14734 Backflush Costing

Backflush Costing and Kaizen Costing

Compiled By: Vishal Chopra

Just-In-Time Production Systems

Just-in-time (JIT) production systems take a“demand pull” approach in which goods are

only manufactured to satisfy customer orders.

Major Features of a JIT System

1. Organizing production in manufacturing cells

2. Hiring and retaining multi-skilled workers

3. Emphasizing total quality management

4. Reducing manufacturing lead time and setup time

5. Building strong supplier relationships

Major Features of a JIT System

What information may management accountants use?

Personal observation by productionline workers and managers

Financial performance measures,such as inventory turnover ratios

Nonfinancial performance measuresof time, inventory, and quality.

Backflush Costing

Backflush Costing

Backflush costing describes a costingsystem that omits recording some or

all of the journal entries relating to thecycle from purchase of direct materials

to the sale of finished goods.

Backflush Costing

Where journal entries for one or more stagesin the cycle are omitted, the journal entries

for a subsequent stage use normal or standardcosts to work backward to flush out the costs in

the cycle for which journal entries were not made.

Trigger Points

The term trigger point refers to a stage in a cyclegoing from purchase of direct materials to saleof finished goods at which journal entries are

made in the accounting system.

Trigger Points

Stage A:Purchase of

direct materials

Stage B:Production resultingin work in process

Stage C:Completion of good

units of product

Stage D:Sale of

finished goods

Trigger Points

Assume trigger points A, C, and D.

This company would have two inventory accounts:

Type1. Combined materials Inventory

and materials in workin process

2. Finished goods

Account Title1. Inventory:

Material and In-processControl

2. Finished Goods Control

Example

Silicon Valley Computers produces keyboards for personal computers.For April there are no beginning Inventory of direct Material and Zero beginning and ending work in process

SVC has one direct manufacturing cost category and one indirect manufacturing cost category(conversion cost)

SVC determines that standard direct material cost per keyboard unit is Rs.19 and the standard conversion cost is Rs. 12

SVC purchases Rs. 19,50,000 of direct material in April & Actual Conversion Cost incurred is Rs. 12,60,000

SVC produces 100000 Keyboards in April and sells 99,000 units

Trigger Points

What is the journal entry when trigger point A occurs?

Inventory: Material and In-process Control XXAccounts Payable Control XX

To record direct material purchased during the period

Trigger Points

What is the journal entry to record conversion costs?

Conversion Costs Control XXVarious accounts(wages payable) XX

To record the incurrence of conversion costs duringthe accounting period

Underallocated or overallocated conversion costsare written off to cost of goods sold.

Trigger Points

What is the journal entry when trigger point C occurs?

Finished Goods Control XXInventory: Material and In-Process Control XXConversion Costs Allocated XX

To record the cost of goods completed during theaccounting period

Trigger Points

What is the journal entry when trigger point D occurs?

Cost of Goods Sold XXFinished Goods Control XX

To record the cost of goods sold during theaccounting period

Conversion Cost Allocated XX

Cost of Goods Sold XX

Conversion Cost Control XX

The ending inventory balances are:Inventory: Mat. And In-process control: XXFinished goods control : XXTotal : XX

Record Under allocated or Over allocated Cost

Kaizen Costing

Kaizan Costing The concept of Kaizen, meaning “improvements in small

steps”, was developed within quality assurance technology Based on this concept, Yashuhiro Monden, from Japan,

developed Kaizen Costing, which can be translated as “enhancement estimation”

Kaizen Costing is applied to a product that is already under production

The time prior to Kaizen Costing is called Target Costing, which involves searching for a target cost for a product before it reaches the market

Together, these two concepts make up lifecycle costing

KAIZEN COSTING: A DEFINITION• Cost reduction systems, by Yashihuro Monden, defines Kaizen

Costing as the maintenance of present cost levels for products currently being manufactured via systematic efforts to achieve the desired cost level

Monden describes two types of Kaizen Costing:

• Asset and organization-specific: Kaizen Costing activities planned according to the exigencies of each deal

• Product-model-specific costing : Activities carried out in special projects with added emphasis on value analysis

(Monden has the automotive industry in mind)

A Kaizen system:

• Is a cost reduction system whose goal is to reduce final estimations to a level that is lower than standard costs

• Checks that costing targets have been reached• Continuously reviews existing production conditions in order

to reduce costs

Standard Costing System: Procedures in standard systems apply standard costs one or two times per

year, carry out deviation analysis between forecast and final estimation, and make investigations as well as corrections when standard costs have not been achieved

