The folllowing sample essay on Backflush Costing Vs Traditional discusses it in detail, offering basic facts and pros and cons associated with it. To read the essay’s introduction, body and conclusion, scroll down.
With backflush accounting, costs are “flushed out” at the end of a process rather than being done sequentially through the process. Thus, no accounting entries are made during the process. Debits and credits are allocated appropriately after the process is complete. Thus, there are no complex work-in-process/work-in-progress (WIP) entries.
Backflush accounting is automated, with a computer handling all transactions. The backflush formula is:
In traditional accounting methods, there is a sequential tracking of goods through the entire process. Along with this tracking is a debit and credit at each stage. As the backflush system does the books at the end of the process, it is only appropriate in a just-in-time system whereby goods arrive at the facility only as required and are processed immediately.
The assumption is thus that there is no inventory at the start of the process.
Additionally, as products are used immediately the assumption is that there is no work-in-progress. This means that companies using this method must manufacture only products with relatively short through-put times as products which remain as WIPs for long periods of time would not be accounted for. Finally, it is assumed that there is no inventory at the end of the process. Since no inventory is being accounted at the beginning of the process, during or at the end, it must be assumed that there is no stock of finished goods.
Using the backflush accounting method has the inherent advantage of reducing time and cost which associated with complex cost allocation. As the costing is done once, simply at the end, as opposed to throughout the process, it’s done only once as opposed to traditional methods which would have costing continue throughout. The system results in fewer records/entries resulting in less opportunity for error.
This could be refuted as more entries could provide balances and checks. Nevertheless, the system is undoubtedly simpler as it has no WIPs. Furthermore, the adage that “inventory has no value until it is sold” holds true in this system. Although there is a dollar figure attached to raw material, WIPs and finished goods, the true value cannot be ascertained until sold. Raw materials and WIPs may not be easily sold if the company needed to liquidate. Attaching a true figure to damages or losses can be cumbersome and arbitrary until the end of the process. Even finished goods ready for sale may not yield the dollar value the company hopes. Thus, the only true “known” value is that affixed to a sold product.
Backflush accounting can only be used with a set and predictable process. The system cannot account for fluctuations in inventory or else it would be essential to go back and value it at different stage in the process. Prices and usage (or sales) must also be consistent. Any changes would require going back to adjust to true cost. As noted above, production must equal sales. Otherwise, there would be unaccounted for inventory in the form of finished goods. More pragmatically, the inventory would need to be accounted for in a way that this system doesn’t allow.
One of the most crucial disadvantages is that backflush accounting cannot be used for external reporting, except in very exceptional circumstances. The key fundamental reason for this is that inventory needs to be valued at the lower of cost and net realizable value in accordance with the conservatism principle. Backflush accounting doesn’t and can’t do this. Moreover, it’s crucial that companies using backflush accounting maintain rigid cost control. There is no way for this system to account for fluctuations. Clearly, maintaining such strict control is difficult to impossible for most companies.
Although they can enter into a contract with suppliers, there are still contingencies that may need to be accounted for. Another drawback is that detailed information for management purposes may not be available where needed, and the production control therefore needs to be stronger. Thus, although backflush saves time for accounting professionals, it may imply extra effort and time for logistics management to provide accurate production count.
Given the inherent difficulty in this system, backflush accounting does not strictly adhere to generally accepted accounting principles (GAAP) for external reporting.
Just in Time (JIT) and Backflush Accounting:
The JIT production method, which was developed by Taichii Ohno at Toyota is an efficiency system used (most typically) in manufacturing or production settings. The system strives to attain a high return on investment by reducing in-process inventory and associated carrying costs. Another key factor in JIT, although it isn’t entirely relevant from an accounting perspective, is the focus on continuous improvement.
Some key benefits of Just in Time are as follows:
1. reduction of inventories
2. improvement in quality
3. shorter lead times
4. lower production costs
5. increased productivity
6. increased machine utilization
7. greater flexibility
To illustrate how Toyota applies JIT production to their daily operations we have laid out the following sequence of activities:
1. When a vehicle order is received, a production instruction must be issued to the beginning of the vehicle production line as soon as possible.
