Purchasing and Inventory Management Notes
Purchasing and Inventory Management: Key Concepts
Relationship between purchasing and inventory
- Purchasing and inventory management go hand in hand. If you are going to sell, you must buy inventory; you can’t sell out of an empty basket.
- Inventory is an investment and an asset that enables revenue generation.
How significant is inventory?
- Inventory ties up a large share of dollars in a pharmacy: literature places it roughly between
to of every dollar in cost of goods sold (COGS) or inventory value; some sources say as low as or as high as of the dollar. In practice, it’s often described as about two-thirds to three-fourths of the expense base in a pharmacy. - This underscores inventory as a major investment and a key driver of profitability.
- Inventory ties up a large share of dollars in a pharmacy: literature places it roughly between
Inventory accounting and balance sheets
- Inventory is an asset and is reported on the balance sheet, not the income statement.
- It represents the investment in goods that are intended for sale to customers.
Role of technology
- Pharmacy software (and wholesaler software) can assist in determining inventory levels and management.
- Technology supports operations but does not replace knowledge and skill; users must learn and leverage the tools effectively.
- Industry example: big wholesalers offer integrated software and inventory management to help pharmacies maintain appropriate stock levels.
Real-world perspective on technology and business risk
- Technology supports processes but does not guarantee success; poor implementation or lack of understanding can still lead to failure—customer service and availability issues matter as much as tools.
- Industry dynamics include price competition and service quality; losing inventory availability or customer service can sink a business.
Important exam focus (application-oriented)
- Expect questions that require applying concepts to determine optimal purchasing/inventory decisions, rather than pure memorization.
Focus on variables you should learn and remember
- Inventory management is influenced by product mix, supplier terms, demand, lead times, carrying costs, and service level requirements.
The cost of inventory and its impact on profits
- Given a constant sales level, profits can potentially change by about 20% for every 1% change in COGS. This is a crucial rule of thumb for understanding the leverage that purchasing costs exert on bottom-line performance.
- Simple illustrative example (from the lecture):
- Total sales:
- COGS:
- If COGS decreases by 1%, net profit rises by about 20% (holding other operating expenses constant). Using a baseline net profit example (approximately ), a 1% COGS decrease could push net profit to about 115{,}000 ext{ (roughly }$115{,}128 ext{).}
- The key takeaway: even small improvements in cost efficiency can produce large changes in profitability when sales are fixed.
Purchasing objectives
- Obtain the right products, in the right quantity, at the right time, and at the right price from the right vendors.
- Right products and right quantity help ensure fast turnover and customer satisfaction.
Inventory turnover ratio (conceptual)
- Inventory turnover helps assess how quickly inventory is sold and replenished.
- Interpretation:
- High turnover: lower investment in inventory, faster cash conversion, but risk of stockouts.
- Low turnover: excess inventory, higher carrying costs, potential obsolescence.
- Formula (standard):
- Also common: using sales instead of COGS, but COGS-based turnover is standard for inventory health.
Inventory mix: breadth and depth
- Product assortment equals breadth plus depth.
- Breadth: number of product lines/categories offered.
- Depth: number of different SKUs within a product line.
- Right product mix requires balancing breadth and depth to meet customer needs while controlling costs.
Product line length and depth examples
- Example product lines: antacids, toothpaste, antibiotics, shampoos, etc.
- Depth decisions: within toothpaste, how many brands and flavors to stock; within antacids, how many brand-name options and formulations.
- Deeper assortment increases revenue potential but raises carrying costs, space, and labor for procurement and management.
Meeting customer expectations: quality and price
- Customer choice is driven by a mix of price and quality; some customers prioritize price, others quality.
- Non-compensatory preference: customers may demand quality even if the price is higher; reducing quality to cut price is not always acceptable.
Market research and understanding the target market
- Understand who lives in the market (e.g., using ZIP-code data) to tailor the assortment.
- Research methods include observations, scanning data from registers, media reports, drug utilization reviews, and insurance claims data.
- Knowledge of prescribing habits of local physicians helps forecast demand for certain medications.
- Pharmacy managers may obtain market data from various sources; use this information to select the right product mix.
