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Understanding Average Cost Variance

An Oracle White Paper

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ABSTRACT ========== Under average cost systems, the unit cost of an item is the average value of all receipts of that item to inventory, on a per unit basis. Each receipt of material to inventory updates the unit cost of the item received. Issues from inventory use the current average cost as the unit cost. By using Oracle Cost Management’s average costing method, inventory can be perpetually valued at an average cost, weighted by quantity (inventory cost = average unit cost * quantity). For purchased items, this is a weighted average of the actual procurement cost of an item. In an average cost environment, all items in inventory are valued at their procurement cost, i.e. PO cost. This valuation methodology results in a unit cost for each item, which is a weighted average of the purchase order unit costs for all quantity on hand. Average cost variances are generated if you issue additional material even though the inventory balances for that material is negative. Inventory balances can be driven negative if the Allow Negative Balances parameter is set in the Organization Parameters window in Oracle Inventory. If negative quantities are allowed, when a receipt (or transfer in) transaction occurs for an item with negative on–hand inventory, the transaction is valued at the current average unit cost or at the normal transaction cost. This behavior of Average Costing method has been explained by carrying out miscellaneous transactions of a buy item. 7 scenarios have been covered using various possible combinations of onhand quantity, transaction quantity, average cost and transaction cost. SCOPE ====== This paper has been authored keeping in view an audience familiar with Oracle Cost Management in general and Average Costing method in particular. An attempt has been made to explain the functionality of Cost Variance in Average Costing method when the onhand quantity of an item is driven negative along with the inventory valuation of the item. Later the onhand quantity of the same item is driven positive and the functionality explained. The functionality of Average Cost Variance has been explained in detail based on these scenarios.

Recalculation of unit cost

For the transactions listed below, the transaction unit cost may be different from the current unit cost for an item. After the transaction has been processed, the item’s unit cost will be automatically recalculated. As a result, at any point in time, inventory value will reflect a current, up-to-date unit cost.

• PO delivery to subinventory

• Return to vendor

• Transfer between organizations where the receiving organization uses average costing

• Miscellaneous and account receipts

• Miscellaneous and account issues

• Average cost update

• Assembly completion

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When a material transaction is performed under the current transaction processing engine, the Average Cost Processor recomputes the average cost. The distribution of the transactions is performed in a separate stage and is performed by the Distribution processor. To achieve this end the Distribution Processor uses the costs stored in the Material Transaction table, computed by the Average Cost processor. The Average Cost Processor recomputes the average cost based on several considerations. A discussion of the same follows. Once these costs are available, the Distribution processor generates debits and credits for appropriate accounts. The transaction cost (TC) can be provided by the user for some material transactions. If the transaction cost is not provided by the user then the Current Average Cost (CAC) is used as the transaction cost instead. The User can provide the transaction cost for all transactions, that can be performed through the Miscellaneous Transactions Form. This includes Miscellaneous Issues/Receipts, Account Issues/Receipts and Account alias Issues/Receipts.

The above behavior has been captured in the form of 7 scenarios and is presented in a sequential format. Before we take off with the scenarios, let us run through some important terminology, which has been used in this document to explain the behavior of Average Costing method.

These are as follows:

Current Onhand Quantity (COQ)

The total quantity of the item that is onhand currently in the Organization.

Transaction Quantity (TQ)

The quantity of a transaction. If a transaction causes an increase in the onhand quantity it is considered to be a positive number. The number is considered to be negative in sign if it results in a reduction in onhand quantity.

New Onhand Quantity (NOQ)

The quantity onhand immediately after the transaction is performed and has been saved. It is related to COQ and TQ by: NOQ = COQ + TQ;

Current Average Cost (CAC)

The weighted average cost per unit of an item in the system, maintained and updated by the system as needed after each transaction.

Transaction Cost (TC)

The cost per unit at which the transaction quantity is being valued. This may be user specified for some transactions. If unspecified, the CAC is used in its place.

New Average Cost (NAC)

The new average cost of an item after a transaction has been performed. It is a function of all the above quantities and values.

Average Cost Variance (ACV)

A variance account used to hold amounts generated when onhand inventory quantity is negative and the unit cost of a subsequent receipt is different from the current unit cost. Average Cost Variance is favorable (a credit) when the current average unit cost is greater than the PO unit

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cost for the aforementioned receipt transaction. The variance account also comes into the picture during an issue transaction when the Inventory Onhand Quantity is positive and Inventory Value is zero. In this case, the average cost variance account gets credited for the entire amount issued.

