High Performance Cost Accounting

Confronting a New World of Higher Production Costs and Greater Volatility

Introduction

Cost accounting and inventory valuation is a critical capability for companies, allowing them to enhance predictability and control over profitable growth. However this function has become substantially more difficult recently, due to far more complex cost structures, which have been driven in part by greater price volatility and fluctuation for commodities and base materials. As a result, manufacturers and distributorsregardless of geographic location or product renderedface significant challenges in their ability to value current inventory and predict and control costs. From mid-2010 to early 2011, global oil prices increased by 25 percent, soybeans were up 49 percent, corn and sugar nearly doubled,1 and cotton tripled.6 In the Canadian market, one economic survey found that food prices grew 4.2 percent in a single month, May 2011,

challenging grocers to either absorb those costs or pass them along to consumers without impacting sales. That same month saw a spike in gas prices of nearly 30 percent.2 In addition to overall rising costs, which alone may present a financial management challenge, volatility and price fluctuations have increased as well, over an extended period of time (see Figures 1 and 2). Such volatility is being driven by a number of global factors, such as extreme meteorological conditions that have led to droughts in central Asia and floods in Australia, and political upheavals in the Middle East. Such factors have combined to impact the supplyand thus the priceof commodities and base manufacturing and production materials.3 As a result, companies have had to adapt their sourcing, market strategies, and other functions in order to maintain profitability (see sidebar on page 8).

This volatility and variance in costs has implications throughout the enterprise, reinforcing the need for a more comprehensive cost accounting and inventory valuation capability. Traditionally, companies have used cost and inventory accounting as a managerial reporting technique to help make key business decisions and stay competitive in the marketplace. Often these decisions begin with a thorough analysis of questions such as: What are my costs and costing trends? What costs should we pay for commodities and basic materials? What prices should we set to maintain margins? What are customers telling me about my prices and in which product groups? How might we pass along cost increases to certain customer segments without impacting sales?

Figures 1 and 2: Commodity prices and volatility have both increased dramatically recently
Commodity Prices
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Source: International Monetary Fund (IMF) Primary Commodity Prices

Source: International Monetary Fund (IMF) Primary Commodity Prices

With this data in hand, companies can apply business analytics to understand their competitive position and drive strategy. These analytics can lead to more effective decision-making and better business outcomes, but accurate cost and pricing data is the foundation on which this process is built. As a result, these analytics are only as sound as the cost and inventory valuation data they are based on. In the current price environment, with significant input price variance, many companies simply may not have data that is sufficiently accurate or timely enough to lead to optimum business outcomes. To address this issue, many organizations require a more robust cost-accounting capability. This capability must be predictable, repeatable, and scalable, and it must account for more dynamic cost variability. In addition, it must be

integrated throughout all areas of the enterprise, as opposed to the current approach at many companies, in which the cost-accounting function effectively occurs in a silo within the Finance department. Only those companies that have a strong grasp of their costsnot only in conventional areas like sourcing but throughout the enterprisemay be able to maintain and even enhance profitability in the face of rising costs for commodities and other production materials. They will develop more accurate cost data, which they can leverage through business analytics to generate actionable information. While this is particularly true of manufacturing companies, which rely on commodities and have a relatively high cost-of-goods-sold, these principles also apply to any company that manages inventory and produces tangible goods.

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Which Method of Cost Accounting to Use

Current levels of volatility can be the basis for intense consternation when selecting an inventory valuation method for managerial accounting and reporting. The two methods most commonly considered are standard cost and moving average cost (MAC). Although moving average cost is typically easier to manage, standard cost provides a basis for increased accountability throughout the organization. In fact, when properly administered, the standard cost method should closely mirror the actual cost method. Standard cost is widely used by manufacturing companies for managerial reporting because of its strengths in cost control. In addition to managerial reporting, companies must also consider the implications for statutory reporting (e.g., financial, tax) when evaluating an inventory valuation method and costing process.

