What is Backflush Costing?
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.
“Flushing” costs to the end of the production run eliminates the detailed tracking of expenses, such as raw material and labor costs, throughout the manufacturing process, which is a feature of traditional costing systems. Backflush costing is also commonly referred to as backflush accounting.
What Does Backflush Costing Mean?
Since journal entries were not made as inventory was used, accountants and must use standard or normal costing to work backward to assign costs to finished goods. In this sense, the costs associated with producing the products are “flushed back” in the cycle after the fact and assigned to the proper goods and categories.
This costing system is particularly useful for more complex products that require many different stages of manufacturing. Normally, each stage of manufacturing would require a separate journal entry to keep track of costs throughout the production process. This can add up to hundreds of entries for a single product. Now imagine if the company produces a couple hundred products. It adds up to a ton of bookkeeping that is somewhat unnecessary.
The backflush costing system eliminates unneeded journal entries throughout the process and simplifies the bookkeeping and administrative duties without losing too much detail or information. It does not however work well for all products or manufacturing systems.
Backflush Costing Example
For example, let’s assume that Company XYZ manufactures widgets. It has a variety of choices in how it handles obtaining and recording the costs of its raw materials and labor. For example, it could order a year’s worth of widget parts every January and warehouse them for use during the next 12 months of widget production. Or it could order widget parts once a month and warehouse them for use during each month’s production. Or it could order widget parts only after it gets an order from a retailer, which minimizes the costs that Company XYZ will have to incur to store widget parts.
This last idea is part of the just-in-time method of inventory management. By the time Company XYZ has to pay the invoices for those raw materials (say, 90 days), it will have already sold or at least finished producing the widgets and will thus have much more cash on hand to pay those invoices.
Accordingly, Company XYZ decides to use backflush accounting, whereby it records the raw materials, labor, and other costs in its cost of goods sold and its finished goods inventory accounts at a predetermined point in the production process (usually at the time of completion, sale, shipment to the customer, or similar). As a result, backflush accounting results in recording very little in a company’s Work in Process accounts.
When is Backflush Costing Used?
Backflush costing is generally used by companies that keep low levels of inventory and experience high turnover in inventory. It is because costs are still recorded relatively close to the day they are incurred. Companies with slow inventory turnover tend to record costs as they are incurred, as the product may remain unsold for a longer duration of time.
The backflush costing method works particularly well, where many different costs go into the production of a good. In such an instance, it can simplify the accounting process significantly. As a result, many manufacturing companies with complex production processes use backflush costing. However, companies that sell more customized products are less suited to a backflush costing method, as the unit cost will vary.
Backflushing is a theoretically elegant solution to the complexities of assigning costs to products and relieving inventory, but it is difficult to implement. Backflush accounting is subject to the following problems:
- Requires an accurate production count. The number of finished goods produced is the multiplier in the backflush equation, so an incorrect count will relieve an incorrect amount of components and raw materials from stock.
- Requires an accurate bill of materials. The bill of materials contains a complete itemization of the components and raw materials used to construct a product. If the items in the bill are inaccurate, the backflush equation will relieve an incorrect amount of components and raw materials from stock.
- Requires excellent scrap reporting. There will inevitably be unusual amounts of scrap or rework in a production process that are not anticipated in a bill of materials. If you do not separately delete these items from inventory, they will remain in the inventory records, since the backflush equation does not account for them.
- Requires a fast production cycle time. Backflushing does not remove items from inventory until after a product has been completed, so the inventory records will remain incomplete until such time as the backflushing occurs. Thus, a rapid production cycle time is the best way to keep this interval as short as possible. Under a backflushing system, there is no recorded amount of work-in-process inventory.
Advantages and Disadvantages of Backflush Costing
Backflush costing allows companies to easily assign costs to corresponding inventory. Only one journal entry needs to be made at the end of the production process to account for all costs designated to the product. Such a process saves companies time needed to record costs during the production process, which lowers accounting costs.
However, companies with slower inventory turnover often can’t use a backflush costing system, as the cost will be recorded too long after it was incurred. Such a costing method often doesn’t conform to GAAP, and therefore can’t always be used. Additionally, it can make a company more difficult to audit.
If an auditor is trying to determine all of the costs linked to a specific product, backflush costing will not be able to provide the information in enough detail. Companies that use the costing method will typically assign a standard cost to each unit of production. The standard cost can vary from reality and may need to be reconciled in future accounting entries.
Why Backflush Costing Matters
Backflush costing is a more streamlined method for accounting for the costs to produce goods and services. Companies can measure the true and complete costs of a particular production run because they record all of the costs at once, at the end of the process, rather than before, during, and after the production process. This hastens the entire accounting process considerably, but it comes at a price: Backflush accounting typically does not conform to generally accepted accounting principles and makes companies difficult to audit.
Because companies using backflush accounting essentially work backward by calculating the costs of products after they’re sold, finished, or shipped (rather than before and during the production process, which is the typical method and is called sequential tracking), they often assign “standard costs” to the units they produce. In the real world, companies that use backflush accounting eventually need to recognize the variances in standard costs and actual costs by, for example, comparing the amount of labor cost they assign to a production run with the actual payroll expense for that production run.
Backflush Costing vs. Conventional Costing
There are major differences in both the type of costing method. Under the conventional costing method, the entry for raw materials goes into the raw material inventory and then transferred to work in process inventory (WIP) and then to finished goods A/c. Under the backflush costing method, raw materials are ordered only when they are required, and they are accounted for. Under the conventional costing method, labor and overhead are charged direct into WIP; then, they are moved to sequential processing that is finished goods and later to the costs of goods sold. Whereas in the backflush costing method, these charges are directed into finished goods inventory or costs of goods sold.
- Simplified accounting process as only single journal entry needs to be made when the backflush costing method is used and that too at the end of the production process, which makes it an easier choice.
- It allows companies to easily assign costs to correspond to inventory.
It saves time for the companies to record each and every data during the production process, which in turn saves the accounting cost.
- It simplifies the bookkeeping process and administrative duties without losing much detailed information.
- It is not useful for companies with slow inventory turnover as the cost recorded will be too long after incurred.
- This method of accounting does not conform to the principles of GAAP and therefore is not ideal for use always.
- The standard cost used in this method may vary with time and thus do not provide accurate accounting entries in the future.
- It is not useful for the businesses of the customized product as it would require the creation of a unique bill for each product, making it a cumbersome process.
- Backflush costing is used by companies who generally have short production cycles, commoditized products, and a low or constant inventory.
- Backflush costing is an accounting method designed to record costs under specific conditions.
- Backflush accounting is another name for backflush costing.
- Backflush costing can be difficult to do and not every company meets the criteria to conduct backflush costing.