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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Backflush Costing

What it is:

An accounting method whereby the costs associated with producing a good or service are recorded only after the good or service is actually produced, completed or sold.

How it works (Example):

For example, let's assume that Company XYZ manufactures widgets. It has a variety of choices in how it handles obtaining and recording the costs of its raw materials and labor. For example, it could order a year's worth of widget parts every January and warehouse them for use during the next 12 months of widget production. Or it could order widget parts once a month and warehouse them for use during each month's production. Or it could order widget parts only after it gets an order from a retailer, which minimizes the costs that Company XYZ will have to incur to store widget parts.

This last idea is part of the just-in-time method of inventory management. By the time Company XYZ has to pay the invoices for those raw materials (say, 90 days), it will have already sold or at least finished producing the widgets and will thus have much more cash on hand to pay those invoices.

Accordingly, Company XYZ decides to use backflush accounting, whereby it records the raw materials, labor, and other costs in its cost of goods sold and its finished goods inventory accounts at a predetermined point in the production process (usually at the time of completion, sale, shipment to the customer, or similar). Accordingly, backflush accounting results in recording very little in a company's Work in Process accounts.
 

Why it Matters:

Backflush costing is a more streamlined method for accounting for the costs to produce goods and services. Companies can measure the true and complete costs of a particular production run because they record all of the costs at once, at the end of the process, rather than before, during, and after the production process. This hastens the entire accounting process considerably, but it comes at a price: Backflush accounting typically does not conform to generally accepted accounting principles and makes companies difficult to audit.

Because companies using backflush accounting essentially work backward by calculating the costs of products after they're sold, finished, or shipped (rather than before and during the production process, which is the typical method and is called sequential tracking), they often assign "standard costs" to the units they produce. In the real world, companies that use backflush accounting eventually need to recognize the variances in standard costs and actual costs by, for example, comparing the amount of labor cost they assign to a production run with the actual payroll expense for that production run.

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