Calculation of item cost per Inventory Accounting Method

Outcome

• You must understand the principles for determining the item cost based on different costing methods and different scenarios.
• You know where you can review the costs and the circumstances under which costs you can change manually.

Use the information to verify that the items manufactured or otherwise acquired by the company have a correct item cost.

Introduction

The calculation method for the item cost is primarily based on these basic parameters:

• The inventory accounting method that is selected for the combination of item and facility on 'Item. Connect Facility' (MMS003/E).
• How the item was acquired, as determined by the acquisition code selected for the combination of item and warehouse on 'Item. Connect Warehouse' (MMS002/E).
• Whether the item is a non-inventory item or an inventory item, as determined by alternatives 0 and 1, respectively, in the 'Inventory accounting' field (MMSTCD) on 'Item. Open' (MMS001/E).

Inventory accounting methods

There are six inventory accounting methods in M3:

• 0 = Zero cost
• 1 = Standard costing
• 2 = Average costing
• 3 = Dynamic product costing
• 4 = Actual costing
• 5 = Simplified purchasing

The three most basic inventory accounting methods are the calculation of standard cost, average cost, and actual cost.

Acquisition codes

There are four acquisition codes in M3:

• 1 = through manufacturing
• 2 = through purchasing
• 3 = through distribution from another warehouse
• 6 = through maintenance.

If an item is connected to several warehouses, it is always the acquisition code for the main warehouse that is used in product costing and cost accounting.

Applicability - Overview

This table shows an overview of the methods that you can select for the different types of items:

Zero cost (Method 0)

Applicability

You can select zero cost for all kinds of items, but normally for non-inventory items.

Calculation

No calculation is made. No inventory value is created for the item. For inventory items (MMSTCD = 1), no internal account entries are created at goods receipt. The accounting number in the MITTRA table, the table for inventory transactions, is always set to 99999999. For non-inventory items (MMSTCD = 0), account entries are created based on accounting type 903, although no inventory value is created.

Standard cost (Method 1)

Definition

A standard cost is a production or operating cost of material and operations that needs to be carefully predetermined. A standard cost is set to reflect the expected cost of acquiring a product over a future number of periods and is therefore used as a target cost that may or may not be attained. The standard cost is compared to the actual cost in order to measure the performance of a given costing department or operation. Thus, out-of-control results are easier to identify for items and operations with a standard cost instead of an average cost or actual cost.

Applicability

Standard costs are appropriate for items manufactured often enough so that material and labor costs are well known through repetition. Overhead is usually added as a percentage of the labor. Sources: Schaefer, Randall: Costing Basics (APICS magazine, June 2006); Ventureline.com (November 2006).

Where displayed

Data model

Calculation

• The standard cost is calculated for each combination of item and facility in local currency. The cost is always calculated based on a costing model. An average cost is calculated and stored in parallel with a standard cost. The average cost is used for information purposes and when valuing your inventory on 'Inventory Value. Open' (CAS180), depending on your settings in 'Settings – Inventory Valuation' (CAS025).
• Standard costs can be calculated for all kinds of items, regardless of their respective inventory accounting method. The standard cost is applied as the inventory value only for items with inventory accounting method Standard cost. For other items, the standard cost is used for information purposes, reflecting the current cost at the time of the latest product costing run.

  See Managing M3 Product Costing.

• You can update the costing takes place on the facility level and the cost of MITFAC in two ways:
  1. The new cost is calculated and updated in MITFAC and costing programs if the costing date is equal to today's date.
  2. If the costing date is set in the future, MITFAC is not updated. The update of MITFAC can then either be done manually with 'Standard Cost/Ordering Cost. Update' (PCS290), or by running inventory transactions when the cost is valid, which updates MITFAC.

Manufactured items (Products)

The standard cost of a manufactured item is based on a combination of a product costing model and a product structure. You can select the product costing model to apply during the cost calculation.

