CHAPTER II
REVIEW OF LITERATURE
Inventory can be the largest investment a pharmacy can make. Dealing with inventory can be intricate unless an organization has a good inventory control system. The purpose of this system is to maximize efficiency and effectiveness. Efficiency is to minimize inventory costs and effectiveness is to meet the customer demands.
Inventory control involves maintaining adequate stock of medications, as well as storing those medications in a safe and secure manner. It also means keeping track of the purchasing and distribution of the medications. Good inventory control allows the pharmacy to have enough medications on hand to fill prescriptions and orders, without having so much stock that drugs deteriorate before they can be used (Askew and Smith-Stoner, 2001).
Inventory Acquisition
Purchasing is not just a routine function to keep inventories on the shelf. However, since pharmacies literally spend a lot to acquire medications and other goods, purchasing is actually a substantial investment process. According to the research of Desselle and Zgarrick (2008), the objective of purchasing is to obtain the right products in the right quantity at the right price at the right time from the right vendor. Right quantity means having just enough products on hand to cover consumer demand at any given time. In order to estimate the minimum quantity needed to meet the demand, the purchasing agent must know how many items on hand, when to order, and how much to order.
Most businesses place an order for replenishment of inventory when the inventory level is already at low point. This low point is predetermined by the management using the reorder point (ROP) system.
A reorder point is simply a level of inventory that is designated as the signal to replenish. Whenever the inventory level reaches the reorder point, a replenishment order is placed. It is set such that the inventory level will reach zero at about the time the replenishment order is expected to arrive. Generally, the quantity to reorder depends on the level of demand and other factors such as market availability, storage space available, and shelf life considerations (Mercado, 2007). Formula for computing the reorder point is:
ROP = (Demand per time period x Lead Time) + Safety Stock
Lead time is the period between placing an order and receiving delivery. When lead time and demand are not certain, the firm must carry out extra units of inventory, called safety stock, as protection against possible stock-outs (Siegel and Shim, 2006). Minner (2000) defined safety stock as the expected inventory just before the next order arrives.
Using this technique of reordering requires a system that can track the inventory level at any given time. This can be accomplished using a perpetual accounting record or a visual method.
Desselle and Zgarrick (2008) explain that too much inventory ties up pharmacy’s money without having adequate return on investment. On the other hand, having too little inventory may result in lost sales and profits when the product is not available for purchase. Not having enough products available also may result in the loss of customers in the future. The management therefore must know the right amount of inventory to order while maintaining the right amount of stock. To determine this, the purchasing agent must identify the economic order quantity (EOQ).
EOQ is the optimum amount of goods to order each time to minimize total inventory costs (Shim and Siegel, 2000). It describes the level of inventory and reorder quantity at which the combined costs of purchasing and carrying inventory are at a minimum. Purchasing or ordering costs include costs of placing the order and received goods while
carrying or holding costs include the storage, handling, property tax, and insurance costs, as well as the required return rate on the inventory investment (Siegel, Shim, and Hartman, 1997).
The classical formula for EOQ model is
Where: D = annual demand in units;
O = unit ordering cost;
H = annual holding or carrying cost per unit
Inventory Protection and Storage
Proper storage of inventory is vital. Improper storage can cause a product to ruin, resulting in a loss of inventory and money. According to Bizmanualz, Inc. (2008), storage refers to protecting inventory from both damage and shrinkage or theft.
Damage control includes insuring and keeping inventory clean and properly sheltered. According to Yadav (2008), proper environmental control (i.e., proper temperature, light, humidity, conditions of sanitation, ventilation, and segregation) must be maintained wherever drugs and supplies are stored. Proper control is required such as expiry dates of drugs stored must be considered. With regards to safety, proper consideration should be given to the safe storage of poisons and flammable compounds.
Control over shrinkage is directed at human error (data entry, POS error, receiving errors, etc.) and customer or employee theft. Human error is a continual possibility. Successful business systems acknowledge this fact and incorporate preventative and detective controls to mitigate the anticipated human error. Preventative controls include written POS procedures, supervisory control, use of logs, cash-up reports and other checklists. Detective controls include cycle inventory counts, exception reports, and gross margin analyses.
Improper inventory also produce a higher risk of theft and fraud. Customer theft protection involves many elements from security to customer return policies. Businesses should focus on high-dollar merchandise that can be easily hidden and carried out of the store. Also, employee theft protection must be given proper attention.
Employee theft protection involves two important ingredients: maintaining a high level of security and eliminating the easy opportunities for theft. A high level of security is maintained when cycle count exceptions are followed, medicines are stored properly and shelved quickly, and unresolved damage claims, customer returns and returns to vendors are not allowed to build up.
Eliminating easy opportunities for theft involves structural security as well as numerous written employee procedures. A well-lit storage space, restricted areas, and installation of security cameras are example of structural security features. Written procedures that reduce opportunities for theft include limiting storage access only to designated personnel, mandating all employees to exit and enter only through the front door, preventing employee from ringing up a sale for him/her or family members, monitoring customer returns, and proper cash drawer and petty cash usage.
