Print 12/5/20, 7:09 PM 9.1 OVERVIEW: THE INVENTORY CONCEPT This overview concerns both the inventory concept and types of inventories. Concept of Inventory in Healthcare Organizations “Inventory” includes all the items (goods) that an organization has for sale in the normal course of its business. Inventory is an asset, owned by the company. It appears on the balance sheet as a current asset, because the individual items that compose the inventory are expected to be “used” (sold) within a 12-month period. Types of Inventory in Healthcare Organizations Various healthcare organizations (or departments within organizations) deal with inventory and must account for it. The hospital gift shop and the cafeteria, for example, own inventory and must account for it. All pharmacies (hospital-based, retail brick-and-mortar, or mail order pharmacies) own inventory in the normal course of their business. In manufacturing companies, inventory typically consists of three parts: raw materials, work in progress, and the finished goods that are for sale. We might think that most inventory items for sale in a healthcare organization are not manufactured, but are finished goods instead. However, consider this example: the hospital cafeteria purchases flour, eggs, butter, and so on (raw materials), mixes the ingredients (work in progress), and produces a cake (finished goods) that is for sale. (Another example might be a pharmacy that compounds drugs.) https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 1 of 1 Print 12/5/20, 7:09 PM 9.2 INVENTORY AND COST OF GOODS SOLD (“GOODS” SUCH AS DRUGS) The interrelationship between inventory and cost of goods sold is at the heart of the inventory concept. Turning Inventory into Cost of Goods (or Drugs) Sold The completed inventory item (“finished goods”) is sold. That is how an item moves out of inventory and is recognized as cost. When the item is recognized as cost, it becomes “cost of goods sold.” (Also note that different terminology may be used. In some organizations cost of goods sold is called “cost of sales.”) For a business such as a retail pharmacy, the cost of inventory sold to its customers is the largest single expense of the business. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 1 of 3 Print 12/5/20, 7:09 PM Recording Inventory and Cost of Goods (or Drugs) Sold Recording inventory and cost of goods (or drugs) sold is a sequence of events. Figure 9–1 (http://content.thuzelearning.com/books/Baker.6866.18.1/sections/ch9_sect1_2#ch9_fig1) illustrates the sequence as follows: Figure 9–1 Recording Inventory in the Accounting Cycle. ■ Beginning inventory (inventory at the start of the period) is recorded. ■ Purchases during the period are recorded. ■ Beginning inventory plus purchases equal “cost of goods available for sale.” ■ Ending inventory (inventory at the end of the period) is recorded. ■ Cost of goods available for sale less ending inventory equals “cost of goods sold.” Purchases added to inventory will typically include “freight in,” or the shipping costs to deliver the items to you. Any discounts received on the purchases should be subtracted from the purchase cost. Thus the purchases become “net purchases”; that is, net of discounts. Sometimes the ending inventory is estimated. An example of “Estimating the Ending Pharmacy Inventory” is shown in the chapter about estimates and benchmarking. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 2 of 3 Print 12/5/20, 7:09 PM Gross Margin Computation Gross margin equals revenue from sales less the cost of goods sold. Gross margin is often expressed as a percentage. Thus, a pharmacy’s gross margin might appear as follows: Sales 100% Cost of goods (drugs) sold 65% Gross margin 35% An organization’s gross margin percentage can be readily compared to industry standards. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 3 of 3 Print 12/5/20, 7:10 PM 9.3 INVENTORY METHODS How is the inventory to be valued? The two most commonly used inventory valuation methods are First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). The method chosen will affect the organization’s financial statements, as explained in the following sections. First-In, First-Out (FIFO) Inventory Method The First-In, First-Out, or FIFO inventory costing method, recognizes the first costs placed into inventory as the first costs moved out into cost of goods sold when a sale occurs. How will this method affect the organization’s financial statements? Under FIFO, the ending inventory figure will be higher (because when the oldest inventory moves out first, the ending inventory will be based on the costs of the latest purchases, which we assume will have cost more). Exhibit 9–1 (http://content.thuzelearning.com/books/Baker.6866.18.1/sections/ch9_sect1_3#ch9_exhibit1) illustrates this effect. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 1 of 5 Print 12/5/20, 7:10 PM Exhibit 9–1 FIFO Inventory Effect Assumptions Sales (Revenue) FIFO Inventory Effect 20 units @$25 = $500 Cost of Sales: Beginning Inventory 10 units @$5 = Plus: Purchases 10 units @$10 = $100 & 10 units @$15 = $150 Subtotal Less: Ending Inventory $50 250 $300 10 units @$15 = (150) Cost of Sales 150 Gross Profit $350 Operating Expenses (50) Earnings Before Tax $300 Income Tax (90) Earnings After Tax $210 Note: Ending inventory computed as number of units in the beginning inventory plus number of units purchased less number of units sold–count oldest units sold first. Last-In, First-Out (LIFO) Inventory Method https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 2 of 5 Print 12/5/20, 7:10 PM The Last-In, First-Out, or LIFO inventory costing method, recognizes the latest, or last, costs placed into inventory as the first costs moved out into cost of goods sold when a sale occurs. How will this method affect the organization’s financial statements? Under LIFO, the ending inventory figure will be lower (because when the latest inventory moves out first, the ending inventory will be based on costs of the earliest purchases, which we assume will have cost less). Exhibit 9–2 (http://content.thuzelearning.com/books/Baker.6866.18.1/sections/ch9_sect1_3#ch9_exhibit2) illustrates this effect. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 3 of 5 Print 12/5/20, 7:10 PM Exhibit 9–2 LIFO Inventory Effect Assumptions Sales (Revenue) LIFO Inventory Effect 20 units @$25 = $500 Cost of Sales: Beginning Inventory 10 units @$5 = Plus: Purchases 10 units @$10 = $100 & 10 units @$15 = $150 Subtotal Less: Ending Inventory $50 250 $300 10 units @$5 = (50) Cost of Sales 250 Gross Profit $250 Operating Expenses (50) Earnings Before Tax $200 Income Tax (60) Earnings After Tax $140 Note: Ending inventory computed as number of units purchased plus number of units in the beginning inventory less number of units sold–count newest units sold first. