Explain the term backflush accounting

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Backflush accounting is a cost accounting system which focuses on the output of an organization and then works backwards to attributed costs to stock and cost of sales. Whereas, traditional cost accounting systems track the sequence if raw materials and components moving through the production systems, and such systems are called "sequential tracking system", the sequential tracking can prove to be very costly.

The minimization of costs will always remain an important consideration. As Just-in-Time (JIT) is an entirely different system it requires it own cost accounting system. Traditional variance analysis focuses on maximizing capacity utilization while attempting to minimize costs allows the growth in the application of backflush accounting systems that are used to support Just-in-Time (JIT) operations.

Backflush accounting is ideally suited to Just-in-Time (JIT) and is employed where the overall cycle time is relatively short and inventory levels are low. Management eager to ascertain the cause of any variances, however, investigations are far more likely to be undertaken using non-financial performance indicators rather than the detailed cost variances.

The backflush accounting in a JIT environment, delays the recording of costs until after the events have taken place, some or all journal entries related to the production cycle are eliminated such as work-in-process. The system then focuses on the production of finished goods, and makes journal entries using either standard or normal costing. The completion of a finished good then triggers journal entries from direct materials and conversion costs to the finished good. Data for variance analysis can also be simultaneously computed by using other systems, such as payroll, within the ERP system. Scrap, rework, and spoilage costs can then be added to correct any discrepancies and ensure accurate costing. There are different versions of backflush costing, depending on the setup of the operation and trigger points.

There are two events that trigger the records kept in most backflush accounting systems:

The first is the purchase of raw materials. In a true JIT system where absolutely no raw material stock is held, even this trigger is irrelevant and raw materials are "flushed" when the following trigger is activated.

The second trigger is either the transfer of goods to finished goods stock or the sale of goods.

The principle of a just-in-time system is that production is pulled by customer demand and this in turn pulls the purchasing procedures which result in zero stocks of raw materials, work-in-progress and finished goods. For such a situation to exist there needs to be an excellent system of production planning and good supply chain management. Backflush accounting is best suited to companies that maintain low inventories because costs then flow directly to cost of goods sold.

ii. Discuss the benefits and the drawbacks of using this system. (10%)

The ability to backflush creates many benefits for any firm that can become a functioning lean enterprise. These benefits cover a wide range of areas in any manufacturing company, such as the factory floor, production and inventory control, and accounting, to name a few common areas. Backflushing eliminates and simplifies activities and transactions that would take place in a traditional operation. This ability is the result of right designing and executing the operational business systems. The following are some benefits of backflushing:

Elimination or reduction of non-value added activities (material/inventory movement transactions)

Just-in-time (JIT) seeks to do the process right the first time and to eliminate any non-value added activities. The time a part is delayed, moved, or inspected is referred to as non-value added time. It is waste time because no value is created for the customer when the product is not being processed. Under the JIT concept activities such as moving parts, waiting for parts, machine setup, and inspection are referred to as non-valued added activities. Inefficiencies in production cause non-value added activities.

Elimination or reduction of accounting transactions

Backflushing's features have physical proof of Coase's theory. In Coase's theory about transactions is a substantial factor in growing an operation's capability to deliver a product or satisfy the customer while shrinking the activities needed to accomplish this very action. Moreover, Church stated that backflushing is an easy and accurate costing. Harley-Davidson discovered backflushing is typically associated with a highly simplified system in which relatively few transcations control points generate entries in the accounting systems. Besides that, backflushing systems is eliminating separate accounting for work-in-progress and closely costs tracking, thus less costly and save time as less documentation have to be maintained.

Less time consuming

As mentioned above, a backflushing system is eliminating separate accounting for work-in-progress. By introducing this system a considerable amount time is saved. Whereas, the traditional system is time consuming and expensive to operate, as it requires a considerable amount of documentation, such as material requisitions and time sheets to support it in order to maintain the WIP records and job cards. If a company operates with low stock level, the benefits of operating the traditional costing are few.

Elimination of material searches and labor tracking

From Example 1, it shows that JIT eliminated direct labor as a cost category. Instead labor is treated as an indirect cost and is included in conversion cost. In addition, there is little work-in-process or direct materials inventory in a JIT system, so prorating under- or over-allocated conversion costs (or manufacturing overhead) is not required. Companies will simply charge the under- or over-allocated cost to Cost of goods sold.

Besides benefits that mentioned above, backflush accounting discourages managers from producing for inventory as inventory does not add value until it is sold. With backflush accounting, the accounting function can be refocused to add value in the strategic and tactical planning aspects of the business. According to Grahame Steven, "Backflush accounting can be appropriate for a well-run modern factory, but problems will inevitably arise, since no system is perfect". It can be seen through the following drawbacks:

Incompliance with Generally Accepted Accounting Principles (GAAP)

The accounting flow under backflush costing does not strictly adhere to GAAP for external reporting purposes. Work-in-process is not recognized; it should show up in the inventory breakdown in the notes to the financial statements. There is no audit trail when using backflush accounting.

Absence of detailed financial information

While backflush costing does work well with a just-in-time inventory approach, the lack of detail can sometimes create issues during an audit of the company's financial records. This can lead to situations where it becomes necessary to use existing documentation to reconstruct the chain of events involved in the production process, rather than simply following the sequence of events as recorded in the accounting records. Due to this reason, the use of backflush costing may generate more work than traditional accounting approach. Besides this, absence of detailed financial information may make the task of management control more difficult.

Moreover, backflush will not suit all companies. It cannot successfully operate in situations where inventory levels are significant and tend to fluctuate. In addition, the production process needs to be relatively short with accurate standard production costs. The reconciliation of cost accounts to financial accounts could be more difficult. Blackflush accounting does not provide any insight for some problems, such as, over-use of raw materials than expected, the consequence of substandard raw materials, differing physical properties of raw materials, production errors etc. However, these could cost the firm thousands of pounds until it is solved, since no material mix and yield variances are available. Even after it is solved, there is still no mechanism in place to analyze future problems. Besides that, the company does not have ready access to information that will explain why the factory operated more efficiently.

Discuss the circumstances that would be appropriate to use this system.

Backflush accounting model cannot be used by all organizations. It is particularly applicable under the following circumstances:

In a JIT environment, or a situation where the overall process time is short, there should be very little inventory of raw materials, WIP and even finished goods, so the bulk of manufacturing costs should be the costs of sale. The JIT production stage is driven by having continuous delivery of items. The use of production planning eliminates the need for material requirements planning (MRP) as a production planning tool. In contrast to the JIT system, a MRT system is a "push-through" system driven by forecasted demand. It examines the finished goods requirements before determining the demand for raw materials, components, and subassemblies. The purpose of MRP is to maintain the lowest possible level of inventory while making certain materials and parts are available, nevertheless, are no longer needed. The lead time in JIT is dramatically different. In a large production type environment, lead time may be reduced from months to hours. With such a short time horizon, it is easy to determine what parts will be needed each day. However, in reality, it is impossible to eliminate all stock as a truck arriving with raw materials creates stock until it is moved to and used production. If backflush accounting is used in a system where a substantial amount is held, a physical stock-take will be needed, because the system does not record the quantity of stock. There is a need of physical stock-take from time to time.

In a Total Quality Management (TQM) environment, where there are strong relationships with suppliers, costs should be known with a high degree of certainty. Hence there will be minimal variances arising during production. Company must establish the long-term contractual relationships with vendors. These relationships will eliminate the need for purchase requisitions and purchase orders.

It would be appropriate to use this system, if a company is able to operate with a success JIT and well TQM.