Accounting Basics for the Pharmacy Manager
A few things I learned in my first MBA course
This past fall I started working on an MBA through West Texas A and M’s distance learning program and the first course I took was accounting, which I had never taken before.
I have been managing pharmacies for almost 6 years, both in community and long-term care, and have seen plenty of income statements; however, I have to admit that the course was an eye-opener, and gave me a lot more tools to start making sense of the business side of pharmacy (even though I am still a beginner!)
It seemed like every month that I was having meetings at work I was hearing terms and concepts I had just read about. While I would highly recommend any pharmacy manager to take at least 1 course in accounting if they have not done so, I wanted to share some particularly useful tools that I gained this past semester.
In addition, I have referenced the book used in the course I took; there is a website available with free Powerpoint presentations for each chapter, which is a tremendous resource to learn more.1
The monthly statement you receive that tells you how much money the pharmacy earned, how much it paid its employees, and all of its other various expenses is called an income statement or profit and loss statement (I mistakenly called it a ‘budget’ for a long time).
The budget is sometimes listed next to the items in the income statement and tells you what the company expected the pharmacy to earn and spend. There are 4 basic financial statements: the income statement, the balance sheet, the retained earnings statement, and the cash flow statement. You can learn a lot about a company’s management style, their future directions, and their potential weaknesses by analyzing those statements. Publicly-traded companies must adhere to a set of standards for how and what they can and must report on those statements; in the US, these are known as Generally Accepted Accounting Principles (GAAP). In the rest of the world, there are a separate set of standards known as the International Financial Reporting Standards (IFRS).
Sales revenue, net sales, gross profit, and net profit (net income)
I think most of us hear these terms a lot in meetings about our pharmacy’s financial performance so I wanted to clear them up. Sales revenue is the total amount in sales that you have generated before any deductions; net sales is sales revenue minus allowances, returns, and discounts. Once you subtract your cost of goods sold from net sales you are left with gross profit. If you take gross profit and subtract operating expenses (payroll, utilities, taxes, etc.), you will be left with net income, also known as net profit. You can also calculate gross and net profit as percentages (also called margins).
Being able to calculate your gross margin and net margin can help you discuss your income statement; for example, I recently realized I had been budgeted a 27% gross margin and pointed out to accounting that industry average has been reported at about 22%,2 and our other location had been budgeted gross margins of 11%, meaning they could actually spend much more on drugs relative to their sales than my location and still meet budget. That helped them understand better why our cost of goods sold has been consistently high compared to budget.
Inventory Turnover Ratio, Days on Hand
The inventory turnover ratio tells you how many times per year you turned over your entire inventory. It is calculated by dividing total sales by average Inventory. If you get 12, for example, that means you turned over your inventory 12 times in a year. To convert that to days on hand, you divide 365 by that number. If your inventory turnover ratio is 12, then your days on hand is roughly 30. This is a powerful number for determining how good of a job you and your team are doing in managing inventory.
Cost Flow Methods
Let’s say you own a coffee shop and you want to prepare the income statement for December 2016. You need to figure out your Cost of Goods Sold — how much you spent on the coffee you sold that month. Let’s also say that on December 1, 2016 a pound of coffee costs you $6, but on December 31, 2016 a pound of coffee costs you $7. There’s of course no way to know exactly which coffee you sold because you just poured it all in the coffee grinder as you needed it. Do you report your cost at $6/pound, $7/pound, or even in the middle at $6.50/pound? What if you bought more coffee that month at $6 than at $7? Would you still use $6.50? This is a very real problem in pharmacy, especially as prices fluctuate drastically, we have open bottles, and it is impractical to record the price for each individual bottle at inventory.
To solve this problem we can use several different inventory valuation methods, all of which are accepted by GAAP (IFRS does not accept LIFO). Let’s assume you bought 5, one-pound bags of coffee at $6/pound, 6 bags at $7/pound, you did not use any coffee from the previous month of November, and you sold 8 bags of coffee in December. Your costs would look like this:
1. First In First Out (FIFO): The first items that arrived are the first ones sold. This seems to be the most intuitive to me since we always try to use the older inventory first. Based on selling 8 bags, it would look like this:
a. 5 bags X $6/pound = $30
b. 3 bags X $7/pound = $21
c. Total cost of goods sold = $51
2. Last In First Out (LIFO): The last items that arrived are the first ones sold. Again, this is not accepted by IFRS but is by GAAP. When I first heard this I thought it didn’t make any sense — why would you use the newest inventory first? However, companies often argue that calculating inventory this way (regardless of what order it is used up in) better matches their current revenue with current expenses. Another advantage for the company is that in times of rising costs it can reduce reported net income and thus lower a company’s tax bill. Here’s what it would look like in our example:
a. 6 bags X $7/pound = $42
b. 2 bags X $6/pound = $12
c. Total cost of goods sold = $54
3. Average cost: This method uses a weighted average of the goods. It would look like this.
a. 5 bags x $6/bag = $30; 6 bags x $7 = $42. Total cost = $72
b. $72/11 bags purchased = average cost $6.55/bag
c. Total cost of goods sold = 8 bags sold x $6.55/bag = $52.40
1. Kimmel, Wegandt, Kieso. Financial accounting: tools for business decision making 8th edition. New Jersey: Wiley; Septemeber 2015. Website: http://bcs.wiley.com/he-bcs/Books?action=index&bcsId=9825&itemId=1118953908.
2. Vecchione A. Industry study reveals mixed state of affairs for independent community pharmacists. Drug Topics. 2016; http://drugtopics.modernmedicine.com/drug-topics/news/industry-study-reveals-mixed-state-affairs-independent-community-pharmacists?page=0,1. Accessed online January 22, 2016.