Backflush Costing or backflush accounting is a product cost accounting approach that is very different from the traditional costing system. Under this system, the costing process is delayed until the final production of goods and services. Or, as the name suggests, this costing system flushes back the cost at the end of the production process. Or it records costs after the production process ends.
This system does away with the requirement of keeping work-in-process accounts and the manual assignment of costs at separate production stages. Companies that use just-in-time (JIT) inventory systems generally use this costing approach. This costing system is entirely automatic, where the computer handles all the things.
Backflush Costing – How it Works?
Once all the production process completes, this system records any direct material usage. Or, we can say when the production process uses raw materials and work in process inventory, this costing system does not create any journal entry to record these transactions. After the production process ends, backflush costing uses one main journal entry to record the entire inventory which was used in the production process.
For example, a producer estimates the standard cost of $10 per unit. The total number of units that the producer produces is 500 units. After the end of the production cycle, a journal entry of $5,000 will be made. The journal entry would be – Dr. Parts Expense $5,000 and Cr. Cash $5,000.
In any other costing system, several journal entries would have to be made, such as – Dr. Part A Expense and Cr. Cash; Dr. Part B Expense and Cr. Cash; Dr. Part C Expense and Cr. Cash; and more.
As no journal entries are not made initially or intermittently, the manager uses standard or normal costing later and works backward to assign a cost to the goods or services. This way, the costs are “flushed back” to the already completed production cycle.
Even though this system is fully automatic, there is a formula to assign the cost.
Number of raw material units used from inventory = Total Production * Listed Unit Count in the Bill of Materials for Each Component.
Backflush Costing – Process
- Once a company gets an order, it records only the essential information into the system, such as quantity, delivery date, and the item code. Based on this, the list of materials needed to complete the order is made.
- When the production is about to start, the company takes the delivery of the raw material and shifts it to the production floor.
- Now software does the routing of all the components for that production order. The cost manager still has a say on what parts and how much quantity to push in.
- After the end of the production process, the operator enters all information about the product into the computer. The software then prepares the production report.
- Based on that report, the operator, in a single transaction, assign materials cost to the production order.
How it Benefits?
Such a costing method is more useful for companies with complex products or where the production process involves several stages. With such companies, each stage of production would require several journal entries to track the cost accurately. It could result in hundreds of entries for one product, making accountants’ jobs very cumbersome.
Now, if such a company uses backflush costing, the accounts department will not have to post journal entries throughout the production process. Thus, we can say that this system simplifies the costing operation and accounting tasks without compromising too much on the information.
Other benefits of this system are:
- It makes it relatively easier to verify the materials used for production.
- Makes post-production issuance simpler.
- It makes it easier to track the inventory.
- When handling bulk materials, it keeps a check on the reverse issuance of materials.
Not Suitable For
Though the backflush costing system seems simple to implement, it is not suitable for all products and production processes. For instance, one should not use this system with a long manufacturing process or products that take too much time to produce. It is because the more time it takes, the more difficult it becomes to assign costs correctly.
Suppose a product takes a day to produce. One can easily assign costs to it. But what if it takes about a year to manufacture a product. It would get complicated to map and keep track of the cost correctly.
Similarly, such a costing method is not suitable for custom orders. It is because such orders would require separate invoices for each material that is used in the production of custom orders. Also, the backflush costing system is not suitable for companies with slow inventory turnover.
On the other hand, this system works best for products with short production times and the ones that use JIT (just-in-time) inventory systems. Usually, the companies that use this costing are those:
- That wants a simple accounting system.
- That is okay with assigning standard costs to every product.
- The inventory of the raw materials is either low or constant.
One big drawback of this costing system is that it is not in line with the GAAP (generally accepted accounting principles) and thus, makes it difficult to audit.
Since this costing system works backward to assign costs after the end of the production, it often assigns standard costs to the product. It could result in variance with the actual costs. Thus, in the real world, companies need to recognize these variances. For example, one can identify the variation by comparing the labor cost assigned to the production with the actual cash outflow for the labor expenses.
Other drawbacks of this costing system are:
- It is relatively difficult to implement.
- For the results to be accurate, this system needs an accurate production count. In the formula above, the finished goods count is one of the two inputs. So, if this number is wrong, then the resultant figure will not be accurate as well.
- Its success also depends on the accuracy of the bill of materials. A bill of material contains the list of all components and raw materials that a product will require. Thus, if there is a discrepancy in the bill of materials, the backflush costing will assign an incorrect amount of raw materials and components.
- Scrap reporting also needs to be accurate. Usually, there is a large amount of scrap in the production process. The bill of material does not account for this scrap. It is essential to remove these scraps from the inventory to get the right picture.
- Since this system does not record the work-in-process inventory, it needs a fast production cycle time. This costing system does not record inventory until the end of the production. So, during this timeframe, the records will remain incomplete. The only way to ensure records get updated quickly is to shorten or quicken the production cycle.
Backflush costing is an easy solution to the difficulties in assigning costs to the products, but its implementation is not that simple. Many companies, however, still use it because of its ease and other benefits.