Unit 8: Activity Based Costing and Back-Flush

Introduction
This chapter explains that the principal purpose of any
costing system is to allocate the costs of production (direct
materials, direct labor, and manufacturing overhead) to the
units produced. The traditional costing systems are job order costing and
process costing. You should also be familiar with the other systems such as
the Activity Based Costing (ABC) and Just in Time (JIT) costing system.

Unit Learning Objectives

By the end of this unit, you should be able to:
 allocate manufacturing costs based on activity-based
costing (ABC); and
 simplify inventory costing by journalizing using
backflush costing.

Timing
Please allot four six (6) to complete the unit – three (3) hours
for reading and comprehension and three (3) hours for
answering the assessments.

8.1 ACTIVITY-BASED COSTING

Activity based costing (ABC) is a refinement of the traditional
costing system of allocating manufacturing overhead to the
units produced. Traditional costing systems always use volume-related
measures, such as direct labor hours or machine hours to allocate
overheads to products.

ABC allocates overhead costs to products on the basis of resources

consumed by each activity involved in the design, production, and
distribution of a particular product. This is accomplished by assigning
costs to cost pools that represent specific activities and allocating these
costs using the appropriate cost drivers to the product. Cost drivers are
those activities which have a direct cause and effect relationship to the
investment of a particular cost.
8.2 COMPARISON OF TRADITIONAL COSTING SYSTEM AND ABC
CPAR produces products two products: L and H. Both are produced
on the same equipment and use similar processes. Production data are as
follows:
Product L Product H
Machine hours per unit 2 2
Direct labor hours per unit 4 4
Units produced 1,000 10,000
Total machine hours 2,000 20,000
Total direct labor hours 4,000 40,000
Number of purchase orders 80 160
Number of Set-ups 40 60
The overhead cost of the activities is as follows:
Volume-related P110,000
Purchasing-related 120,000
Set-up related 210,000
Total Overhead P440,000

a. Traditional costing system:

Overhead rate per machine hour (P440,000/22,000 hours) P20 per DL

(P440,000/44,000 hours) P10 Cost per unit of:

Product L – based on machine hours (2 hrs x P20) P40
Product H – based on direct labor hours (4 hrs x P10) P40

b. ABC system

Volume-related Purchasing-related Set-up related

Overhead costs P110,000 P120,000 P210,000
Cost drivers 22,000 machine hrs 240 purchase orders 100 set-ups
Overhead cost
per unit of
consumption P5/machine hr. P500/per order P2,100 per set-ups

Allocated costs to products:

L P10,000(2,000xP5) P40,000(80xP500) P84,000(40xP2100)
H P100,000(20,000xP5) P80,000(160xP500) P126,000(60xP2100)

Overhead cost per unit:

Product L = P134 (P10,000+P40,000+84,000)/1,000 units
Product H = P30.60 (P100,000+P80,000+P126,000)/10,000 units
8.3 JUST IN TIME SYSTEMS

Just in time (JIT) manufacturing is a production systems in which

each component in a production line is produced immediately as needed
by the next step in the production line. The aim of JIT systems is to produce
the required items, of high quality, exactly at the time they are required. JIT
systems are characterized by:
 A move towards zero inventory
 Elimination of non-value added activities
 An emphasis on perfect quality ie, zero defects
 100% time deliveries
 Demand-pull manufacture

It is the latter characteristics which gives rise to the name of Just in

Time. Production only takes place when there is actual customer demand
for the product so JIT works on a pull-trough basis which means that
products are not made to go into stock. JIT systems result in reduction in
inventories so that inventory valuation becomes less relevant. Simplified
accounting procedures can be used for allocation costs between cost of
sales and inventories. This simplified procedure is known as backflush
costing. You should be familiar with the features and the accounting
procedures of backflush costing.

Illustrative Problem
The following data will be used to illustrate the three methods:

Materials purchase on credit for the period P195,000

Conversion costs for the period 120,000
Number of units manufactured 10,000 units
Number of finished units sold 9,900 units

The cost per unit is P31 (19 materials + P12 conversion costs). There are
no opening stocks and for simplicity it is assumed that there are no
variances. Using the backflush costing the journal entries under the three
methods are:
a. Purchase of Raw Materials
Raw in Process 195,000
Accounts Payable 195,000

b. Incur conversion costs

Conversion Costs 120,000
Various Accounts 120,000

c. Completion of finished goods

Finished Goods 310,000
Raw in Process RIP 190,000
Conversion Costs 120,000
(10,000 units x P31= P310,000)

d. Cost of goods sold

Cost of goods sold 306,900
Finished Goods 306,900
(9,900 units x P31 = P306,900)
 SELF-CHECK
Instructions: Read and solve the problem.
Stillwater manufacturing has a cycle time of less than a day, uses a
Raw and In Process (RIP) account and expenses all conversion costs to Cost
of Goods Sold. At the end of each month. All inventories are counted; their
conversion cost components are estimated and inventory account balances
are adjusted accordingly. Raw Materials is backflushed from RIP to
Finished Goods. The following information is for the month of August:
RIP beginning, including P6,900 of conversion Cost P42,600
FG beginning, including P17,000 of conversion cost 45,000
Raw Materials purchased on credit 356,000
RIP end, including P4,500 of conversion cost estimate 22,500
FG end, including P5,000 of conversion cost estimate 16,500

Required: Prepare all journal entries that involve the RIP account and/or
finished goods account.

ANSWERS:

1. Raw and In Process 356,000

Accounts Payable 356,000

2. Finished Goods 373,700

Raw and In Process 373,700
Raw materials purchased 356,000
RIP beg. (42,600 -6900) 35,700
RIP end (22,500-4500) (18,000)
Materials content of units completed 373,700

3. Cost of Goods Sold 390,700

Finished Goods 390,700
Mat. Content of units completed 373,700
FG beg. (45,000-17,000) 8,000
FG, end (16,000-5,000) (11,000)
Mat. Content of units sold 390,700

4. Cost of Goods sold 330,000

Payroll 150,000
FO Applied 180,000

5. Cost of Goods Sold 14,400

Raw and In Process 2,400
Finished Goods 12,000

Conversion cost RIP FG

End 4,500 5,000
Beg (6,900) (17,000)
Inc./Dec. (2400) (12,000)
UNIT SUMMARY
 Backflush costing is a product costing system generally
used in a just-in-time (JIT) inventory environment. In
short, it is an accounting method that records the costs
associated with producing a good or service only after
they are produced, completed, or sold.

 Activity-based costing (ABC) is a costing method that

identifies activities in an organization and assigns the
cost of each activity to all products and services
according to the actual consumption by each. This model
assigns more indirect costs (overhead) into direct costs
compared to conventional costing.