Mar 31, 2011

Inventory Valuation / Costing Challenges in an ERP implementation

Introduction: One of the key challenges in an ERP implementation is the identification of the correct costing method to be used to get the maximum benefit to the organization. Most of the time, the selection of costing method is determined by the Consultant's familiarity with a particular costing methodology and not out of any specific organizational costing or inventory valuation challenges. In addition, most of the costing consultants are not aware of the accounting impact of their decisions. And finally, despite the fact that the costing process is an inherently 'averaging' activity, many consulting teams spent considerable amount of time debating on the 'most accurate' costing method. I start off this article by describing the various costing methodologies used. In this section, I will try to cover as many points as possible regarding the business benefits and disadvantages of each of the methodologies. In addition, costing being a performance evaluation criteria for different departments of the organization, I will also throw some light on the various incentives perspectives related to different methods. From there I move on to describe what I call as a 'Costing Continuum' with Specific costing at one end and standard costing at the other end. In the final section, I look at the various challenges faced by consultants with regards to costing. Costing has many impacts. It has an impact on the closing inventory valuation and by corollary, on the profit / loss of the organization. Since this impacts the P&L statement, this is considered by many organizations to be very sensitive configuration. Due to the incentive nature of Costing, many organizations build their bonus / incentive structure around costing. This has the impact of trying to load all the cost components on each and every unit of the finished product. This may lead to significant requirement of expertise on costing analysis and any attempt to change the costing method may be met with reluctance and even hostility by the end customer. It is very important for the consultant to navigate these challenges. Once she is able to do that, the rewards that accrue to the success of the project can be significant. My article attempts to help you succeed in your costing battle....

My Credentials: I think I am one of the few experts on implementing Costing solutions for manufacturing industries. I have implemented different costing solutions for manufacturing industry ranging from Specific costing on the one hand to Standard costing on the other with multiple methods like FIFO, PMAC etc thrown in in between.

Costing Methods

There are mainly 5 broad categorizations of Costing Methods. They are:

1. Specific costing

2. FIFO (First In, First Out)

3. Weighted moving average methods

4. LIFO (Last In, First Out)

5. Standard Costing.



As shown in the figure, the weighted moving average methods can further be broadly classified as:
a. Transaction Moving Average Method b. Period Moving Average Method (The period can be a day, a week, a month or even a year).

Some of the methods above are used only in case of discrete items (where the cost of each individual unit of the item can be clearly assigned, for example a piston), Period Moving average method is normally used if the cost of the individual unit of the item cannot be assigned (for example, milk).

Note that while we use the above methods to assign costs to the raw materials, these methods helps us to calculate the cost of the finished products. While the above difference is explainable in theory, the same difference brings in lots of challenges when we try to decide on a costing method. More of it later...

Let us examine each of these methods in a little bit of detail.

1. Specific costing: In this costing method, the cost of each individual unit of the item is identified and assigned on the basis of the actual / specific cost incurred in procuring the same. As you can easily see, the effort required in tracking separate cost for each individual unit of the item makes this a cumbersome method to handle. This type of costing is used mostly in case of low volume, high value purchases. An industry where this type of costing method is generally used is Jewellery manufacturing industry where the cost of each unit of finished product is different from another (based on the content of gold present in the item).

2. FIFO (First In, First Out): In this costing method, it is assumed that the individual units of items are consumed in the same sequence as they are purchased. For example, the first item procured is used up first, the second item purchased is consumed next and so on. This type of costing can be used in scenarios where the item do not lose its value over time with storage and there is a regular flow of items in the warehouse. Pl. note that, it is not necessary that the units are actually consumed in the same sequence of their arrival into the system, but for costing purposes it is assumed that the consumption pattern is the same as the receiving pattern.

As you can see, FIFO method is less accurate than Specific costing. Also pl. note that in times of inflation, FIFO method will show lower cost of consumption and will inflate the profit. Since the calculated profit has a taxation impact, the companies may be averse to show inflated profit in their books. This is an impact the consultant has to consider while recommending a costing decision.

3. Weighted Moving Average Methods: In weighted moving average methods, the cost of the item is calculated based on a formula which considers the quantity as weight. In this method, based on every transaction of the item, the cost of the item will get updated with the latest cost. The formula used is (Current Quantity X Current Cost + New Quantity X New Cost) / (Current Quantity + New Quantity). The weighted average cost method overcomes the drawback of FIFO method of not considering the inflation in Costing. Weighted average method reflects the market cost better than FIFO.

There are two methods of Averaging the cost. In the Transaction Moving Average Method, the cost of the units are updated based on each procurement receipt transaction. In Period Moving Average method, the procurements of the period are aggregated and the cost of the item reflects the cost of all the purchases of that item in the relevant period.

4. LIFO (Last In, First Out): LIFO method is not used in India, but is widely used in US and European Countries (I think). This method assumes that the items which were received last, are consumed first. (While formally this method is not used in Indian accounting system, this method is widely used in the Vegetable market in India. All the consumers want 'Fresh' stocks and the price of all the vegetables are updated with the latest cost. Classic LIFO). As can be seen, this method approaches closest to the current cost. It should also be mentioned that in times of deflation (or recession) this method inflates the profit and thereby the tax outflow. This is a double whammy for the organizations since in these periods the revenue also will be hit and organization ends up paying higher tax on lower revenue.

Not a very comfortable scenario......

