Lot Costing: Costing Solution for Commodity Industries...

Caveat: This is an imaginary situation designed to explain a concept. I have used Agro Products as an example since I have expertise in that industry. I have used Oracle Product since I have implemented multiple costing solutions in that product. Almost all the commodity based industries, including Oils and Fats, Jewellery etc face similar costing challenges. The situation mentioned in this post is based on many a average ERP implementation that I have seen in my career (Other than those implemented by me, of course. :). If you see similarities between your case and the case of PAF, especially relating to Post Implementation Challenges, probably you should give me a call ASAP.

With that out of my chest, let us jump right in into the blog post. 

Mr.Amar Sharma, COO of M/s Prime Agro Foods (an imaginary company) specializing in the manufacturing and selling of Spices and Agri Products, was a worried man. 

About a year and half ago, his company had implemented Oracle Applications ERP with much fanfare. The enthusiasm soon fizzled out as the quality of implementation was average and  the implementation discipline was not adhered to in many cases, resulting in some major disturbance to the business post ERP Implementation. The challenges were the same as you see in many projects. Inadequate training, lack of user involvement and ownership, Data Conversion gone wrong and rectified....etc. I got into the project 4 months after it had gone live. I remember that there were a lot of challenges at that time. We, me and the PAF IT Team,  patiently identified and filled the gaps in the implementation with active support from the Product Vendor. Now, after about a year since my entry, the application had stabilized and Mr.Mehta, the owner of PAF, had started demanding that the senior management provide management reports from ERP itself. In fact he has gone to the extent of informing the managers that they should 'Log In' to the application during the meeting and run the reports from ERP and discuss the same during the management review meetings. 

(Mr.Mehta had given one month for his managers to get the relevant reports developed. It was a struggle since none of the management report requirements had been discussed during the implementation and with the owner's demand, there was a mad rush to identify, develop, test and move the reports to production. I had played a key part in this endeavor since I had deep expertise in the entire application landscape of PAF.

PAF is a company categorized as 'SMB' (Small and Medium Businesses) with a revenue turnover of about 300 Crores per year. While evaluating the ERP Applications, the solution from Oracle seemed to be the best fit for the Organization.  The product vendor and the implementation partner had promised PAF that Core Oracle Applications, called eBusiness Suite (EBS) with their Process Manufacturing (OPM) application was the widely accepted solution for a process manufacturing organization like PAF. It also helped that other customers in similar industry were  running on this solution.

The applications implemented in PAF were:

• Oracle Purchasing
• Oracle Inventory
• Oracle Process Manufacturing
• Oracle Process Manufacturing Financials
• Oracle Order Management
• Oracle Financials, including Accounts Payables, Accounts Receivables, Cash Management, Oracle Assets and Oracle General Ledger
• India Localization for Financials.

During the implementation, there was some discussion on Costing Method to be adopted. In the end it was decided to implement PMAC (Period Moving Average Costing), the default costing method in OPM Financials as the Costing Method for PAF.

(There was a discussion on the feasibility of using Standard Costing. But the CFO had rejected Standard Costing saying that with the Agri Commodity Prices being decided at the global level and with the Raw Material Availability being seasonal in nature, the cost drivers were external to the Organization and it was not feasible for the company to fix Standard Costs for its procured ingredients.)

So the company chose PMAC. Now that the ERP had stabilized, the key personnel in the company were beginning to feel the impact  of choosing that costing method.

[ PMAC calculates the product costs on a periodic basis, known as costing period, which normally each month. It is a Quantity Weighted Average Method of Costs calculation. The formula for calculating cost of the current period is given by the formula:

Cost of the Current Period = ((Prior Period Closing Quantity X Prior Period Cost) + Sum of(Current Period Transaction Quantity X Transaction Cost)) / (Prior Period Quantity X Sum of Current Period Quantity) ]

Click here for more information on  challenges faced in Inventory Valuation and Costing in ERP Implementation

I know Mr.Sharma on a professional basis. He had been my 'Go To' person for any executive decisions during my 10 months tenure in the ERP Stabilization Project in PAF. Having worked together he knows about my expertise in Oracle ERP in OPM Financials environment. Over a period of time I evolved to become his 'Go To' person when he wanted company to have a beer with  and unburden his frustrations about how ERP is complicating his simple business..We had not spoken for over two months since I moved out of the project.

Today he had his weekly review with Mr.Mehta and the review had not gone well. When he called me up, Mr.Sharma was very agitated.

"Ram, ERP is not beneficial to me as a COO of a Agro Product Company", he told me

I was surprised. "Why do you say that? Last time I spoke to you, you were very happy that ERP has stabilized".

"That is true, when I spoke to you last time, I was satisfied that after about a year and a half of struggle post go-live, we have stabilized the ERP. Of course, I have to acknowledge your excellent support in getting us out of the abyss that we were looking at. In fact, till you came along, we did not even realize that ERP has so much potential to track and manage our business."

"It was not me", I responded, "It was you who stabilized the ERP System. Without the commitment of Senior Management, and your decision to invest in special expertise (me), it would have taken at least another year for you to stabilize and that too, it would have been a sub-optimal stability.  If we had not rectified some of the original design issues, ERP would have been a mill stone around your neck, and not a  facilitating software, that you have now." 