As mentioned, standard costing is widely used, especially by companies that utilize SAPs Product Costing functionality. Typically, semi-finished goods (WIP) and finished goods are valued using the standard cost method. Raw materials can be valued using either standard cost or moving average cost. Standard cost values inventory at a cost that remains constant over a period of time, while MAC values inventory after each goods receipt, invoice receipt, or production order settlement. Since standard cost provides a consistent cost value over a period of time, it becomes easier to analyze customer and product profitability, assuming that variance distributions and other selling, general & administrative (SG&A) cost allocations are simplified.

Variances are the result of differences between actual cost and planned cost due to changes in product mix, yield, volume, acquisition cost of materials and labor rates. Companies analyze these variances to determine their treatment, e.g., a period cost versus capitalization. This can be done each month, but at a minimum this analysis takes place quarterly, to help ensure the accuracy of external financial statements. In addition, these variances are typically charged back to customer and product dimensions to analyze profitability. Standard cost allows enhanced analysis and transparency into the manufacturing process, since many of the cost fluctuations from materials, labor, and overheads are more easily identified. In many respects, MAC can mask cost fluctuations, both positive and negative. This makes it more challenging to analyze margin results.

Figure 3: Companies should consider updating cost standards depending on inventory turnover and cost fluctuation

Frequency for Changing Standards

High

Review at a minimum once per year Cost Fluctuation

Review based upon company wide thresholds Could be multiple times each year

Review on an as needed basis

Review on an as needed basis

Low Low

Inventory Turnover

High

A common method to achieve a simplified variance distribution and allocation process is by using a concept known as contribution margin. This method differentiates variances and allocations between those that are controllable by a manager/executive and those that are not, allowing the enterprise to assess accountability where it belongs. Although net income doesnt change, the company can more easily identify what a plant manager is responsible for and can control versus what a purchasing manager is responsible for and can control. When standard costing is used, an enterprise should determine how often to establish or change standards. This requires striking a balance between the effort, cost and time it takes to update the standard versus the effort, cost, and time it takes to manage corresponding variances.

Companies frequently ask, How often should a standard be changed? Some companies review and change standards for every class of inventory on an annual (fiscal year) basis, coinciding with their annual planning cycle. However, a leading practice is to segment inventory based on changes in cost and turnover (see Figure 3). For inventory items that have low cost fluctuation and low turnover, changes in the standard cost may occur less frequently. However, even if the standard cost is not changed, this class of inventory may still be subject to other statutory requirements, such as asset impairment. Likewise, an inventory class categorized by high turnover and high cost fluctuation may warrant a more frequent review of the standard cost. This could result in standards being changed throughout the fiscal

year. Additional factors which could trigger a mid-year review include a significant change to a production line (e.g., new models or stock-keeping units being introduced); a change in the cost of inputs (new purchasing contracts or labor contracts); a change in key components of a bill of materials (new materials, machinery); discovery of a costing error; significant changes in foreignexchange rates or tariffs, and so on. To assist in identifying a potential change, the company should evaluate the impact of these events, when aggregated, by considering both the percentage change and the absolute dollar amount for the fiscal year. Regardless of how often the standard cost is changed, the end result is typically the revaluation of inventory on hand, along with a reversal of any variances that have been booked to the balance sheet.

Mitigating The Impact Of High Production Material Costs

Once companies develop a better grasp of their inventory valuation and costing data, they have a range of options in mitigating the impact of rising and volatile production material costs. Some companies have adapted by successfully altering their packaging, in order to reduce volume while holding retail prices consistent. For example, Thai Union Group reduced the size of its tuna cans from six ounces to five ounces (17 percent), and Mars reduced its king-size Snickers bar by 0.41 ounces (11 percent), while keeping unit prices level.4 Other companies have substituted materials to better manage their costs. Due to a historically rare price inversion in which wheat is now cheaper than corn, poultry producers such as Tyson Foods and Pilgrims Pride are now adding wheat to the corn they feed chickens, to reduce overall costs.5 Similarly, some ethanol producers have begun using a corn feedstock with 5 percent wheat.

