Backflush Costing

Learning Objective 7 Describe different ways backflush costing can simplify traditional inventory-costing systems

• for example, by not recording journal entries for work-in-process, purchase of materials, or production of finished goods

Organizing manufacturing in cells, reducing defects and manufacturing cycle times, and ensuring the timely delivery of materials enable a company’s purchasing, production, and sales to occur in quick succession with minimal inventories. The absence of inventories makes choices about cost-flow assumptions (such as weighted average or first-in, first-out) or inventory-costing methods (such as absorption or variable costing) unimportant: All manufacturing costs of the accounting period flow directly into cost of goods sold. The rapid conversion of direct materials into finished goods that are immediately sold greatly simplifies the costing system.

Simplified Normal or Standard-Costing Systems

Traditional normal or standard-costing systems (Chapters 4, 7, 8, and 18) use sequential tracking, which is a costing system in which the recording of the journal entries occurs in the same order as actual purchases and progress in production. Costs are tracked sequentially as products pass through each of the following four stages:

A sequential-tracking costing system has four trigger points, corresponding to Stages A, B, C, and D. A trigger point is a stage in the cycle, from the purchase of direct materials and incurring of conversion costs (Stage A) to the sale of finished goods (Stage D), at which journal entries are made in the accounting system. The journal entries (with Dr. representing debits and Cr. representing credits) for each stage are displayed below the box for that stage (as described in Chapter 4).

An alternative approach to sequential tracking is backflush costing. Backflush costing is a costing system that omits recording some of the journal entries relating to the stages from the purchase of direct materials to the sale of finished goods. When journal entries for one or more stages are omitted, the journal entries for a subsequent stage use normal or standard costs to work backward to “flush out” the costs in the cycle for which journal entries were not made. When inventories are minimal, as in JIT production systems, backflush costing simplifies costing systems without losing much information.

Consider the following data for the month of April for Silicon Valley Computer (SVC), which produces keyboards for personal computers.

• There are no beginning inventories of direct materials and no beginning or ending work-in-process inventories.
• SVC has only one direct manufacturing cost category (direct materials) and one indirect manufacturing cost category (conversion costs). All manufacturing labor costs are included in conversion costs.
• From its bill of materials and an operations list (description of operations to be undergone), SVC determines that the standard direct materials cost per keyboard unit is $19 and the standard conversion cost is $12.
• SVC purchases $1,950,000 of direct materials. To focus on the basic concepts, we assume SVC has no direct materials variances. Actual conversion costs equal $1,260,000. SVC produces 100,000 good keyboard units and sells 99,000 units.
• Any underallocated or overallocated conversion costs are written off to cost of goods sold at the end of April.

We use three examples to illustrate backflush costing. They differ in the number and placement of trigger points.

Note that there is no journal entry for Production resulting in work in process (Stage B) because this method is used when work-in-process inventory is minimal (units started are quickly converted to finished goods).

SVC records two inventory accounts:

Exhibit 21-7, Panel A, summarizes the journal entries for Example 1 with three trigger points: Purchase of direct materials and incurring of conversion costs, Completion of good finished units of product, and Sale of finished goods (and recognizing under- or overallocated costs). For each stage, the backflush costing entries for SVC are shown on the left. The comparable entries under sequential tracking (costing) are shown on the right.

Consider first the entries for the purchase of direct materials and incurring of conversion costs (Stage A). As described earlier, the inventory account under backflush costing combines direct materials and work in process. When materials are purchased, these costs increase (are debited to) the Materials and In-Process Inventory Control account. Under the sequential tracking approach, the direct materials and work-in-process accounts are separate, so the purchase of direct materials is debited to Materials Inventory Control. Actual conversion costs are recorded as incurred under backflush costing, just as in sequential tracking, and they increase (are debited to) Conversion Costs Control.

Next consider the entries for production resulting in work in process (Stage B). Recall that 100,000 units were started into production in April and that the standard cost for the units produced is $\mathrm{\$}31\hspace{0.17em}(\mathrm{\$}19\hspace{0.17em}\text{direct\ materials}+\mathrm{\$}12\hspace{0.17em}\text{conversion\ costs})$ per unit. Under backflush costing, no entry is recorded in Stage B because work-in-process inventory is minimal and all units are quickly converted to finished goods. Under sequential tracking, work-in-process inventory is increased as manufacturing occurs and later decreased as manufacturing is completed and the product becomes a finished good.

The entries to record the completion of good finished units (Stage C) give backflush costing its name. The costs have not been recorded sequentially with the flow of the product along its production route through work in process and finished goods. Instead, the output trigger point reaches back and pulls (“flushes”) the standard direct material costs from Materials and In-Process Inventory Control and the standard conversion costs for manufacturing the finished goods. Under the sequential tracking approach, Finished Goods Control is debited (increased) and Work-in-Process Control is credited (decreased) as manufacturing is completed and finished goods are produced. The net effect of Stages B and C under sequential tracking is the same as the effect under backflush costing (except for the name of the inventory account).

Finally consider the entries to record the sale of finished goods (and under- or overallocated conversion costs) (Stage D). The standard cost of 99,000 units sold in April equals $\mathrm{\$}\text{3,069,000}\hspace{0.17em}\mathrm{(}\text{99,000}\hspace{0.17em}\text{units}\times \mathrm{\$}31\hspace{0.17em}\text{per\hspace{0.17em}unit})\mathrm{.}$ The entries to record the cost of finished goods sold are exactly the same under backflush costing and sequential tracking.

Actual conversion costs may be underallocated or overallocated in an accounting period. Chapter 4 discussed various ways to dispose of underallocated or overallocated manufacturing overhead costs. Companies that use backflush costing typically have low inventories, so prorating underallocated or overallocated conversion costs between work in process, finished goods, and cost of goods sold is seldom necessary. Generally, companies write off underallocated or overallocated conversion costs to cost of goods sold only at the end of the fiscal year. Other companies, like SVC, record the write-off monthly. The journal entry to dispose of the difference between actual conversion costs incurred and standard conversion costs allocated is exactly the same under backflush costing and sequential tracking.

The April 30 ending inventory balances under backflush costing are as follows:

The April 30 ending inventory balances under sequential tracking would be exactly the same except that the inventory account would be Materials Inventory Control. Exhibit 21-7, Panel B, provides a general-ledger overview of this version of backflush costing.

The elimination of the typical Work-in-Process Control account reduces the amount of detail in the accounting system. Units on the production line may still be tracked in physical terms, but there is “no assignment of costs” to specific work orders while they are in the production cycle. In fact, there are no work orders or labor-time records in the accounting system.

The three trigger points to make journal entries in Example 1 will lead SVC’s backflush costing system to report costs that are similar to the costs reported under sequential tracking when SVC has minimal work-in-process inventory. In Example 1, any inventories of direct materials or finished goods are recognized in SVC’s backflush costing system when they are acquired or produced (as would be done in a costing system using sequential tracking). International Paper Company uses a method similar to Example 1 in its specialty papers plant.