Coltman and Jagels (2003) provide the following control practices that should be used for product storage:
1. Immediately after goods have been delivered and all receiving checks performed, they should be moved to storage areas or sent directly to the departments that requested them. Proper storage facilities should be used.
2. Storage areas should be locked when the storekeeper is not present. Access to storerooms should be limited to the storekeeper and other authorized employees.
3. Storekeepers should not maintain or have access to formal inventory records, nor should accounting department employees who maintain those records have access to storerooms except to take inventories.
4. Inventory counts of stored products should be taken periodically by accounting office employees and compared to perpetual inventory cards (if used). A perpetual inventory card is maintained for each separate item in stock. It has recorded on it, for each item, quantities received in and quantities issued from the storeroom to provide a running balance of what should be in inventory.
5. The best procedure for taking inventory is to make two accounting office employees responsible. One completes the actual physical count; the other compares this with the perpetual inventory card figure and then records the actual count on an inventory sheet.
6. If there are any significant differences that cannot be reconciled between the inventory count and what should be in inventory according to perpetual inventory cards, the differences should be investigated to determine the cause.
7. To aid in inventory count, preprinted inventory sheets that list items in the same order as they are located on storeroom shelves should be used.
Inventory Obsolescence and Disposal
According to Bragg (2006), there is inevitably a certain amount of inventory that will not be used, due to excessive purchasing of materials beyond a company’s needs or customers not buying certain items. In the pharmacy’s perspective, inventory (specifically drugs) becomes obsolete because of its limited shelf life. Obsolete inventory can constitute a large portion of the total inventory, so it is suggested to consider giving controls in this area.
Bragg further explains that the primary risks associated with obsolete inventory are that the inventory will not be promptly recognized as obsolete, that inventory will be improperly designated as obsolete, and that dispositioned inventory will be accidentally reordered. He also provided some controls dealing with these risks.
Regularly complete an obsolete inventory review. The best way to ensure that obsolescence is recognized promptly is to conduct a regularly scheduled obsolescence review of the entire inventory, typically using an obsolescence report.
Move obsolete inventory to segregated area. It is much easier to review and leave as-is obsolete inventory if it is congregated in a single area rather than scattered throughout the warehouse.
Match obsolescence authorization to tagged obsolete inventory. It is possible that warehouse employees will deliberately tag inventory as being obsolete, so they can remove it from the warehouse or acquire it at a low price from the company. To avoid this problem, periodically compare the obsolete inventory review procedure to tagged obsolete inventory,
to ensure that only authorized items are tagged. Any other items marked as obsolete should immediately be brought to the attention of the warehouse manager and internal audit manager as being a possible case of fraud.
Moini (2004) also provided some controls in disposing expired stock. He explains that expired, deteriorated, contaminated, or other non-reusable drug products should be removed immediately from usable pharmacy stock and disposed of. Expired drugs should be placed into containers labeled with “expired drugs – DO NOT USE” or any similar understood warning. Disposal requirements for most drugs that have expiration date are listed in the package inserts. Expired drugs and their disposal should be documented regardless of whether they are put into biohazard bags for collection by approved biohazard disposal companies, returned to pharmaceutical representatives, or disposed of in any other way.
Inventory Measurement and Tracking System
There are two ways to measure the inventory and cost of goods sold. These are:
Periodic System. This method has historically been the one used by pharmacies because it requires much less record keeping, as opined by Carroll in 2006. It is based on costing out physical counts at both beginning and ending periods. The cost of goods sold is calculated by adding purchases to the beginning inventory and subtracting the ending inventory (Toomey, 2000).
The major disadvantage of this method is the requirement of conducting a complete physical inventory count to obtain a calculation of the inventory cost. With this, calculation of the inventory will be costly and time-consuming. Accuracy may also be an issue in this procedure.
Perpetual System. In perpetual system, detailed records of each inventory purchase and sale are maintained. This system provides a current record of inventory on hand and cost of goods sold to date (Robles and Empleo, 2007). This method keeps the accounts current and accurate because the balances are updated constantly. It continually accumulates all incoming and outgoing transaction quantities of an inventory item so that, at any time, there is a record of the current balance on hand (Mercado, 2007).
Carroll (2006) provides the following advantages of the perpetual system:
1. It provides the cost of goods sold without a physical inventory. Consequently, financial statements can be generated easily and inexpensively at any time during the year.
2. It provides information that managers can use to control inventory levels. Individual inventory accounts show frequency of sales for each stock keeping unit (SKU). Managers can use this to determine optimal purchase quantities and maximum and minimum inventory levels for SKUs.
3. It provides a basis for measuring shrinkage. Shrinkage refers to the amount of inventory that is lost, broken, or stolen. Shrinkage is estimated by comparing the inventory level recorded in the inventory account with that found by a physical inventory. The difference between these two levels represents shrinkage.
