularly troublesome in pharmacy since medications have such
significant implications when used improperly or abused. Shrink can be caused
by shoppers or employees. A rule of thumb is that nearly one-half of all shrink
occurs at the hands of employees. Employee theft occurs just like shoplifting,
when an employee conceals merchandise and removes it from the business. Theft
can also be the result of an employee allowing others to steal from the
business. Regardless of how the theft occurs, the result is inventory loss. Ideally,
there would be some way to identify a dishonest employee. Unfortunately,
dishonest employees are found in all work settings and it is impossible to
identify these individuals by some demographic or physical characteristic. Careful
screening of employees (e.g., character, honesty, and integrity) and corporate
policies (e.g., lockers for personal items such as coats or purses, clear
policies that all theft will be prosecuted and result in termination) that
reduce opportunity are the best defense against employee theft. Not having a
medication in stock, in any pharmacy arena, has expensive costs associated with
it. These costs are the final basic inventory cost, stock out costs. For example,
if an extreme emergency requires that the out-of-stock item be procured
overnight, a non-discounted price with additional overnight shipping charges is
often paid. While these costs are readily quantifiable, sometimes they are not.
Consider the case of an extremely upset customer at the independent community
pharmacy. The lack of availability of the item may cause them to take their
entire prescription business to a competitor, or worse, customers who are close
friends of the irritated customer may sympathize and change pharmacies as well.
This lost opportunity may exist for only
A
few weeks, or forever. Therefore, prevention of stock outs is a goal of proper inventory
management. Stock outs may be avoided by maintaining a safety stock, or minimum
amount to always be on hand. It is determined in relation to expected usage as
well as any delivery lead times. Although there are carrying costs associated
with safety stock, the potential cost of damaging customer relations and future
business usually exceeds them and justifies having a cushion of safety stock.
Case-in-point
6.6 Stock outs
JB
is a 40year old diabetic who uses insulin 500units/ml. This concentration is
convenient and saves JB from having to give multiple injections because of his
high insulin dose requirement. Even so, his insulin dose has remained
relatively constant over time. He has recently changed pharmacies because the pharmacy
he had been patronizing required him to call a day ahead so the insulin he
needed could be ordered, rather than stocking it routinely. The pharmacy
maintained that having this concentration was not desirable since it could be accidentally
sold to a patient who might inject it as if it were the 100-unit concentration.
JB was accepting of this, but, on several occasions over the past year, the
insulin was not available from the wholesaler on short notice and JB had to
resort to multiple injections. This prompted him to switch to a pharmacy
willing to keep the 500-unit concentration in stock. In fact, the new pharmacy
manager decided to order JB’s supply after each purchase so that a safety stock
could be maintained and JB’s needs would be sure to be met.
Case-in-point
6.7 Stock outs large chain pharmacy perspective
Most
large-chain pharmacy district managers continually monitor ordering levels,
especially for items typically available from the store’s own warehouse. As
discussed above, emergency overnight purchases through a wholesaler are made at
much greater costs than from the chain’s warehouse. District managers want to
see as low a percentage of emergency/non-warehouse purchases as possible.
Inventory
record keeping methods
There
are two basic ways to keep a record of inventory values and quantities, known
as perpetual and periodic methods. The perpetual inventory system is most
commonly used, and, as implied by its name, this system can provide details of the
inventory quantities and values whenever they are needed. When using the
perpetual inventory method, each purchase is recorded along with individual
sales when they occur. Since a beginning balance for any time period is
available, this period activity is recorded and an ending inventory balance is
shown as illustrated in Figure 6.2. Note that both dollar and quantity details
of purchases and sales are shown.
The
perpetual recording of activity produces both the inventory recording method’s
name as well as inventory details. When this process is replicated many times
over for each individual item (referred to as SKUs, or stock keeping units),
the sum of all SKUs will produce the final inventory amount, which is shown on the
balance sheet. In theory, the actual inventory quantities on the pharmacy’s
shelves should exactly agree with the values shown in the perpetual inventory
record keeping systems. Discrepancies between recorded quantities and actual
quantities are a result of various factors, such as counting or recording
errors.
