ACCA F5 Performance Management - 2010 - Study text

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Chapter 2: Other costing systems

Back-flush accounting

 The basic concept of back-flush accounting

 Back-flush accounting and just-in-time production systems

 Traditional costing systems and back-flush accounting compared

 Back-flush accounting with two ‘trigger points’

 Back-flush accounting with one ‘trigger point’

 Implications of using back-flush accounting

3 Back-flush accounting

3.1 The basic concept of back-flush accounting

Back-flush accounting is a method of cost accounting for a manufacturing

environment in which the measurement of costs is delayed until production has

been completed, or until the end of an accounting period.

Total costs incurred in producing the output in the period are then worked

backwards (‘flushed back’) and are allocated between cost of sales and closing

inventories. No cost accounting records are made until after the end of the period.

This is completely different from traditional cost accounting methods, where costs

of production are tracked through the system as production takes place, from raw

materials to work in progress and then to finished goods and cost of sales.

3.2 Back-flush accounting and just-in-time production systems

Back-flush accounting is ideally suited to a production system where:

 the production cycle is short (the speed of production is quick) and

 inventories of raw materials and work-in-progress are low.

This makes it suitable for manufacturers that use a just-in-time approach to

purchasing and production.

 Just-in-time (JIT) purchasing involves arranging with suppliers for the delivery

of materials just before they are needed for production. In theory this would

mean holding no inventory at all of raw materials. In practice, when JIT

purchasing methods are used, raw materials inventories are very low, but not

actually zero.

 Just-in-time JIT) production involves manufacturing items just in time to meet

sales demand from customers. Often this means starting production only when a

customer order is received. JIT production methods are only practicable when

the production time cycle is short, which means that inventories of work-in-

progress should be very low.

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Transfers between processes are often made at standard cost, and any variances are

taken directly as a total variance to the income statement as a gain or a loss.

3.3 Traditional costing systems and back-flush accounting compared

Traditional costing systems

Traditional cost accounting systems for manufacturing costs are ‘sequential

tracking’ systems. They track the costs of items as they progress through the

manufacturing process, from raw materials, through work in progress to finished

goods. At each stage of the manufacturing process, more costs are added and

recorded within the cost accounting system.

 Raw material costs are recorded in a raw materials inventory account when the

materials are purchased. When the raw materials are issued to production, a

record is made in the cost accounts of the cost of materials issued to production,

often using FIFO or weighted average costs to measure the cost of the materials.

 Direct labour costs are recorded in a direct labour cost account, and then

transferred to the work in progress account.

 Production overhead costs are calculated by absorbing overheads into

production costs at a pre-determined overhead absorption rate. At the end of the

period there will be some over- or under-absorbed overheads. Under-absorption

is reduced or over-absorption is increased by maximising production volume.

The main benefit of sequential tracking costing systems is that they can be used to

put a cost to items of inventory. When inventory is large, there is a need to measure

inventory costs with reasonable ‘accuracy’.

Features of back-flush accounting

As the term ‘back-flush’ might suggest, and as explained earlier, costs are calculated

after production has been completed. They are allocated between the cost of goods

sold and inventories in retrospect. They are not built up as work progresses through

the production process.

Back-flush accounting is a method of cost accounting that is consistent with JIT.

With a system of JIT purchasing and production, the benefit of ‘accurate’ costing of

inventory does not exist, or is insignificant. Inventory should be small, or even non-

existent. The cost of inventory is therefore fairly insignificant. A costing system that

measures the cost of inventory is therefore of little or no value, and is certainly not

worth the time, effort and expenditure involved.

 With back-flush accounting, there is no work-in-progress account in the costing

system. The only inventory accounts in the costing system are an account for

finished goods and (possibly) an account for raw materials.

 However there is no need to value raw materials inventory using FIFO or

weighted average cost.

 Back-flush accounting also keeps no records of direct labour times and direct

labour costs. Labour costs are included with other expenses in a single account

for ‘conversion costs’. Consequently, the system does not record any direct

Chapter 2: Other costing systems

labour variances. It simplifies costing accounting, because it ignores labour

variances and work-in-progress value.

 There is no need to calculate an absorption rate and absorb production

overheads into the cost of production as work progresses through the

production system.

 Back-flush accounting systems often make use of standard costs, particularly for

the valuation of closing inventory. Standard costs are applied retrospectively, at

the end of the costing period.

Back-flush accounting is therefore a much simpler method of costing than

traditional costing methods.

However the cost information produced by a system of back-flush accounting is of

relatively little value for management, because a detailed analysis of the costs of

production does not exist.

3.4 Back-flush accounting with two ‘trigger points’

A back-flush accounting system has either one or two ‘trigger points’. A trigger

point is a point in the production process when entries are made in the cost

accounting system.

When there are two trigger points, these are usually:

 the purchase of raw materials and

 the manufacture of completed products.

A numerical example will be used to illustrate the costing method.

