Backflush Costing

What is Blackflush Costing?

Backflush costing is a delayed accounting process used in Just-in-Time (JIT) inventory system where the cost of producing goods and services like raw material cost, labour cost and various other direct, indirect cost, 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 quantity of goods produced.

Features

How Does it Work?

By assigning a standard cost to per unit of goods manufactured, the organization estimates the cost per unit of material produced. Once the production cycle ends, the number of units manufactured is multiplied by the standard cost to evaluate 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 that includes quantity, item number, and date of delivery. 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 cost 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

Total units produced and sold during January is 60,000 units

Now, instead of recording each individual cost transaction, under backflush costing, ABC Inc. needs to pass 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 account 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 which are 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 low inventory holding period and a high turnover in inventoryTurnover In InventoryInventory Turnover Ratio is a measure to determine the efficiency of a Company concerning its overall inventory management. To calculate the ratio, divide the cost of goods sold by the gross inventory. 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. Companies that sell more customized products do not opt for such type of cost as the cost per unit of good varies with the product manufactured.

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 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 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 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. Whereas 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 a time span 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 that has a long production process but may prove a theoretically elegant process for complex accounting solutions.

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