The behavior under Average Costing is presented with the help of miscellaneous transactions carried out for a buy item, ITEM. To start with, ITEM does not have any defined cost or unhand in the organization. Now, let us understand the way in which costs are computed by the system. Scenario 1: Let us create an unhand of 10 quantities and a unit cost of 30 for ITEM in the inventory organization by carrying out a miscellaneous receipt transaction for 10 quantities at a unit cost of 30. This transaction is represented by the following distributions:

Fig.1 Material Transaction Distributions 01-000-1410-0000-000 is the Material sub-element account of the Organization in which the material is being received. This transaction debits the material account. 01-580-7740-0000-000 is the miscellaneous account entered during the miscellaneous transaction. The transaction credits this account. The Unit Cost of ITEM as shown in the Item Costs form:

Fig. 2 Unit Cost of Item in Item Costs Form. Please note that, in this case the entire unit cost of the purchased item is represented by the cost of Material sub-element only. This case can be represented in the following manner: COQ>=0; TQ>0; NOQ>0; NAC = (COQ*CAC + TQ*TC)/(NOQ) = [(0*0)+(10*30)] / 10 = 30 As a result, the values are as follows:

COQ CAC TQ TC NOQ NAC 0 0 10 30 10 30

Table 1

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Scenario 2: Now let us issue a quantity of 5 at a unit cost of 40 by carrying out a miscellaneous issue transaction. This scenario can be represented as: COQ>0; TQ<0; NOQ>0; where

COQ CAC TQ TC NOQ 10 30 -5 40 5

Table 2 There are 2 sub cases satisfying these criteria. Let us deal with the first sub-case in this scenario, where ABS (TQ*TC)<ABS (COQ*CAC) i.e. 200 < 300. In this case Dr = abs (TQ*TC) = 200 Cr = abs (TQ*TC) = 200 The material distributions generated are as follows:

Fig.3 Material Transaction Distributions NAC = (COQ*CAC + TQ*TC)/(NOQ) = [(10*30)+(-5*40)] / 5 = 20 as shown in the Item Costs form:

Fig.4 Unit Cost of Item in Item Costs Form. The Item Cost History form displays all the transactions carried out for ITEM in descending chronological order.

Fig.5 Item Cost History The last line in the above screenshot displays the first transaction wherein 10 quantities were received at a unit cost of 30. The first line represents the next transaction where in 5 quantities

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were issued at a unit cost of 40 leading to a new / current onhand of 5 and a new / current average cost of 20. Hence, at the end of this scenario, NOQ and NAC are represented as follows:

NOQ NAC 5 20

Table 3 Scenario 3: This scenario represents a sub case of the criteria discussed above. COQ>0; TQ<0; NOQ>0; where

COQ CAC TQ TC NOQ 5 20 -3 50 2

Table 4 In this scenario, the inventory value is being driven negative as we are issuing quantities worth 150(3*50) from an inventory whose value for this item is 100(5*20). TQ<0 could potentially result in a situation of a negative resultant NAC if ABS (TQ*TC) > ABS (COQ*CAC) i.e. 150 > 100 If resultant NAC<0 then it is set to ‘0’ since negative costs cannot exist in the system. So when crediting inventory we have to ensure that there is no value left in Inventory. To ensure this: Dr = ABS (TQ*TC) = 150 Cr = (COQ*CAC) = 100 ACV = Abs (Cr) – Dr = -50 These Distributions are represented as follows:

Fig.6 Material Transaction Distributions

Fig.7 Material Transaction Distributions The Cost Variance account is defined using the following Navigation: Inventory Setup Organizations Parameters Other Accounts (T)

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Fig.8 Navigation for defining Cost Variance Account So, one more line is added to the item Cost History representing an issue of 3 numbers at a unit cost of 50 and a new cost of zero for the current onhand quantity of 2.

Fig.9 Item Cost History As discussed above, the unit cost of the item is shown as zero in the item costs form too.

Fig.10 Unit Cost of Item in Item Costs Form. So, the NOQ and NAC can be represented as follows:

NOQ NAC 2 0

Table 5 Scenario 4: In this scenario, we would discuss the impact on the unit cost when we drive the onhand negative. Please note that this scenario differs form the previous one where the inventory value was driven negative though the onhand remained positive. This scenario can be represented as: COQ>0; TQ<0; NOQ <= 0;

COQ CAC TQ TC NOQ 2 0 -4 20 -2

Table 6 This is an extension of the previous case. Since quantity is being driven negative, when the quantity is zero, we have to ensure that the value in inventory is also zero.

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Hence Dr = abs (TQ*TC) = 80 Cr = [(COQ*CAC)+abs (NOQ*TC)] = [(COQ*CAC)+abs (NOQ*NAC)] = 40 ACV = Abs (Cr) – Dr = -40 The same is represented by the Distributions created as follows:

Fig.11 Material Transaction Distributions In this case, NAC = TC; This transaction is represented in the Item Cost History by changing the new cost to 20, which is same as the transaction cost.

