How Does Backflush Costing Work?

How Does Backflush Costing Work?

Backflush costing is a simplified method of costing that eliminates the need for separate (wip) raw material, work in progress (WIP) and finished goods inventories. It does this by using the actual costs to produce the goods when calculating a full cost per unit of production. This full cost is then used to record the costs of goods sold in a single transaction.

How Does Backflush Costing Work?

While traditional costing places a strong emphasis on the assignment of costs to units of production and then to finished goods using the established accounting periods, the backflush costing system eliminates the need for wip and finished goods inventories. This is achieved by ‘backflushing’ or directly assigning the cost of goods sold to either cost of goods sold for items sold in the current month or to raw material costs for future inventory production in the following months.

1. Production: When raw materials are issued to production, they are charged to the raw materials inventory account. Direct labor costs are charged to the factory labor account. Applied overhead costs are charged to the manufacturing overhead account.
2. Finished Goods: When finished goods are completed, they are not placed into a wip or finished goods inventory. Instead, the cost of the finished goods is directly charged to the cost of goods sold account.
3. Cost of Goods Sold: The cost of goods sold is calculated by adding up the cost of raw materials, direct labor, and applied overhead costs for the period.

Advantages of Backflush Costing

• Reduced Overhead Costs: Eliminating or significantly reducing the need for physical inventories greatly reduces the time, effort and the physical warehousing costs.
• Increased Efficiency: Backflush costing can help companies streamline their production process by eliminating the need forWIP and finished goods inventories. This can free up employees to focus on other tasks, such as improving quality or increasing production.
• Improved Accuracy: Since finished goods costs are recognized immediately at the time they are produced, this real-time approach to measuring costs reduces the possibility that costs are understated or overstated since there is less reliance on estimations.

Disadvantages of Backflush Costing

• Not Suitable for All Companies: As this method ignores wip and finished goods inventory, it may not be suitable for companies that have complex production processes that result in a high level of wip or finished goods.
• Inaccurate Costing: Backflush costing can result in inaccurate costing if the cost of raw materials, direct labor, and applied overhead costs are not accurate.
• Complex Implementation: The implementation of backflush costing can be complex and time-consuming.