Backflush accounting Definition Backflush accounting is a cost accounting system which focuses on the output of an organization and then

works backwards to attributed costs to stock and cost of sales. This system records the transaction only at the termination of the production and sales cycle. The emphasis is to measure cost at the beginning and at the end with greater emphasis on the end or outputs. Since back flushing is usually employed in parallel with JIT, there is no work-in-progress to considered nor, does work –in-progress materially fluctuate. What is essential, however, is an accurate bill materials goods measures of yield generally effective production control and accurate engineering change notice when yields do change. The principle of a just-in-time system is that production is pulled by customer demand and this in turn pulls the purchasing procedures. Thus, theoretically there are zero stocks of raw materials. Work-inprogress and finished goods. For such a situation to exist there needs to be an excellent system of production planning ad communication with materials suppliers. The philosophy of traditional cost accounting methods Traditional cost accounting methods are based upon the principle that value is obtained by the creation of the assets known as stock. As a consequence this value must be measured and cost accumulation systems are used for this purpose. In modern JIT based production, stock does not exist and therefore such cost accumulation techniques are unnecessary. Instead costs are recognized at the point of sale rather tan at the point of production. The variants of Backflush accounting There are a number variants of the Backflush system, each differing as to the ‘trigger points’ at which costs are recognized within the cost accounts and thus associated with products. All variants, however, have the following common features : • the focus is on output – costs are first associated with output (measured as either sales or completed production ) and then allocated between stocks and costs of goods sold by working back.

Conversion costs (labour and overheads) are never attached to products until they are complete (or even sold ) – thus the traditional WIP account doesn’t exist. Materials are recognized at different points according to the variant used, but only to the extent of being either stock of raw materials or part of the cost of stock of finished goods. Again, materials are not attached to WIP. Two variants of the Backflush system are summarized below. Note that in each as conversion costs (labour and overheads) are incurred they will be recorded in a conversion cost (CC) account. Variant 1 This has tow trigger points (TP) : TP 1 TP 2 purchase of raw materials / components. A ‘raw and in process (RIP)’ account will be debited with the actual cost of materials purchased, and creditors credited.

completion of good units. The finished goods (FG) account will be debited with the standard cost of unit produced and the RIP and CC account will be credited with the standard cost. Under this variant, then, there will be two stock accounts : • raw materials (which may, in fact, be incorporated into WIP ) • finished goods Variant 2 This as only trigger point – the completion of good units. The FG account is debited with the standard cost of units produced, with corresponding credits to the CC account and the creditors account.

Thus the cost records exclude : • raw materials purchased but not yet used for complete production • the creditors for these materials (and any price variance ) and there is only stock account, carrying the standard cost of finished goods stock. Other variants include those using the sale of complete goods units as a trigger point for the attachment of conversion cost to unit -- thus there is no finished goods account, just a raw materials stock account, carrying the materials cost of raw materials, WIP and finished goods. It should be seen that as stock of raw materials, WIP and finished goods are decreased to minimal levels, as in a ‘pure’ JIT system, these variants will give the same basic results. Backflush accounting -- example 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 Finished goods manufactured during the period Sales Standard cost per unit Materials Labour Overhead £’000 4,250 2,800 1,640 Units (‘000) 180 145 £ 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 follows 1. RIP account Creditor 2. CC account Cash Cash/ creditor 3. FG account (180 X 44) RIP account (180 X 20 ) CC account (180 X 24 ) 4. COGS (145 X 44 ) FG account Dr. £’000 4,250 4,250 4,440 2,800 1,640 7,920 3,600 4,320 6,320 6,380 Cr. £’000

The ledger would appear as follows Raw and in process materials  £’000 £’000 Creditor 4,250  4,250  Bal b/d 650 FG Bal c/d 3,600 650  4,250 

Conversion costs  £’000 £’000 Cash/creditor 4,440  4,440  Bal b/d 120 FG Bal c/d 4,320 120 - 4,440 

Finished goods  £’000 £’000 RIP CC 3,600 4,320  7,920  1,540 COGS Bal c/d 6,380 1,540  7,920 

Bal b/d

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 (on completion of units) would be simpler. DR CR £’000 £’000 1. CC account Cash Cash/creditors 2. FG account (180 X 44 ) Creditors (180 X 20 ) CC account (180 X 24 ) 3. COGS FG account 4,440 2,800 1,640 7,920 3,600 4,320 6,380 6,380

This variant is thus only suitable for JIT system with minimal raw materials stocks. Suitability of Backflush accounting Both variance illustrated above eliminate the WIP account. If stocks are low in general a large proportion of manufacturing costs will be attributable to cost of goods sold. Te principle of Backflush costing is that in these circumstances, the work involved in tracking costs through WIP, COGS and FG is unlike to be benefit. As noted above, the stock and cost of goods sold values will be close to those derived from a conventional costing system, with a considerably reduced volume of recorded transactions. Another theory on Backflush Accounting Traditional cost accounting systems track the sequence of raw materials and components moving through the production systems, and as a consequence are called ‘sequential tracking system’ As JIT is an entirely different system it requires its own accounting system. The absence of stocks makes choice about stock valuation systems unnecessary and the rapid conversion of direct materials into cost of goods sold simplifies the cost accounting system. The approach is know as Backflush accounting. Backflush accounting delays the recording of costs until after the events have taken place, then standard costs are used to work backwards to ‘flush’ out the manufacturing costs. There are two events that trigger the records kept in most Backflush accounting systems. • The first is the purchase of raw materials. In a true JIT system where absolutely no raw materials stock is held even this trigger is not relevant and raw materials are ‘flushed’ when the second trigger is activated.

