Inventory and Accounting in Pharmacy

Inventory refers to the stock of products held to meet future demand. Pharmacies hold
inventory to guard against fluctuations in demand, to take advantage of bulk discounts, and
to withstand fluctuations in supply (e.g., late deliveries)

Inventory usually represents a pharmacy’s largest current asset. Inventory also is the least
liquid current asset, given that it generally cannot be turned to cash until it is sold to a
consumer. The value of inventory to all pharmacies continues to rise owing to the increased
variety and expense of pharmaceutical products. Therefore, proper management of
inventory has a significant impact on both the financial and the operational aspects of any
pharmacy (Huffman, 1996; West, 2003).

Acquisition, procurement, carrying, and stockout or shortage costs are the four general
“costs” associated with inventory. Acquisition, procurement, and carrying costs can be
calculated accurately and are an important financial consideration in pharmacy
management. These three types of inventory costs generally place little direct stress on busy
pharmacy staff but can depress the organization’s operating margins if not monitored
appropriately. Shortage costs represent failures in customer service and therefore lost sales.
These costs may be difficult to quantify but definitely have an impact on any pharmacy.

From a financial perspective, effective inventory management decreases the cost of goods
sold and operational expenses, resulting in increased gross margins and net profits. For
example, saving $100 on the purchase of prescription drugs will increase the gross margin
and net profit by $100 (assuming that operational expenses remain constant). Moreover,
having less money invested in inventory improves cash flow (West, 2001). A pharmacy that
has merchandise that is not selling or an oversupply of product sitting on the shelf has less
cash available to pay expenses and/or invest in other business operations. A pharmacy that
is able to reduce its inventory by $100 has that much more cash to spend on day-to-day
operations, invest in new services, or place in a savings or checking account.

From an operational perspective, effective inventory management is important in meeting

consumer demands for both goods and services (Carroll, 1998). Not having a product when
needed may cause the pharmacy to lose a sale and potentially a customer. Furthermore, not
having a needed product at the right time may cause physical harm to a patient, especially in
settings (e.g., hospitals) where lifesaving emergency drugs are needed routinely at a
moment’s notice.

Inventory management means minimizing the investment in inventory while balancing supply
and demand

There are four costs associated with having inventory: acquisition costs, procurement costs,
carrying costs, and stock-out costs.

The acquisition cost is the price the pharmacy pays for the product. Procurement costs are
the costs associated with purchasing the product: checking inventory, placing orders,
receiving orders, stocking the product, and paying the invoices. Carrying costs refer to the
storage, handling, insurance, cost of capital to finance the inventory, and opportunity costs.
Another carrying cost is the cost of loss through theft, deterioration, and damage.
 Inventory and Accounting in Pharmacy

The fourth cost is the stock-out cost, which is the cost of not having a product on the shelf
when a patient needs or wants it. This is frustrating to the pharmacist who has to explain
why the product is not available and is an inconvenience to the patient and prescriber.

Inventory management is the practice of planning, organizing, and controlling inventory so

that it contributes to the profitability of the business. The goals of inventory management are
to minimize the amount invested in inventory and the procurement and carrying costs while
balancing supply and demand. Inventory management is a key factor to success in a
pharmacy because efficient inventory management can keep costs down, improve cash flow,
and improve service. Alternatively, inventory mismanagement results in increased operating
and opportunity costs.

The most common ratio used to determine how well a pharmacy is managing its inventory is
the inventory turnover rate (ITOR). It can be calculated for the entire pharmacy, for
departments (e.g., prescriptions or OTC products), and even for individual products.
The ITOR is expressed as a ratio and is calculated by using the following formula:

ITOR = cost of goods sold ÷ average inventory value (at cost)

ITOR = cost of goods sold ÷ [(beginning inventory value + ending inventory value) ÷ 2]

The cost of goods sold (COGS) can be found on the pharmacy’s income (profit-and-loss)
statement for a given period of time. The average inventory value can be found by obtaining
the pharmacy’s balance sheets for both the beginning and the end of the period represented
on the income statement. The balance sheets should contain the value of the pharmacy’s
inventory at each point in time. The ITOR indicates the efficiency with which inventory is
used. It measures how quickly inventory is purchased, sold, and replaced. Two advantages
of increasing the ITOR are that reducing the investment in inventory frees capital for other
business activities and increases the return on investment in inventory.
Another indicator of a pharmacy manager’s ability to manage the investment in inventory
efficiently is the net-profit-to-average-inventory ratio. This ratio indicates whether the
inventory is being used efficiently to make a profit. Pharmacy managers desire to have a
ratio greater than 20 percent.

