Backflush Costing

Updated on April 11, 2024
Reviewed byDheeraj Vaidya, CFA, FRM

What is Blackflush Costing?

Backflush costing is a delayed accounting process used in a Just-in-Time (JIT) inventory system where the cost of producing goods and services like raw material cost, labor cost, and various other direct, indirect costs, overheads are determined, calculated, and recorded only after they have been produced, completed or sold by using a standard cost per unit multiplied by the number of goods produced.

Features

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How Does it Work?

By assigning a standard cost per unit of goods manufactured, the organization estimates the cost per material produced. Once the production cycle ends, the number of units manufactured is multiplied by the standard cost to evaluate the expense journal entry. This journal entry is recorded once at the end of the production cycle. Whenever an order is processed, only basic information is entered, including quantity, item number, and delivery date. Backflushing comes into play after the production process gets completed.

Example of Backflush Costing

ABC Inc., a Jute bag manufacturing company, has just started manufacturing business on 01/01/2020 and wishes to account for product costing. They have incurred various costs during January 2020 are as follows: –

  • Direct material – “A” purchased on 05/01/2020 – $2,00,000
  • Direct material – “C” purchased on 06/01/2020 – $1,00,000
  • Direct labor for processing paid on 28/01/2020 – $3,00,000

The total units produced and sold during January is 60,000 units

Now, instead of recording each cost transaction, under backflush costing, ABC Inc. needs to pass a single accounting entry at the end of the period, which is: –

Expenses A/c Debited by $6,00,000 and bank A/c credited (assuming paid via bank)

Journal Entry of Backflush Costing

Entries passed are as follows: –

  1. Simple entry is passed by debiting expenses accounts and crediting payment a/c, i.e., bank or cash A/c or creditor A/c when purchased on credit.
  2. Finished Goods A/c is debited with all costs incurred in point 1. With corresponding credit above Cost A/cs like Direct Material CostDirect Material CostDirect Material Cost is the total cost incurred by the company in purchasing the raw material along with the cost of other components including packaging, freight and storage costs, taxes, etc. that are related directly to the manufacturing and production of various products of the company.read more, processing cost (labor), etc.
  3. At the time of sales, the cost of corresponding goods sold is transferred to the cost of goods Sold with credit to Finished goods A/c.

When is Backflush Costing Used?

It is generally used by those companies which maintain a low inventory holding period and a high turnover in inventoryTurnover In InventoryInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.read more Companies that experience slow turnover in inventory; they record the cost as and when they are incurred since the product may not be sold for a longer duration and may lead to incorrect inventory/ cost records.

It works well in the business process where huge costs are incurred in the production process of goods as it simplifies the accounting process in that case. Accordingly, companies with complex production processes opt for the backflush costing method. On the other hand, companies that sell more customized products do not opt for such costs as the cost per unit of goods varies with the product manufactured.

Backflush Costing vs. Conventional Costing

There are major differences in both types of costing methods. Under the conventional costing method, the entry for raw materials goes into the raw material inventory and then transferred to work in process inventoryWork In Process InventoryWIP inventory (Work-in-Progress) are goods which are in different stages of production. WIP inventory includes materials released from the inventory for the process but not yet completed. The accounting system accounts for the semi-finished goods in this category.read more (WIP) and then to finished goods A/c. Under the backflush costing method, raw materials are ordered only when required, and they are accounted for. Under the conventional costing method, labor and overhead are charged directly into WIP; then, they are moved to sequential processing, finished goods, and later to the costs of goods soldCosts Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more. In the backflush costing method, these charges are directed into finished goods inventory or costs of goods sold.

Benefits

Backflush Costing

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For eg:
Source: Backflush Costing (wallstreetmojo.com)

Limitations

Conclusion

The backflush costing method is a simplified method of recording expenses incurred in manufacturing products where all costs incurred are accounted for after some time of their incurrence. This can be used in a hybrid system where multiple methods of production accounting are used. It may not be suitable for an organization with a long production process but may prove a theoretically elegant process for complex accounting solutions.

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