Accounting for Hospital Cost of Goods Sold (#386)
/How does a hospital determine its costs of goods sold for the medical products used in patient care?
Cost of Goods Sold Inclusions
The cost of goods sold as it relates to patients covers things like bandages, IV fluids, medications, artificial joints, and pacemakers that are either administered or implanted during a hospital stay. These expenses are not actually called the cost of goods sold. Instead, they’re listed in the income statement as medical supply expense, or maybe as the cost of patient care supplies.
Another consideration is which items are not included in the cost of goods sold. That would be things like linen, reusable equipment, and capital assets – such as ventilators, infusion pumps, or that Bair Hugger that I just mentioned.
Cost of Goods Sold Process Flow
The foundation of the cost of goods sold calculation is the same as what you’d find in any other organization. These items are received and logged into inventory, and then charged to the cost of goods sold when they’re used. The difference from other businesses is that the cost of goods sold is usually calculated on an individual department basis. This means that you have a cost of goods for Emergency, and Surgery, and the pharmacy, and so on. These cost of goods figures are then rolled up into a single cost of goods sold total for the entire hospital.
Inventory Tracking Systems
Let’s talk about the inventory tracking systems being used. For anything remotely expensive, a perpetual inventory tracking system is used that monitors the exact quantities on hand. Or, for anything cheaper, such as gloves, you use a periodic inventory system, where items are ordered in bulk and only reviewed at longer intervals; in this case, there’s no need to be exactly correct in regard to how many units are on hand. If you run out, just go back to the supplies area and bring out another box.
Cost Assignment Processes
Now – how does a hospital figure out exactly which costs are assigned to each patient? After all, they have to bill the cost to the insurer. There are two ways to do it. One is with a charge capture system, which is the most common. With this approach, most medical products used on a patient have a corresponding charge code. So, for example, when nurses open a sterile kit or administer a medication, they scan the item and charge it to the patient. This creates a charge for the billing, and a consumption record for supply cost tracking. If the staff follows the scanning procedure, then this is a very accurate approach.
But, it’s not very effective for high-volume, low-cost items like gloves or gauze. In these cases, a hospital uses an allocation method, and assigns an average cost to patients for each day they’re in the hospital. Alternatively, the hospital could charge a standard rate that’s based on the procedure; for example, the supplies used during a colonoscopy differ from the supplies used for a pacemaker implant.
In short, these two approaches represent a blend of accuracy, with the charge capture system, and practicality, with the allocation system.
Standard Cost Usage
Next up, what about how costs are tracked? Hospitals typically track supplies using a standard costs, which is a predetermined estimate that should be fairly close to the actual cost. Standard costing simplifies pricing, so that a hospital is consistently charging the same amount to a range of patients when the same supplies are used.
It’s not always that easy to keep a reasonably accurate standard cost on file, for a couple of reasons. First, there may be contracts with suppliers, who change their prices whenever a new contract takes effect; if so, you have to adjust the standard cost file. Or, the hospital might be due for a rebate, but only after it achieves a certain volume of purchases.
A variation on the concept is called GPO tier advancement. GPO stands for group purchasing organization, and it refers to a cluster of hospitals that get together and order in bulk from a set of suppliers. Whenever the purchasing volume of the group exceeds a certain threshold value, the hospitals in the group advance to a higher tier, where the supplier prices are lower.
For example, Tier 1 might be base pricing for low-volume purchasers, while Tier 2 represents an improved discount, and Tier 3 is the best possible discount. Whenever there’s a change in tier, the associated standard costs have to be changed. This can involve a lot of reconciliation work, since a fair number of items that are still in stock were priced at the old standard cost, and now any additional items being purchased are coming in at a new standard cost.
Variance Analysis
As a further complication, hospitals have to adjust back to actual costs when they prepare financial statements. The difference between the total of these standard and actual figures is then recorded as a variance in the income statement. Ideally, management wants to see a purchase price variance, as well as a usage variance which shows how unit usage levels varied from expectations.
The Importance of the Cost of Goods Sold
Why is all of this important in a hospital? There are a bunch of reasons. First, the management team needs it to figure out the profits by service area, such as orthopedics or cardiology. They also need it to negotiate reimbursement rates with insurers. And, like any other business, they need to understand where supplies are being wasted or lost. Medical product waste may involve expired items, supplies that were opened but not used, and quite probably undocumented consumption.
And on top of that, there may be regulatory compliance issues, such as the extremely rigid tracking controls that a pharmacy has to impose on any controlled substances, like Oxycontin.
In short, hospitals use a mix of charge capture and cost allocation systems, use different inventory tracking systems to arrive at a cost of goods sold, and calculate that cost separately for different service areas within the organization.