Factors to Consider in Inventory Management

● Selection of generic products: Generic drug products usually have a lower

acquisition cost, and therefore, by stocking generic products, the amount of money
invested in inventory is reduced.
● Reduction of inventory size: A pharmacist may decide to have a small front end in
his or her store to reduce the amount invested in inventory. He or she may carry only
basic product lines (i.e., a smaller numbers of brands and items) as opposed to full
product lines (i.e., every brand and every item).
● Returned-goods policies: One critical component is the evaluation of
returned-goods policies. Many manufacturers and wholesalers have established
policies regarding merchandise that may be returned. In exchange for returning
unsalable goods, these vendors may provide credit on future purchases, replacement
goods, or even cash back to the pharmacy.
 Inventory and Accounting in Pharmacy

● Management of unclaimed prescriptions: Approximately 1.5 percent of all

prescriptions received and/or filled in community pharmacies remain unclaimed). A
pharmacist must be aware of the amount of inventory that has been used to fill these
unclaimed prescriptions. It is important for pharmacists to monitor these unclaimed
prescriptions and after a specified period (e.g., 14 days) return the stock to the shelf
● Monitoring shrinkage: Inventory shrinkage includes losses owing to shoplifting,
employee theft, and robbery. It is important to recruit honest personnel and monitor
their activities, especially those working in the prescription area of a pharmacy.
Equally important; however, is for the pharmacy staff to be observant, say hello to
customers, keep displays neat, install security mirrors and cameras, and remove high
fixtures to minimize shoplifting.
● Use of formularies: A formulary allows the pharmacy manager to carry one
therapeutic equivalent within a class of drugs instead of each drug product within the
class. This allows pharmacy managers to lower their overall investment in inventory.

Methods of Inventory Management

1. The visual method: The visual method requires the pharmacist or designated
person to look at the number of units in inventory and compare them with a listing of
how many should be carried. When the number falls below the desired amount, an
order is placed.
2. The periodic method: The periodic method requires the pharmacist or designated
person to count the stock on hand at predetermined intervals and compare it with
minimum desired levels. If the quantity is below the minimum, the product is ordered.
3. The perpetual method: Perpetual inventory management systems are the most
efficient method to manage inventory. This method allows the inventory to be
monitored at all times. The entire inventory may be entered into the computer, and
with the filling of each prescription, the appropriate inventory can be reduced
automatically. A perpetual system can tell precisely the amount of inventory on hand
for any product at any time. Moreover, the pharmacy manager can quickly assess the
value of current inventory

The value of information technology can be recognized in pharmacy inventory management,

where computerized systems are broadly available in virtually all pharmacy practice settings
in industrialized countries. Technology makes methods of inventory management and
methods of evaluating inventory management more efficient, more precise, and more
accurate. Examples of the role of technology in inventory management include utilizing
hand-held scanning devices for periodic inventory control by scanning the barcodes on the
product packaging or shelf labels, submitting purchasing orders electronically after inputting
the scanned information into a computer via a web-based system, e.g. e-procurement.
Nowadays, technology is utilized in almost all pharmacy operations, from ordering,
procurement, storage, to paying for products. Pharmacists should employ the benefit of
newer technologies in their practice for better management of their pharmacy inventory.
Furthermore, automation in pharmacy inventory management creates additional time for
pharmacists to provide pharmaceutical care and other pharmaceutical services to patients
and customers.
 Inventory and Accounting in Pharmacy

ACCOUNTING IN PHARMACY
Accounting is the essence of any business organization as it provides a useful tool for
creditors, employees, investors, managers, owners, and all interested parties to make
well-informed business decisions. Accounting is basically an artificial business language.
Some basic accounting and financial terms include accruals, payables and receivables,
yields, and evaluations.

Accounting is the process of analyzing, classifying, recording, summarizing, and interpreting

business information into understandable financial terms to facilitate effective business
decision making. The first part of the definition refers to the following:

• Analyzing entails examining business transactions that involve basic ongoing activities,
such as investing personal cash or equipment into the business, purchasing supplies with
cash or credit, and the like.
• Classifying refers to the activity of providing a name for each specific account analyzed in
the transactions, such as assets, liabilities, and owner’s equity.
• Recording is the process of writing the accounting transactions in journals, ledgers, and
financial statements to provide a permanent record of the accounting activities.
• Summarizing is the totaling of the ledgers and statements in order to acquire final figures to
be used in the next step.
• Interpreting involves the various interested parties analyzing the final totals to facilitate
comprehensive and effective business decisions.

The need for accounting and the accounting entity concept

There are vital reasons for using accounting concepts. First, annually compiling and
presenting the firm’s financial data can provide a picture of the financial history of the
organization. The financial history of a firm is not always available without accounting
statements, and the financial history of a pharmacy is important in many investment
decisions. Second, an immediate snapshot of a pharmacy’s financial condition is provided
via financial statements such as a balance sheet, income statement, or statement of owner’s
equity. Investors, company managers, creditors, governmental agencies, and the general
public can analyze and interpret this accounting data for effective business decision making.
While there are many other advantages to accounting, one interesting use revolves around a
situation referred to as the accounting or separate entity concept. An accounting entity is any
organizational unit for which financial data is gathered and interpreted for decision making
purposes.