2. The assembly line must be stocked with required number of all needed parts so that any type of ordered vehicle can be assembled.
3. The assembly line must replace the parts used by retrieving the same number of parts from the parts-producing process (the preceding process).
4. The preceding process must be stocked with small numbers of all types of parts and produce only the numbers of parts that were retrieved by an operator from the next process.
Toyota JIT manufacturing practice shows us that it enables purchasing, production, and sales to occur in quick order with stock being maintained at minimum levels. The absence of stock renders decisions regarding cost-flow assumptions (such as weighted average or first-in, first-out) or stock costing methods (such as absorption or marginal costing) unimportant. This is because all of the manufacturing costs attributable to a period go directly into cost of goods sold. Job costing is simplified by the rapid transmission of direct materials into finished goods that are then sold immediately. We can say that the absence of stocks makes choices about stock valuation systems unnecessary and the rapid conversion of direct material into cost of goods sold simplifies accounting system.
Therefore the implementation of JIT will cause a change in the accounting system of Toyota and prompt for backflush accounting use. Why? This is because traditional management accounting techniques are inappropriate due to their incompatibility for use in conjunction with JIT operations. For example, traditional variance analysis focuses on maximizing capacity utilization while attempting to minimize costs.
The reduction of costs will always remain an important consideration. However, with the focus has shifted to value appreciation while attempting to minimize costs. Management is therefore required to provide financial and non-financial information regarding supplier performance, on-time deliveries, cycle times, and the number of defective items manufactured.
These new requirements for management information have necessitated changes in the processes and accounting methods in order to enable the provision of such information. This explains the growth in the application of backflush accounting systems that are used to support JIT operations. Besides, Backflush accounting system simplifies the accounting records by avoiding the need to follow the movement of materials and work-in-progress through the manufacturing process within the organisation.
Difference between GAAP and JIT accounting
There are several areas in which throughput accounting varies from GAAP. The most important issue is that GAAP requires that overhead cost be allocated to inventory, which in turn may or may not be charged to expenses in the current period. This is done under the assumption that operating expenses incurred during the current period are related to any inventory produced during that period, and so can be associated with the inventory until such time as it is sold. Thus GAAP clearly states that overhead must be allocated to inventory and the failure to do so is not acceptable.
Throughput accounting takes the opposite stance that overhead costs are not related to inventory in any way, and so should not be allocated to inventory. Instead operating expenses represent the cost of production capacity during a period of time, and should be charged to expense during that period.
There is another underlying difference between the two systems that is somewhat less obvious. GAAP accounting assumes that both the inventory held in storage and the overhead cost allocated to it are valuable company assets only to be charged to expense when the inventory is sold. Under throughput accounting the preference is to avoid the production of excess inventory because it represents an immediate use of cash (for the materials contained within the inventory) requires additional storage expenses, and can lose its value over time because of damage or obsolescence. Thus, throughput accounting assumes that inventory is to be avoided, which is common characteristic of liability.
Another difference between the systems is the treatment of direct labour expenses. Under GAAP, direct labour assumes to be directly related to the incremental production of inventory, and its cost is therefore assigned to inventory. This means that, as was the case with overhead costs, direct labour can be stored as an asset across multiple accounting periods.
Toyota had to switch from traditional accounting system to backflush accounting system due to the fact that Toyota adopted the principles and practices of JIT system and because the traditional accounting system conflicted with the JIT initiatives. Toyota with its adopted JIT system was facing problems in regards to traditional costing and accounting methods because it was designed primarily to satisfy the financial accounting requirements for inventory valuation and as a result are not appropriate for performance measurement and operational control. Thus there was a need to align cost management and accounting methods with JIT thinking. To do so Toyota chose to use backflush accounting which is ideally suited to JIT thinking. Backflush costing is most appropriate only when used to complement a JIT inventory management system. This is because as we stated before backflush accounting simplifies the costing process in these situations. However, we should also keep in mind that such accounting practice doesn’t conform to GAAP and this can be criticized because it doesn’t leave sequential auditing.