Some companies are taking a more comprehensive approach. Procter & Gamble recently reported that commodity costs in the past year have increased about 20 percent, creating what its Chief Executive Officer (CFO) described to investors as an earnings headwind of USD $1 billion after taxes. Because the company has such a wide range of products, it is implementing a number of measures. P&G will raise the price of some of its products; adapt the production process for others by substituting less expensive materials; and trim its selling, general, and administrative (SG&A) costs.3 In some cases, companies may be able to pass along higher costs to consumers, particularly if they know the price-sensitivity of segments within their audience. They can also restructure the cost components of specific products or services, in order to better align them with their

perceived value among customers. For example, at one high-tech manufacturer, analysis revealed that the customer-service cost drivers were out of proportion to customers perception of value (see Figure 4). More than half of the companys customer-service spending was devoted to producing users manuals, while customers expressed far greater demandand willingness to payfor accessible and responsive hotline support. Once it recognized this imbalance, the company shifted its spending accordingly. It scaled back costly activities that added little value for consumers, while expanding and repricing others. As a result, the company improved its margins, while delivering greater customer satisfaction.

Finally, organizations can develop a more sophisticated sourcing strategy. Monro Muffler Brake, the auto-repair chain, monitors rubber prices closely, and when it recognized an opportunity in market conditions, it jumped. Between March and December 2010, the company increased its inventory by 11 percent to USD $95.6 million, including USD $8 million in tires. That gave the company more of a cushion against rising rubber costs in the future.3 While all of these approaches can be effective for various sectors, they represent what is possible once companies have an accurate and comprehensive understanding of their inventory and cost data.

Figure 4: One company addressed rising customer-service costs by better aligning its spending to customers perception of value
The Cost-Value Gap
Spending on Customer Service Customers Perception of Value

5% 10% 10%

10% 5% 20%

15%

60%
Respond to letters Revise manuals/send updates Help locate repair service Answer hotline Produce manuals

60%

5%

Respond to letters Manual updates etc. Help locate repair service Hotline support Manual availability

Impact on the Enterprise

All too often, the costing and inventory valuation process is considered an accounting function and is limited to the Finance department of a company. This may lead to suboptimal cost-accounting results. Moreover, as Figure 5 shows, this process may have implications throughout the organization, on functions involving engineering, production, purchasing, sales and marketing, and human resources. Accordingly, these functions can and should play a larger role in costaccounting, specifically by providing more accurate and comprehensive cost data at the front end. Below are some suggested areas where companies can focus their efforts with respect to cost accounting: Purchasing (PTP) should consider any discounts and volume rebates, since these adjustments can have a significant bearing on establishing standard costs and recording actual costs. Other key inputs to landed cost are inbound

freight (air, water, land), and insurance and packaging. Often companies use tax deferred vehicles such as tax free enterprise zones when they import materials. This may cause challenges when booking accruals for duties related to the landed cost. Still other considerations include brokerage fees, miscellaneous import and financing fees, duty drawback, and currency hedges. If a company is dealing in commodities, it should consider product hedging, which would add yet another variable to the purchasing departments standard cost function. Human resources (HTR) can help determine the most accurate cost data for incentive compensation such as bonuses, along with training, roles and responsibilities, goals and targets, and performance management. Sales organizations (OTC) should consider the impact of pricing strategies and margins (including a subsequent explanation of any variances), along with compensation

and incentive costs. Sales should also collaborate with Finance in the credit management process and participate with Manufacturing in the sales and operations plan (S&OP). Manufacturing and production (PC) can weigh considerations such as normal plant capacities, peak production, idle capacity, retooling and machine set-up, and product mix. These functions must also work with Finance to create bills of materials and overhead rates; value physical inventory; manage consumables; and ensure that data is available to support various manufacturing modes (such as process, batch, discrete, repetitive make-tostock, repetitive make-to-order). Treasury needs to understand inventory valuation in order to effectively manage cash flows, plan for liquidity, hedge currency and commodities, and report against loan covenants.

