Manufacturing has always been a bit more of a challenge than other aspects of implementing ERP systems. There are many, many variables and specifics that need to be thought through thoroughly before deciding which approach and setup is best suited for any particular company.
Over the several decades I have been working in manufacturing projects, there are always a few traps that people fall for during implementations. Although there are countless areas where vigilance is recommended, I am highlighting the top 4 mistakes that I see most often. Most of them are subtle, but a couple seem obvious. Here they are:
- Machine time and labor time
- Run units / machine units and lot sizes
- Backflushing delays with material
- Average costing vs standard costing
Doubling up machine time and labor time on BOMs
While setting up routing operations on Bills Of Material (BOM), most systems will allow entry for machine units and machine time in addition to the standard setup, run units, and run time. In over 50% of the implementations with which I have been involved, I see these set up incorrectly, most often due to improper training or being in a hurry to get the BOMs setup.
But missing this step will often create a rolled-up cost that is inaccurate, oftentimes by a large margin. Take for example, a situation where labor is applied to setup the machines to run the process without the need for labor, since the machines run on their own in this case. More often than not, when I review the BOM I’ll see setup time, run units, run time, machine units, and machine time all populated with a number. But since the machine will run on its own after setup, no labor is involved. The BOM, however, shows run units and run time. This inflates the cost of the operation and the BOM because it is rolling up labor costs that are not being used.
Accepting the default lot size of 1
Most ERP systems will default the lot size on a BOM to 1, assuming that the user will change the lot size according to their specific situation and process. Unfortunately, this can be very misleading. The default lot size on a BOM should be the most economic run units for a specific processing task, taking into account the setup time involved in the run.
For example, assume the setup for machine run of 1,000 units takes 8 hours to set up before the process can be executed, and the labor per hour rate is $60 ($480). Further assume that all other costs going into the run (material, labor, overhead, etc.) amount to $10 per unit. With a lot size of 1, the full setup cost of $480 plus the additional costs of $10 make the cost per unit $490. If the lot size is 1,000 instead, the unit cost is spread over the total units in the run or $0.48 each, bringing the total cost per unit for the 1,000 unit run to $10.48 – quite a large difference.
Inventory inaccuracies due to backflushing
Using backflushing to record material and labor for production has many advantages. For instance, material and labor can be recorded as each operation is done in just one transaction, reducing the time it takes in labor hours to enter transactions. But it has its drawbacks too.
One of the traps that companies fall into when using the backflushing technique is that they forget about timing. If a production order is created and completed in one day or a few hours, then the impact is minimal. For example, say a production order is created and backflushing will be used, and the whole production run will take approximately 2 hours. The material is physically taken out of inventory at the beginning of production, but it is issued to the production order using backflushing two hours later. The discrepancy of what is physically in inventory and what the system says only last for two hours in our example.
But now let’s take that to a magnitude of time later. Assume same scenario as above, but now the process take a full two weeks, not two hours. It is easy to see that physical material will be issued when the order process calls for it. But if one operation takes a week, then there will be a discrepancy for close to a week because the backflushing is often done when all items on the production order operation are completed. Multiply this by hundreds or even thousands of component material items, subassemblies, etc. and the inventory can easily be off by a good 10% to even 25% in some cases.
Average Cost Valuation Vs Standard Cost Valuation
Most manufacturing companies in my experience rely on either standard cost valuation throughout the system or standard cost valuation for at least finished goods. This is a rather simple approach that easily controls the cost of production, overhead, and other costs related to the production of an item. It provides a solid foundation for cost-plus pricing and works very well when the prices of component items and outside processing remain fairly stable. When done properly, the costs are re-evaluated at least annually, and often quarterly.
But there is also a good argument to use average costs to smooth out fluctuations in component costs. Average cost valuation becomes very stable after the first 10 to 20 purchases for each component, and from then on, the costs usually remain very stable.
But there is a hidden issue when using average cost valuation for component parts on the creation of BOMs. For most of the systems I have worked with, when a component part is added to the BOM, the user enters the cost at the time. But when the cost is rolled up on the BOM as a preview, the BOM will take the average cost of the items at that moment. If the cost has changed in the meantime, the average cost will be used and not the cost on the BOM. The difference gets booked to the variance account.
It is totally acceptable to use average cost valuation on component parts, but it is important to know what is happening so that variances can easily be reconciled. An average cost valuation does have a distinct advantage compared to standard costs because there is no need to adjust costs and rollup standards on a periodic basis.
The main takeaway is that manufacturing can become complex during implementations or when learning a new system but knowing where to look and what to look for can save a lot of grief in the long run. I hope this information will help you accomplish this. If there is anything I missed or something you want to discuss further,
drop us a line!