Case-in-point
6.8 Perpetual inventory
When
a retail pharmacy operation places an inventory order, either from a full
service wholesaler or a company owned warehouse, the inventory received in each
order must be added to the quantity on hand, to accurately reflect new
inventory levels. This is usually done by “applying” the order to the existing
inventory maintained in the pharmacy computer system. Applying the order serves
to increase the inventory count of the products received. Invoices are then
provided to the accounting department for collating and payment, as well as
inventory auditing.
Perpetual
inventory
Plavix
75 mg tablets
100
count bottles
Date
Purchases
Sales
Balance on hand
No.
$
No.
$ No. $
4/1/20xx
300
500.00
per
bottle
300
1,500.00
4/5/20xx
60
300.00 1,200.00
4/17/20xx
90
450.00
750.00
4/29/20xx
60
300.00 90 450.00
4/30/20xx
300
390
2025.00
525.00
per bottle
240
150
Perpetual
inventory example for single item.
The
second inventory record keeping method, the periodic inventory system, is less
often used because it provides fewer details. As one can imagine from the name,
the inventory value is determined on a periodic basis. Since the periodic system
is less sophisticated, many details regarding prices and quantities are not maintained
as shown in Figure 6.3. Under this system, at the end of various operating
periods, the inventory account is updated to reflect the actual value of the
ending inventory on the balance sheet and the corresponding amount to be recorded
as COGS. During the period, all of the inventory purchases are recordedonlyinthetotaldollaramountofpurchases.Attheendofanoperating
period, the ending inventory value is determined by taking a physical inventory.
A physical inventory is a labor-intensive process and each inventory item is physically
counted on a specific date. Owing to the nature of taking a physical inventory,
there are various vendors available for hire by companies to complete a
physical inventory. By employing personnel trained in counting pharmacy
inventory, a physical inventory can be completed quickly and efficiently with
the appropriate preparation. Completing the actual physical count is only half
of the process. After obtaining details of all SKUs and their corresponding
quantities, the appropriate cost information must be assigned. The extension
process begins whereby the actual quantity on hand is multiplied by the current
cost, which yields an extended inventory. The extended inventory provides the final
dollar value of the inventory and is shown on the balance sheet. There are
benefits, as well as drawbacks, to each of these two inventory record keeping
methods. If simplicity is desired, the periodic system functions very well,
although there is much less timely information available for pharmacy managers.
Description
Balance
in $
Beginning
balance
0
Add
:
April purchases
600,000
Total
available
600,000
Less
:
4/30/20xx physical count
390,000
Quantity
sold during April 20xx 210,000
Figure 6.3
Periodic
inventory example for single item.
Since
only dollar amounts of purchases need to be reflected in the accounting
records, summary entries can be made. In contrast, the perpetual system
requires more recording effort; however, computers and automation have greatly
reduced this impact with much of the information being provided electronically
from wholesalers and other vendors. The periodic system has a significant
limitation in being unable to provide COGS on a regular basis, thus preventing
the preparation of a consistent income statement.
Some
pharmacy managers have operating environments that are able to function
effectively in this manner, namely the independent owners of community
pharmacies. They are often very skilled at understanding their pharmacy’s
operations and can estimate operating results through cash flow and visual
inspection of inventory levels. On the other hand, the perpetual inventory
system provides pharmacy managers and others with much more timely inventory
details. Additionally, each accounting period may be closed and COGS be
calculated along with the corresponding net income. One of the major strengths
of the perpetual inventory system is the ability to perform individual item
analysis and identify, assess, and correct inventory shrink.
Inventory
valuation methods
As
previously mentioned, the physical flow of inventory is implicit – oldest items
are sold first, and then replaced with newer items. In pharmacy practice, this
means medications with earlier expiration dates are dispensed first and normally
replaced with medications that have much later expiration dates. When a company
determines an inventory value at the end of any accounting period, there are
three inventory valuation methods which may be used. It is important to
emphasize that these inventory valuation methods are obtained through the
accounting system information flow from detailed transactions of company
activities. Therefore, the physical flow of inventory will not match the
assumed flow of the accounting data. Under each inventory valuation
Method,
assumptions must be made regarding the flow of inventory costs. As a result,
COGS are different under each inventory valuation method, which in turn will
yield different ending inventory balances, gross profit and net income amounts.