Generally accepted accounting principles

Consistency is an essential aspect of accounting and because it is vital for everyone who
acquires accounting reports to be able to interpret them, a set of guidelines has been
 Inventory and Accounting in Pharmacy

developed. These guidelines describing how the accounting process should be completed
are called the generally accepted accounting principles (GAAPs). The GAAPs, developed
and agreed upon by accountants, provide the rules that cover financial accounting rather
than other types of accounting such as tax accounting. In relation to a pharmacy, financial
accounting develops financial statements that report the pharmacy’s overall performance to
internal and external users.

Accounting planning and budgeting

A crucial management task is to project where the pharmacy should be in the future and
consider the steps needed to achieve this goal. A vital part of this planning process is to
create budgets that act as tools to facilitate these business decisions.

Budgets are usually operational (short-term) plans concerning sales and profit forecasts
within the next year. In essence, they are organizational financial plans expressed in
monetary terms for future periods of time. Three types of budgets are commonly used by
pharmacies:

1. Cash budget. Is a schedule of cash receipts and disbursements reflecting a pharmacy’s

projected cash inflows and outflows.
2. Operating budget. Presents a pharmacy’s anticipated revenues and
expenses. In addition to the cash budget, a sales expense budget
provides a vital degree of management control.
3. Capital budget. Shows a pharmacy’s possible investment in fixed assets.
Hospitals, chain pharmacies, and long-term care pharmacy providers
commonly use capital budgets more often than small local pharmacies.
Because planning involves an estimate of future demand, it is an extremely
difficult and inexact process. Therefore, many forecasts of demand are for
the short term, usually for the next 6 to 12 months.

Users of accounting data

Compiling organized financial records guarantees that needed accounting information is

available on a timely basis to internal and external users. For external purposes, these
accurate accounting statements are essential for meeting the requirements of creditors, tax
obligations, concerns of outside investors, and the general public. For example, the Internal
Revenue Service (IRS) and regulatory agencies such as the boards of pharmacy require
detailed accounting information about a pharmacy. In addition, investors and creditors may
be interested in the liquidity or profitability of a specific pharmacy for their respective
investment and credit-availability decisions. Internal uses by company managers at all levels
include inventory control, depreciation valuation, cash flow, and availability. Additional
internal reasons for the proper use of accounting records parallel a major external concern,
i.e., liquidity and profitability, which are also serious internal concerns for pharmaceutical
managers.

Conclusion
 Inventory and Accounting in Pharmacy

Accounting statements and tools such as ratio analysis increase the supply of current
financial information and facilitate more effective business decisions, as decision making
often occurs in an uncertain and constantly changing environment.

Accounting data does not solve a problem, but it alerts the pharmaceutical professional that
a problem exists in a company. The accounting process, statements, and tools help the
pharmaceutical professional acquire the financial expertise to make more informed
decisions, but they are not crystal balls that predict the future.

Therefore, a basic understanding of accounting concepts is essential for the operation of all
pharmaceutical organizations, from neighborhood pharmacies to chain pharmacies and
international pharmaceutical corporations. Accounting skills and knowledge are not only
assets for pharmacy management, but also contribute to the overall success of
pharmaceutical business
ventures.

Numerous activities occur on a daily basis that can change assets (things that we own, e.g.,
a computer), liabilities (debts that we owe, e.g., notes payable), and the owner’s equity (the
worth of the owner, e.g., Amy Harris, capital). These changing events must be entered in
accounting records.
Developing a set of financial records is the responsibility of the firm’s owner, and a system
should be developed that is compatible with the company’s owner and managers who use
this information.

Many other types of transactions occur after analyzing the accounting equation and
classifying different account titles, such as cash, account receivables, account payables, and
capital. It is necessary to record the transactions in various journals.

In the sequential order of the accounting cycle, after all business transactions are analyzed,
they are journalized in the general journal and then posted to the general ledger. Posting is
the transfer of amounts from the general journal to the specific individual accounts in the
book of final entry, the general ledger.

A financial statement is a report developed by the accounting department for both internal
and external users. Numerous statements are developed by way of journal and ledger
entries. However, a firm uses four major financial statements to report its financial condition:

1. Income statement
2. Statement of owner’s equity
3. Balance sheet
4. Statement of cash flows

These statements provide a snapshot of the business in relation to profit

and losses increases and decreases in capital, status of assets and debts, and
the efficient or inefficient use of cash by the firm.