Kaizen System In the Kaizen system the procedure sets new cost reduction targets each

month by which the existing gap between the target and current costs is to be closed

Carries out Kaizen activities during the entire operational year in order to achieve cost targets

Analyzes deviations between targets and current costs; and makes investigations and corrections when cost reduction targets have not been reached

Kaizen Costing

Contd. When planning, a cost target is set and a gap occurs Then it’s a matter of trying to establish why the goal was set and

what the possibilities are of reaching the target Major cost reductions can be broken down into smaller reductions

and form their own activities where they are easier to handle The activity is planned for a particular day when the change should

be made and the new cost applies Individual activities have a status in that the activity is either

initiated, preliminary, final, verified, or rejected Each activity bears its own investment and contribution according

to an investment estimate The activity does not commence until the investment estimate has

been approved and resources with the appropriate competence have been allocated and planned

Life Cycle Costing• Life-cycle costing tracks and accumulates all product costs in the value

chain from research and development and design of products and processes through production, marketing, distribution, and customer service

• The value chain is the set of activities required to design, develop, produce, market, and service a product (or service)

• Life-cycle costs are all costs associated with the product for its entire life cycle.

These costs include development (planning, design, and testing), manufacturing (conversion activities), and logistics support (advertising, distribution, warranty, and so on)

Contd..• Target Costing and Kaizen Costing together makes the Life Cycle cost

• Whole-life cost is the life-cycle cost of a product plus after-purchase (or post-purchase) costs that consumers incur, including operation, support, maintenance, and disposal

• Thus reducing whole-life costs can provide an important competitive advantage

• Cost reduction is achieved by judicious analysis and management of activities

• Studies show that 80 percent or more of a product`s costs are committed during the development stage. Thus, it makes sense to emphasize management of activities during this phase of a product`s existence

• The real opportunities for cost reduction occur before manu facturing begins• Therefore, Managers need to invest more in premanufacturing assets and

dedicate more resources to activities in the early phases of the product life cycle so that overall whole-life costs can be reduced.

Contd..

Pricing based on target costing• Target selling price - Desired profit = Target cost

• - Markets determine prices (given);- Desired profit must be sustained for survival (given);- Target cost is the residual, the variable to be managed

Contd..• Target costing is a pricing method that involves (1) identify ing the price at which a product will be competitive in the

marketplace, (2) defining the desired profit to be made on the product, (3) computing the target cost for the product by subtracting the desired

profit from the competitive market price. The formula• Target Price - Desired Profit = Target Cost• Target cost is then given to the engineers and product designers, who use

it as the maximum cost to be incurred for the materials and other resources needed to design and manufacture the product.

• It is their responsibility to create the product at or below its target cost

An Example Toyota, for example, calculates the lifetime target profit for a new

car model by multiplying a target profit ratio times the target sales They then calculate the estimated profit by subtracting the

estimated costs from target sales Usually, (at this point), target profit is greater than estimated profit. The cost reduction goal is defined by the difference between the

target profit and the estimated profit Toyota then searches for cost reduction oppor tunities through

better design of the new model Toyota`s management recog nizes that more opportunities exist for

cost reduction during product planning than in actual development and production.

Throughput Costing Also called super-variable costing, throughput costing is a

relatively new development. Throughput costing treats all costs as period expenses except

for direct materials. In other words, the matching principle is honoured only for

direct materials

Throughput Costing

Define:• Method of costing a product where only the unit level direct

costs are assigned to the product

• Criteria's1.Nature of the manufacturing process2.Management preference of cost accounting information

Contd..

• Throughput costing only makes sense for companies engaged in a manufacturing process in which most labor and overhead are fixed costs

For example, thirty factory employees might be required to work a given shift, regardless of whether the machinery is set at full capacity or less

The second criterion is that management prefers cost accounting information that is helpful for short-term, incremental analysis,

such as whether the company should accept a one-time special sales order at a reduced sales price

How Throughput accounting income statement is constructed

Product Cost(Direct Material)

Period Cost

Production Cost:Direct LaborVariable Overhead

Non production CostFixed Variable

Inventory

Beginning InventoryProduct Cost Incurred:Direct Material

Goods Available for sale

Less: Ending InventoryCost of Goods Sold

Throughput

Costing Income Statement

How Throughput accounting income statement is

constructed Revenue(Units Sold* Price per unit) XXDirect Material Cost:Production(Unit Sold*Direct Material unit cost) XX