Regardless of the inventory valuation method chosen, the flow of the actual
physical inventory dispensed should always be based upon the earliest
expiration date of individual inventory items. A detailed discussion of each of
the three inventory valuation methods follows, using the detail of purchases
for one month as shown in Figure 6.4. It is
important
to note that regardless of the inventory valuation method used, the inventory
purchases are recorded in exactly the same manner. Perhaps the easiest
inventory valuation method to understand is the one that simulates the actual
physical flow of inventory throughout a company.
Therefore,
the first-in, first-out method , known as FIFO, reduces inventory value for
dispensed inventory in the same order in which shipments are received. Since
the FIFO inventory valuation method results in the remaining inventory items
being those most recently purchased, it is sometimes also referred to as last-in,
still here or LISH. The advantage of the FIFO inventory valuation method is
shown on the balance sheet, where the ending inventory value reflects the most
recent purchase costs. Under FIFO, the cost of goods sold (COGS) is based upon
the cost of material bought earliest in the period, while the cost of inventory
is based upon the cost of material bought later in the period. This usually
results in inventory being valued at a higher level. During periods of inflation,
the use of FIFO will result in the lowest estimate of COGS and higher net
income.
As
the name implies, the last-in, first-out (LIFO) inventory valuation method is
the direct opposite of the FIFO inventory valuation method. The earliest
inventory items purchased are the last inventory items sold, therefore LIFO may
be referred to as first-in, still here
,
or FISH. Accordingly, since the last inventory items purchased are assumed to
be the first inventory items to be sold, there is a better matching on the
income statement with COGS reflecting the current cost of inventory items.
Under the FIFO inventory valuation method, the income statement reflects
earlier inventory acquisition costs, which may or may not reflect current
inventory replacement costs. The importance of the closer matching of current
inventory costs on the income statement under the LIFO inventory valuation
method is critical in periods of inflation or rising costs. In essence, LIFO
will produce the highest estimate of COGS and lowest corresponding net income
estimate when compared with
FIFO.
Any
Hospital Name
Detail
inventory sheet
March
20XX
D5W,
1 liter bags, 12 count cases
Date
Cases
received
Per
case cost Total cost
3/8/20XX
60
$15.25
$915.00
3/16/20XX
80
$14.93
$1,194.40
3/28/20XX
90
$15.37
$1,383.30
Total
purchases
230
$15.19
(average
case
cost)
$3,492.70
Figure 6.4
Sample
inventory purchases.
The
effect of these two methods can also be seen on the balance sheet. LIFO will
understate the inventory values on the balance as compared with the FIFO
inventory valuation method. Some firms may use a LIFO approach for the tax
benefits during periods of high inflation. When firms switch from FIFO to LIFO
in valuing inventory, there is likely to be a drop in net income and a
concurrent increase in cash flows (because of the tax savings). The reverse
will apply when firms switch from LIFO to FIFO.
The
weighted average cost (WAC) inventory valuation method is a compromise between
FIFO and LIFO. The WAC per unit is calculated by taking the COGS available for
sale and dividing this by the total number of units for the period. At the end
of each accounting period, this weighted average cost per unit of inventory is
determined and reflected in both the balance sheet and income statement as
COGS. The WAC valuation method levels out the effects of market fluctuations in
inventory prices, as seen with the FIFO and LIFO inventory valuation methods in
periods where prices are rising. Therefore, in periods of fluctuating prices,
the effects on both the balance sheet and income statements can be minimized
through the use of the WAC inventory valuation method.
Figure
6.5 compares the various ending inventory valuations and corresponding COGS
shown on the balance sheet and income statement when the three inventory
valuation methods are used. This example assumes there was no beginning
inventory balance and a periodic inventory system is used. A physical inventory
count resulted in the ending inventory quantity remaining for March 20XX of 75
cases. Pay close attention to the variation in both the COGS and ending inventory
values under each inventory valuation method. It is important to note the
selection of which inventory valuation method is
employed
by a particular company, especially in the chain and hospital setting, is often
made by upper management or the accounting department, not pharmacy managers.