The second trigger is either the transfer of goods to finished goods stock or, in a true JIT system, the sale of goods. Two examples of possible Backflush accounting systems are given below. Table 1: System 1 A small stock of raw materials is held no finished goods stock. Dr. £ 1. Raw materials are purchased -- £3,200 Stock control Creditors control 2. Conversion costs are incurred -- £3,000 Conversion cost control 3,000 3,200 3,200 Cr. £

Individual a/cs. 3. Goods sold -- £6,000 worth at standard cost Cost of goods sold Stock control 4. Under or over allocation of conversion costs Conversion cost allocated Cost of goods sold Conversion costs control Figure 1 : Ledger accounts for system 1
Materials Stock control  1. 3,200 3. 2,900 Bal c/d 300 Cost of good sold  3. 6000 4. 100

3,000

6,000 6,000

3,100 100 3,000

Conversion cost allocated  4. 3,100 3. 3,100

Labour overhead

and

Conversion cost control  2. 3000 4. 3000

This is the system used by Toyota in its UK factory. In true Japanese it manipulates employees to behave in a certain way. Firstly employees must concentrate on achieving sales because cost of sales is the trigger— nothing gets recorded until the sales is made. Secondly there is no benefit in producing foods for stock. In traditional system which have a finished goods stock managers can increase in finished goods stock reduces the cost of sales in traditional financial accounts. The model just described may be to cope with in progress in the system by using a raw and in progress account (RIP) in place of the stock control account All other entries remain the same. Table 2 : System 2 No raw material stock is held but some finished goods is held. The figures are the same as for system 1, but the transfer to finished goods is assumed to be £6,000 and the cost of goods sold is £5,900 leaving a finished goods stock of £100. Dr. £ 1. Raw materials are purchased –no entry 2. Conversion costs are incurred -- £3,000 Conversion cost control Individual a/cs 3,000 3,000 Cr. £

3.

Finished goods units produced £6,000 Finished goods control Creditors control Conversion costs allocated 6,000 2,900 3,100 5,900 5,900 3,100 100 3,100

4. Finished goods sold -- £5,000 Cost of goods sold Finished goods control 5. Under or over allocation of conversion costs Conversion costs allocated Cost of goods sold Conversion costs control Figures 2 Ledger accounts for system 2
Finished goods stock control  3. 2,900 4. 5,900 3. 3,100 Bal c/d 100

Creditors’ control

Cost of goods sold  4. 5,900 5. 100

Conversion cost allocated  5. 300 3. 3,100

Conversion cost control  2. 3,000 5. 3000

The Backflush accounting model cannot be used by all organisation. It can only be used where a JIT type system is in operation. Where it is used it does have advantages. The traditional system is time consuming and expensive to operate, as it requires a considerable amount of documentation, such as materials requisitions and time sheets to support it in order to maintain the WIP records and job cards. If a company operates with low stock levels the benefits of operating the traditional costing system are few. By introducing a Backflush system a considerable amount of clerical time is saved. From the Backflush accounting examples it can be seen that JIT eliminates direct labour as cost category. Instead labour is treated as in indirect cost and is included in conversion cost with the overheads. This is because production is only required when demand requires it and so production labour will be paid regardless of activity. All indirect cost are treated as a fixed period expenses. With JIT failed or rework must be almost eliminated if the system is to work and so no accounts for this will exist in Backflush accounting whereas they are required in traditional systems. The Backflush accounting model does not conform to the accepted financial accounting procedures for external reporting in the UK. This is because work in progress is treated as an assets in the amount does. This can be countered by claming, quite rightly, immaterial. If only one tenth of one day’s production is held in work in progress then it is immaterial. It can also be claimed that it is immaterial if the work in

progress does not change from one period to the next as opening and closing stock will cancel each other out. Backflush accounting can be criticised because of the lack of information that it provides. Some argue quite rightly, that in reality it is impossible to eliminate all stock as a truck arriving with raw materials creates stock until it is moved to an used in production. If Backflush accounting is used in a system where a substantial amount of stock is held, a physical stock-take will be needed, because the system does not record the quantity of stock. Instead it is derived on paper by the difference between the standard cost of materials in the foods sold and the amount of materials purchased. This must be checked by a physical stock-take from time to time.

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