Example

Suppose that a manufacturing company operates a JIT system. At the beginning of a

period, it has no inventory of raw materials or finished goods. It manufactures a

single product, Product P, which has the following standard cost:

Raw materials 20

Direct labour 8

Overheads 22

During the period, it incurred the following costs:

Raw materials purchased $2,030,000

Direct labour costs incurred $775,000

Overhead costs incurred $2,260,000

The company made 100,000 units of Product P and sold 98,000 units.

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The company uses a back-flush costing system, with trigger points at raw materials

purchase and at completion of production.

Trigger point 1

The purchase of raw materials is recorded in a raw materials inventory account as

soon as the purchases occur.

Raw materials inventory account

Creditors 2,030,000

Trigger point 2

The next accounting entries occur at the end of the accounting period, or when

production has been completed. In this example, at trigger point 2 when 100,000

units have been produced, the cost of their manufacture is recorded in a finished

goods inventory account. Standard costs are used in this example.

Finished goods inventory account

Raw materials

(100,000 × 20)

2,000,000

Conversion

costs

(100,000 × 30)

3,000,000

Here, it is assumed that actual raw materials costs were the same as the standard

materials cost. The costs used for finished goods in back-flush accounting need to be

close to actual costs to avoid large variances.

Raw materials inventory account

Payables 2,030,000

Finished goods inventory 2,000,000

Closing balance c/f 30,000

2,030,000

A conversion costs account is used to record the actual and standard costs of labour

and production overheads.

Conversion costs account

Bank (labour cost) 775,000

Finished goods inventory 3,000,000

Payables (overheads) 2,260,000

Balance (profit or loss) 35,000

3,035,000

The closing balance on the raw materials account may represent the cost of closing

inventory. If so, it is carried forward as an opening balance to the start of the next

Chapter 2: Other costing systems

period. However, any cost variance (difference between standard and actual

material cost) should be taken to profit or loss for the period.

Similarly, the balance on the conversion costs account probably represents cost

variances for labour and overhead, and this should be written off to profit or loss for

the period.

The cost of sales and closing inventory of finished goods are simply recorded as

follows:

Finished goods inventory account

Raw

materials

(100,000 × 20)

2,000,000

Cost of goods

sold

(98,000 × 50)

4,900,000

Conversion

costs

(100,000 × 30)

3,000,000

Closing

inventory

(2,000 × 50)

100,000

5,000,000

There is no work in progress. The only items recorded in the system are:

Cost of production $5,000,000

Cost of sales $4,900,000

Finished goods inventory $100,000

Raw material purchases $2,030,000

Raw materials closing inventory $30,000

Conversion costs incurred $3,035,000

Written off to profit or loss: conversion costs $35,000

3.5 Backflush accounting with one ‘trigger point’

An even simpler back-flush accounting system has just one trigger point, the

manufacture of finished units.

With this system, raw material purchases are not recorded in the system until

production is complete (or at the end of the accounting period).

Using the same example, the cost accounting entries would be as follows, starting

with finished goods:

Finished goods inventory account

Creditors

(100,000 × 20)

2,000,000

Cost of

goods sold

(98,000 × 50)

4,900,000

Conversion

costs

(100,000 × 30)

3,000,000

Closing

inventory

(2,000 × 50)

100,000

5,000,000

Costs can then be worked back through the system, to conversion costs and raw

materials.

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Conversion costs account

Bank (labour cost) 775,000

Finished goods inventory 3,000,000

Creditors (overheads) 2,260,000

Balance 35,000

3,035,000

The only difference with the one-trigger point system compared with the two

trigger-point system is that in the one trigger-point system, there is no raw materials

inventory account. The $30,000 of materials that has been purchased but not used is

simply not recorded in the costing system, and is therefore not included in closing

inventory at the end of the period.

A one trigger-point system is acceptable when inventories of raw materials are very

small.

3.6 Implications of using back-flush accounting

Back-flush accounting avoids the need to maintain a detailed cost accounting

system, which can be regarded as a non-value added activity. Costs are worked out

retrospectively, and work-in-progress is ignored. This makes the costing system

very much simpler than traditional costing methods.

A consequence of a simplified costing system is the loss of management

information. The cost records in a system of back-flush accounting provide little or

no management information about performance; for example they do not indicate

whether production operations have performed well or badly during the period.

There are no detailed variances to report, for example.

Management need information about performance in order to control operations

effectively. When a system of back-flush accounting is used, performance

measurements should come from other sources, and non-financial measures of

performance are likely to be used extensively.

Chapter 2: Other costing systems

Throughput accounting

 The nature of throughput accounting

 Assumptions in throughput accounting

 Throughput, inventory and operating expenses

 Profit and throughput accounting

 The value of inventory in throughput accounting

 Comparing throughput accounting with absorption costing and marginal

costing

4 Throughput accounting

4.1 The nature of throughput accounting

Throughput accounting is not really a costing system at all, because with costing no

costs are allocated to units of production, with the exception of materials costs.

 With traditional costing systems, the main focus of attention is on costs and how

to control or reduce costs.

 With throughput accounting, the main focus of attention is on how to achieve

the goals of the entity successfully. For profit-making companies, the goals of the

entity are assumed to be the maximisation of profit.

