One of the reasons for implementing an ERP system is often a need to get costs under control. Especially when margins are tight, there is a need to measure costs accurately. At a basic level, companies need to know that they are actually making a profit on specific jobs and products. What can happen, though, is that they choose an inappropriate costing methodology and then can’t see the woods for the trees. A look at the main costing methodologies may allow companies to feel confident that they are picking the right one.
A standard cost is effectively a budget or target cost that is applied to both purchased and manufactured items. With standard costing, every item that is bought or made is given a standard cost. If a manufacturer holds routing information (i.e. details of resources such as labor and machines, along with process times) on the system, it would be normal to just enter standard costs for materials and resources and then have the system calculate the processing costs via a process usually known as a “cost roll-up”. Traditionally, standard costs are re-calculated yearly and, if companies find they are re-calculating them much more frequently, that is usually a sign that standard costing is not appropriate for them.
Having set a standard cost for each item, all transactions for that item are then costed at that standard until it is changed. In real life, of course, the actual cost will frequently differ, as purchase costs can vary, as will manufacturing costs because process times can vary from batch to batch. This is actually the strength of standard costing because every time there is a variance between standard (budget) and actual costs, that variance is written to a variance account in the financial system.
Why? Well, companies that use standard costing frequently set the selling price for their products yearly. Those selling prices are not necessarily based directly on a budgeted (i.e. standard) cost but, in setting them, any organization must be aware of what their products are likely to cost so that they don’t find themselves selling at a loss. By monitoring the variance accounts regularly, companies can check that costs are broadly in line with expectations and that profitably, in consequence, is likely to be on target also. Of course, companies can get positive variances when costs are less than expected. This can be a sign that it may be possible to increase market share by reducing selling prices, but it would be wise to check carefully first!
If costs are out of line with expectations, the system should be able to identify where the problems are; be they problems with the cost of particular materials or with a failure or inability to manufacture products within expected times. Only by knowing where the problems are can they be remedied and, for that reason, it is imperative that the variance accounts are structured carefully and checked regularly. It is not good enough to get to the end of the financial year before noticing that costs are higher than budgeted and products, perhaps, have been sold at a loss.
Standard cost variances also give excellent trending information: companies can’t change the past but they can certainly influence the future. So, in an industry where items are manufactured repeatedly, standard costing may be the answer. But, when moving along the manufacturing spectrum from continuous process to job shop, it becomes less so.
At the other end of the manufacturing spectrum are companies that manufacture, and sometimes even engineer, to order. Frequently, manufacturing volumes are low but the key thing is that these companies need to look at profitability by order, and not by batch as standard costing does.
When manufacturing against a contract, for example, they need to know exactly what the job has cost and that can’t be done easily with standard costing because the variances, at least for materials, will have been written away separately. The problem can be compounded in an ETO (engineer to order) environment when the customer requests design changes after production has commenced. Sometimes these changes result in the purchase of extra materials for which premium prices (or special delivery charges) have to be paid to ensure quick delivery. In these circumstances, there is no alternative to knowing exact (i.e. actual) costs.
Everything comes at a price though. If companies want to know exactly what a manufactured item has cost, they need first to know exactly what components, in terms of item and quantity, went into making it. But some companies have variable material usages. For example, waste can vary greatly in industries that use wood because wood is not uniform. The number (and distribution) of knot holes varies, so waste is only approximately predictable.
Material is only part of the problem. Labor and processing times can also vary; particularly if rework or rectification work is required. So, to get accurate costs, it is necessary to measure, record and report actual usage of both materials and labor.
This can be a problem in some industries that use bulk materials when the cost of those materials varies. Imagine that two batches of liquid are going into the same tank and those two batches have come in at different actual costs. When drawing liquid from the tank, it is impossible to know which batch is being used (in fact, it is almost certainly some of both). Luckily most ERP systems get around this problem by allowing the issue on a theoretical FIFO (first in, first out) basis, so the oldest batch is ‘assumed’ to have been used.
FIFO issues may not be a true reflection of reality, of course, but on the occasions when cost allocation to particular jobs has to be precise, ERP systems usually allow users to override this automatic selection and record a different batch. As the batches must have been of essentially identical material in order to have been mixed, it is of course generally irrelevant which was actually used. An exception would be when handling things like foodstuffs but, in these circumstances, if a batch of product is recalled because of a problem with an ingredient, it would be normal to also recall the product that theoretically used ingredients from batches either side of the suspect batch.
So, in a manufacturing environment where precise costings for each individual job or batch are essential, Actual (or FIFO) Costing is obviously more appropriate even though it is harder to identify trends that show up easily in Standard Costing. Be aware, though, that Actual or FIFO Costing tends to not work well in backflushing environments where material or labor variances are common, unless the ERP system chosen allows easy adjustment of resources used.
Weighted Average Costing
One problem that can arise with Actual/FIFO costing is that of handling fluctuating prices for regularly-used items. When prices of consecutive batches vary significantly (as can happen when, for whatever reason, a material has to be procured at a higher than normal price) one or more jobs might be penalized unfairly. To get around this, some companies use Weighted Average Costing, whereby fluctuations in costs are evened-out by transacting at an average cost, rather than a batch cost.
To illustrate how this works, let’s imagine the following:
A company starts with no stock but then takes delivery of ten items at $1 each. They then have a stock quantity of ten, a stock value of $10 and, of course, an average cost of $1.
They now issue (or sell) five of these, so the issue cost is $1 each.
Then they receive another ten, but this time the cost is $2 each. They now have a stock quantity of 15 and a stock value of $25 (five at $1 and ten at $2), giving an average cost of $1.67.
When they issue another one, that issue is costed at $1.67 (the average cost), and they now have a stock quantity of 14 and a stock value of $23.33 with the average cost remaining at $1.67 (systems generally do not re-calculate the average cost after every issue; just after every receipt).
So Weighted Average Costing smoothes out the effect of cost variations when prices are volatile. But why, then, is it probably the least-used costing option? Because it has an idiosyncrasy that some companies, and some people, don’t feel comfortable with. To understand, let’s look at the example again.
The transactions have left a balance of $23.33p in the General Ledger. But running a detailed stock valuation report will show that there are in stock:
- 4 items at $1 each = $4
- 10 items at $2 each = $20
The total stock value in the stock file is then $24 but, in the General Ledger, it is $23.33p. Now, no-one is going to worry about a difference of $0.67 but this example deals with a small number of low-cost items. In real life the apparent discrepancy could, overall, total to hundreds of dollars and, even though it is only an ‘apparent’ anomaly to anyone who understands Weighted Average Costing (the numbers always add up in the end), some companies just don’t feel comfortable with it.
So companies have a choice of costing methods. Although, in some systems, it can be different to change their methodology after go-live, it may be something that companies have to consider if they are just not getting the information that they need.