Understanding the cost of manufacturing a product is an important factor in many other business decisions, as these costs affect profitability and margin calculations. It is important to understand that the way product costs are captured is intertwined with the manufacturing strategy of a product. In a make-to-stock environment, for example, products are standardized and no options or variants are possible. For example, a computer CD drive is typically sold with no choices allowed — each drive that is manufactured is exactly the same and costs the same to produce. Alternatively, in a make-to-order environment, the customer may be given choices. A desktop computer may allow options such as upgrading the processor or hard drive, choices that influence the cost to manufacture a product because different components are required. To obtain accurate information about the cost of manufacturing a product, the product costing (CO-PC) module captures information from related processes within SAP ERP, including financials and logistics information from production, materials management, and sales and distribution. (Legacy systems can differ; see the sidebar "Differences Between SAP and US Legacy Systems.") I’ll focus on tracing each step in a manufacturing process and analyzing the postings that are made in both FI and CO. I’ll use a make-to-stock process as an example and cover the FI and CO postings made in one accounting period with the assumption that the product is not yet finished at the end of that period.

Make-to-Stock Example Scenario

To illustrate the product costing postings made, I’ll use a simple example of a music player (Figure 1). Each product is manufactured according to the same specifications. The bill of material (BOM) contains the components that are required to produce the music player. The routing contains the tasks, or steps, that must be performed to put the components together to complete the finished product, the number of hours required, and the cost — or activity rate — for each hour of each task. You then use these settings plus an overhead calculation to create a standard cost for the music player. The standard cost is used for inventory valuation. Costs incurred during production that are either above or below the standard cost are written off to the profit and loss (P&L) statement as variances when the product is completed and placed into inventory.   I will describe the postings made in the first accounting period, assuming that the production order is open (not completed) at the end of the period. I’ll analyze the following controlling objects (Figure 2):

• Production order: The production order is the primary cost collector for the costs associated with manufacturing the product
• Production cost center: One production cost center is used to capture the direct costs associated with production, including the direct labor and machine costs
• Overhead cost center: Four overhead cost centers are used to capture indirect costs associated with production, such as costs related to support departments and central services

For simplicity, I’ll leave Profitability Analysis (CO-PA) and Profit Center Accounting out of this example.  

Period Postings

The postings that are made in the first accounting period, assuming that the production order is open (not completed) at the end of the period, are:

• Postings are made to cost centers that supply resources (both direct and indirect) to the production order. The cost center structure in my example is one possible design and I’m using it because it includes commonly used allocations in a manufacturing company.
• Raw materials are issued from inventory to the production order
• The production cost center resources confirm activities to the production order

Post Expenses to Service and Administrative Cost Centers

Costs such as utilities, rent, maintenance, repair, and overhaul (MRO) materials, and support services are incurred in a plant throughout the period, regardless of whether the production line is running. These indirect costs are managed in cost centers. In the manufacturing process, they are ultimately treated as overhead. In my example, actual salaries are posted to a utility cost center at the beginning of the period, as shown in posting A-1 in Figure 3. These salaries are a direct cost for the utility cost center but are treated as indirect costs of the overall production process. The accounts payable (AP) account is credited on the balance sheet and debited to the P&L salary expense account, referencing the utilities cost center.  

Allocate Costs from Indirect Cost Centers to Manufacturing Overhead Cost Centers

Costs are allocated from the service and administrative cost centers to manufacturing overhead pools, which are also managed as cost centers. Typically, many service and administrative cost centers allocate their costs to these overhead pools. You can accomplish the allocation by direct activity postings or by using cost center assessments and distributions. In this example, the expenses incurred by the utilities cost center are evenly allocated to all manufacturing overhead pool cost centers, as shown in posting A-2 in Figure 3. Because the posting only moves the original salary expense between cost centers, no postings are made directly to the General Ledger accounts. Instead, secondary cost elements are used to track the allocations between the cost centers. (For more, refer to the sidebar “The Role of Cost Elements.”)