Purchased and distributed items

The standard cost of a purchased or distributed item is based on a separate costing model that differs in structure from the product costing model, although they have many features in common. For purchased items, the costing model is connected automatically to the purchase order. For distributed items, the costing model is applied when costing the items. In both, you can override the default costing model by selecting another costing model manually when costing the items.

When performing the costing in (PCS280), you can manually override the default costing model.

See Costing Purchased Items and Costing Distributed Items.

Manual update of standard cost

You can change the standard cost manually for a manufactured, purchased or distributed item in 'Product Costing. Update Manually' (PCS260), provided that the standard cost has the current date as the costing date. If you change the cost, all detailed costing values are deleted and only the total cost is saved. For manufactured items, the total cost is then displayed for costing component A01 in the product costing model.

Average cost (Method 2)

Definition

An average cost, an average actual cost, is the cost of items issued from inventory. It is a weighted cost for items in the inventory rather than the actual cost for each specific item. The average cost is calculated by dividing the total cost by the units bought or produced. For example, if a company produces 10,000 units of output for a total cost of EUR 25,000, the average cost of each unit is EUR 25,000/10,000 units, that is, EUR 2.50 per unit.

Average cost is made up of costs that remain unchanged throughout a range of output and costs varying directly with output. Companies with the lowest average cost in an industry have a competitive advantage in the event of severe competition and price cutting.

Sources: Schaefer, Randall: Costing Basics (APICS magazine, June 2006); Dictionary.reference.com (from Wall Street Words, November 2006)

Applicability

Average costing can be used for all kinds of inventory items but is primarily used for purchased items when the exact cost cannot be defined in advance. Average costing is suitable for items that are subject to significant price fluctuations from one order to the next, for example, raw material subject to highly variable pricing. In order to calculate the average cost, the actual cost for items on hand must be calculated first, since the average value of the items is based on the actual costs. In M3, the current average cost is used as the transaction price for all negative inventory transactions.

Where displayed

You can review the average cost history for an item on 'Average Cost. Display/Update History' (CAS371), accessed from (CAS370). For each change, both the previous and the updated average cost are displayed.

Data model

Calculation

The current average cost is calculated for each combination of item and facility in local currency for all positive inventory transactions and at invoice matching. The cost can also be calculated for specific attributes; see below. Each time an item is added to the inventory, M3 recalculates the average cost based on the remaining on-hand quantity. The cost is saved in the MITFAC table. Every transaction that triggers a new calculation of the average cost is stored in the table for average cost history (FCAAVP). Note that M3 only calculates an average cost if the 'On-hand balance total' check box is selected for the applicable warehouse type in 'Warehouse Type. Open' (MMS006).

Rolling average cost vs. true average cost

An average cost is calculated continuously when an item is added to the inventory, that is, whenever a new inventory transaction is created. In this "rolling" average cost calculation, the average cost, that is, the old average cost in the standard formula below, depends on current on-hand balance, the old on-hand balance in the formula below. The lower the on-hand balance is, the lower the impact the current average cost has on the new average cost. However, you can manually trigger a recalculation of average costs. Depending on your selection, this calculation does not take into consideration the current on-hand balance, meaning that the true impact of the inventory transactions on the average cost is identified. The result is a true average cost.

Standard formula for rolling average cost

The rolling average cost is calculated using the moving weighted average costing method. This is the formula for automatic calculation of the average cost:

((Old on-hand balance x Old average cost) + (Transaction quantity x Acquisition cost)) / New on-hand balance

For a description of exceptions, see below. This cost calculation is always based on the entry date of the transaction, regardless of the transaction date itself.

Formula used at invoice matching

he average cost is changed automatically when matching purchase orders and supplier invoices. Any difference between the acquisition cost for goods receipt and the invoiced amount updates the average cost. This is done using this formula:

((Current on-hand balance x Current average cost) + (Invoice quantity x Difference between acquisition cost and invoice amount)) / Current on-hand balance.

For a description of exceptions, see below.

