Inventory Cost Flow Method and Inventory System for a Pharmaceutical Company

In Accounting Principles: A Business Perspective (2011) we get a detailed description of the different types of inventory cost flow methods. The text starts off describing specific identification, which attaches actual cost to an identifiable unit of inventory (Hermanson 2011, 289). It then moves on to FIFO, which stands for first in, first out and is one of the most commonly used cost flow methods (291). After that it mentions LIFO (last in, first out) and weighted average, both of which are somewhat self-explanatory, but we will cover them in more detail later in this paper (292-293). In my opinion, the information in this text is accurate and perfectly describes the different inventory cost flow methods. It does a great job of breaking down the information and giving specific details to help better understand the content. Now, let’s compare it to a pharmaceutical company.

My first accounting job, after completing undergrad, was at a pharmaceutical company, Chadwick Pharmaceuticals. They supplied inventory, to many pharmacy’s, as well as managed the accounting and other business operations, of a few pharmacies they owned themselves. As an accountant, I was dealing with the inventory accounting first hand. However, thinking back, it wasn’t clear to me which inventory method we were actually using. I began to think about the specific prescriptions that were filled and recorded by me. Every prescription was recorded at the time that they were filled. Each prescription had an identification code called an NDC, which stands for National Drug Code. We recorded the name of the person who was purchasing the drug, the NDC number, the quantity, and the amount of money to be collected.

So, initially, I thought specific identification was the inventory method being used. However, there were drugs with the same NDC number that were, sometimes, ordered at a greater or lower price. Therefore, we could be selling a specific NDC, but that doesn’t mean that we were selling from a specific bottle that we ordered. This ruled out specific identification, so we move on to the possibility of using FIFO. This is the inventory method that was being used, and the reason why is expiration dates. Every drug has an expiration date; therefore, you would want to use your oldest inventory first, to avoid them reaching the expiration date, before they are sold. This also tells you that the LIFO method isn’t a good option, you wouldn’t want to use your newest inventory first, to avoid older inventory from reaching its expiration date, before being sold. Another option would be weighted average, which is also a good method to use, it’s a “middle of the road” approach. In a situation of rising prices, its cost of goods sold is less than that obtained under LIFO and more than that obtained under FIFO (Hermanson 2011, 299).

In addition to this, a company must also decide if they want to keep periodic or perpetual inventory records. Under periodic inventory system, a company would determine the cost of goods sold by taking an inventory at the end of a period. The cost of goods sold, under periodic, is determined by figuring the difference between cost of goods available for sale and ending inventory (Hermanson 2011, 285). Under perpetual inventory systems, the cost of goods sold is already calculated because you keep a record of it each time you make a sale (286). In this scenario, I believe that a smaller company could use periodic inventory; but a larger company is likely to have a lot more inventory, so perpetual is a better option, for them.

In conclusion, in my opinion, a pharmaceutical company’s best option would be to use FIFO and a perpetual inventory system. Why? Due to required procedures, prescriptions have to be recorded when filled. Why not go ahead and adjust your inventory when you make that record?

And as we determined earlier, FIFO should be used, because of the expiration dates, of prescription drugs. You will want to get rid of your oldest inventory first, before it expires and you can no longer sell it. However, all four methods of inventory costing are acceptable; no single method is the only “correct” method (Hermanson 2011, 299).

References

Hermanson, Roger H., James Don Edwards, and Michael Maher. Accounting Principles: A

Business Perspective. 1. Vol. 1. Athens, GA: Global Text, 2011.