Any
Hospital Name
Affects
of inventory valuation methods
D5W,
1 liter bags, 12 count cases
Method
Ending
quantity
Ending
inventory
value
COGS
FIFO
75
$1,152.75
$2,339.95
LIFO
75
$1,138.95
$2,353.75
WAC
75
$1,139.25
$2,353.45
Affects inventory valuation methods. (See the chapter
glossary for an explanation of the abbreviations.)
The
ending FIFO inventory value of$1,152.75 is determined as if all of the remaining
75 cases were part of the last purchase of 90 cases at a cost of $15.37 per
case. The COGS amount is calculated by the formula:
Beginning
inventory
Using
the LIFO inventory valuation method, the remaining 75 cases are valued at
$1,138.95, the cost of the initial 75 purchased [(60 cases @ $15.25)
Þ
(15 cases
@ $14.93/case)]. WAC produces an ending inventory value of $1,139.25 and uses
the average cost per case for the period to value the ending 75 cases (75 cases
@ $15.19/case).
Managing
inventory turnover
Other
than physical facilities, inventory represents one of the largest uses of cash
within a pharmacy. Once purchased, inventory must be sold and the funds from
the sale received before the firm’s cash can be used for various aspects of the
pharmacy operation. In institutional and chain settings, pharmacy managers may
not be directly responsible for the cash flow of the business, but these
managers are acutely aware of the impact high inventory levels can have on operating
efficiency. Inventory is perhaps the most carefully
controlled
of all operating costs and an expected function of all pharmacists involved in
dispensing in any way.
Financial
ratios (discussed in Chapter 5) are routinely used to assess the effectiveness
of a pharmacy operations inventory control techniques. The most common of these
ratios is the inventory turnover ratio. The inventory turnover ratio is a
benchmark used by pharmacy managers to assess inventory control and measure how
many times the inventory of a company is used up during a period, usually a
year. The expression “turns” or “turn days” is calculated by dividing 365 by
the annual inventory turnover. This number is used to estimate the number of
days of inventory available for sale.
The
inventory turnover ratio is calculated by the formula:
Inventory
turnover
¼
Cost
of goods sold
=
Average
inventory
Average
inventory is calculated by averaging the beginning and ending
inventory
balance (from the balance sheet) and given by the equation:
Average
inventory
¼ð
Beginning
inventory
þ
Ending
inventory
Þ
= 2
In
general, an inventory turnover ratio of approximately 12 turns per year is
considered optimal for most pharmacy operations. This means, on average, the
pharmacy will operate with about 30 days, or one month, of inventory on hand.
Some items may have higher turnover rates than the overall operation. These
items, usually referred to as “fast movers” in the pharmacy environment, vary
by area and represent the most commonly used medications. Fast movers may be
purchased in larger quantities, turnover more frequently and can have a
significant impact on profitability. Thus, it is important to price these items
carefully, which is discussed in Chapter 8. Using the information shown in
Figure 6.6, the pharmacy’s actual prescription inventory turnover of 10.5 for
the year is determined by dividing the prescription COGS by the pharmacy
average inventory.
Inventory
turnover (IT) ¼
COGS/Average
inventory
Inventory
turnover (IT)
¼
$1,678,407/$159,848
¼
10.5
A
separate turnover can be calculated for other sales (OTC, etc.):
Other
sales IT
¼
COGS/Average
inventory
Other
sales IT
¼
$536,748/$65,716
¼
8.2
Accordingly,
the overall inventory turnover ratio for the entire pharmacy business would be:
Overall
IT
¼
Combined
COGS/Combined average inventory
Overall
IT
¼
$2,215,155/$225,564
¼
9.8
For
the year ended December 31, 20XX
Description
Actual
Budget Last year
Average
inventory
Prescription
sales
$159,848
$150,980 $140,844
Other
sales
65,716
56,624
52,130
Total
225,564
207,604
192,974
Cost
of goods sold
Prescription
$1,678,407
$1,670,545 $1,575,241
Other
sales
536,748
411,002
331,105
Total
2,215,155
2,081,547 1,906,346
Inventory
turnover ratio
Pharmacy
10.5
11.1
11.2
Front
end
8.2
7.3
6.4
Combined
9.8
10.0
9.9
Figure 6.6
Sample
inventory turnover analysis report.