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 4 of 5 Print 12/5/20, 7:10 PM Other Inventory Treatments Two other inventory treatments deserve mention, as follows. Weighted Average Inventory Method This inventory costing method is based on the weighted average cost of inventory during the period. (The weighted average inventory method is also called the “average cost method.”) The weighted average inventory cost is determined as follows: divide the cost of goods available for sale by the number of units available for sale. No Method: Inventory Never Recognized This inventory costing method is no method at all. That is, inventory is never recognized. For example, a physician’s office may expense all drug purchases as supplies at the time of purchase and never count such drugs as inventory. This treatment might be justified when such supplies were only a small part of the practice expenses. However, if the physician is purchasing very expensive drugs and administering them in the office (infusing expensive drugs is a good example), then not recognizing any such drugs being held as inventory on the financial statements is misleading. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 5 of 5 Print 12/5/20, 7:10 PM 9.4 INVENTORY TRACKING The two most typical inventory-tracking systems are described as follows. Perpetual Inventory System With a perpetual inventory system, the healthcare organization keeps a continuous, or perpetual, record for every individual inventory item. Thus the amount of inventory on hand can be determined at any time. (A real-time system is a variation of the perpetual inventory system, whereby transactions are entered simultaneously.) A perpetual inventory system requires, of course, a specific identification method for each inventory item. Bar coding is often used for this purpose. You are most likely to find a perpetual inventory system in the pharmacy department of a hospital. Periodic Inventory System With a periodic inventory system, the healthcare organization does not keep a continuous record that identifies every individual inventory item on hand. Instead, at the end of the period the organization physically counts the inventory items on hand. Then costs per item are attached to the inventory counts in order to arrive at the cost of the inventory at the end of the period (the ending inventory). https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 1 of 2 Print 12/5/20, 7:10 PM Necessary Adjustments Certain inventory adjustments will commonly become necessary, as discussed here. Shortages When the periodic inventory results are compared to the inventory balance on the financial statements, it is not uncommon to find that the actual physical inventory amount is less than the amount recorded on the books. This difference, or shortage, is commonly termed “shrinkage.” The inventory amount on the books must be reduced to the actual amount per the periodic inventory, and the resulting shrinkage cost must be recorded as an expense. Obsolete Items Most inventories will inevitably come to contain certain obsolete items. For example, the pharmacy inventory will contain drugs that have “sell by” or “use by” expiration dates. Obsolete inventory items should be discarded. Their cost must be removed from the cost of inventory on hand, and the resulting obsolescence cost must be recorded as an expense. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 2 of 2 Print 12/5/20, 7:11 PM 9.7 OVERVIEW: THE DEPRECIATION CONCEPT Depreciation expense spreads, or allocates, the cost of a fixed asset over the useful life of that asset, as discussed here. Fixed Assets and Depreciation Expense Fixed assets, also known as long-term assets, are classified as long term and placed on the balance sheet as such because they will not be converted into cash in the coming 12 months. The purchase of a fixed asset is a capital expenditure. (Capital expenditures involve the acquisition of assets that are long lasting, such as buildings and equipment.) “Capitalizing” means recording these assets as long-term assets on the balance sheet. We recognize the cost of owning buildings and equipment through depreciation expense. When the cost is spread, or allocated, over a period of years, each year’s financial statements (for that period of years) recognize some portion of the cost, expressed as depreciation expense. Useful Life of the Asset The useful life determines the period over which the fixed asset’s cost will be spread. For example, a piece of laboratory equipment is purchased for $20,000. It has a useful life of five years. So depreciation expense is recognized in each of the five years until the $20,000 is used up. Salvage Value Before depreciation expense can be calculated, we need to know whether the fixed asset will have salvage value at the end of the depreciated period. Salvage value, also known as residual value or scrap value, represents any expected cash value of the asset at the end of its useful life. If the laboratory equipment is expected to have a salvage value of $1,000 at the end of its five-year useful life, then $19,000 will be spread over the five-year life as depreciation expense, and the $1,000 will remain undepreciated at the end of that time. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 1 of 1 Print 12/5/20, 7:11 PM 9.6 CALCULATING INVENTORY TURNOVER Inventory turnover is a ratio that shows how fast inventory is sold, or “turns over.” The computation is in two steps as follows. Figure 9–2 (http://content.thuzelearning.com/books/Baker.6866.18.1/sections/ch9_sect1_6#ch9_fig2) illustrates the sequence. Figure 9–2 Calculating Inventory Turnover. Step 1. First compute “Average Inventory”: Beginning Inventory plus Ending Inventory divided by two equals Average Inventory Step 2. Next compute “Inventory Turnover”: Cost of Goods Sold (or Cost of Sales) divided by Average Inventory equals Inventory Turnover For example, Step 1. $100,000 (beginning inventory) plus $150,000 (ending inventory) divided by 2 equals $125,000 (average inventory). Step 2. $500,000 (cost of goods sold, or cost of sales) divided by $125,000 (average inventory) equals 4.0 (inventory turnover). An organization’s inventory turnover ratio can be readily compared to industry standards. https://content.ashford.edu/print/Baker.6866.18.1?sections=ch9_sect…t&clientToken=6401faf5-fee4-5f27-c522-28ea06b83291&np=ch10_sect1_3 Page 1 of 1 
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