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Standard Costing Presentation for Sage User Network Sept 11 th 2008

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Standard Costing Who Am I? Steve Littlewood Independent Sage Line500 / 1000 Consultant Preactor Reseller Stock / Production Controller in the past 1994 Systems Manager on a Chameleon site 1998 Consultant with MIH / TSP / BDE Specialising in Stock / Manufacturing / Reporting / Distribution / Project Management

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Standard Costing: Background Story A manufacturing company <£10M turnover 2 factories 250 miles apart, making similar and different products They were working hard to make BOMs accurate and therefore frequently running a full BOM revaluation to ripple the changes up the levels Lack of trust in the revaluation – it sometimes set standard costs to 0 Trying to run Standard Costing Hooked on looking at individual sales invoices to see the margin, but the margin calculation was based on actual costs of the stock batches sent They liked this because many purchased raw materials have fluctuating buying prices and they wanted to see the effect of this on sales invoices No posting of the stock GL journal Accounts publishing gross margin using the OPEN – CLOSE + PURCHASES method A frustrated MD who couldn’t trust the margin figures! Frustrated managers & staff who couldn’t understand the MD’s frustration!

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Standard Costing: What We Changed Solved the BOM revaluation problems Explained how the revaluation program works resulting in a trusted system! Explained where the data was coming from for the invoice margin calc Explained how that calc can go wrong, for example stock adjustments or doing WO Completions before all the WO Issues have been made resulting in understanding of how the data should be interpreted! Recommended that they pay less attention to margin on individual invoices and start looking at variances against standard cost on all transactions Created a set of variance reports and made sure the business processes supported what we needed to measure Lastly we needed some way of expressing this underlying frustration What was the problem?!

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Standard Costing Along with the Operations Director, I created the following set of slides to try and explain standard costing and gross margin calculations. So this was created by non-accountants for a non-accounting audience! Please tell me if we have got it wrong!

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Standard Costing... in The Perfect Company Ltd

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The End Result Understanding the Company’s gross margin statistics

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The Accounting Dept. Opening Stock – Closing Stock + Purchases Eg: £100,000 – £70,000 + £50,000 = £80,000 **STOCK IS CALCULATED USING THE STANDARD COST, NOT ACTUAL OR BATCH** So you could say..... “In selling whatever we sold, the stock went down by £30,000. We also bought £50,000 of new goods. So the Cost Of Sales = £80,000” At each period end the accounting department work out the Cost of Sales (COS) using a simple calculation of these £ values: If the Sales Value = £100,000, then the Gross Profit = £20,000

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The Sales & Operations Team Obvious but we’ll mention it anyway Under a STANDARD COSTING system the Cost Of Sale should be calculated using the STANDARD COST of the products sold! At each period end they are interested in knowing what has been sold and to which customers. So they produce Sales Analysis reports. But they also show the Sales Margin on these reports. Where does this come from? Their calculation is: Sales Margin = Sales Value – Cost Of Sale where the COS is the sum of the Qty x Cost of the products invoiced

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The Managing Director Wants to know... a) What has been sold? b) What it cost to make those sales? c) What the profit is? d) What can be changed to increase the profit? And most importantly he wants to get consistent figures from the Finance dept and the Sales & Operations team. They will agree on the Sales Value, but probably get a different Profit figure!

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So..... Let’s try and get the figures to match! First we’ll take a quick look at the BOM Then we’ll look at a calculation for a period

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The Bill Of Materials (BOM) A 1 x B1 x C To make 1 of A we need 1 each of B and C Standard Costs = £10 and £15 Therefore the Standard Cost of A will be calculated by the system as (1 x £10) + (1 x £15) = £25 These are manually keyed onto the stock item, and typically represent the price that you usually pay from your main supplier. ! Note that throughout this example we are only dealing with material costs, not labour, overhead or subcontracting.

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The Perfect Period 1 The company only sells product A. In this period it makes 1 of A and sells it to a customer for £100. Accounts Calculation Opening Stock ProductStd CostQtyValue C£154£60 B£100£0 A£250£0 Total=£60 ProductStd CostQtyValue C£153£45 B£101 A£250£0 Total=£55 Closing Stock B is out of stock so the company buys 2 of B at a PO price that is EXACTLY the STANDARD COST. 1) PO Receipt for 2 of B at £10 each PurchasesPO for £20 Cost Of Sale Open – Close + Purch: £60 - £55 + £20 = £25 Operations Calculation Transactions 2) WO Issue for 1 of B and 1 of C 3) WO Completion for 1 of A 4) Sales Invoice for 1 of A, sold at £100 CBA Opening Stock: Sales Analysis Report Cost Of Sale Says that the SALES VALUE = 1 x £100 = £100 Margin/Profit Sales - COS: £100 - £25 = £75 It was only product A, and the STD COST = £25 So the COS = 1 x £25 = £25 Margin/Profit Sales - COS: £100 - £25 = £75 Period End

