The purpose of this post is to discuss why someone would want to use Average Invoice costing in a perpetual accounting or ERP system. This question bothered me for many years, and a recent conversation enlightened me. Therefore, I will take the time to share my thoughts with you. If you have further insight into this topic or if you disagree with a point, please take the time to share your thoughts. I very much appreciate the conversation.
Let’s start with some definitions:
- Perpetual Inventory Accounting – tracking the purchase and sale of inventory in near real-time
- Periodic Inventory Accounting – tracking the purchase and sale of inventory on a periodic basis. The most common period is your financial calendar period.
Many of the ERP installations I perform are in situations where the old warehouse management system (WMS) and old accounting system where not integrated. Therefore, the company periodically updates the accounting system with a snapshot from the WMS. There are many videos on youtube that illustrate how Average Invoice costing yields the most accurate inventory values for this scenario.
As a result, when these companies look to install an ERP system, the assume they will continue to use average invoice costing. I would, in-turn, recommend they go away from average invoice costing for the following reasons:
- ERP is a perpetual inventory accounting system. Therefore, the system will post every inventory transaction as they happen. There is no reason to use the average invoice. You lose the benefits of average costing accuracy arguments.
- When you use average invoicing, your inventory valuation will almost always be inaccurate. For example, Let’s assume you buy a bunch of products over time over different costs. Then, over time, you sell all product. The resulting inventory GL balance will almost always be non-zero. Therefore, you will have a phantom inventory balance.
- If your operations are even a little complex, the variances that result from average invoice costing can be difficult to track and explain.
The most common way to manage inventory costing in a perpetual system for wholesale distribution and manufacturing is with standard costing. Therefore, my recommendation was almost always to move to standard costing. Generally speaking, this advice is still true today for the following reasons:
- With standard costing, your material cost of goods sold (COGs) are predictable. This fact helps with many financial control scenarios including, invoice price variance, inventory value, manufacturing variances, etc…
- Ancillary costs, costs other than the product purchase cost (or cost at source), are automatically accrued when product is purchased. As duty, freight, brokerage and other costs arrive for a previous purchase, you simply code them to your accrual GL account.
- With standard costing, you have better control over how abnormal business events hit the GL. An example of an abnormal event includes when you need to ship inbound product via air-freight (expensive) to meet a customer deadline. The normal cost of ground freight is built into the costing of your product.
Back to the million dollar question: When, if ever, would you use average invoice costing in a perpetual accounting or ERP system?
The answer is: when your purchase cost is highly variable and you value the accuracy of your profit and loss (P/L) statement more than the accuracy of your balance sheet, you should consider average invoice costing. Said in a slightly different manner, choose average invoice costing when you value the accuracy of your gross profit more than the value of your inventory.
Let’s use gold trading as an example. The purchase price of gold can vary all over the place. When you use standard costing in ADempiere or iDempiere, the purchase price variances show up in a general ledger accrual account called invoice price variance (IPV). This situation is troubling because:
- Your accounting team is now left to defend the accuracy of your IPV account.
- Your COGs entries do not reflect the true cost of your product.
Therefore, you do not know how much profit you are really making. If you go with average invoice costing, your product shipment COGs entries should follow the variable cost of your product much more closely. Therefore, your profit and loss statements should be much more accurate. You will still deal with IPV variances; however, they should loosely track (and potentially defend) the variances in your gross profit.
If you would like to discuss this or other ERP accounting topics, please do not hesitate to contact me.
I hope this helps and thanks for reading!!! Please do not hesitate to share your thoughts, questions or concerns.
Why consider Open Source ERP
Open source ERP gives you every opportunity to prove or disprove its ability to support your company’s ERP needs on a timeline that satisfies your organizational needs. With open source ERP, you do not face the same financial constraints nor do you face the same conflicts of interest as with commercial ERP. Instead, you invest in the appropriate skills and knowledge for your people and processes. Best of all – if open source ERP cannot solve your company’s needs, you can safely justify spending the additional $2K to $5K per person per year for life of your commercial ERP to help drive your organization’s success.
ADempiere vs iDempiere vs Openbravo vs Compiere
The ADempiere, iDempiere, Openbravo and Compiere environments are amazingly similar. iDempiere came from ADempiere. ADempiere and Openbravo came from Compiere. Compiere came from Jorg Janke. Jorg came from Oracle. As a result, iDempiere and ADempiere have much in common with Oracle’s ERP in terms of the financial feature set.
This is both good and bad. Good because iDempiere and ADempiere are quite capable to help a company grow beyond $500M USD. Bad because they tend to be more complex in that they account for multiple languages, accounting schemas, currencies, calendars, costing types, costing methods, etc…. If you are a growing organization, and you need a system that will grow with you, and you have the right internal talent/resources, iDempiere or ADempiere will be a big asset for you.
The biggest difference between these products is that ADempiere and iDempiere are pure open source. ADempiere and iDempiere make all feature available for free. Compiere and Openbravo hold back features behind a commercial or paid license.
iDempiere and ADempiere vs OpenERP:
iDempiere/ADempiere (iD/AD) and OpenERP approach ERP from two very different directions. OpenERP comes out of the box with very simple options. If you are coming from QuickBooks, and you need a simple ERP system help you manage your business, OpenERP will look and feel comfortable.
iD/AD comes out of the box with every feature installed and configured to run a $200M+ USD business. If your business is growing rapidly, and you are willing to invest the time to learn an enterprise accounting system, then iD/AD will give you confidence.
Which one is best for you depends on your internal talent, growth and business complexity. Here is a post to help you learn more.
About Chuck Boecking: I am an ERP educator. I believe that open source ERP have achieved mainstream capabilities, and as a result, more companies can create greater efficiency across their organization. I started using the iDempiere code base in 2003. Back then, it was called Compiere. In 2006, I started my first multi-million dollar installation. Since then, ADempiere has helped me create great success with distribution and manufacturing companies all over the world. My vision of success is to find companies that can best use open source ERP to help them achieve a single, global instance that drives a discontinuous increase in profitability. I believe that organizations win when they own their technology.
If you have questions, comments or concerns, let me know. I definitely want your feedback.
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Thank you for taking the time. I look forward to speaking with you.