In an engineer-to-order manufacturing environment, you iteratively design a product with your customer and then produce the product based on these newly developed specifications. These projects typically run over many financial periods. At the end of each period, you need to ensure that you correctly value the work in process, the cost of goods sold, and the project revenue on your financial statements.
Key Concept
Costs in an engineer-to-order manufacturing environment are captured using the Project System (PS) module, and reside on the profit and loss (P&L) statement. To correctly value the project at the end of each financial period, a results analysis (RA) process calculates the value of the project, based on the costs incurred and any revenue received from your customer.
In an engineer-to-order (ETO) manufacturing environment, a product is designed specifically for a customer, which is often an iterative process. After the engineering design has been signed off, the product is manufactured based on these specifications. These projects can last months or years, depending on the scope of the item that is being designed.
In my prior article, “Understand Your Project Costs in an Engineer-to-Order Manufacturing Environment,” which was posted to the Financials Expert knowledgebase in February 2014, I covered the postings made in the first period of a project, using the example of designing and producing an airplane. I assumed that the engineered product was not completed at period-end. These same postings are made in subsequent periods as well, because costs continue to be incurred on the project. For a summary of these processes, refer to the sidebar “Period Postings.”
The costs that are incurred throughout the period reside on the profit and loss (P&L) statement. As a result, at each period-end you must ensure that you correctly account for the work in process (WIP) and the cost of goods sold (COGS) of the project. In this article, I describe the calculations that are made in the Project System (PS) module, and the resulting entries in both the FI and Controlling (CO) modules at period-end.
To demonstrate the period-end postings at the end of each of the three accounting periods as part of the financial close, I assume the following:
- In period 1, costs are incurred on the project, but no revenue is received from the customer.
- In period 2, costs are incurred, and the customer is invoiced based on a project milestone.
- In period 3, costs are incurred, the product is completed and delivered to the customer, and final invoicing of the customer takes place.
Example Engineer-to-Order Scenario
In this example scenario, the design and production of an airplane began in the first accounting period. The controlling objects that are used in the production process (Figure 1) include:
- Project: Three work breakdown structure (WBS) elements are used to structure the phases of the project. One of these WBS elements is designated as a billing element, which captures revenue from the customer invoices. The other two WBS elements are accounting elements, which capture costs. In this example, a network, which can be thought of as a complex production order, is used to manage the resources and the work on the project, and therefore captures all costs associated with the resources used throughout the duration of the project.
- Engineering and production cost centers: One engineering cost center is used to capture the direct costs associated with the design of the product, and one production cost center is used to capture the direct costs associated with the manufacturing of the product, including the direct labor and machine costs.
- Overhead cost centers: Four overhead cost centers are used to capture indirect costs associated with the ETO process, such as costs related to support departments and central services.
The letters in Figure 1 show the postings that are made during each of the three accounting periods. I describe in detail the steps labeled in black, which are the period-end postings. For a detailed description of the steps labeled in blue, which occur throughout a period, see my prior article.
Figure 1
The steps in the engineer-to-order manufacturing process. The black-lettered labels show each step that takes place in the period-end process.
Note
The diagrams that I use in this article show the posting details, including:
- An excerpt of the diagram in Figure 1 to highlight individual steps being described in the overall process. Because of the volume of postings, I show representative T-accounts within the steps.
- Postings to the general ledger, both on the balance sheet and the P&L, and whether the P&L accounts have been created as primary cost elements.
- Postings using only secondary cost elements, which are reflected only in CO.
- Postings to the controlling objects, which are the cost centers and the project (both WBS elements and network activities) in this scenario.
References to the general ledger in this article are relevant to both the new SAP General Ledger and the classic General Ledger.
Cost Center Postings
In each accounting period, a series of period postings was made for the indirect and direct cost centers involved in the engineering and manufacturing process. For the period-end, overhead is collected in overhead cost centers and is applied to the project.
