Inside: Use these inventory management formulas to minimize costs, free up cash flow, and keep your pharmacy in the black.
Inventory is the crux of every independent pharmacy business, and it’s the most costly expense.
With so much money on the line, mastering inventory management becomes a crucial skill. These six inventory management formulas will help you keep a tight grip on your inventory management for a more profitable pharmacy.
Read Next: Pharmacy Inventory Management: How to Master Pharmacy Inventory for a Better Bottom Line
Economic order quantity
When you have inventory in your pharmacy, you incur costs related to holding, ordering, and shortages.
The economic order quantity model of inventory management helps you find out the ideal quantity of merchandise to buy per order to minimize those costs.
It’s determined using this formula:
Economic order quantity = The square root of [(2 x annual product quantity x ordering costs) / Holding costs]
The economic order quantity method can help you get control of your cash flow so your cash isn’t unnecessarily tied up in inventory, although one pitfall is that it doesn’t take into account changes in seasonal demand. If you have a period of increased demand, the EOQ method could lead you to experience unnecessary shortages.
Open-to-buy
The open-to-buy method of inventory management helps you create a monthly budget for your inventory.
To find out how much you can spend each month, use this formula:
Monthly inventory spending available = Planned sales + Planned markdowns + Planned end-of-month inventory – Planned beginning of month inventory
The advantage of this method is that it lets you stay within a tightly controlled budget and gives you tight reins on your cash flow. If your forecasts are good, you’ll always have enough inventory to meet demand.
However, for your forecasts to be helpful, you have to dig deep into your past sales data to make accurate forecasts. In a situation where demand often changes from month to month, you’ll have to constantly recalculate the formula to find an appropriate budget.
For more control when using the open-to-buy method, you can use the ABC method (see below) to create a budget for each of your three product categories.
Inventory turnover rate
Your inventory turnover rate is how many times you turn over your inventory in a given year. It’s calculated with items from your balance sheet using this formula:
Inventory turnover rate = Annualized inventory cost of goods / total inventory
A high inventory turnover rate means you are selling your inventory quickly. The average independent pharmacy turns over its inventory 11 times a year.
If you have an inventory turnover rate of less than 10, that’s a sign you need to focus on inventory management.
A few tactics to improve your inventory turnover rate include:
- Measuring your inventory accurately. If you’re eyeballing your inventory, you may not have a true sense of how things are moving.
- Stocking items that patients actually want. This may mean paring down items that come in multiple sizes or not restocking items that are collecting dust on the shelves.
- Changing your pricing strategy. This could mean lowering prices on high-margin items to encourage more overall purchases or slowly raising prices throughout the pharmacy.
- Minimizing inventory. More inventory takes longer to turn over, and it will incur excess holding costs.
Inventory turnover days
Another way to measure your inventory turnover is in the number of days it takes to turn over your entire inventory. That number can be found using this formula:
Inventory turn days = 365 / Inventory turnover rate
For a pharmacy that has an average inventory turnover rate of 11, inventory would turn over every 33 days.
This metric can be useful for allocating storage space, since you’ll have a better idea of around how long you’ll have to hold your inventory before it leaves your shelves.
Percent net profit
Sometimes known as the net profit ratio, net profit percentage compares your after-tax profits to your sales.
Percent net profit = (Net income / revenue) x 100
When you have a slim net profit percentage (or worse, a negative net profit) that can be a sign that the costs associated with holding and ordering inventory are high compared to the income earned from sales.
To improve your net profit percentage, you should start looking for ways to streamline your inventory management process or reduce other overhead expenses associated with running the pharmacy.
The net profit percentage is designed to be looked at over time. One snapshot of the metric won’t tell you much, but if it’s going up or down over time, that can be a big picture indicator of whether your inventory strategy is working.
ABC analysis
Although the ABC analysis is not technically a formula, it is a helpful method for optimizing your inventory management.
When using ABC analysis, you categorize your inventory into three groups: A items, B items, and C items.
As you might guess, your A items are the most important items in your inventory. Even though they probably are a small percentage of the items on your shelves, they make up the majority of your sales.
On the other end of the spectrum, C items make up a lot of what your pharmacy stocks, but don’t account for a large portion of your sales. B items fall somewhere in the middle.
How you categorize items will depend on your pharmacy, but they often break down along these lines:
- A items: 10 percent of inventory, 70 percent of sales
- B items: 20 percent of inventory, 20 percent of sales
- C items: 70 percent of inventory, 10 percent of sales
When using the ABC analysis, you’ll change your approach to inventory management based on the category. Because your A items are extremely high-value, you’ll pay more attention to them. You’ll perform cycle counts more frequently to ensure you know where you stand and reorder more often to ensure you never run out.
For B and C items, you may cycle count less frequently and set less aggressive reorder points.
A Member-Owned Company Serving Independent Pharmacies
PBA Health is dedicated to helping independent pharmacies reach their full potential on the buy-side of their business. Founded and owned by pharmacists, PBA Health serves independent pharmacies with group purchasing services, wholesaler contract negotiations, proprietary purchasing tools, and more.
An HDA member, PBA Health operates its own NABP-accredited secondary wholesaler with more than 6,000 SKUs, including brands, generics, narcotics CII-CV, cold-storage products, and over-the-counter (OTC) products — offering the lowest prices in the secondary market.