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The Variances The figures for period 1 were always going to balance. That’s because the Purchase Order was placed at a price that EXACTLY matched the Standard Cost of the purchased item. What if there had been a “Purchase Price Variance” ? In the Period 2 example we will raise another PO for 2 of B and set it with a PO Price of £12 as against the Standard of £10. (We don’t really need to buy B because there is 1 in stock, but we’ll do it anyway to keep a safety level!) Then we’ll make 1 of A again and sell it to the same customer for another £100.

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The Not So Perfect Period 2 Accounts Calculation Opening Stock – from the end of Period 1 ProductStd CostQtyValue C£153£45 B£101 A£250£0 Total=£55 ProductStd CostQtyValue C£152£30 B£102£20 A£250£0 Total=£50 Closing Stock 1) PO Receipt for 2 of B at £12 each PurchasesPO for £24 Cost Of Sale Open – Close + Purch: £55 - £50 + £24 = £29 Operations Calculation Transactions 2) WO Issue for 1 of B and 1 of C 3) WO Completion for 1 of A 4) Sales Invoice for 1 of A, sold at £100 CBA Opening Stock: Sales Analysis Report Cost Of Sale Says that the SALES VALUE = 1 x £100 = £100 Margin/Profit Sales - COS: £100 - £29 = £71 It was only product A, and the STD COST = £25 So the COS = 1 x £25 = £25 Margin/Profit Sales - COS: £100 - £25 = £75 A difference of £4. So we have to give additional reports to the Finance dept. to show them the PO Price Variances in the period. Calculated as : 2 of B received at £12, but STD = £10, so Variance = 2 x (10 – 12) = -£4 Adverse

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The End Result The -£4 Adverse variance can be calculated from the system and is effectively a Cost Of Sale. So we get different figures for the profit, but now we can explain the differences. The same can apply to other types of variance, for example WIP Scrap where the BOM says you should have issued 20 but you had to issue 25 to cover some problems. The PO Price Variance report becomes a measure of the Purchasing Department. The Sales Analysis reports get their Margin from the STANDARD cost and therefore the margin for a given product only goes up if the salesperson negotiates a higher price. So the Sales Analysis report measures the Sales Department. It does not measure the Production Department. That would come from WIP, Scrap and Labour Variance reports. NOTE that we have NEVER used the costs associated with Stock Batches. To our Works Order in Period 2 we could have issued B from batches at either £10 or £12 because we had 2 lots available! It does not matter, because we have already analysed the difference at the purchasing point. We must not count the same variance twice! Finally, yes of course this depends on the accuracy of the Standard Costs. So we have to strike a balance between making them as accurate as possible whilst keeping them stable for a period of time so that we can have confidence in the reports. It will be very difficult to balance the reports if the stock Standards Costs are changing within the period. Note though that the Sage Auditing module can do this and provide enough information for an exception report showing the associated change in value of stock.

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The Alternative: Actual / Batch Costs Tracking actual costs is tempting, but what does it involve and what does it really measure? Sage is quite happy to let you track actual costs via the stock batches, and by default the sales invoice history calculates the margin based on the batches sent at Despatch Confirmation. Here’s just 1 example of how it can go wrong: if the WO Completion is made BEFORE all the WO Issues have been made then the batch costs of the made items will be wrong. And even if you can trust the figures then what do they mean? You will have passed purchasing and manufacturing variances through the whole process and at the end you will get figures that say you made 20% profit selling product A to customer 1, but only 16% on selling it to customer 2. Your next question will be “Why?”. And after ruling out the sales team selling for a lower price you will start looking for the sort of variance reports that we have already discussed!

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Appendix1 List Of Variance Reports Changes in stock value due to changes in std costs* Purchase Price Variance (Receipt and Invoice) Manufacturing Variances – Use of alternative products – Scrap, yield gain/loss – etc WO Closing / WIP Report * Stock Adjustments Inter WH transfers where the 2 products have different std costs etc

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Appendix2 Report of: Changes in stock value due to changes in std costs

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Appendix3 Report of: WO Closing / WIP

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Steve Littlewood

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