First, allocations are made from the service cost centers to the overhead cost centers, designated by postings A-2 in Figure 2. In this example, I use one service cost center representing utility costs, but there are usually many others. In this allocation, I use an even split between the receiving overhead cost centers. Alternately, the allocation can be based on other postings that have been made to the receiving cost centers.
Figure 2
The service cost center assesses costs to the overhead cost centers
I use an assessment, which uses secondary cost elements to move the costs into the overhead cost centers. This means that the costs on the P&L that were originally posted to the cost centers still reside in the original accounts. Using an assessment with secondary cost elements allows you to better trace the flow of costs between cost centers at period-end.
Overhead is then applied from the overhead cost centers to the project. In this example, the overhead is a percentage of the direct costs that have already been posted to the project (in this example to the network activities). Postings include overhead for machine time, labor time (including setup) as shown by postings F-3 in Figure 3, material, and administrative costs. The overhead postings from the manufacturing overhead cost centers to the project are also made using secondary cost elements.
Figure 3
Overhead is applied to the network from the overhead cost centers
Variances can be written off for the direct and indirect cost centers. The balance of the cost centers at period-end is rarely zero, due to over- or under-absorption of overhead for the indirect cost centers, and the over- or under-utilization of direct engineering and production resources for the direct engineering and manufacturing cost centers.
In this example, these variances are allocated to profitability analysis segments at the end of the month, using a cost center assessment, as shown by the R-postings in Figures 4 and 5. The assessment takes place only in CO, as shown in the summary postings in Figures 4 and 5, so no posting is made to the general ledger (G/L). Once these cost center variances reside in the profitability analysis (CO-PA) module, they can be allocated within CO-PA to products, product lines, customers, geography, or other combinations of dimensions (characteristics) that are tracked in the CO-PA operating concern.
Figure 4
A summary of all secondary cost element postings made for cost centers
Figure 5
A summary of all controlling object postings
If you are not using CO-PA, you can make a manual posting to clear the cost centers. This process is not shown in this example since the assessment already clears the cost centers.
Figures 4 and 5 summarize all period-end postings for the cost centers. Postings beginning with an A are the assessments, postings beginning with an F show the overhead application to the project, and postings beginning with an R show the CO-PA assessments.
Results Analysis Calculation
To correctly value the work in process of a project, a results analysis (RA) calculation takes place to determine its value. A project is typically open across many periods, so a financial close process is necessary to ensure that the revenues and costs that have been posted to the project are recognized correctly in the general ledger.
You can choose between two different types of RA:
- Revenue based: The system uses planned and actual revenues of the project to determine the associated cost of sales that should be posted. If the actual expenses incurred are higher than what should be recognized as the cost of goods sold (COGS), as is often the case in the early stages of a project, a posting is made to WIP for the difference.
- Percent of completion: The system determines the completion of the project by comparing the planned and actual costs of the project. The revenue that needs to be recognized on that basis is calculated based on the percentage of completion of the project. For projects in which there is a significant cost overrun, it may be the case that more revenue must be recognized than has been billed.
Because the manufacturing costs are tracked on the P&L statement in the SAP system, the balance of the manufacturing costs, and the COGS as related to posted revenue, are calculated to ensure that these costs are posted to the balance sheet. This movement ensures that the materials issued to the project, whether to a WBS element or to a network activity, remain in inventory and are not written off before production is complete. If the open project balance is positive, the P&L is credited, and the balance sheet is debited. If this balance is negative, the P&L is debited, and the balance sheet is credited. Even though manufacturing costs may be split between the WBS elements and network activities, the WBS element that is designated as the billing element and is referenced in the sales order is used as the controlling object for ETO month-end processing.
A project is considered open until its status has been manually set to technically complete (TECO). Because a direct goods receipt against the project is not required, a delivery status is not relevant, as described in the sidebar “Period Postings.” Additionally, a billing plan is used to spread out the invoices that are sent to the customer, and therefore, invoicing alone does not indicate when a project is complete. While the project remains open with a status of released (REL), the system calculates the costs incurred that should be posted to WIP, and the estimated COGS that should be posted based on the amount for which the customer has been invoiced. When the status of the project is TECO, all prior WIP is canceled.