Fig.12 Item Cost History However, the same cost of 20 is not displayed in the Item Cost form as it picks up the cost from CST_ITEM_COSTS table where the item_cost column would still show as ‘0’.

Fig.13 Unit Cost of Item in Item Costs Form. As a result of this scenario, NOQ and NAC are as follows:

NOQ NAC -2 20

Table 7

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Scenario 5: In this scenario we would drive the onhand and thereby the inventory value more negative by issuing 2 numbers of ITEM at a unit cost of 30. Hence COQ<0; TQ<0; NOQ<0 where

COQ CAC TQ TC NOQ -2 20 -2 30 -4

Table 8 This is a mirror image of Scenario1. Hence, Dr = abs (TQ*TC) = 60 Cr = abs (TQ*TC) = 60 This is represented by the Material Distributions as follows:

Fig.14 Material Transaction Distributions In this case, NAC = (COQ*CAC + TQ*TC)/(NOQ) = [(-2*20)+(-2*30)] / (-4) = 25 The first line of the Item Cost History displays this cost as follows:

Fig.15 Item Cost History The Item Costs form continues to display a unit cost of ‘0’.

Fig.16 Unit Cost of Item in Item Costs Form.

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NOQ NAC -4 25

Table 9 Scenario 6: Now, we will receive quantities in such a way that the onhand of ITEM increases but still remains negative. This scenario can be represented as follows: COQ<0; TQ>0; NOQ<0 where

COQ CAC TQ TC NOQ -4 25 1 40 -3

Table 10 In this case we are driving quantity upwards from a negative number. This is a mirror image of Scenario 3 as far as the accounting implications are concerned. Dr = TQ*CAC = 25 Cr = TQ*TC = 40 ACV = Abs (Cr) – Dr = 15 The Distributions created are as follows:

Fig.17 Material Transaction Distributions Here NAC = CAC Item Cost History represents this new average cost as 25

Fig.18 Item Cost History

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The Item Costs form still displays a unit cost of ‘0’.

Fig.19 Unit Cost of Item in Item Costs Form. NOQ and NAC as a result of this scenario are:

NOQ NAC -3 25

Table 11 Scenario 7: In this last scenario, we will drive the onhand quantity upward so that it results in a positive value by receiving a quantity of 5 at a unit cost of 30 as represented by COQ<0; TQ>0; NOQ>=0 where

COQ CAC TQ TC NOQ -3 25 5 30 2

Table 12 This is an extension of the previous case and a mirror image of Case3. The following accounting entries are arrived at. Dr = ABS (COQ*CAC)+(NOQ*TC) = 135 Cr = TQ*TC = 150 ACV = Abs (Cr) – Dr = 15 These accounting entries are represented as follows:

Fig.20 Material Transaction Distributions

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Here NAC = TC. The first line of the Item Costs History form displays the new cost as 30 for a quantity of 2.

Fig.21 Item Cost History Now, the Item Costs form displays the new cost of 30 and not the earlier cost of ‘0’.

Fig.22 Unit Cost of Item in Item Costs Form. Hence it can be concluded that the Item Costs form displays the current average cost of an item when the current onhand of the item is positive. In order to know the average cost of an item when the onhand is driven negative, we would need to refer to the Item Cost History form. Thus, the final NOQ and NAC are as represented below:

NOQ NAC 2 30

Table 13 This NAC can be retrieved from the CST_ITEM_COSTS table using the following SQL query: Select MATERIAL_COST mat, MATERIAL_OVERHEAD_COST matovhd, RESOURCE_COST res, OUTSIDE_PROCESSING_COST osp, OVERHEAD_COST ovhd, ITEM_COST cst from CST_ITEM_COSTS where inventory_item_id = 11626 and cost_type_id=2 and organization_id=606;

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The output of the above query is:

MAT MATOVHD RES OSP OVHD CST 30 30

Table 14 As unit cost of ITEM is entirely represented by the Material sub-element, cost under Material (MAT) column is shown as 30, which is picked up by the Item Costs form. The following table summarizes all the 7 scenarios in a serial order:

S.No COQ CAC TQ TC NOQ NAC ACV 1 0 0 10 30 10 30 0 2 10 30 -5 40 5 20 0 3 5 20 -3 50 2 0 -50 4 2 0 -4 20 -2 20 -40 5 -2 20 -2 30 -4 25 0 6 -4 25 1 40 -3 25 15 7 -3 25 5 30 2 30 15