Post Expenses to Direct Production Cost Centers

The production cost center accumulates the direct costs associated with the production process. In this example, I’ll use one of these costs as an example — production line workers’ salaries that are directly posted to the production cost center. The production cost center supplies the direct resources (e.g., as labor and machine time) to the production order. The cost of these resources is typically calculated as an hourly rate. You can enter this rate manually or the system can calculate it based on the planned expenses and the planned number of available hours of the resources. In this example, actual salaries are posted to the production cost center at the beginning of the period, as shown in posting A-3 in Figure 3. These salaries are a direct cost for the production cost center, as well as for the overall production process. The AP account is credited on the balance sheet and is debited to the P&L salary expense account, referencing the production cost center.

Issue Raw Material from Inventory to the Production Order

Raw material is issued to the production order from inventory. The quantity of finished goods to be produced, together with the BOM used in the order, defines the quantity of raw materials that will be issued. You can manually update the raw materials to reflect actual usage. The BOM might also contain a semi-finished good or a sub-assembly as a component of the finished product. In this example, the raw materials are issued from inventory to the production order through a materials movement transaction; the financial entries are made automatically, as shown in posting B in Figure 4. The raw material is a direct cost for the production process. The raw materials inventory account is credited on the balance sheet and is debited to the P&L raw material consumption account, referencing the production order.  

Confirm Activities from the Production Cost Center to the Production Order

The production cost center supplies value-added resources (e.g., direct labor and machine time) to the production order. These resources are represented by system activities such as labor hours and machine hours. Each activity has a planned rate. The expected number of hours required to produce the finished product is based on the quantity of finished goods to be produced by the production order and the routing used in this order. You can manually update the number of hours that were used as each step of the production order is confirmed or completed in manufacturing, or you can update this through time entry in SAP ERP Human Capital Management (SAP ERP HCM) or SAP HR. In this example, the activities are confirmed as follows:

• The standard setup time is developed for a lot size, so it is spread over the entire quantity of finished products that are manufactured with the production order. If there are lot size fluctuations from the lot size used to develop the standard cost, the standard setup time still does not change. In this example, the setup hours are assumed to be labor hours.
• The labor and machine hours are developed on a per-unit basis, so the standard hours required for one unit are multiplied by the number of units produced in the production order

When the hours are confirmed on the production order, the financial entries are made automatically, as shown in postings C-1 to C-3 in Figure 5. Because this posting only moves the original salary expense from the production cost center to the production order, no postings are made directly to the General Ledger accounts. Instead, secondary cost elements track the allocations between the controlling objects and the production cost center is credited and the production order is debited.  

Month-End Postings

At the end of the first accounting period, the order is still open. A series of period-end postings are made to ensure that the production costs of the order, which are currently on the P&L, are appropriately recognized on the balance sheet as WIP. These postings are typically scheduled to take place in batch at the end of the period as part of the month-end closing process. Postings for the production order in this example are as follows:

• Overhead is applied from the manufacturing cost centers to the production order
• The WIP values are calculated for the production order
• A settlement is run to post the calculated WIP values to the General Ledger accounts

Apply Overhead from the Manufacturing Overhead Cost Centers to the Production Order

Applying overhead posts additional costs to the production order. The overhead can be a percentage of the direct costs that have already been posted to the production order during the period, as in this example. It is also possible to apply the overhead based on the quantity of material components that were issued to the production order. If this step is run multiple times during the same period, only the overhead difference from the previous run is applied to the production order. The costing sheet that is associated with the production order stores the rules for applying these overhead costs. In this example, separate manufacturing overhead cost centers and separate overhead rates are used for each type of overhead applied to the production order. These four manufacturing overhead pool cost centers collected the overhead costs in a prior step (in posting A-2):

• Material overhead: A manufacturing overhead cost center collects indirect costs related to materials, such as material handling or quality inspections. In this example, the overhead percentage rate is based on the cost of the material components that were issued to the order during the period.
• Machine overhead: A manufacturing overhead cost center collects indirect costs, such as maintenance or utility consumption, that are related to the machines on the production floor. In this example, the overhead percentage rate is based on the cost of the machine time that was confirmed for the production order during the period.
• Labor overhead: A manufacturing overhead cost center collects indirect costs (e.g., those for the human resources and accounting departments) that are related to production workers. In this example, the overhead percentage rate is based on the cost of the labor time that was confirmed for the production order during the period. Based on the assumptions in this scenario, this rate is used for both setup and normal labor time.
• Administrative overhead: A manufacturing overhead cost center also collects other indirect costs, such as facilities and administrative costs or depreciation. These costs cannot be directly associated with a specific direct cost in the production order. Instead, administrative overhead is related to all costs on the production order.