Bragg (2004) pointed out that the perpetual inventory system is highly recommended because it avoids expensive periodic inventory counts, which also tend not to yield accurate results. Also, it allows the purchasing staff to have greater confidence in determining the inventory on hand for purchasing planning purposes. Accountants can complete period-end financial statements more quickly, without having to guess at ending inventory levels.
Inventory Valuation
Determination of inventory cost is the major aspect of financial reporting. Whether the periodic or the perpetual system is used, it is necessary to use a specific method for the assignment of costs to the ending inventory as well as to the cost of goods sold. Assignment of costs can be complex because goods are usually purchased at different costs during the accounting period. Thus, there must be a consistent procedure in assigning costs which is called the cost-flow assumption (Eisen, 2007). There are three cost-flow assumptions that can be used:
First-In, First-Out (FIFO) Method. This is based on the assumption that the first units brought are the first units sold. The oldest cost assigned to the inventory is the cost assigned to the goods first sold. Consequently, the most recent cost is assigned to the ending inventory. Although business organizations are free to choose among a number of inventory methods, many adopt FIFO simply because there is a tendency to dispose of goods in the order of their acquisition (Eisen, 2007). This method, though not as accurate as specifically identifying the item being sold, would give a close approximation of value.
Last-In, Last-Out (LIFO) Method. This method assumes that the most recent cost of goods acquired should be charged at the most recent sales made. Thus, the assignment of the cost to the ending inventory represents the cost of all earlier purchases, without regard to the order in which the goods are actually sold, since it is assumed that the goods are all the same and readily interchangeable (Eisen, 2007).
Weighted Average Cost Method. This method yields a cost that is representative of the cost of the product over the entire accounting period. The weighted average cost of a unit of inventory is determined and all units are assigned this cost. The average cost is weighted by the number of units purchased at each cost (Carroll, 2006).
Eisen further notes that in accounting periods where costs remain relatively constant, the FIFO method is probably the most appropriate. If it is important that replacement costs relate as closely as possible to the cost of the goods sold, the LIFO method is better. The weighted average method is a third option, even though it does not necessarily bring about the matching of costs and revenue. Its simplicity may have a cost-saving effect.
Principles of Internal Control
To meet the purpose of an inventory control system, the management must apply internal controls in its business. A broad definition of internal control was given by Trenerry (1999):
“A system of controls and checks instituted by the various levels of management that are independent and interdependent and are integrated into the financial and non-financial activities and operations of a business to ensure that the business operations are conducted efficiently and effectively and operating results for all aspects of the business are reliably reported to ensure management decision-making is well based and that all relevant laws and regulations are complied with.”
The objectives of internal control are to provide reasonable assurance that: (1) assets are safeguarded and used for business purposes; (2) business information is accurate; and, (3) employees and managers comply with laws and regulations (Warren, Reeve, and Duchac, 2008).
Coltman and Jagels (2003) discuss some basic principles that provide a solid foundation for a good internal control. Some of them are the following:
Establish preventative procedures. Internal control procedures should be established so that they minimize and/or prevent theft. This is much more effective than suffering losses from theft or fraud and having a system that detects the culprits only after the event.
Establish management supervision. Complete absence of any controls will yield some employees to temptation and become dishonest. If management does not care, why should the employees?
Monitor control systems. Any system of control must also be monitored to ensure that it is continuing to provide the desired information. The system must therefore be flexible enough to be changed to suit different needs.
Establish responsibilities and prepare written procedures. Once the designated person is established, that person must be given a list of receiving procedures, preferably in writing, so if errors or discrepancies arise, that person can be held accountable.
Maintain adequate records. Another important consideration for good internal control is to have good written records. Without good records, employees will be less concerned about doing a good job.
Separate record keeping and control of assets. One of the most important principles of good internal control is to separate the functions of recording information about assets and the actual control of the assets.
Limit access to assets. The number of employees who have access to assets such as cash and inventory should be limited. The larger the number of employees with access, the greater is the potential for loss from theft or fraud.
Divide the responsibility for related transactions. Responsibility for related transactions should be separated so the work of one person is verified by the work of another. This is not to suggest duplication of work—that would be costly—but to have two tasks that must be carried out for control reasons done by two separate employees. This procedure keeps one person from having too much control over assets and may prevent their theft.
Set standards and evaluate results. One of the requirements of a good internal control system is not only to control the obvious visible items, such as cash or inventory, but also to have a reporting system that indicates whether all aspects of the business are operating properly. Once procedures have been established and the various employees have been given detailed written guidelines about how to perform tasks, standards of performance should be established.
Create an audit trail. Most good internal control systems are based on having an audit trail that documents each transaction from the time that it was initiated through source documents and defined procedures through to the final recording of the transaction in the operation’s general ledger. A good audit trail allows each transaction, where necessary, to be tracked again from start to finish.
Supervise the system and conduct reviews. One of management’s major responsibilities in internal control is constant supervision and review of the system. This supervision and review is necessary because the system becomes obsolete as business conditions change. Also, without continuous supervision the control system can collapse.
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