Separate secondary cost elements, called RA cost elements, track the WIP and COGS amounts. These postings to the RA cost elements refer to the balances of the cost elements posted to the project at the end of each period. These RA amounts are not directly posted to the project, and they do not appear in standard project system reports. Different RA cost elements can be set up for different purposes.
The RA cost elements capture the following calculated information:
- Creation of the ETO product. These RA cost elements are categorized according to the original cost elements posted to the network and WBS elements, such as the material, labor, and overhead. They represent the current cost of material, as the product is being designed and produced, and capture the debits to the current WIP balance.
- Use of the ETO product. These RA cost elements are also categorized according to the original cost elements posted to the network and WBS elements, and represent the credits to the current WIP balance.
- Creation of reserves for the ETO product. These RA cost elements are again categorized according to the original cost elements posted to the network and WBS elements. They represent the current cost of the material that exceeds the calculated COGS and are used to calculate the credits to the current WIP balance based on expected losses.
- COGS. These RA cost elements contain the COGS data, which is the COGS value that is later posted to the G/L to represent the completed product. In this example, revenue-based RA is used, so the COGS is not calculated until revenue has been posted to the WBS element during billing. If the product is not complete, but revenue has been posted, the system calculates the percentage of the total expected revenue that was actually posted (actual revenue or planned revenue), and multiplies the planned cost by this percentage to obtain the estimated posted COGS value. Once final billing has taken place and the project is set to TECO, the COGS RA elements are updated with the actual postings for the revenue, the discounts, and the COGS of the product.
- RA cost elements for calculated values. These RA cost elements may be used to calculate the revenue that should have been posted, based on the cost to revenue ratio posted to the project. This calculation may be used to post revenue accruals to the balance sheet and to adjust the revenue that has actually been posted to reflect the calculated value that should have been posted. In this example, I am not posting calculated revenue to the G/L because my concentration is on matching the cost of sales with the revenues. Revenue accruals are most commonly used when using an earned value calculation for a project; such projects are usually resource intensive, which is often the case in service-oriented industries or for projects that span a longer period of time than in this scenario.
This example covers three periods. By running the RA calculation, the only postings that are made are to the RA cost elements; a selection of these RA cost elements is shown in Figure 6. No postings are made to the project or to general ledger accounts when the RA calculation is run. The financial posting takes place during project settlement.
Figure 6
RA cost elements capture the valuation of the project in preparation for a posting to WIP
The postings to the RA cost elements are as follows:
- At the end of the first period, the project in this example was open. The customer was not invoiced, so no revenue was posted to the project, and only WIP was calculated (posting G-1 in Figure 6).
- At the end of the second period, additional costs were posted to the project, and the customer was invoiced, so there is also a revenue posting against the project, which is reflected in the RA cost elements. In addition to WIP, the COGS value is calculated in proportion to the posted revenue (posting G-1 in Figure 6).
At the end of the third period, the project was completed, so any work in process that was calculated in prior periods is reversed (posting G-2 in Figure 6).
Run Project Settlement to Post the WIP Value to the General Ledger
The previously described RA process updates secondary cost elements, but these values remain in the CO module. When project settlement is run at the end of each period, the RA values for WIP and the COGS are posted to the FI module, and the appropriate G/L accounts are updated. Although the RA process calculates additional values that could be posted, such as revenue and profit accruals, only the WIP and the cost of sales are posted to the G/L in this scenario.
The networks are settled to the WBS elements to which they are linked. The system automatically creates this settlement rule when the project structure is created using the sales order line item. Separate secondary cost elements that mirror the original cost elements are used for this settlement. After the project is technically complete, all lower-level WBS elements are settled to their higher-level billing element using the same secondary cost elements that were used during the network settlement. These settlement rules must be manually created. Before the final settlement, the billing WBS element must also have account assignment activated so that it can receive postings for the settled costs. Figure 7 shows a summary of the general ledger postings for customer revenue (postings Y) and during settlement (postings G).
