Accelerate Your Ride to the Cloud: Extending ERP with Oracle Profitability & Cost Management Cloud Service (PCMCS) for Standard Cost Rate Development

A common need among manufacturing organizations is improvement in the process of developing annual labor and overhead standards to use as input into standard cost rates for product cost and inventory valuation. In spite of the investments that have been made in ERP solutions, it is typically an offline Excel-based exercise that is required to take historical data from the ERP to determine the updated direct labor rate & overhead rate components of a product standard cost for an upcoming fiscal year.  The release of Oracle Profitability and Cost Management-Cloud Service (PCMCS) in October 2016 provides a unique opportunity for manufacturers to ease, streamline and document the process of generating the cost-per-direct labor hour or cost-per-machine-hour rates that are requisite in standard costing.

Background

Generally accepted accounting principles (GAAP) allow for one of multiple methods for the valuation of inventory to a manufacturer: Last-In, First-Out (LIFO); First-In, First-Out (FIFO); or a Weighted Average.

Because prices for labor and materials fluctuate throughout a year and inventory is built or drawn, it is difficult to track inventory on an on-going basis using these methods. Further, from a management perspective, it is more meaningful to separate the effects of price changes and inventory builds/draws from values associated with normal business.  Pricing decisions, incentive compensation and matching expenses to the physical flow of goods would all be adversely impacted by trying to constantly manage to these methods.

A common approach to achieve meaningful inventory and cost of goods sold values is to establish a “standard cost” for every product and then adjust the value of inventory on a separate line at year-end, to bring it to the GAAP basis.

This standard cost requires direct labor, direct material and an inclusion of an amount representing the “absorption” of certain of plant-related overhead costs into the inventory value.

There are two forms of overhead that must be included in the inventory value from a GAAP perspective: 1) Labor overhead and 2) Manufacturing overhead, sometimes called Indirect Overhead.

  1. Labor overhead represents the costs of direct labor resources above and beyond their direct hourly wage rate. This amount includes payroll taxes, retirement and health care benefits, workers’ compensation, life insurance and other fringe benefits.
  2. Manufacturing overhead includes a grouping of costs that are related to the sustainment of the manufacturing process, but are not directly consumed or incurred with each unit of production. Examples of these costs include:
  • Materials handling
  • Equipment Set-up
  • Inspection and Quality Assurance
  • Production Equipment Maintenance and Repair
  • Depreciation on manufacturing equipment and facilities
  • Insurance and property taxes on manufacturing facilities
  • Utilities such as electricity, natural gas, water, and sewer required for operating the manufacturing facilities
  • The factory management team

The most common first step for determining the value of overheads in inventory is to use a predetermined rate that represents a cost charge per direct labor hour or cost per machine hour. From product bills of material and routings, the total number of hours or labor or machine usage for a unit volume of production is known. The value of the overhead cost rate per direct labor hour (or machine hour) x the number of hours required per unit of production, yields the overhead cost rate per unit. In the example below, the ERP will calculate the cost per work center, but it is reliant on the Direct Labor and Overhead Rates to complete this process.

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The challenge comes when calculating the applicable pre-determined rate for overhead per direct labor hour or machine hour by the applicable cost or work center. PCMCS can assist with automating and updating this process.

A Better Solution: The Ranzal PCMCS Standard Cost Solution

PCMCS provides the ability to quickly and flexibly put the creation of multi-step allocation processes into the hands of business users. It also provides for the management of hierarchies without the need for external dimension management applications as well as standard file templates for data upload.  Further, a series of standard dashboard and report visuals augment the viewing and monitoring of results.  These capabilities allow organizations to quickly load and allocate expenses to applicable overhead cost pools and then merge those cost pools with applicable labor or machine hour values to obtain the relevant overhead rates.

PCMCS allows users to quickly select the cost centers or work centers that are applicable as sources to be included in the overhead rate:

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Users then can easily select the targets for collecting these costs into relevant pools,

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as well as the operational metric to use to assign these overhead costs to their applicable pools.

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Users then can easily select the targets for collecting these costs into relevant pools,

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Edgewater Ranzal is the leading implementation services provider of Oracle and Hyperion EPM solutions and has extensive experience with Hyperion Profitability and Cost Management (HPCM). Following the release of PCMCS, Ranzal will be announcing a Cloud servicing offering that will leverage the power of the Cloud to provide an accelerated method of producing the required inputs for overhead allocation in standard costing.

More than just Standard Costing

Additionally, while PCMS provides an excellent way to develop overhead rates for standard costing, it can simultaneously be utilized to determine allocations and costing valuations that leverage other methodologies for product and customer costing and profitability. Much has been written about the potential for inaccuracies if the standard cost basis of overhead allocation in product costing were to be used universally or exclusively for management analysis.  Overhead has become such a large portion of the total cost, that in many cases, overhead rates can be three or four times higher than their respective direct labor rates.  This suggests a general lack of causality between overhead and direct labor hours in many cases, and this has led to the evolution of other methods for costing.  Activity Based Costing is one such example, while simply allocating manufacturing variances to product lines is another.

PCMCS can be used to meet the requirements for both the externally reported methods and the management methods of product costing.

All of the Results in One Place

Determining the method by which overhead should be captured in the cost of different products of inventory is an important process because it represents a step by which a large number of dollars is moved from an expense to an asset, usually temporarily but sometimes permanently, and this can impact profitability and stock share price.

For the purpose of valuing inventory for statutory reporting, the overhead rate method is considered acceptable and it is widely used. It is therefore important that organizations find a way to develop and manage these cost valuations in a manner that is well-documented, has transparent methodology and is one that reduces the amount of time spent on the process.  However, it is not the only method that should be used for considering overhead in product and customer costing and profitability analysis.  Further, selling, general and administrative expenses (SG&A) represents another layer of cost that while not part of standard inventory cost, should be considered in overall product costs from a management perspective.

To this end, the Edgewater Ranzal PCMCS Standard Cost solution will provide an opportunity to fulfill multiple needs in costing and profitability and will do so in a manner that will be faster and more user-friendly than what has previously been experienced.

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