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Understanding Traditional Costing Methods
By David J. Piasecki, with
Hope Rachel Hetico; RN MHA, CMP™
A good inventory management system offers opportunities for improved efficiency in any healthcare organization. The following traditional methods of inventory cost accounting and management are useful when one is calculating the cost of supplies (as opposed to medical items for resale and DME).
a. LIFO
The last-in first-out (LIFO) inventory costing method means the last items purchased are the first to be used (at least for cost calculations if the inventory consists of identical units). In times of rising prices, a lower total cost inventory is produced with a higher cost of goods sold. The last items purchased are most often the most expensive, and used first for the calculation. This happens because LIFO increases an expense (cost of goods sold) and decreases taxable income. Given the same revenue, higher expenses mean less profit. Deflation has the opposite effect.
b. FIFO
The first-in first-out (FIFO) inventory costing method means the first items purchased are the first to be used (at least for cost calculations if the inventory consists of identical units). In times of rising prices, a higher total cost inventory is produced with a lower cost of goods sold. This happens because FIFO decreases an expense (cost of goods sold) and increases taxable income. Deflation has the opposite effect.
Note: Any switch from FIFO to LIFO does not change reality, and although a decrease in reported incomes occurs, it does not increase cash outflows. However, for a taxable healthcare entity, after-tax net cash flow does increase.
c. Specific Identification
Specific identification is used for larger pieces of equipment, as it traces actual costs to an identifiable unit of product and is usually applied with an identification tag, serial plate, or radio frequency identification device (RFID) scanner. It does not involve flow-of-cost analysis. It does, however, permit the manipulation of income because healthcare entities state their cost of goods sold, and ending inventory, at the actual cost of specific units sold.
d. Average Cost
Average costing calculates ending inventory using a weighted average unit cost. When prices are rising, cost of good sold is less than under LIFO, but more than that under FIFO, and hence income manipulation is also possible.
e. Just-in-time Management
Although technically not a costing technique, JIT inventory management means that inventory supplies like DME are delivered as soon as needed by the healthcare organization, the prescribing doctor, or the patient. In JIT, inventory is “pulled” through the flow process. This is contrasted to the “push” approach used by conventional IM. In the push system, DME is already on-site, with little regard to when it is actually needed. In the JIT “pull” system, the overriding concern is to keep a minimum cost inventory, so that means having a system in which inventory is obtained on an as-needed basis.
The key elements of JIT consist of six parts:
1. a few dependable vendors or suppliers willing to ship with little advance notice;
2. total sharing of demand information throughout the supply chain;
3. more frequent orders;
4. smaller size of individual orders;
5. improved physical plant (hospital or clinic) layout to reduce travel flow distance; and
6. use of a total quality control system to reduce flawed medical products.
Using the JIT method, inventory is delivered when needed, rather than in advance, saving handling and storage costs. The healthcare entity never needs to stockpile inventory, and cash flow is enhanced. JIT is further characterized as follows:
- little or no work orders;
- little or no tracing of materials;
- fewer inventory accounts or accounts payables;
- reduction or elimination of work-in-progress or handling activities; and
- no tracing of overhead and direct labor costs
JIT requires a dependable working relationship with suppliers and the precise calculation of inventory needs, especially for the following:
- sterile surgical packs;
- gastro-intestinal and gastro-urinary instrumentation;
- orthopedic and OB-GYN inventory;
- invasive heart and lung equipment;
- radio isotopes and trace radiographic materials; and
- equipment for almost all pre-schedule medical interventions and procedures.
Assessment
This means that, when JIT inventory monitoring is used, healthcare managers are better prepared with the proper inputs to control and reduce inventory, including when dramatic bursts or declines occur. This means a more rapid and higher cash flow balance, rather than inventory balance. Each of these traditional methods of inventory cost accounting is adequate for most healthcare facilities, but as inventory orders and costs continue to increase, economic order quantity [EOQ] costing may be the most effective means of accounting for inventory in DME-intensive organizations.
Conclusion
And so, your thoughts and comments on this Medical Executive-Post are appreciated. Can you think of any other inventory management technologies? Tell us what you think. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, be sure to subscribe to the ME-P. It is fast, free and secure.
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A common element that can help with each of the accounting methods noted above is technology. By having appropriate technology in place to track inventory, a medical facility can improve efficiency as well as patient care. A good system for monitoring inventory can often be used to assure that appropriate charges are being captured.
The value of JIT inventory management increases proportionally with the value of the supplies or equipment involved. Practices which require larger amounts of costly inventory, such as orthopedic practices and surgical facilities, can often see the most benefit from JIT management.
Economic Order Quantity costing may provide the best method to quantify the benefits of various inventory management decisions. EOQ considers many factors, including the costs of ordering and holding items as well as the costs of a potential shortage, in determining the optimal amount to order. This model also has limitations, as it assumes that demand for an item is constant, and that it is depleted at a fixed rate. These assumptions do not always hold true in the provision of medical care.
Brian J. Knabe, MD
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Supply-Chain Management
Improved management of the supply chain has long been a focus in many industries; it is now having an impact on the healthcare industry. For instance, one study has shown that hospitals in the United States have been more successful than hospitals in France in reducing levels of supplies inventory.
Just-in-time approaches to inventory management can improve financial performance. Improved supply chain management can reduce costs by eliminating unnecessary delays and eliminating defects in healthcare supplies.
Current competitive trends will likely make supply chain management more important. The emergence of complementary medicine has implications for the supply function in hospitals, as these therapies require supplies of rather exotic items such as acupuncture needles, herbs, beads, and so on. Thus, improvements in patient care often require concomitant improvements in operations management processes.
Improving the quality of care using patient-focused care can also improve the financial performance of a facility. Patient-focused care not only refers to a holistic approach to care, but it also refers to the re-engineering of processes to facilitate patient care. This re-engineering may lead to increased efficiency of healthcare providers that result in lower costs.
For example, in an effort to provide patient-focused care, a hospital may conduct job analyses leading to cross-training of personnel and the elimination of the duplication of performance of tasks.
Dr. David Edward Marcinko; MBA
[Editor-in-Chief]
http://www.HealthcareFinancials.com
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