Financial
aspects of inventory management
Generally,
pharmacy managers track inventory turnover year by year to assess the
effectiveness of their inventory control efforts. Industry averages or benchmarks
are often used to further assess pharmacy operations inventory policies. When
the inventory turnover ratio is lower than the benchmark (12 turns per year),
this can be an indicator that inventory is too high. Possible reasons for this
might include deterioration, damage, obsolescence or over estimation of need.
When the inventory turnover ratio is higher, it usually means pharmacy managers
are using inventory more efficiently. Higher inventory turnover ratios indicate
the purchases of new inventory items are replacing the inventory actually being
sold and fewer inventory items are sitting idle on the shelves. This means less
cash is tied up in inventory and is available for other uses, including
increased profitability.
Other
inventory control techniques
In
today’s pharmacy business, inventory is often received daily and many pharmacy
practice environments control inventory by ordering products to arrive just in
time as it is needed for sale. This is known as a just-in-time (JIT) inventory
control method. JIT is a quality-control process aimed at reducing inventory
costs. This method can benefit a pharmacy business by reducing average inventory
and even improving customer satisfaction when stock outs do not occur. JIT
inventory control is generally not sensitive to rapid changes in demand, for
example, during allergy season when there can be rapid increases in demand for
certain allergy, cough, and cold medications. While today’s automated computer
systems certainly facilitate a JIT system by maintaining a perpetual inventory,
more information is needed to maintain an optimal inventory level and customer
satisfaction. To assist the pharmacy manager in making purchasing decisions,
the ideal inventory level is also needed. This is based on how much of a
product a business uses, how fast they use the product and the costs associated
with ordering and carrying the product. When a business places orders based on
these variables, it can minimize total inventory costs (ordering and carrying
costs). Using this information, a pharmacy manager can determine the most
efficient quantity of product to order – known as the economic order quantity or
EOQ. EOQ should be used as a tool to inform the JIT inventory process. Inventory
models for calculating optimal order quantities, such as EOQ; have been
available to business managers for many years. Computerization has automated
the decision making associated with these kinds of models, and is an excellent
tool for pharmacy managers to use in determining when to purchase and how much
to purchase. Mathematically, the quantity is given by:
EOQ
¼
2 ð
Annual
usage in units
Þð
Order
cost
Þ
Annual
carrying cost per unit
Case-in-point
6.9 EOQ example
Pharmacy
operations are frequently presented with special pricing and deals associated
with purchasing larger quantities of merchandise. EOQ is a useful tool for the
pharmacy manager to use in determining whether or not the deal actually makes
good business sense. For example, if a pharmacy purchases 1,600 bottles of
cough syrup annually with a unit cost of $4, order cost of $25 and inventory
carry costs of 5%, the EOQ for this product would be
H (2
1,600
$25/($4
0.05))
¼
632
units per order. The total cost of inventory would be $4/unit
1,600
units
þ
$25
(1,600/632)
þ
0.05
(632/2)
¼
$6,479.05.
If the
terms
of the deal were a $3.75 purchase price if ordered in quantities
of
300 bottles at a time, the total cost of inventory for the purchase
deal
would be: $3.75
1,600
þ
$25
(1,600/300)
þ
0.05
(300/
2)
¼
$6,140.50.
This analysis would imply that even though smaller quantities would be
purchased more frequently, the deal will lower total inventory costs.
Optimizing
inventory decisions
Using
modern computer systems, knowledge of EOQ and RP, and understanding the needs
of one’s customers enables the pharmacy manager to make inventory management
decisions that result in fewer out-of-stock situations and minimal inventory
costs. Given the realities of modern day pharmacy operations, including lower
profit margins, it should be clear inventory management is critical to the
prudent pharmacy manager.