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Figure 5: Cost accounting has a significant impact on functions throughout the organization
Business Decision Support Processes
Financial Planning & Analysis (FP&A)
Financial Analysis Financial Planning Budgeting Forecasting

Illustrative
Management Reporting (MR)
MultiExpense/ Performance Dimensional Profitability Revenue Mgmt. Analysis Analytics Allocations

Key
Inventory Valuation Significant Impact

Specialized Expertise
Acquisitions Contract Real Estate & Risk Mgmt. Accounting Management Divestitures

Financial Reporting (FR)

Legal Entity Reporting Statutory Reporting Tax Reporting

Stewardship Governance Processes

Control
Accounting/ Tax Policy Internal Audit Corporate Internal Governance Consulting Project Mgmt.

Finance Management
Finance Function Mgmt. Human Training & Performance Development Mgmt. Business Liaison

Tax Planning New Business Partners

Capital Planning Operate New Business

Transaction Processing
Record to Report & Intercompany (RTR)
Record Aggregate Transaction Sub-Ledger Analyze & Consolidate Adjust Monthly Close Fixed Assets

Purchase to Pay (PTP)

Create Requisition Manage Goods & Services Process Payments Create PO Process Invoices Manage AP

Order to Cash (OTC)

Receive Order Process Order Collect & Apply Cash Authorize Credit Invoice Customer Misc. A/R

Product Costing (PC)

Product Cost Planning
Period-End Closing & Inventory Valuation

Projects
Project Creation

Tax Mgmt. (TM)

Data Collection
Tax Calculation Tax Reporting

Hire to Retire (HTR)

Recruit, Select, Deploy Benefits Mgmt.
Succession Planning & Talent Mgmt.

Production Execution

Employee Admin. Time, AttendancePayroll Incentive Comp.

Project Reporting & Financial Cost Management Analysis

Record Production Transactions

Count Inventory

Generate PA Transactions

Finance and accounting (RTR, TM, FP&A, MR, FR) is involved with establishing standard cost; managing variances; planning, budgeting, and forecasting; dimensional reporting; working with manufacturing executives; and statutory reporting (e.g., asset impairment, inventory valuation, transfer pricing, unrealized profit in inventory, Uniform Capitalization (Uni Cap) calculations, Last in First Out (LIFO) reserves). The goal is to understand not only the costing implications for these individual functions but also how they interconnect, in order to determine the overall impact on the company. An enterprise-wide approach can lead to a range of benefits. The business model will become more clarified and easier to monitor, allowing managers to analyze margin targets by customer or product. All key internal stakeholdersthe executive team, sales force, finance, supply chainwill be

able to explain the business model and operating results to external groups such as banks, investors, Wall Street, and potential partners. The company will have clear and well-documented tax positions, and financial statements will more accurately and fairly present the results of operations. (Historically, problems with inventory valuation such as inaccurate accruals, revenue recognition, and asset impairment have been a major factor behind financial restatements.) In addition, this process can help engage the workforce. Every employee will better understand the elements that are within his or her realm of responsibility and direct influence. Employees may also be compensated and incentivized appropriately.

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Organizational Considerations
Where should the costing and inventory valuation function be located? Historically, this function was closely aligned, and often co-located, with individual business units (BUs). The BU cost accountants typically reported directly to the corporate CFO and indirectly to the BU. However, with significant advances in technology, workflow, and distributed reporting capabilities, many companies are consolidating their cost accountants into a center of expertise (CoE) that serves multiple BUs and geographies (see Figure 6). This approach works well in situations that require deep specialized skills but little daily faceto-face contact. These CoEs can be located regionally throughout the world, similar to the placement of shared service centers. Figure 6: While many companies traditionally place the cost and accounting function with individual business units, a leading practice is to consolidate this function into a center of expertise (CoE)
Distributed Business Partner

CEO

BU 1 Indirect BU Cost Accountant

BU 2

CFO

BU Cost Accountant Direct

Corporate Inventory Valuation

Center of Expertise

CEO

CFO Direct Center of Expertise

Business Units

Center of Expertise

Provide deep, specialized financial expertise

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High Performance Product Costing

As discussed, product costing and inventory accounting is an end-to-end, enterprise-wide process. By implementing this capability, management can regain predictability and control over profitable growth. Potential key dimensions for a high performance organization include:

Basic
Role/Focus/ Impact Focus on capturing product costrelated data only for high-level general ledger information.

