The system calculates the average cost of the items which are manufactured in house based on the average cost of the component items which are used to produce it. Generally, the component items and quantities required to build a specific item are listed in the BOM (Bill of Materials) for the item.
The cost of each component is based on the current unit or average cost of the component item in the Inventory Master file at the time that it is transferred into Work In Process (WIP) or consumed by the Manufacturing process. For example, if a Bill of Materials is created for Item ABC (a Multimedia computer kit) and the kit contains the following components with the following unit costs, then item ABC should be costed at the total of the current component costs from the Inventory Master file.
BOM for Item ABC (Multimedia Computer Kit).
Qty Description (Unit cost - from Inventory Master File)
1 Sound Card with CD interface 45.00
1 4X CDROM drive 95.00
2 PC Speakers @7.5 ea 15.00
1 Set of CDROM software 100.00
Total cost for item ABC $255.00
Since a material conversion transaction simply represents the conversion of component items to top level and vice versa, the system should be able to just add up the component costs and use this for the top level item. The same logic should also work in reverse when top level items are disassembled (the top level part should be removed from inventory at current cost and the components returned to inventory at current cost). Unfortunately, several factors complicate this scenario. These factors are:
• Changes to component costs when top level items have on hand quantity. Component costs can and do change over time, and the current costs of the components included in a top level item may not add up or equal the cost of the top level item which was calculated when it was built. This factor can have a substantial financial impact when built or manufactured items are stocked (kept in inventory) while changes occur to the costs of the components that they are made up of. For example, if we build one item ABC when component costs are equal to above example, the system correctly calculates the top level cost at $255.00. If this top level item is built and is put into stock, and the cost of the CDROM drive in inventory later decreases to 85.00, then the next time we build the item ABC it should be costed at $245.00. If the first item ABC that was built is also in stock at the time that the second item is processed, then it is also necessary to average the quantity and cost of the new item ABC (1 @ 245.00) in with the quantity and cost of the first item ABC (1 @ 255.00) to get a new average cost for the total quantity of item ABC in inventory (2 @ 250.00). This allows the two identical items to be sold at the same margin and price (preferable since the items are identical). If the costs are not averaged together then the first item would show an inflated cost and the second item would show a cost below the actual cost to produce the item (the average cost is assumed to be the most accurate number to use when calculating margins and profit in this example). This example illustrates why a positive Materials Conversion transaction (a build) requires the system to recalculate the cost of the top level item based on current component costs. It also illustrates why the new quantity and cost of the item should be averaged into inventory. This allows the items to be treated as identical (which they are) and it also provides the sales force with the most accurate cost which can be calculated for the item.
• Fundamental differences in the costing logic for items being built vs. items which are being disassembled. Building an item is substantially different from a costing standpoint than exploding or disassembling it. In the last example, the logic for updating the top level item each time it is built is fairly straightforward. Recalculating the cost of the top level item each time it is built, and averaging the new cost into inventory keeps the cost of the item current and it prevents variations in average cost for identical inventory items. If an item is being disassembled, the logic is a bit different. Since we are merely converting the top level item back into components there is no basis for averaging the cost of the top level item (it should already be correct as of the last time the item was built). The goal on a disassembly transaction is merely to deduct the top level item from inventory at current cost and to increment the component inventory levels (again at current cost). This result can be accomplished by rolling up the component costs and quantities, updating the top level item with the total current cost of the components and then just modifying the on hand quantities of the inventory items as appropriate. The top level inventory item cost is modified by the roll up process only if the costs of the components have changed. If there is a change to the top level cost, then this change is written to the top level inventory item record and recorded using Inventory Activity transaction records. These records store the previous cost and new cost of the top level part and the quantity on hand for the item when the change was made. This information can later be reported on to allow the appropriate journal entries to be made to the Inventory Control account (these are required to keep the inventory control account in balance with the Inventory sub ledger).
• Changes made to the Bill of Materials for the top level item during processing. The final and worst complication to costing materials conversion transactions is when modifications are made to the Bill of Materials being processed. If the BOM for a top level item is not static (it is changed on a regular basis), then the cost of the top level item cannot be current or accurate (as the components are changed each time the item is built). This can cause large fluctuations in the cost of the item and make the average cost information for the item useless for decision making purposes. This problem can be avoided when assembling items by using the Configuration option in the Shop Order system. The Configuration option in the order entry and shop floor programs allows the user to custom configure or modify a top level item by modifying the BOM which defines the item. This is useful when selling customized systems but it is dangerous when the top level item is kept in inventory.