"I know that Ram. But now that management is demanding more I see that I am not able to provide the information.", complained Mr.Sharma.

"What is the problem?", I asked.

"You know my industry. Our raw materials being commodity, we have no control over the input prices. Add to that the availability of our ingredients is seasonal. During season, we procure ingredients through auctions and we buy in different batches on different days. For example, if I buy Chilly, I might buy the same on different batches on 1st, 15th and 28th of Month One and 7th, 10th and may be 25th of Month two etc. I might be buying each of the batches at different prices."

"I am very clear of the prices that I paid for  each batch. So when I have to produce the FG today, I look at the costs of various batches and selects the batch that will give me the greatest profit as on today's price. That way I always ensure a profit margin on the sales. Since I am selecting a specific batch to input to production, I am not using FIFO."

"Till Mr.Mehta started demanding reports from ERP, I used to ask my team to prepare a simple profitability sheet showing the Cost of the Input Material and the derived cost of the output material. I was able to show regular profitability on my sales. Mr.Mehta used to be happy about my cost management expertise. But with ERP, everything has turned topsy turvy.", said Mr.Sharma.

I could see where this was headed. But I wanted to know more. I asked him to elaborate.

"Take for example the production of the current month. This is a lean season and commodity price is about 250 Per Kg. I have batches that I procured at 200 Per Kg, 250 Per Kg and 325 Per Kg. All the three batches were procured during the same month during the last season. I chose the batch costing 200 per Kg to produce the FG. So our cost is 200 per KG (as per me), and the selling price is 250 per Kg and hence we made a profit of 50 Per Kg. However, as per ERP, the PMAC Cost is showing 255. So as per ERP, I made a loss of 5 on sale of each Kg of the Finished Product. Now Mr.Mehta is doubting all my previous profitability projections. Now I have to prepare a reconciliation sheet integrating my calculations and ERP calculations. Unnecessary additional effort", commented Mr.Sharma.

"If only ERP had a method of costing based on batches procured", said Mr.Sharma wistfully. 

"There is", I told him, "There is a costing method in OPM suited to just this type of situations.", I told him.

Mr.Sharma was interested. "Tell me more about this costing method".

"This costing method is called 'Lot Costing'. It is a combination of Specific Costing and Transaction Weighted Averaging. What this method does is to track the costs per batch ('Lot' as in OPM Terminology). The cost of the lot is tracked till the time quantity exists in the lot. If you add multiple purchases to the same Lot, it does transaction weighted averaging within a lot."

"When you use a lot in the production order, the cost of that Lot flows into the FG. In your case, if you were using Lot Costing, you would create different Lots for purchases at different dates. The cost of each Lot will be the price that you paid for that Lot. So, when you use the Lot in Production, the cost of that Lot flows into the FG. If you receive FG also in Lots, each Lot of FG will have the costs associated with the specific Ingredient Lot. In your example, if you use the Lot costing 200, the cost of FG Lot would also be 200 and when you sell that FG Lot at a price of 250, Oracle will recognize a COGS of 200, revenue of 250 and bingo ! there is your profitability."

"Now that we have gone live on PMAC, can we use Lot Costing now? How much effort will it entail? Will you be able to handle this? Have you implemented Lot Costing anywhere?" Mr.Sharma had so many questions.

"To answer your questions one by one. First question that you ask me if you can start using Lot Costing now. The answer to that is a qualified 'Yes'. OPM allows you one costing method for accounting and inventory valuation, but you can have many costing methods for cost analysis. For  accounting and inventory valuation you are currently using PMAC. Changing that now, is feasible, but will entail more effort and may destabilize your nascent ERP Implementation. So for your case, we can define Lot Costing as a costing method for cost and profitability analysis. That is simple to achieve. For your business, it may entail about 40-50 person days of effort including configuration, testing, user training and data conversion", I said

"That means, I can do away with the creation of the Reconciliation Sheet that my team is making at the end of every month. That will definitely save us about 6-8 Person Days per month. Which means about 80 Person days of effort in a year. So I get my payback in about 6 months Also, since data is coming from ERP, Mr.Mehta will also be satisfied", said Mr.Sharma thoughtfully.

I nodded in ascent. "You ask me if I have the expertise of handling this. The answer is yes. I am probably the first consultant in the world to have implemented Lot Costing. When we implemented it, there were many issues, but we patiently resolved each one of them. We did so many tests, raised so many SRs (TARs as they were called back in 2004) that I was called TARZAN (I smiled at the thought). But the upshot is that we (I along with an excellent resource from the customer team and with excellent support from the Oracle Support Team) stabilized the product. So, to answer your question, I have done it and I can easily do it.", I concluded

"So lets get this done. You send me a T and M proposal for implementing Lot Costing for Cost Analysis at PAF. Also include effort for developing the management reports. Send it to me ASAP. I will get it approved immediately and if you are available, we can start it by next Monday.", said Mr.Sharma.

"What I have seen working with you, Ram, is that the quicker we get you into our project, the better it is for us. You may be expensive, but you are the best insurance that we have against failed projects.", concluded Mr.Sharma

If only the other customers realize this.

If only getting business was this simple.