Table 15

Let us now look at the way in which 2 important tables get updated and thereby store the related information of the above transactions. MTL_MATERIAL_TRANSACTIONS The following SQL statement captures the required information: Select TRANSACTION_ID tranid, TRANSACTION_TYPE_ID typeid, TRANSACTION_ACTION_ID actid, TRANSACTION_SOURCE_TYPE_ID srcid, TRANSACTION_QUANTITY qty, VARIANCE_AMOUNT varamt, ACTUAL_COST actcst, PRIOR_COST pcst, NEW_COST newcst, PRIOR_COSTED_QUANTITY pcstqty from MTL_MATERIAL_TRANSACTIONS where inventory_item_id=11626 order by transaction_id; The output of the query is as follows: TRANID TYPEID ACTID SRCID QTY VARAMT ACTCST PCST NEWCST PCSTQTY

11377152 42 27 13 10 0 30 0 30 0 11377378 32 1 13 -5 0 40 30 20 10 11377539 32 1 13 -3 -50 50 20 0 5 11378135 32 1 13 -4 -40 20 0 20 2 11378287 32 1 13 -2 0 30 20 25 -2 11378365 42 27 13 1 15 40 25 25 -4 11378443 42 27 13 5 15 30 25 30 -3 Table 16

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A transaction_source_type_id of 13 represents inventory transactions. Transaction_type_ids of 42 and 32 represent miscellaneous receipt and miscellaneous issue transactions respectively. Similarly, transaction_action_ids of 27 and 1 represent actions of ‘Receipt into Stores’ and ‘Issue from Stores respectively. A close look at the transaction_quantity (QTY) column of the mtl_material_transactions table shows that the values in this column are same as the ones in the TQ column of Table 15. Similarly the TC, CAC and NAC columns of Table 15 contain data that is in tandem with the actual_cost (ACTCST), prior_cost (PCST) and new_cost (NEWCST) columns of the mtl_material_transactions table. The COQ column in Table 15 has data that is same as the one in Prior_costed_quantity (PCSTQTY) of mtl_material_transactions table. Variance_amount column (VARAMT) of mtl_material_transactions table is the column that stores the Actual Cost Variance (ACV) caused by each of the 7 transactions. MTL_CST_ACTUAL_COST_DETAILS This table stores actual cost, prior cost and new cost information for a transaction. This information obtained from the table is a subset of the information got from mtl_material_transactions table. This is another way of retrieving similar information from the table level. The SQL query used to get the information is as follows: Select TRANSACTION_ID tranid, ACTUAL_COST actcst, PRIOR_COST pcst, NEW_COST newcst, VARIANCE_AMOUNT varamt, TRANSACTION_ACTION_ID actid from MTL_CST_ACTUAL_COST_DETAILS where inventory_item_id=11626 order by transaction_id; The output of the above SQL is:

TRANID ACTCST PCST NEWCST VARAMT ACTID 11377152 30 0 30 0 27 11377378 40 30 20 0 1 11377539 50 20 0 -50 1 11378135 20 0 20 -40 1 11378287 30 20 25 0 1 11378365 40 25 25 15 27 11378443 30 25 30 15 27

Table 17 These column names carry the same meaning as the corresponding ones in the mtl_material_transactions table. Another table that can be used to retrieve similar information is MTL_CST_TXN_COST_DETAILS

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This concludes the discussion on the seven scenarios. Points that can be drawn in summary from the above:

• If the TQ > 0 then the Cr = TQ*TC always; The debit varies depending on the relative values/sign of COQ and NOQ.

• If the TQ < 0 then the Dr = TQ*TC always; The credit varies depending on the relative

values/sign of COQ and NOQ.

• The variance generated is always posted to the Average Cost Variance account for the organization.

ACKNOWLEDGEMENT =================== My heartfelt thanks to:

• Barry Kuntz for the prompt and valuable review in all aspects which helped making this document a complete one.

• Santhi Kaza and Nilesh Padwankar for their encouragement and constant support on this piece of work.

• Diane Davis for the comprehensive review and publication.

White Paper: Average Costing – Unit Cost Calculation Logic for Buy Items January 2004 Author: Dhannawada Sreenivasa Rao Contributing Authors: N/A Oracle Corporation World Headquarters 500 Oracle Parkway Redwood Shores, CA 94065 U.S.A. Worldwide Inquiries: Phone: +1.650.506.7000 Fax: +1.650.506.7200 www.oracle.com Oracle is a registered trademark of Oracle Corporation. Various product and service names referenced herein may be trademarks of Oracle Corporation. All other product and service names mentioned may be trademarks of their respective owners. Copyright © 2004 Oracle Corporation All rights reserved.

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