BACKFLUSH COSTING

BACKFLUSH COSTING Definition of Backflush Costing : A streamlined cost accounting method that speeds up, simplifies, and reduces accounting effort in an environment that minimizes inventory balances, requires few allocations, uses standard costs, and has minimal variances from standard Product costing approach, used in a just - intime (jit) operating environment, in which costing is delayed until goods are finished. Standard costs are then flushed backward through the system to assign costs to products. The result is that detailed tracking of costs is eliminated. The system is best suited to companies that maintain low inventories because costs then flow directly to cost of goods sold. Work-in-process is usually eliminated, journal entries to inventory accounts may be delayed until the time of product completion or even the time of sale, and standard costs are used to assign costs to units when journal entries are made, that is, to flush costs backward to the points at which inventories remain.

Characteristics Of Companies Adopting Backflush Costing : The companies adopting backflush costing often meet the following three conditions : 1. Management wants a simple accounting system and no detailed tracking of direct material and direct labour through a series of operations is required. 2. Each product has a set of standard cost. 3. Material inventory levels are either low or constant. If inventories are low, the bulk of manufacturing costs will flow into costs of goods sold and it is not deferred as inventory cost. Backflush costing is especially attractive in companies that have low inventories resulting from JIT.

What are the advantages of Backflush Costing : 1. Less entries have to be passed so it saves time. (major benefit) 2. Less costly as less documentation have to be maintained. 3. It uses JIT environment which saves holding cost of inventory

What are the disadvantages of Backflush Accounting : 1. One of the main disadvantages of the system is that it only works under some quite strict requirements. If these are not met, the system will become unbalanced and may be quite unusable, or a nightmare to maintain: 2. Standard costs must be reliably estimated and variances kept to a minimum The premise of the system is that a sale triggers the manufacturing process, therefore Buildup of work in progress or finished goods needs to be avoided 3. Another drawback is that detailed information for management purposes may not be available where needed, and the production control therefore need to be all the stronger. 4. The cost accounts used in back-flush accounting may be more difficult to reconcile to financial accounts needed for reporting

Uses of backflush costing in Cost Accounting : 1. Backflush costing is defined as a streamlined cost accounting method that speeds up, simplifies, and reduces accounting effort in an environment that minimizes inventory balances, requires few allocations, uses standard costs, and has minimal variances from standard. Therefore there is a delay in the costing process until the production of goods or services is completed. Under this costing method records purchases of raw material and accumulates actual conversion costs. At a predetermined trigger point such as at the completion of production or on the sale of goods, an entry is made to allocate the total costs incurred to cost of goods sold and to finished goods inventory using standard production costs. 2. The Backflush costing is a method of costing a product that works backwards i.e. the standard costs is allocated to finished products on the basis of the output of a repetitive manufacturing process. Used where inventory is kept at minimum. This method necessitates the need for detailed cost tracking required in absorption costing, and usually eliminates separate accounting for work-in-process. It is also known as Backflush accounting. 3. The Backflush costing as a method is concerned or associated with a justin-time or JIT operation. The main goal is to keep the inventory of raw materials low. Therefore the orders for raw materials are scheduled so that the goods arrive just before the production commences. By the time

materials invoices are received, the goods are produced, costs are calculated, and the products are sold at a rate that covers the expenses. All the recordings in the company’s accounting books are made at that point and the books are kept balanced and factual without making multiple postings all through the production process. 4. There are two drawbacks of this costing method. The Backflush costing is a concept that is not widely considered to be in compliance with generally accepted accounting principles. It also lacks the sequential audit trail.

Example of Backflush Cost Accounting : The following example will be used to illustrate the first two variant outlined above. The manufacturing cost information for March for a division of XYZ plc is as follows : Cost incurred in March Purchase of raw materials Labour Overheads Activity in March

£’000 4,250 2,800 1,640 Units (‘000)

Finished goods manufactured during the period Sales 145 Standard cost per unit Materials Labour Overhead

180

£ 20 15 9  44

There were no opening stocks of raw materials, WIP or finished goods. It should be assumed that there are no direct materials variance for the period. Variant 1 : The double entry would be as followsDr. £’000 1. RIP account Creditor

Cr. £’000

4,250 4,250

2. CC account Cash Cash/ creditor

4,440

3. FG account (180 X 44) RIP account (180 X 20 ) CC account (180 X 24 )

7,920

2,800 1,640 3,600 4,320

4. COGS (145 X 44 ) 6,320 FG account The ledger would appear as follows

6,380

Raw and in process materials  £’000 £’000 Creditor

4,250

FG Bal c/d

 4,250  Bal b/d

3,600 650  4,250 

650

Conversion costs  £’000 £’000 Cash/creditor

4,440

FG Bal c/d

 4,440 

4,320 120 - 4,440 

Bal b/d

120 Finished goods  £’000 £’000 RIP

3,600

CC

4,320 

COGS Bal c/d

6,380 1,540 

7,920  Bal b/d

7,920 

1,540

Cost of goods sold  £’000 £’000 FG

6,380

The stock balances at the end of March would be £’000 650 1,540  2,190  The balance on the conversion cost account would be carried forward and written off at the end of the year. Raw and in process materials Finished goods

Variant 2 : The accounting entries where there is only one trigger point completion of units) would be simpler. DR CR £’000 £’000 1. CC account Cash Cash/creditors

4,440

2. FG account (180 X 44 ) Creditors (180 X 20 ) CC account (180 X 24 )

7,920

3. COGS FG account

6,380

(on

2,800 1,640

3,600 4,320

6,380

This variant is thus only suitable for JIT system with minimal raw materials stocks.

Another Example of Backflush Cost Accounting : The manufacturing cost information for March Purchase of raw material = $4,250 Labour = $2,800 Overhead = $1,640 Finished good manufactured = 180 units Sales units = 145 units Standard cost per unit Direct material = $20 Direct labour = $15 Overhead = $9 Assume that there were no opening stock of all types and no material variances arise during March Answer : 1. Dr. conversion cost $4,440 Cr. Creditor $4,440 2. Dr. Raw & in progress $4,250 Cr. Creditor $4,250 3. Dr. Finished goods $7,920 Cr. Creditor (180 x $20) $3,600 Cr. Conversion cost $4,440 4. Dr. Cost of sales (145 x $44) $6,380 Cr. Finished goods $6,380 Notes : 1) Closing stocks at month end = $1,540 2) Conversion cost = Direct labour + Overhead 3) Conversion cost are not applied to output until they are completed or even sold. 4) All stocks are valued at standard costs. 5) Double entry is unlikely to be examined in this paper, the emphasis is on explanation and discussion.