Throughput accounting is also associated wit the Theory of Constraints. This is a

theory an entity always has a constraint that sets a limit on the achievement of its

goals. The task of management should therefore be to:

 identify what this effective constraint is

 maximise the performance of the entity in achieving its goals, within the limits

of this constraint

 look for ways of removing the constraint, so that performance can be improved

still further.

Although they are different, throughput accounting has some close similarities with

marginal costing and limiting factor analysis, which you should be familiar with

from your earlier studies.

4.2 Assumptions in throughput accounting

Throughput accounting is based on a number of assumptions.

 In traditional marginal costing, it is assumed that direct labour costs are a

variable cost, but in practice this is not usually correct. Employees are paid a

fixed weekly or monthly wage or salary, and labour costs are a fixed cost.

 The only variable cost is the purchase cost of materials and components

purchased from external suppliers.

F5: Performance management

 A business makes real profit by adding value. Value is added by selling goods or

services to customers whose market value is more than the cost of the materials

that go into making them. However, value is not added until the sale is actually

made.

 Value added should be measured as the value of the sale minus the variable cost

of sales, which is the cost of the materials.

4.3 Throughput, inventory and operating expenses

Throughput accounting is based on three concepts:

 throughput

 inventory (investment) and

 operating expenses.

Throughput

Throughput can be defined as the rate at which an entity achieves its goals,

measured in ‘goal units’. In not-for-profit entities, the goal of the entity could be

measured in terms of a non-financial goal. For profit-making entities, the goal is

profit, and:

Throughput = Sales minus Total variable costs

Throughput differs from contribution in traditional marginal costing because

variable costs consist only of real variable costs, which are (mainly or entirely)

materials costs.

It is therefore appropriate to define throughput as:

Throughput = Sales minus Cost of raw materials and components

Inventory (or investment)

Inventory or investment is all the money that is tied up in a business, in inventories

of raw materials, WIP and finished goods. The term ‘investment’ is normally

preferred to ‘inventory’ because it includes the amount of capital tied up in making

the product and selling it to customers. Investment therefore includes not only the

amount invested in inventories but also investment in non-current assets.

Inventory is eventually converted into throughput, but until it is sold it is capital

tied up earning nothing. When inventory is sold, throughput is created.

Throughput is not created until finished goods are sold. Creating finished goods for

inventory is therefore damaging to the entity’s goals, because it ties up finance in

investment and investment finance has a cost.

Chapter 2: Other costing systems

Operating expenses

Operating expenses are all the expenditures incurred to produce the throughput.

They consist of all costs that are not variable costs, and so include labour costs.

4.4 Profit and throughput accounting

Profit in throughput accounting is measured as throughput minus operating

expenses.

Example

Sales 800,000

Raw materials and components costs 350,000

Throughput 450,000

Operating expenses 340,000

Net profit 110,000

4.5 The value of inventory in throughput accounting

Inventories do not have value, except the variable cost of the materials and

components. Even for work-in-progress and inventories of finished goods, the only

money invested is the purchase cost of the raw materials. No value is added until

the inventory is sold.

 In throughput accounting, all inventory is therefore valued at the cost of its raw

materials and components, and nothing more.

 It should not include any other costs, not even labour costs. No value is added

by the production process, not even by labour, until the item is sold.

 It is impossible to make extra profit simply by producing more output, unless

the extra output is sold.

4.6 Comparing throughput accounting with absorption costing and

marginal costing

The difference between throughput accounting and the traditional methods of

accounting can be illustrated with an example.

Example

A company makes 1,000 units of a product during May and sells 800 units for $32,000.

There was no inventory at the beginning of the month. Costs of production were:

Raw materials 6,000

Direct labour 8,000

Fixed production overheads 10,000

Other non-production overheads 5,000

F5: Performance management

Required

Calculate the profit for the period using:

(a) absorption costing

(b) marginal costing

Assume for the purpose of absorption costing that budgeted and actual production

overheads were the same, and there are no under- or over-absorbed overheads.

Answer

The value of closing inventory:

Absorption costing: $4,800 ($24,000 × 200/1,000)

Marginal costing: $2,800 ($14,000 × 200/1,000)

Throughput accounting: $1,200 ($6,000 × 200/1,000) in throughput accounting.

Profit for the month using each costing method is therefore as follows:

Absorption costing Marginal costing Throughput

accounting

$ $ $

Sales 32,000 Sales 32,000 Sales 32,000

Production

costs

24,000 Variable

production costs

14,000 Materials

bought

6,000

Closing

inventory

4,800 Closing inventory 2,800 Inventory 1,200

Cost of sales 19,200

Variable costs of sale

11,200 4,800

Gross profit 12,800 Contribution 20,800 Throughput 27,200

Other

overheads

5,000 Fixed overheads 15,000 Operating

expenses

23,000

Profit 7,800 Profit 5,800 Net profit 4,200

The differences in profit are entirely due to the differences in inventory valuations.

ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing

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