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Valuation Alternatives – Between the Devil and the Deep Blue Sea

Valuation Alternatives

– Between the Devil and the Deep Blue Sea

“Results are being quantified: We’re massaging the numbers so they will agree with our conclusions.”

This was the most common phrase I had been hearing frequently in an organization where I started my career as a young and enthusiastic accountant. I use to observe my seniors so that I can learn something from them. By that time I had understood why my father would always say that everything isn’t taught in Harvard. Closing the books had been an all time favourite subject to me and I was very excited as the last date of the fiscal year was nearing. Sleepless nights, enormous efforts and repeated calculations and reconciliations finally led to the book closure. Since I had been working in largest business unit of the organization the focus was more on the inventory valuation as it was the key to profitability. My significant learning that time was that there is something called standard cost for the finished goods and work in process and moving average price for the raw materials. The accountants didn’t rely on the standard cost as it was far from actual and moving price was something they relied as it was near to the actual, but that was highly unpredictable. So a parallel estimate used to be created out of the information in the existing SAP system and based on this inventory valuation was carried out. I could remember another popular phrase – “the estimations are logically correct!”

In my consulting days the dismal picture started getting clearer with the various options to value inventory in an SAP system. I could find that SAP has an edge over the other ERPs because of the Controlling module and its capability to actualize costs. In addition to standard and moving average price there is periodic unit price or a weighted average price in simple words that is computed by the Material Ledger module. Despite these options people still tend to use the combination of standard cost and moving price ignoring the accuracies offered by the material ledger module. The leopard can not change its spots, the mindset of the accountant though has changed from what it was two decades back but still they are more rigid when inventory valuation is concerned. They can not simply rely on an ERP to provide results and they still look for some simple solution which leaves a space for human interference despite their businesses being quite complex.

Material Ledger has always received strong opposition from the business analysts and also from the fellow consultants working in the logistics module because of its inborn complexities. In my experiments with material ledger I could find that it is one module where the configurations are minimal in the module but fine tuning in accounting and logistics is more important and this is where it becomes challenging to a very experienced consultant even. It differs from many of the modules where most of the configurations are standard and you concentrate on the scenarios presented to you. In material ledger there are only two scenarios – valuation in multiple currencies and actualization of the valuation. And this requires the consultant to understand each business process particularly in logistics and how it influences the valuation of the final product

Perhaps the automatic segregation of the variances between consumption and stock and rolling up to the higher level is the most significant achievement of material ledger. In controlling everything is controlled by a cost object that holds costs according to nature and requirement, this happens in case of CO-PA as well, but when it comes to material ledger there are no such objects and the focus shifts to material. Probably the name speaks it all. I could find that the users seem more comfortable with the cost objects because till the time the cost come through that route they somehow find a place where costs are stored safe and secure than material ledger which according to some is like values flowing in air with tons of documents getting generated.

Coming to the world without material ledger to many accountants moving average price for the raw materials is a very good option to value stock. This is so because the accounting standard recommend carrying inventory in weighted average price and that is somewhat substantiated by moving price which tends towards actual. Another reason why moving price is preferred because with standard price for raw materials in many ERPs accountants had sleepless nights in allocating those variances between consumption and stock and between various materials, which is now easy with moving price. Despite this advantage the major disadvantage is that moving price valuates raw materials with past variances which may not be relevant for the period. This happens when an invoice is received for a goods receipt two months back and the prices are not according to the purchase order. Another problem with moving average price is that it can not be used as a benchmark as it is always changing and profitability analysis can not be carried out.

Another valuation option is that of standard price which offers same price over the entire period and helps in consistent cost management of the production process. Variances are transparent in this process and this makes it the recommended approach for raw materials as well when material ledger is implemented. Usually in most of the SAP systems used worldwide the internally produced goods are initially valued at standard price since the actual can not be known at the time when goods movement takes place. The disadvantage of standard price is that it is standard and can lead to inexact valuation when the prices of the components vary a lot and the cost of the finished product does not reflect the most recent data.

Having considered these fact most of the organizations not using material ledger move towards huge manual calculations with human interference and discretion in arriving at the actual cost and that was even true with my first organization where the conclusions were drawn before calculation. It is true that actual costing can happen without material ledger but the fact is that if you are afraid of the devil then you need to swim out of the deep blue sea. The advantages offered by material ledger are huge and can not be substantiated by any manual system but the accountants would follow the system with which they are more content as a bird in hand is worth the two in the bush. This system may be backed up with huge ABAP reports and programs as well.

The conclusion is whether or not material ledger is implemented an organization should be following a full proof costing methodology which helps it to achieving its organizational goals of profitability and growth. The correct costing methodology is the key to success. Some useful questions for ascertaining a successful methodology are appended below:

  • Does the organization really understand the true cost of product and services?
  • Do the costing methods operate at the right level of detail?
  • If some form of activity based costing is being used, are these models transparent enough? Can the activity costs be traced back to the line items of the expenses that drive them?
  • Is the organization satisfied with the way the shared services are allocated?
  • Are the people spending too much time maintaining the costing models and other elements in costing system?
  • Can the people in the company quickly test how changes in commodity and other input costs would affect profitability or what would be the impact of lower or higher volumes? Or whether profits would be affected by which plant or production line produces the goods?
  • Are the answers from the costing system fast enough to be actionable?
  • Are all the data needed to understand the true cost available in a single ERP system?

The economic volatility that has characterized the last two years is likely to diminish over time, but the need to do a better job of understanding cost to manage pricing and profitability will not. By employing the right methodology, the right information and the right tools, companies will be able improve their returns and serve their customers more effectively.

 

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      Author's profile photo Former Member
      Former Member
      Thanks for initiating this topic, hope we see more follow-up articles.