5. Standard Costing: Can you guess what is the fundamental issue with almost all the methods we discussed above? The fundamental issue is that all the methods focus on correctly recording the cost information and hence there is very low emphasis on detailed analysis leading to cost efficiencies. In addition, all these methods calculate the costs post facto. This is where Standard Costing comes in.

In standard costing, the cost of the item is fixed for a given period. The value fixed is normally based on historical analysis of the costs. Since the costs are fixed for a particular period, the emphasis shifts to analysis of Variance. This means that whenever the actual cost shifts from the standard cost, the reasons for the variance are identified and corrective actions quickly taken. The corrective action could either be a process change or if the variance is secular in nature, the Standard cost itself is changed in the next period to reflect the secular change.

Standard costing has many an advantage. First of all, the cost information is used for analysis purposes, which is as it should be. To record the costs post facto is just a mechanical activity and do not benefit the organization at all. Also, Standard costing, based on its emphasis on analysis, helps to identify process or efficiency gaps and helps the organization to fill these gaps effectively leading to cost optimization. On the flip side, standard costing calls for some very detailed knowledge of the method and analytical tools on both the consultant and the organization. And finally, in case the cost of raw materials and resources are fluctuating around a mean, there is no much difference between Standard Costing and Actual Costing. In fact, I know of many organizations that use Actual Costing, but use the previous periods cost for analysis purposes (like in standard costing).

If the consultant knows the method and organization is ready for it, Standard costing can be a powerful tool for cost analysis and optimization, especially in challenging times.

Consultant's challenges in decision of costing method.

1. What is the impact of the decision on P&L : Every costing decision has two impacts. One is a balance sheet impact showing the value of the closing inventory. And the second is a P&L impact, showing the Cost of goods sold and thereby the operating profit. For the same revenue, if the closing inventory value increases, the operating profit of the company increases. When you are going to implement an ERP application, there will definitely be a change in the way the costs are presently calculated by the company. This in turn will lead to a P&L impact. An implementation consultant should be very clear as to how the change in the costing methodology will be impacting the P&L account. Pl. note that any impact on the P&L could have audit & taxation implication and implications for Shareholder value. So companies are very careful regarding making any changes to parameters that impact P&L.

2. What is the data entry impact?

Any packaged application works on the principle of GIGO (Garbage In, Garbage Out). For the consistent and correct calculation of costs, it is very important that correct and accurate data regarding material and resource usage is input into the system. While it sounds quite logical in practice, data entry can be very cumbersome, especially in a manufacturing industry. I have observed that in manufacturing industry, the entry of labour and overheads are the most difficult since these need to be manually entered and these tend to change over each production batch. I know of many companies who have decided not to enter the usage of labour into their process data and allocating the costs at the end of the period on the inventory (which is not a good idea).

Data entry can be of two types: One is the one-time data entry associated with the entry of opening balances of inventory. The other is the regular data entry, which the user on the ground have to enter on a daily basis. While the implementation team motivates themselves to enter data correctly as a part of go live, the entry of data accurately and regularly, over a long time can be challenging to the organization. One way to handle this is to identify data errors quickly through effective use of Exception reports. (more of it later in another post).

3. What is the costing incentive system in the organization?

Costing information is a very powerful tool. Like any other powerful tool, the effectiveness of the tool lies in the knowledge and purpose of the user of the tool. Costing information can be used both positively and negatively by the organizations. For example, the purchase price variance can be analysed in detail and the standard costs can be optimized to make it as close to the actual cost as possible. In this way the purchase price variance will decline over time. Also, this level of detailed analysis will provide the organization with a wealth of information regarding its procurement process.

However, many organizations use the purchase price variance to punish the purchasing manager. For example, if the supplier provides volume discount, a high level of PPV could show that the purchase manager did not make use of the volume discount facility. Or if the supplier provides early payment rebate, a high level of variance could show that the AP user did not pay promptly and this led to the firm losing the early payment rebate. In this case, the organization could use this information to punish the purchase manager or AP user respectively.

It goes without saying that in the long term, using the costing information for positive purposes can lead to lasting benefits for the organization.

4. What are the parameters in costing decision (Type of item, Volume of purchase, inflation..)

This is a difficult topic to address. For example, if the input prices are highly fluctuating, standard costing may not be of much use. If cost of the inputs vary from product to product (in precision industry or ETO industry), you are better off using the actual cost. If the purchase prices are stable, then use of standard costs can help you analyse the operational performance better than actual cost. If the number of item codes is very high, then standard costing may be very cumbersome. In case the number of new items being produced are very high, then again, identifying the standard costs may not be feasible.

Coming to inflation, as mentioned before, in an inflationary economy, FIFO will show high profit and hence will lead to high taxation.

In case of volume of purchase is high, then it is better to go with standard costing since you can track the operational performance better with this method.

Conclusion

As you can see, there are multiple parameters and implications to costing decision. In addition, an effectively implemented costing methodology can provide rich dividends to the organization in the form of valuable analytical data which can help improve operational effectiveness and increase profitability. It is the kind of intellectual challenge and the intellectual value add that you can give to an organization that makes working on 'Costing' very exciting.

1 comment:

Peter Loo said...

Thanks for your detailed explanation to the costing methods.

"If the number of item codes is very high, then standard costing may be very cumbersome. In case the number of new items being produced are very high, then again, identifying the standard costs may not be feasible.

In case of volume of purchase is high, then it is better to go with standard costing since you can track the operational performance better with this method."

Do you have an example of the industry that will have high purchase volumes but standard low volume (item) outputs, to use Standard costing on purchases but average costing on the items?

Thanks