Throughput Contribution

Other Cost:Production(Direct labor Fixed and Variable Overhead) XXNon Production Cost(Fixed and Variable Selling & Adm.) XX

Operating Income

Comparison between Absorption, Variable and Throughput Costing

Quality Costing• Quality costs are the costs associated with preventing, finding, and

correcting defective work. These costs are• huge, running at 20% - 40% of sales.• Many of these costs can be significantly reduced or completely avoided. • One of the key functions of a Quality Engineer is the reduction of the total

cost of quality associated with a product

Contd..Quality costs can be broken down into four broad groups1. Prevention Cost2. Appraisal Cost3. Internal Failure Cost4. External Failure Cost

Prevention Costs:

• Generally the most effective way to manage quality costs is to avoid having defects in the first place

• It is much less costly to prevent a problem from ever happening than it is to find and correct the problem after it has occurred.

• Prevention costs support activities whose purpose is to reduce the number of defects. Companies employ many techniques to prevent defects for example statistical process control, quality engineering, training, and a variety of tools from total quality management.

• Prevention costs include activities relating to quality circles and statistical process control.

• Quality circles consist of small groups of employees that meet on a regular basis to discuss ways to improve quality. Both management and workers are included in these circles.

Appraisal Costs• Any defective parts of products should be caught as early as possible in the

production process.• Appraisal costs, which are sometimes called inspection costs, are incurred

to identify defective products before the products are shipped to customers. • Unfortunately performing appraisal activates doesn't keep defects from

happening again and most managers realize now that maintaining an army of inspectors is a costly and ineffective approach to quality control.

• Employees are increasingly being asked to be responsible for their own quality control. This approach along with designing products to be easy to manufacture properly, allows quality to be built into products rather than relying on inspections to get the defects out.

Internal failure Costs:

• Failure costs are incurred when a product fails to conform to its design specifications. Failure costs can be either internal or external. Internal failure costs result from identification of defects before they are shipped to customers.

• The more effective a company's appraisal activities the greater the chance of catching defects internally and the greater the level of internal failure costs.

• This is the price that is paid to avoid incurring external failure costs, which can be devastating.

External Failure Costs:

• When a defective product is delivered to customer, external failure cost is the result.

• External failure costs include warranty, repairs and replacements, product recalls, liability arising from legal actions against a company, and lost sales arising from a reputation for poor quality. Such costs can decimate profits.

• In the past, some managers have taken the attitude, "Let's go ahead and ship everything to customers, and we'll take care of any problems under the warranty." This attitude generally results in high external failure costs, customer ill will, and declining market share and profits.

• Internal failure costs, external failure costs and intangible costs that impair the goodwill of the company occur due to a poor quality so these costs are also known

as costs of poor quality by some persons.

Incremental Analysis for Decision Making

Acceptance of a special order:This refers to the situation when a company receives requests to provide a good or service which is not in their regular schedule. Examples include production of ad-hoc orders on apparel, or the provision of

special cleaning services.

Before management makes the decision of whether or not to accept the special order, they have to assess if additional profit brought in by the acceptance.

ExampleSuppose PBE Company produces caps for sports brand names. The company currently produces and sells 200,000 caps and has a monthly fixed cost of $500,000. The variable cost per cap is $4 which consists of $3 direct material and $1 direct labour. Each cap is sold for $10 to sports retailers. If PBE receives a special order for 15,000 caps at $9 each, should management accept this order?

Situation 1 – spare capacityFirst we simplify the situation by assuming that PBE has spare capacity to take up the special order. The fixed cost of $500,000 is incurred regardless of whether PBE takes up the order or not. This cost is a sunk cost which is irrelevant to our decision-making process. The only concern is whether after accepting the order will bring in additional profit. We can present the result as follows:

Order rejected Order acceptedRevenue $0 $135,000 Cost $0 ($60,000) Profit $0 $75,000

Situation 2 – full capacityThe picture will be different if PBE is already running at full capacity. When full capacity is reached, there is no surplus to accept an additional order. If it is accepted, the current orders will have to be given up. Accepting an order of 15,000 caps of $9 each means PBE has to give up the original order worth $10 each. The result can be presented as follows:

Order rejected Order acceptedRevenue $0 $135,000 Cost $0 ($60,000) Opportunity cost $0 ($90,000)Profit $0 ($15,000)