For anyone who has managed any retail location (not just a pharmacy), you know that at least a couple times per year an inventory company visits your site and counts everything in the store to provide a total value for current inventory. You know that it is critical to get an accurate count and might have had regional or corporate offices providing detailed instructions on preparing for inventory. In an upcoming post, we'll talk about preparing for inventory to ensure that you do get an accurate count.
Today, however, I want to illustrate why getting an accurate inventory is so important by discussing the effects that inventory has on the income statement and going over the inventory adjustment to Cost of Goods Sold that occurs after inventory is taken.
Let's use examples to illustrate:
Let's say you ended the last inventory with $100,000 on the shelf. You purchased $50,000 from your wholesaler between then and now. Because your purchases were $50,000, in a periodic inventory system your reported COGS (Cost of Goods Sold) for the period between inventories would be $50,000:
The total value of all the drugs you had in your possession during that time period is equal to the previous inventory + purchased goods over that time period: $150,000.
Now let's go through a few scenarios to see how different ending Inventory amounts will affect COGS for the period:
Scenario 1: Ending inventory of $80,000
This means that you had to have sold $150,000 - $80,000 = $70,000
You sold $70,000, but you only reported selling $50,000 (your COGS). That means you need to adjust COGS by $20,000, increasing your total expenses for the period and decreasing Net Revenue.
Scenario #2: Ending inventory of $95,000
In this case the pharmacy sold $150,000 - $95,000 = $55,000
As in Scenario #1, we reported selling $50,000 but we actually sold $55,000; thus we need to add $5,000 to COGS, decreasing Net Revenue, but to a lesser extent than in Scenario #1.
Did you see what happened? A higher ending inventory decreases COGS for the period because it implies that you did not sell it and it instead is still on the shelf.
Basically what we are saying is if inventory is $95,000, you had to have sold all $50,000 off the shelf PLUS $5,000 of the $100,000 you originally had.
Many people I've met call this "taking a hit" at inventory when inventory is low because their income statement was falsely inflated and "looked better" prior to the COGS adjustment. It's a frustration of many pharmacists and pharmacy managers, but it is required for accurate accounting!
Now let's look at one last example:
Scenario #3: $120,000
The pharmacy sold $150,000 - $120,000 = $30,000
However, we reported selling $50,000. So this time we need to subtract $20,000 from COGS, increasing Net Revenue for the period.
Again, these drugs were not sold yet (and so do not go under COGS) but rather were purchased and are still in inventory.
That is why an accurate count is so important.
As a manager or owner, if the inventory company arrives to count and a section is missed, for example, it basically appears you sold that entire section but you never got revenue to show for it; because of this, your overall revenue is going to look much lower than it should.
If you are interested in learning more about accounting and decoding that income statement you get every month, one of my favorite sites to learn more is actually the website for the textbook I used during my accounting courses for business school. If you are a manager (and especially if you are an owner) I highly encourage you to bookmark it. All materials on the site are free and include powerpoints and sample questions so it's a great resource.