Summary
Pharmacy
managers should routinely use the financial information from their businesses,
along with knowledge of the marketplace and customer needs, to appropriately
control the inventory of a pharmacy operation. Proper inventory control starts
with an understanding of the four basic inventory costs described in the
chapter (purchase, ordering, carrying and stock out). Applying the understanding of these costs,
along with indicators such as inventory turnover, EOQ and RP, should result in
optimal inventory levels which keep costs to a minimum while at the same time
ensuring customer satisfaction. In managing inventory, a pharmacy manager must
keep these principles in mind while routinely:
Monitoring
the adequacy of inventory levels, balancing this with expected demand; this is
especially important for products or services that fluctuate seasonally, such
as Tamiflu for influenza
Taking
full advantage of pricing discounts such as prompt payment discounts and other
price incentives
Conducting
a physical review of the inventory periodically, to look for slow-moving or
obsolete items; this will reduce inventory carrying costs and improve cash flow
Maintaining
an awareness of the average inventory level, keeping it to a minimum, since
this is the source of carrying costs and can dramatically impact profitability
Keeping
enough inventory on hand to ensure patients’ needs are met
Using
the financial information to ensure inventory levels are providing sufficient
profitability, in particularly by monitoring the financial ratios associated
with inventory, EOQ, RP, and inventory turnover.
Suggested
reading
Chisholm-Burns
MA, Vaillancourt AM, Shepherd M.
Pharmacy
Management, Leadership,
Marketing,
and Finance.
Sudbury,
MA: Jones & Bartlett Publishers, 2011.
Desselle
SP, Zgarrick DP.
Pharmacy
Management: Essentials for all Practice Settings, 2nd edn.
New York,
NY: McGraw-Hill, 2009. Carroll NV.
Financial
Management for Pharmacists: a Decision-Making Approach, 3rd edn.
Baltimore,
MD: Lippincott Williams & Wilkins, 2007.
National
Community Pharmacists Association (2008).
Managing
the Pharmacy Inventory.
Alexandria,
VA: NCPA. www.ncpanet.org/members/pdf/ownership-managinginventory.pdf
Blackburn
J (2010).
Fundamentals
of Purchasing and Inventory Control for Certified Pharmacy Technicians.
The
Woodlands, TX: J&D Educational Services. https://secure.jdeducation.com/
JDCourseMaterial/FundPurch.pdf
McKesson
Corporation.
Home Page.
San
Francisco, CA: McKesson Corp. http://www.mckes-son.com
AmerisourceBergen
Corporation.
Home Page.
Valley
Forge, PA: AmerisourceBergen Corp.
www.amerisourcebergen.com
Cardinal
Health, Inc.
Home Page.
Dublin,
OH: Cardinal Health, Inc. http://www.cardinal-health.com
Review
questions
The
carrying costs associated with inventory management include:
A
Insurance costs, shipping costs, storage costs, and obsolescence
B
Storage costs, handling costs, capital invested, and obsolescence
C
Purchasing costs, shipping costs, set-up costs, and quantity discounts lost
D
Obsolescence, set-up costs, capital invested, and purchasing costs
The
ordering costs associated with inventory management include:
A
Insurance costs, purchasing costs, shipping costs, and spoilage
B
Obsolescence, set-up costs, quantity discounts lost, and storage costs
C
Purchasing costs, shipping costs, set-up costs, and quantity discounts lost
D
Shipping costs, obsolescence, set-up costs, and capital invested
Shrink
related to employees is not an issue to be concerned with in a
pharmacy
business. True or false?
The
result of the economic order quantity formula indicates the:
A
Annual quantity of inventory to be carried
B
Annual usage of materials during the year
C
Safety stock plus estimated inventory for the year
D
Quantity of each individual order during the year
In
inventory management, the safety stock will tend to increase if the:
A
Carrying cost increases
B
Cost of running out of stock decreases
C
Variability of the lead time increases
D
Variability of the usage rate decreases
Calculate
the EOQ for a chain pharmacy using 15,000 bottles of Lipitor 10mg per year at a
cost of $100 per bottle. Assume carrying costs are 5% and it costs the pharmacy
$50 to place a direct order from the manufacturer.
A
JIT inventory can be used in conjunction with EOQ to optimize inventory
control. True or false?
When
the inventory turnover ratio is lower than the benchmark (12 turns per year),
this can indicate:
A
Inventory levels are too low
B
Overestimation of the inventory needs
C
Efficient use of inventory
D
Increasing sales
Which
inventory system provides the pharmacy manager with much more timely inventory
details – periodic or perpetual inventory?
Discuss
the impact of inventory management on customer service and store performance.
The
statement is false.
As
discussed in the text, inventory management, customer service and store
performance are all interconnected. In a primarily product-driven business, a
pharmacy manager must have adequate inventory on hand to meet customers’ needs.