Progressive
Product costing is used for partial evaluation of the supply chain. Supply chain is concerned with product costing data only to improve local operations at the tactical level, not to make strategic global supply chain decisions.

Pioneering
Product costing drive strategic supply chain decisions. Business performance target setting includes cost accounting targets, such as balanced reduction of variances. Product costing information is used for competitive pricing. Granular cost accounting processes are in place. Repetitive tasks are automated. Variance analysis processes are specialized by variance types and are executed by supply chain teams. Global supply chain decision support reporting processes are delivered to supply chain executives. A single product costing approach exists for all locations. ERP system with integrated master and transactional data. Automated real-time interfaces ensure that data flows from the material management and technical modules to the financial modules. Automated reporting eliminates the root causes of variances and allows for fact-based supply chain decisions.

Process

Cost accounting processes are limited Most cost accounting processes are in place, but no cost accounting to the finance department and focus on closing the books. process map exists. Limited to no variance analysis, and preventive processes are in place. Processes are executed when it is an absolute must, e.g., at month-end. Limited or no specialization in variance analysis processes. No preventative processes are in place. Most repetitive tasks are manually performed. Reporting processes deliver a great volume of details to all audiences.

Systems

Separate applications system for managing the general ledger, inventory of materials, master data and technical specifications, and production activities. Full product costing is completed manually and offline, using extracts from various applications.

Single enterprise resource planning (ERP) system used to carry out product cost planning, but only with many manual interventions and checks. Application allows for variance analysis but requires some manual data collection and enrichment. Application functionalities do not accommodate all product costing scenarios. Some product costing data is available, but does not reconcile with other master and transactional data. Product costing data is accurate only for the most frequently occurring business scenarios. Physical and book inventory units tie only at month-end.

Data

Product costing data is available only as a high-level estimate and does not allow for variance analysis. Supporting documentation, if available, is kept separately. Physical and book inventory units do not reconcile.

Product costing data is available for all materials and integrates with other master transactional data. Legal and management valuation is available. Product costing allows for concurrent valuation in several currencies. Physical and book inventories always reconcile real-time.

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Basic
Organization Product costing is a month-end accounting task, with no awareness of the relationships between variances and their root causes. No rewards structure in place for eliminating the root causes of variances. No controls are in place to prevent product costing data inconsistencies. There is no control to reduce variances.

Progressive
Cooperation between cost accounting and supply chain is sporadic and limited to issues that occur when processing is stopped. Variance awareness exists but no reward structure is in place to eliminate the root causes of variances. Some manual, retroactive controls are in place to check the consistency of limited product costing data. Only major variances are reduced; medium variances are ignored. Controls are typically triggered when required by issues. Reporting is focused on historical events. No preventive reporting. Reporting covers some supply chain areas but does not specialize and typically does not trigger action items. Profitability reporting is limited to a single dimension and product cost valuation.

Pioneering
Supply chain organizations collect and review financial performance data and are rewarded for their financial performance. The focus of cost accounting is on decision support, not manual retroactive data gathering and manipulation. Preventive controls exist to eliminate the possibility of product costing inconsistencies. Controls are triggered on a predefined schedule.

Controls

Reporting

Reporting is limited to balancing the financial books.

Preventative reporting to reduce product costing errors and variances. Multi-dimensional profitability reporting offers multiple valuation approaches.

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What Value can Accenture bring?