Figure 7
A summary of the revenue, WIP and COGS postings made to the project
In ETO manufacturing, settlement is used to post values related to the project to CO-PA, as shown in Figure 5. Before the project is complete, the revenues and the estimated COGS are posted to CO-PA. After the project is technically complete, the remaining revenue and actual COGS (all costs involved in the manufacturing process) are posted to CO-PA. The COGS and the revenues are matched in CO-PA in cost-based profitability analysis, so there are no timing differences between the time that the cost of sales is posted to the G/L and the time it is posted to CO-PA. This settlement should occur at the billing WBS element level, as it includes all costs at lower levels of the project.
Keep in mind that in an ETO process, the product is unique to a customer. For this reason, a standard cost is not determined in the system, so there is no variance calculation or postings to variance accounts. All actual costs are the COGS. To manage the performance of such an ETO project, you need to analyze the difference between your planned and actual costs.
Period Postings
The postings that are made in each of the three accounting periods in this example assume that there is ongoing work on the project throughout three accounting periods. Additional costs are posted to the project, resulting in similar postings that were made in the first period, which were described in detail in my prior article.
The postings made throughout each period include both direct and indirect costs.
Cost Center Postings
Postings are made to cost centers that supply resources (both direct and indirect) to the project. Indirect costs are posted to general ledger accounts, as well as to administrative cost centers, using primary cost elements. These costs include utilities; rent; maintenance, repair, overhaul (MRO) materials; and support services. In addition, direct costs of both engineering and manufacturing resources, such as the salaries of engineers and production workers, are posted to general ledger accounts, as well as to the engineering and production cost centers, using primary cost elements.
Inventory Postings
Raw materials are issued from inventory to the project, which results in a posting both to the general ledger accounts, as well as to the project (specifically the network activities), using primary cost elements.
Activity Confirmations
The engineering and production cost center resources confirm the time spent on the network activities, such as direct labor and machine time. Each activity has a planned rate. The postings to the network activities are made using secondary cost elements.
Invoice Postings
In an ETO scenario, it is unlikely that invoicing is delayed until a complete delivery has taken place, especially if the engineering and manufacturing process takes months or years. In this scenario, I assume that particular network activities are associated with billing milestones. When each network activity is confirmed, the customer is invoiced. The revenue postings are made using primary cost elements to capture the revenue and any applicable sales discounts.
Optional: Goods Receipt into Inventory and Delivery to the Customer
It is possible to process a goods receipt into inventory; for example, when a portion of a number of airplanes ordered by the customer are completed. This is an optional step because billing milestones drive the invoice process, not the inventory postings. The finished products are placed into sales order stock, which are reserved for the customer who placed the order. No accounting entry takes place at this time, and all costs incurred on the project remain on the P&L.
The delivery, or a goods issue out of sales order stock, is also an optional step, which should be carried out only if a goods receipt into inventory was previously processed in the system for the network. Because the product was not received into inventory, it is not taken out of inventory; so again, no accounting entries take place at this time in this example.
The goods receipt and delivery are not shown here.
Birgit Starmanns
Birgit Starmanns is a senior director in solution marketing at SAP for EPM (Enterprise Performance Management) and Finance solutions. Birgit has more than 20 years of experience across solution marketing, solution management, strategic customer communities, and consulting. Her functional experience is in finance, including core SAP ERP and enterprise performance management, as well as customer relationship management, which has allowed her to focus on the integration of cross-functional business processes. Prior to joining SAP, she was a principal in management consulting organizations, redesigning business processes and implementing SAP R/3 and R/2 for numerous Fortune 500 and SME companies, with a focus on management accounting. Birgit holds a BA and an MBA from the College of William and Mary.
You may contact the author at birgit.starmanns@sap.com.
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