The main area where this becomes a problem and negatively impacts service
levels and store performance is with partial fills and stock outs, especially
with maintenance medications. A customer who has received a prescription for a
new treatment just on the market, or one rarely used, can understand the
product not being stocked and needing ordered. However, the same customer who
comes to the pharmacy every month and gets the same three prescriptions will
not appreciate having to make multiple trips to the pharmacy because you do not
have enough or any of those medications. This decreases customer service and
possibly negatively impacts store performance if that customer, and possibly
many others, decides to patron another pharmacy.
Glossary
Capital
investment Actual purchase price of the inventory, major and most easily
identifiable component of carrying costs and the primary factor in relation to
the cash conversion cycle. Carrying costs Expenses associated with having
inventory, including the capital investment or actual purchase price of the
inventory, inventory service costs, such as handling, insurance, and taxes, and
storage costs outside of the actual pharmacy.
Cash
conversion cycle (or cash cycle) The length of time, usually expressed in days,
needed to return cash outlays for purchases of inventory (a use of cash) back
into collected cash (a source of cash) after the sale of the inventory and the
corresponding collection of the accounts receivable from the customer or third
party payer.
Economic
order quantity (EOQ) Most efficient quantity of product to order and should be
used as a tool to inform the JIT inventory process.
First-in,
first-out (FIFO) method
Inventory
valuation method which reduces inventory value for dispensed inventory in the
same
order in which shipments are received and results in the remaining inventory
items being those most recently purchased. The advantage of the FIFO inventory
valuation method is shown on the balance sheet, where the ending inventory value
reflects the most recent purchase costs.
Inventory
turnover ratio
A
benchmark used by pharmacy managers to assess inventory control and measure how
many times the company’s inventory is used up during a period, usually a year.
“Turns” or “turn days” are calculated by dividing 365 by the annual inventory turnover,
which is then used to estimate the number of days of inventory available for
sale.
Just-in-time
(JIT) method
A
quality control process aimed at reducing inventory costs control inventory by
ordering
products
to arrive just before it is needed for sale. This method can benefit a pharmacy
business by reducing average inventory and even improving customer satisfaction
when stock outs do not occur.
Last-in,
first-out (LIFO) method Inventory valuation method which is the direct opposite
of the FIFO method. With LIFO, the earliest inventory items purchased are the
last inventory items sold. Accordingly, since the last inventory items
purchased are assumed to be the first inventory items to be sold, there is a
better matching on the Income Statement with COGS reflecting the current cost
of inventory items. Ordering costs Those costs associated with placing an order
and processing the corresponding payment. Any costs associated with receiving
the goods and getting them to the shelves for dispensing are also included, for
example, putting the order on the shelves is also considered part of routine
daily duties of the pharmacy staff. If significant, these
costs
could also be identified separately. If an institution wishes to make bulk
purchases of intravenous supplies and these orders require additional outlays,
such as offsite storage and labor to unload and redistribute when needed, these
costs should be added to the overall purchase price when placing orders. Periodic
inventory Inventory maintenance method where a physical count of the inventory
is performed at specific intervals. This method only keeps track of the inventory
at the beginning of a period, the purchases made and the sales during the same period.
Perpetual inventory Keeping book inventory continuously in agreement with stock
on hand within specified time periods. In some cases, book inventory and stock
on hand may be reconciled as often as after each transaction. This is useful in
keeping track of actual product availability and determining the correct time
to reorder. Product obsolescence Product condition that occurs when an existing
product becomes out of date or obsolete. Prompt pay discount Discount offered
by vendors to entice prompt, or even early, payment in order to help them maintain
their own cash conversion cycle. Often quoted as, for example, “2% net 10”,
meaning a 2% cash discount of the total invoice is taken if the entire balance
is paid within 10 days instead of the traditional 30 days.
Shrink
Any
shortage after the final calculated inventory value in a company’s accounting
records is compared with the final valuation from the physical inventory. Weighted
average cost
(WAC)
method Inventory valuation method which is a compromise between FIFO and LIFO.
The WAC per unit is calculated by taking the inventory purchases and dividing
this by the total number of units for the period. At the end of each accounting
period, WAC per unit of inventory is determined and reflected in both the
balance sheet and income statement as COGS.