Formula used for true average cost

First, the total acquisition value is calculated per inventory transaction (Transaction quantity per transaction x Acquisition cost). Then, the resulting total is divided by the total quantity of the selected transactions.

Formula used for recalculation of rolling average cost

This recalculation uses the same formula as for the normal rolling average cost. The only difference is that the acquisition cost in the formula is retrieved from the invoice line price, if such a price exists, instead of from the purchase order price for received goods. This cost calculation is always based on the transaction date.

Exceptions

• Rolling average cost
  This table shows the three exceptions to the calculation of rolling average cost:

  Scenario	Result
  The total on-hand balance is negative.	No normal calculation of rolling average cost is done as long as the on-hand balance is below zero. Instead, the average cost is set to the acquisition cost of the transaction.
  The total on-hand balance is positive but was negative before the current transaction.	No normal calculation of rolling average cost is done for the inventory transactions that turn the on-hand balance positive again. Instead, the new average cost is set to the acquisition cost of the transaction.
  The average cost is negative or zero.	A new average cost cannot be negative or zero. The average cost is set to the previous average cost, that is, the average cost before the average cost calculation.

• Calculation during Invoice Matching
  This table shows the three exceptions to the calculation of average cost when a transaction is recorded during invoice matching:

  Scenario	Result
  The total on-hand balance is negative.	No normal calculation of rolling average cost is done as long as the on-hand balance is below zero. The average cost is set to the invoice price.
  The total on-hand balance is lower than the invoiced quantity.	The adjustment quantity is set to the total on-hand balance.
  The average cost is negative or zero.	A new average cost cannot be negative or zero. The average cost is set to the invoice price.

How the acquisition cost is determined

Since the acquisition cost is used in the formula for calculating the average cost, you must understand how the acquisition cost is determined. This table shows how it is determined:

Calculation

Recalculation of average cost

• You can manually trigger an automated recalculation of average costs on 'Average Cost. Recalculate' (CAS375). This procedure can be required, for example, when you want to calculate the true average cost or when items have received an incorrect average cost. The recalculation is based on records in the FCAAVP table but replaces the acquisition cost with the valid invoice price, if such a price exists. The results are printed on a report. If you select to update M3 with the calculated values, the average cost for the combination of item and facility in (MMS003/E) – the MITFAC table – is updated and an adjusting transaction is created in the table for average cost history (FCAAVP).
• Basis for recalculation

  You can also manually trigger an automated recalculation of average costs in (CAS375). This procedure can be required, for example, if you want to calculate the true average cost or when items have received an incorrect average cost. The recalculation is based on records in the FCAAVP table but replaces the acquisition cost with the valid invoice price, if such a price exists. The results are printed on a report. If you select to update M3 with the calculated values, the average cost for the combination of item and facility in (MMS003/E) – the MITFAC table – is updated and an adjusting transaction is created in the table for average cost history (FCAAVP).

  The recalculation can be done based on one of these alternatives:

  • 1 = True average cost based on a range of transaction dates.
  • 2 = True average cost based on all transactions for the selected item or items.
  • 3 = True average cost based on transactions that cover the current on-hand balance based on the FIFO rule, that is, the last transactions build the outgoing balances.
  • 4 = True average cost based on transactions that cover the current on-hand balance based on the LIFO rule, that is, the first transactions build the outgoing balances.
  • 5 = Set equal to a specific product costing record in the MCHEAD table. This alternative is suitable during the implementation of M3 in order to create an initial average cost. The prerequisite is that a cost has been calculated first using a basic product costing model.
  • 6 = Rolling average cost based on invoice line price as acquisition cost instead of purchase order price.
• See the formulas above.

Manual update of average cost

You can manually specify an average cost for an item or facility in 'Average Cost. Enter per Item/Facility' (CAS370). You can do this to set an initial average cost for an item or to change an incorrect average cost. You can also change the acquisition cost of a detail record, which will result in a recalculation of all subsequent transactions.