Customer insight and market research tools mentioned in class
- Personal observations (e.g., Portland door-to-door/ street-level observation to gauge foot traffic).
- Scanning/point-of-sale data to track sales and inventory movement.
- Media sources and press coverage to identify promotions and consumer signals.
- Drug utilization reviews and claims data to understand usage patterns.
- Knowledge of local physicians and specialties to anticipate prescribing patterns.
- Market data by zip code and local demographics to gauge demand.
The product mix and the concept of breadth plus depth in practice
- A strong product mix requires selecting a few areas to go deep (specialties) while maintaining reasonable breadth to cover key needs.
- The balance reduces the risk of over-concentration in a single category while ensuring core needs are met.
The role of marketing research and merchandising decisions
- Marketing research informs which products to stock and how to position them.
- Merchandising decisions shape product visibility and accessibility to customers.
Key merchandising concepts and their rationale
- Planogram: a merchandising blueprint that defines stock levels, product positions, and the number of facings.
- Shelf space and shelf facing: prime real estate that influences attention and sales; self shelf space and shelf facing are key factors.
- Best shelf position: between waist and eye level to maximize visibility and accessibility.
- Positioning near a leading seller increases sales due to comparison effects.
- Shelf signs and promotions (e.g., buy-one-get-one-free) influence purchasing decisions.
- Clustering similar products enhances visibility and choice ease for customers.
- Private label or store brands placed next to leading brands can drive substitutions.
International and design perspectives on store layout
- Merchandising design is sophisticated and market-specific (examples include Italian design firms creating pharmacy layouts). Layout and lighting reflect market preferences and customer behavior.
- Space is expensive; optimizing real estate (shelf height, width, and proximity) affects sales and profits.
Inventory management methods
- Three popular methods:
1) Visual (spot checks, informal): quick and inexpensive but prone to errors.
2) Periodic inventory: checks at set intervals; analyzes a single point in time.
3) Continuous (perpetual) inventory: perpetual tracking via scanning; most effective but requires investment. - Perpetual inventory is used by many large retailers (e.g., Walmart) to keep real-time stock data and trigger replenishment automatically.
- Three popular methods:
The stock depth formula and its components
- Stock depth (order quantity and timing) is influenced by:
- Review time: time between stock checks.
- Lead time: time between placing an order and receiving it.
- Average demand: average usage over a period (seasonality considered).
- Safety stock: buffer to cover demand variability and supply disruption.
- Stock depth equation (conceptual):
- The point is to balance order timing with demand and risk buffers.
Just-in-time (JIT) vs traditional stocking
- JIT aims to order and receive goods as needed to meet demand, minimizing on-hand inventory.
- Pros: lowers carrying costs; cons: higher risk of stockouts and vulnerability to supply disruption.
- Example cited: Dell’s model of placing an order and initiating production/fulfillment automatically when the customer places an order; advanced coordination reduces inventory carrying but can impact availability during supply shocks.
Right price dynamics and vendor negotiations
- Right price depends on timing, vendor willingness, and inventory position.
- Discounts and payment terms can alter total cost (e.g., cash discounts, volume discounts, and promotional terms).
- Product bundling: trading one product for another to improve overall sell-through.
- Minimum purchase requirements: suppliers may require a minimum order value to qualify for discounts.
- Prompt payment discounts: paying quickly can yield better terms.
- Word of caution: excessive discounting can erode perceived value and reduce urgency to buy now.
The right vendor and return policies
- Vendor selection factors include return goods policies, financing terms, marketing support, and co-op advertising.
- A vendor with favorable return policies reduces risk of unsold stock and obsolescence.
The propensity to use data to optimize procurement
- Procurement decisions should consider interdependencies among product choice, quantity, timing, price, and vendor.
- The key is to optimize multiple variables simultaneously rather than optimizing in isolation.
Historical and economic context in stock management
- Ford, Harris and the 1913 framework (economic order quantity, EOQ) is historically referenced as a foundational model for order quantities.
- While the original math is older, the underlying concepts (demand, ordering cost, holding cost) remain relevant for understanding how much to order and how much to keep on hand.
- Key EOQ-style variables in the historical model (for reference):
$$EOQ = \