At Accenture we know that volatility and fluctuations in commodity and base material costs are serious business issues that require cost accounting capabilities to manage at an enterprise level. To help you achieve this, Accenture, through its experience brings deep and extensive cost accounting and inventory valuation capabilities and knowledge. We can help you avoid potential missteps by working with you to design and execute a plan to help transform your cost accounting capabilities, so you can make the right decisions to stay competitive. Our people know the cost accounting space and understand the enterprise implications. Their knowledge comes not only from their experience with Accentures broad range of global clients but also from the fact that many worked in industry before arriving at Accenture. Their broad experience with SAP-based solutions and our process excellence model can help you on your journey to enhancing predictability and control over potential profitable growth. Please call on us to discuss how we can do that for you at [email protected].

About Accenture Management Consulting, Finance & Performance Management

Accenture is a leading provider of management consulting services worldwide. Drawing on the extensive experience of its 13,000 management consultants globally, Accenture Management Consulting helps clients move from issue to outcome, with pace, certainty and strategic agility. We enable companies and governments to achieve high performance by combining broad and deep industry and functional offerings and capabilities across seven service lines: Customer Relationship Management, Finance & Performance Management, Process & Innovation Performance, Risk Management, Talent & Organization Performance, Strategy, and Supply Chain Management. Accenture Finance & Performance Management consulting services help finance organizations maximize the value they create for their enterprises. This document is intended for general informational purposes only, it does not take into account the readers specific circumstances, and may not reflect the most current developments. Accenture disclaims, to the fullest extent permitted by applicable law, any and all liability for the accuracy and completeness of the information in this document and for any acts or omissions made based on such information. Accenture does not provide legal, regulatory, audit, or tax advice. Readers are responsible for obtaining such advice from their own legal counsel or other licensed professionals. For more information, please contact: [email protected].

References
Can you profit in agricultural commodities? USA Today; May 20, 2011.
1 2 Loblaw

eyes food price inflation, looking for 'sweet spot' in its own pricing, The Canadian Press; July 21, 2011. Prices: High and Volatile; CFO.com; March 1, 2011. Companies Shrink Packages as Food Prices Rise; Daily Finance, April 4, 2011. Wheat Swap Roles as Prices Surge; The Wall Street Journal; August 9, 2011. to the Future: Will Rising Commodities Prices Create a New Inflation Generation? Knowledge@Wharton; April 13, 2011.

3 Commodity

4 US

5 Corn,

6 Back

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About the authors

Les Stone Senior director, Finance & Performance Management, New York. Les is a Certified Public Accountant specializing in financial business process improvement, finance and accounting operations, shared services and finance operations strategy. He has held senior finance roles with a Fortune 150 firm and has over 35 years of practice experience. With his extensive skills in the areas of strategic planning, transportation and logistics, information technology, and deep experience in manufacturing, distribution and retailing, Les guides global companies on their journey to high performance.

Doug Derrick Managing director, Management Consulting, Atlanta. Doug leads Accentures North American automotive, industrial equipment, infrastructure and transportation services management consulting practice. With extensive strategy, logistics, operations and dealer development experience and capabilities, Doug and his team help automotive, consumer packaged goods, retail, and health and life sciences clients address and deliver on the toughest management and performance issues on their journey to high performance.

George Marcotte Senior director, Accenture Analytics, London. George leads the Enterprise Analytics Offering Group in Europe, Africa and Latin America as well as the Enterprise Performance Management Strategy Group globally. Specializing in targeting and delivering value, George helps clients improve their productivity and elevate their business results on their journey to high performance.

Copyright 2011 Accenture All rights reserved. Accenture, its logo, and High Performance Delivered are trademarks of Accenture.

About Accenture
Accenture is a global management consulting, technology services and outsourcing company, with more than 223,000 people serving clients in more than 120 countries. Combining unparalleled experience, comprehensive capabilities across all industries and business functions, and extensive research on the worlds most successful companies, Accenture collaborates with clients to help them become high-performance businesses and governments. The company generated net revenues of US$21.6 billion for the fiscal year ended Aug. 31, 2010. Its home page is www.accenture.com.

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