Occurrence of incorrect average cost after invoice matching

The formula M3 uses to adjust the average cost after invoice matching will yield an incorrect cost in certain situations. This example illustrates this rare situation. All prices below are expressed in euros, EUR.

• This table shows the goods receipt of purchase order no. 1:

  Item	Value
  Quantity	1 piece at 50.00
  Average cost	50.00
  Inventory balance	1 piece
  Inventory value	50.00

• This table shows the goods receipt of purchase order no. 2:

  Item	Value
  Quantity	19 pieces at 60.00
  Average cost	59.50
  Inventory balance	20 pieces
  Inventory value	1,190.00

• This table shows the customer order delivery:

  Item	Value
  Quantity	– 18 pieces
  Average cost	59.50 (not changed)
  Inventory balance	20–18 = 2 pieces
  Inventory value of issued items	1,071
  Inventory value of remaining stock	1,190.00–1,071.00 = 119.00

• This table shows the recording of supplier invoice for purchase order no. 1

  Item	Value
  Invoice quantity	1 piece
  Invoice price	60.00
  Price variance	Price variance 60.00–50.00 = 10.00
  New average cost	(((60.00–50.00)x1)+(2x59.50))/2 = 64.50
  Inventory (price variance for average cost items, posted using accounting rule PP20–910)	10.00
  Inventory balance	2 pieces
  Inventory value	129.00

• Recording of supplier invoice for purchase order no. 2

  The invoice price for purchase order no. 2 is EUR 60. Thus, it does not change the average cost.

• Result

  The correct average cost would be 60.00, not 64.50, as calculated according to the M3 formula. To correct the average cost and reset it back to 60.00, run (CAS375).

  Since the program will calculate the inventory value as transaction quantity multiplied by the acquisition cost (or invoice price), the calculation based on alternatives 1 to 4 in (CAS375) results in these values:

  • Purchase order no. 1: Inventory value = 1 x 60.00 = 60.00
  • Purchase order no. 2: Inventory value = 19 x 60.00 = 1,140
  • Average cost: Total inventory value/Total quantity, that is: (60.00+1,140.00)/20 = 60.00.

Dynamic product cost (Method 3)

The calculation of dynamic product costs is a variant of standard costing applied primarily to configured items where a regular standard cost cannot be calculated. Configured items are items that are product variants with unique item numbers.

Applicability

A dynamic product cost can only be calculated for manufactured inventory items. The cost is primarily used for configured items. The calculation requires that the item is lot controlled, that is, you can identify from which lot an item is taken when sold or otherwise issued. The 'Lot control method' field in 'Item. Open' (MMS001/E) determines whether the item is lot-controlled.

Where displayed

You can review the cost on 'Product Costing. Display' (PCS300).

Data model

Calculation

• The cost is set for each order number and facility in local currency when the order, manufacturing order, requisition order, or distribution order, is released.
• Manufacturing Order Receipts

  The dynamic product cost is calculated automatically in the manufacturing facility when the manufacturing order is created. As long as no quantity has been put away, you can recalculate the cost for the order on 'Product Costing. Calculate MO' (PCS240).

• Requisition order returns

  When specifying a requisition order return in 'Requisition/Distribution Order. Open' (MMS100), one of these happens:

  • If there is no cost for the lot number, the cost is set to the transaction price specified in (MMS101/F). The default value for the transaction price is in turn set to the current average cost.
  • If there is a cost for the lot number, the cost is displayed for information purposes but cannot be changed.
• Distribution order receipts
  • For distribution orders between facilities, and not within the same facility, a new cost must be calculated in the receiving facility, provided that there is no cost in the receiving facility. The reason for having to calculate the cost when a cost is missing is that the cost is defined for each order number and facility.
  • The '050 Auto transfer of lot cost to receiving facility' field in 'Settings – Cost Accounting' (CAS900) determines whether the cost is copied from the supplying facility or the internal transfer price is used instead. The search path for the internal transfer price is defined on 'Internal Transfer Price. Open' (MFS001).