In this example, the overhead percentage rate is based on the costs posted to the production order throughout the period, as shown in postings F-1 to F-4 in Figure 6. These overhead postings are an indirect cost for the production order, as well as for the overall production process. Because the postings only move the original cost center expenses between controlling objects, no postings are made directly to General Ledger accounts. Instead, secondary cost elements track the allocations between the controlling objects. The manufacturing overhead cost centers are credited and the production order is debited.  

Calculate the WIP for the Production Order

If a production order is open, the balance of the order (all costs debited minus the standard cost of completed finished goods credited) is calculated by a period-end program and is considered the WIP amount. Separate cost elements, called results analysis (RA) cost elements, track the WIP amounts. These amounts are not directly posted to the production order. The valuated RA cost element contains the total amount of WIP on the order. Other RA cost elements contain the details of the types of costs that make up that WIP balance. When the WIP process is run, the WIP is calculated for production orders with a status of Released (REL). If a production order remains open for several periods, the WIP balance is recalculated for each period, and the adjustments are posted to the RA cost elements. In this example, the production order remains open at the end of the first accounting period. The WIP is calculated and the only postings made are to the RA cost elements, as shown in posting G-1 in Figure 7. No postings are made to the production order or to General Ledger accounts when the WIP calculation is run.  

Post the WIP to the General Ledger

Because the production order costs are tracked on the P&L statement, you need to move the balance of all open production orders to the balance sheet at period end. This movement ensures that the materials issued to the production order remain in inventory and are not written off before production is complete. In the previous WIP calculation, the RA cost elements were used to capture the value of the WIP. By running the month-end settlement process, these calculated WIP amounts are posted to General Ledger accounts. If the open production order balance is positive, the P&L WIP offset account is credited and the balance sheet WIP account is debited. If this balance is negative, the P&L WIP offset account is debited and the balance sheet WIP account is credited. No postings are made directly to the production order. When the system displays production order costs, the WIP postings to the RA cost elements and to the General Ledger accounts are not displayed. This impact is purely a financial transaction, which does not affect the normal production process or the order balances in a production order. As shown in the sample posting G-1 in Figure 8, a debit to the WIP inventory account is posted on the balance sheet. A credit is made to the WIP offset account on the P&L. This P&L account is not created as a cost element because no posting to a controlling cost object should be made and all costs remain on the production order for manufacturing analytics.  

Posting Cost Center Variances

The balance of the cost centers, including the manufacturing overhead cost centers that collect indirect costs and the production cost center that collects direct costs, is rarely zero. These variances result from the over- or under-absorption of the manufacturing overhead costs of the indirect cost centers and the over- or under-utilization of direct production resources. In this example, these variances are cleared by manually posting a financial entry, as shown in postings S-1 to S-5 in Figure 9. The costs in each cost center were under-absorbed. For each cost center, a credit is posted to a P&L cost center variance offset account that is also created as a primary cost element referencing the individual cost center. The debit, which writes off the variances, is posted to a P&L cost center variance account that is not created as a cost element. All variances of the overhead cost centers are posted to one account, while the variances of the production cost center are posted to a different account.   Figures 10 and 11 show a summary of all postings that were made to General Ledger accounts and to the controlling objects. The cost centers have all been cleared to zero. The production order still carries a balance because production on the finished product has not been completed. This balance was posted to the balance sheet as WIP, but this WIP posting is not reflected in the reporting on the production order to avoid any confusion for reporting of the manufacturing lines.