What is a Backlog?
Frequently used in manufacturing industries, backlog refers to unfinished work or to customer orders that have been received but are either incomplete or in the process of completion.
How Does a Backlog Work?
Let's assume XYZ Company is able to manufacture 10,000 widgets per day. On Monday morning, the company receives an order for 50,000 widgets. Given the company's daily production capacity, XYZ Company will end Monday with a backlog of 40,000 widgets. If each widget sells for $1, XYZ Company would report a $40,000 backlog.
Backlogs are usually measured in dollars and generally occur when there is a shortage of labor or supplies. Building products to each customer's specifications may also lead to backlogs.
Why Does a Backlog Matter?
Changes in a company's backlog may have profit implications. A rising backlog may indicate that a company is experiencing either increased sales or production problems; a falling backlog may indicate the company's sales are falling or that it is increasing production efficiency.
It is important to study a company's revenue recognition policies when evaluating backlog. Some companies may use the percentage-of-completion method, whereby a percentage of the anticipated revenue from the sale of the product is recognized according to the percentage of work complete on a specific product. If a company is not able to reasonably measure the costs and revenues attributable to different stages of the production process, it may use completed-contract accounting, whereby the revenue is recorded when the project is complete.