  M3 Functional solution

  The calculation is triggered automatically when the inventory transaction in the receiving facility is being written to the MITTRA table. The (MMS901) program then calls the CRRTVCRC program to either retrieve the cost or calculate it, if it is missing.

• Reclassification of Item Number

  If an item number is reclassified on 'Balance Identity. Reclassify' (MMS130), the cost is copied automatically from the old item number to the new item number.

Actual cost (Method 4)

Definition

An actual cost is the cost of an item based on incurred costs of material, labor, and overhead required in manufacturing or acquiring it.

Applicability

Actual costing is suitable for low-volume parts that are not produced often.

Where displayed

You can review the actual costs for all items with inventory accounting method 4 (Actual cost) on 'Actual Cost. Update/Display' (PCS265).

Data model

Calculation

• The cost is calculated for each lot number in local currency.
• Actual cost per lot number

  The actual cost is stored per lot number, costing date, and costing time and is displayed in a new program in (PCS265). Sorting order 1 in (PCS265) displays the actual costs for a combination of facility and item number sorted by lot number and costing date and time. Sorting order 2 displays actual costs for a specific facility sorted by reference category and order. In (PCS265) you can also select to display up to three subtotals, that is, the costing elements reserved as subtotals that are used in the product costing model.

• Manufacturing order receipts
  • For manufactured items, all costs incurred during production are included in the actual cost. There are no production variances. The cost is calculated automatically in the manufacturing facility when the manufacturing order is finished, that is, it receives status 90.
    Note: No internal account entries will be created before the manufacturing order receives status 90.
  • The accounting number in the MITTRA table, which stores inventory transactions, is set to 99999999. When the manufacturing order receives status 90, this happens:

    The actual cost is calculated based on the product costing model.

    The MITTRA table is updated with the cost.

    The accounting number in the MITTRA table is changed to 0.

  Note: You cannot issue any partial deliveries until the manufacturing order receives status 90.

  The average cost is not updated for manufacturing order receipts. The average cost must be calculated at the same time as the inventory transaction is created, since the old quantity and old average cost is included in the formula. At manufacturing order receipt, the acquisition cost is zero.

• Purchase order receipts, put-away

  For purchased items, the actual cost is calculated automatically as the cost at goods receipt in (PPS300), based on the purchase costing model connected to the purchase order.

• Requisition order returns

  When a requisition order return is specified in 'Requisition/Distribution Order. Open' (MMS100), one of these happens:

  • If there is no cost for the lot number, the cost is set equal to the transaction price specified in (MMS101/F). The default value for the transaction price is in turn set equal to the current average cost.
  • If there is a cost for the lot number, the cost is displayed for information purposes but cannot be changed.
• Distribution order receipts
  • For distribution orders between facilities, not within the same facility, a new cost must be calculated in the receiving facility, provided that there is no cost in the receiving facility. The reason for having to calculate the cost when a cost is missing is that the cost is defined for each order number and facility.
  • The '050 Auto transfer of lot cost to receiving facility' field in (CAS900) determines whether the cost is copied from the supplying facility or the internal transfer price is used instead. The search path for the internal transfer price is defined in 'Internal Transfer Price. Open' (MFS001).
• Reclassification of item number: If an item number is reclassified in (MMS130), the cost is copied automatically from the old item number to the new item number.

Manual update of actual cost

You can manually set an actual cost or change an incorrect cost in (PCS265). You can create new actual cost records manually. You cannot update an existing actual cost record with a costing date and costing time in the past. If you change the cost, all detailed costing values are deleted and only the total cost is saved. For manufactured items, the total cost is then displayed for costing component A01 in the product costing model.

Simplified purchasing (Method 5)

Applicability

You can only use simplified purchasing can for purchased non-inventory items such as office supplies.

Calculation

No account entries are created at goods receipt in (PPS300). Instead, internal account entries are created based on accounting rule PP20–903 when the invoice is matched to the purchase order and goods receipt afterwards.