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Notes - Chapter 8
Understanding Inventory and Depreciation Concepts
Inventory includes all the items that an organization has for sale in the normal course of business. In a health care environment, the inventory would consist of nursing supplies, medical supplies, housekeeping and maintenance supplies and any other type of supplies that will be need to care for the patient/resident. Inventory appears as a current asset on the Balance Sheet because if it were necessary to close the facility, those supplies can be readily sold for cash within a 12 month period.
All departments that deal in inventory must account for it on an ongoing basis. Some examples are the nursing supplies, maintenance and housekeeping supplies, cafeteria, pharmacies and gift shops.
Typically, in a health care organization, inventory might consist of different departmental supplies, for example housekeeping supplies, medical supplies, maintenance supplies. These items are purchased from outside vendors and kept in storage until ready to be used. This is where the difference between a manufacturing company and healthcare differ greatly.
Inventory is turned into cost of goods sold when an item moves out of inventory and is recognized as cost. A retail pharmacy, cost of inventory sold to its customers is the largest single expense of the business.
Continuing with the Pharmacy example, recording inventory and cost of drugs sold follows a sequence of events:
Inventory at the beginning of a period is recorded
Purchases during the period are recorded
Beginning inventory plus purchases equal “cost of drugs available for sale”
Ending inventory (inventory at the end of the period) is recorded
Cost of Drugs available for sale less ending inventory equals cost of drugs sold
Gross Margin Computation
Gross Margin equals revenue from sales less cost of goods sold. The Gross Margin is expressed as a percentage.
Gross Margin is similar to Gross profit so it calculates what the profit is in a particular business unit.
Inventory Methods
Inventory must be costed out in order to obtain a value that will be used in the Balance Sheet. At the end of a period, whether it’s monthly or annually, whatever supplies are in the storerooms are counted and a value is given to each item to determine its current value. The two most commonly used methods to cost out inventory is First In-First Out (FIFO) and Last In-Last Out (LIFO). The inventory that resides in a healthcare organization’s storage needs to be given a value so it can be expressed accurately on the financial statements.
The FIFO method recognizes the first costs placed into inventory as the first costs moved out when providing care. This effects the financial statements because the ending inventory will be higher because the oldest inventory moves out first, the ending inventory will be based on costs of the latest purchases which we assume will cost more.
The LIFO method recognizes the latest or last costs placed into inventory as the first costs moved out when providing care. Under LIFO, the ending inventory will be lower because the latest inventory moves out first, the ending inventory will be based on costs of the earliest purchase which we assume will have cost less.
The most difficult part of inventory control is inventory tracking. Historically, before computerization, inventory control was tracked manually. The Storeroom would log each purchase manually on an individual basis. As supplies were requisitioned or given to a using department, that outgoing items would also be logged and tracked. As you might imagine, this was a tedious chore which often never completed or resulted in unreliable outcomes.
What has evolved over recent years is a perpetual inventory system whereby the organization keeps a continuous or perpetual record of every individual inventory item. This is now a much simpler task because it involves every item having a bar code scanned and entered into a software program.
A Periodic Inventory System continuous records are not kept. Instead, at the end of the period, the organization physically counts the inventory items on hand. Then costs are attached to the items to arrive at the ending inventory.
Shortages and Obsolete Items
Sometimes the actual physical inventory amount is less than what has been recorded on the books. The difference is called shortage. The inventory amount on the books should reflect the lower balances and the difference has to be recorded as an expense.
The same is true with obsolete items. In Pharmacy inventories, drugs have expiration dates. When they are not used by their expiration dates, they need to be discarded. That discarded amount is also treated as an expense.
Calculating Inventory Turnover
Inventory turnover is a calculation that shows how quickly inventory is used or turned over. It’s a two-step process that involves computing the average inventory which is as follows:
Beginning Inventory plus Ending Inventory divided by 2 gives you the average.
Example: If Beginning Inventory is $250,000 and Ending Inventory is $150,000, divide the difference by two, $250,000+$150,000 equals $400,000, divided by 2 equals’ $200,000 average inventory.
If Cost of Supplies Used is $400,000, then $400,000/$200,000 = 2.0 Inventory Turnover. That means the total inventory in the storeroom is completely turned over twice.
The Depreciation Concept
Depreciation expense spreads or allocates the cost of a fixed asset over the useful life of that asset.
Fixed Assets or long term assets are classified as long term because they will not be converted to cash within the current 12 month period. The purchase of a fixed asset is a capital expenditure. Typical examples of a capital expenditure may be a building or a major piece of equipment. The purpose of spreading the cost over a period of years is to recognize a portion of the cost that aligns with the number of years that the capital expenditure is available for use.
All equipment has an estimated useful life in years. The useful life of the equipment will be used to spread the cost over a certain number of years. The advantage of spreading out the cost of a major piece of equipment is that instead of the entire cost being recognized in the year its purchased, which may be a large dollar amount and would therefore reflect negatively on the Profit and Loss Statement, that cost will be spread out over the life of that piece of equipment and therefore reflect a lower cost each year of its life.
Depreciation Expense and Reserve for Depreciation
Depreciation Expense that has been accumulated over the years is included in the Reserve for Depreciation account.
Depreciation is recorded as an expense on the Income Statement while Reserve for Depreciation is reflected on the Balance Sheet offsetting the Cost of the Asset resulting in the Net Book Value.
Example:
If a major piece of equipment is purchased and has a useful life of 10 years. The cost of the equipment is $200,000. Each year, $20,000 ($200,000/10=$20,000) is recorded as an expense on the Income Statement. The offsetting entry is that the $20,000 is recorded as Reserve for Depreciation which offsets the Book Value of the asset. The Reserve for Depreciation and the resulting Net Book Value are reflected on the Balance Sheet. So after Year 1, the Balance Sheet looks like this:
Major Equipment $200,000 less $20,000 Reserve = $180,000 Net Book Value
If this cost was not depreciated, the entire $200,000 would be reflected in one year.
Methods for Booking Depreciation
Straight Line Method – assigns an equal amount of depreciation expense over each year of the assets useful life. This is the most common method of depreciating a piece of equipment.
Cost = $100,000
Life = 10 years
Depreciation Expense for each year = $10,000
Accelerated Book Depreciation Methods
These methods write off more depreciation in the first part of the assets useful life.
Sum of the Years Digits – See attached worksheet
Double Declining Balance
150% Declining Balance
Units of Service or Units of Production (UOP)
