Legal Entity Design Considerations in Global Implementations

Reflecting on my experiences with global SAP implementations, I found a common thread: the majority of my clients had complex legal entity structures that took significant effort to design in an SAP system.

To gain competitive advantages in today’s global business environment, corporations often reorganize into legal entity structures that provide significant tax benefits. These structures frequently take advantage of legally owning assets, revenue, and expenses in different countries where tax rates are more advantageous. Accordingly, SAP company code design is driven by tax and legal requirements, including financial ownership of assets, employee expenses, and facilities.

Three common legal entity structures include contract manufacturing, toll manufacturing, and maquiladora. I outline the characteristics of each of these legal entity structures, how the SAP organizational structure is typically designed for each, and lessons learned from my field experience.

SAP Supporting Design

These legal entity structures are reflected in an SAP system by using one or more company codes to represent the contracted legal entities as separate from the parent company. If the contract is with an outside legal entity that is not owned by the parent company, that company code is not created in the SAP system and it is treated as an external supplier.

The following are key areas to consider in the SAP design:

Raw material inventory: In the case of a maquiladora or in a contract manufacturing model, the parent company typically provides the inventory of input materials. In these cases, input materials are extended both to the parent company codes (i.e., where the inventory is originally sourced from external vendors), and the contract company codes (i.e., where the inventory is imported). In a toll manufacturing model, the third-party sources the inventory, so it is only extended to the contract company code. It is important to ensure that raw material inventory is valued in the correct legal entity, and transferred between companies with the appropriate transfer price.

Lesson learned: In an SAP system, you can map a purchasing condition in your costing run to account for intercompany markup on stock transfer orders (STOs). A basic purchase information record (PIR) with just the material, plant, and vendor (i.e., sending plant) is required in order to cost the material in the receiving plant at cost plus markup.

Direct and indirect labor: Direct labor is typically owned and managed by the contracted company, and therefore is recorded on the contract company code, which may be the same or different than the manufacturing company code. Direct labor can be isolated in a separate contract company code in order to apply a markup to the contract production company code. Isolating direct labor within a distinct company code also provides the separation of cost ownership that may be required for tax-reporting purposes if labor is provided by a different company than the parent or production contract company. Also, an intercompany transaction will likely be required in order to charge the production company code for the direct labor recorded on the contracted company code.

Lesson learned: Separating direct and indirect labor as different cost elements is an ideal way to ensure visibility into these two components of cost.

Production/process orders: Within the SAP system, production orders or process orders represent the physical manufacturing that is occurring within a plant. Thus, production work centers should be created in the contract production company code to reflect the production that is tangibly occurring in that company. In the case of a maquiladora, production or process orders should be created in the contracted company code. In the case of contract manufacturing or toll manufacturing, production or process orders should be created in the third-party company code.

Activity rates: Production activity rates can be managed in the contract company code in its currency, or in the parent company code in its currency. Activity rates are maintained in the SAP system by work center and cost center.

Lesson learned: The SAP system allows you to assign a cost center to a work center in a different plant or company code: it simply provides a warning message to communicate the cross-plant or cross-company design. For instance, I have used activity rates in the currency (USD) of the parent company code for a contract production company code in another currency. However, consideration must be given to the fact that exchange rates will flow through production orders since the activity rates are established with the P (i.e., planning) exchange rate.

Plant equipment/assets: Production equipment can be managed as assets owned by the contract production company code. Under a maquiladora, production equipment can be provided by the parent company to the contract company under the same duty-free and tariff-free arrangement as production input materials.

Lesson learned: The contract company, rather than the parent company, is likely to provide plant maintenance, including labor and service parts. For this reason, maintenance work centers and activity rates are typically maintained in the contract company code to record the internal services provided for these assets.

The design of a maquiladora, toll manufacturing, and contract manufacturing legal entity structure is complex in terms of tax consequences, let alone in terms of SAP system design and configuration. Careful consideration is required to understand the tax and legal implications of the company code structure, inventory and fixed asset ownership, and expense recording. My experience has taught me to rely on experts in country-specific tax law to properly design the system to provide the required tax reporting. Each client I have served has used a different model, but the common design themes apply to almost any type of legal entity structure.