COSTING SYSTEMS AND MANUFACTURING
PHILOSOPHY
Costing systems have evolved to reflect a manufacturing philosophy that is based on the need to achieve competitive advantage.
- Flexibility and the ability to respond quickly to customer demands are vital.
- Product life cycles are shorter and products must be brought to the market quickly.
- New technology has been introduced.
Costing systems
- Designed to complement the organisation’s operations flow
- Should reflect management philosophy and style
- Provide information which management can use to plan and control operations on a daily, monthly and longer-term basis
- Changes in manufacturing philosophy and new technology (CAM (computer aided manufacturing) and FMS (flexible manufacturing system)) require changes in information and cost reporting systems
− Collecting information in a different way
− Rethinking what data need to be collected
− Rethinking what information should be reported
New Systems
− Unit quantities (rather than monthly monetary values) reported to production employees
− Performance measures based on output (rather than hours worked) reported to management
Activities important to the organisation’s success should determine the information required. These might include:
− Accurate product costing
− Information to control costs
− Knowledge of customer costs
− Cost reduction
Traditional manufacturing philosophy
- Labour and manufacturing equipment are so valuable they should not be left idle.
- Resulting raw materials and stock not needed should be stored (thus hiding inefficient and uneven production methods).
- To increase efficiency and reduce production cost per unit, batch sizes and production runs should be as large as possible.
- Concerned with balancing production run costs and inventory holding costs.
Modern manufacturing philosophy
- Smooth, steady production flow (throughput)
- Flexibility, providing the customer with exactly what is wanted, exactly when it is wanted (making the organisation a more complex affair to manage), so as to achieve competitive advantage.
- Volume versus variety
- JIT
Just-in-time (JIT)
Just-in-time is an approach to operations planning and control based on the idea that goods and services should be produced only when they are needed, and neither too early (so that inventories build up) nor too late (so that the customer has to wait).
Just-in-time is a system whose objective is to produce or procure products or components as they are required rather than for inventory.
In traditional manufacturing, where there is a production process with several stages, management seek to insulate each stage in the process from disruption by another stage, by means of producing for, and holding, inventory.
For example, suppose a manufacturing process consists of four consecutive stages. In a traditional manufacturing system, there would be inventories of raw materials and finished goods, and also inventories of part-finished items between stage 1 and stage 2, between stage 2 and stage 3 and between stage 3 and stage 4. If there is disruption to production at, say, stage 2, the other stages would not be immediately affected. Stages 3 and 4 would continue to operate, using the inventories of part-finished items from stages 2 and 3. Stage 1 would also continue to operate, producing inventory for stage 2. The responsibility for resolving the disruption would fall mainly on the managers of the stage affected, which in this example would be the management of stage 2.
In contrast, in its extreme form, a JIT system seeks to hold zero inventories. In the same fourstage process described above, a disruption at any stage would immediately have an impact on all the other stages. For example, if a disruption occurs at stage 2, stages 3 and 4 will have to stop working because they have no output from stage 2. Stage 1 will also have to stop working, because it will only produce when stage 2 is ready to receive and use its output.
With JIT, a disruption at any point in the system becomes a problem for the whole operation to resolve. Supporters of JIT management argue that this will improve the likelihood of the problem being resolved, because it is in the interests of everyone to resolve it. They also argue that inventories help to hide problems within the system, so that problems go unnoticed for too long.
JIT can be regarded as an approach to management that encompasses a commitment to continuous improvement and the search for excellence in the design and operation of the production management system. Its aim is to streamline the flow of products through the production process and into the hands of customers.
BACKFLUSH COSTING
Backflush costing is suitable for use in a JIT environment. Costs are attached to output only, thereby simplifying the costing system.
Backflush accounting is the name given to the method of keeping cost accounts employed if backflush costing is used. The two terms are almost interchangeable.
Traditional costing systems v backflush costing
Traditional costing systems use sequential tracking (also known as synchronous tracking) to track costs sequentially as products pass from raw materials to work in progress, to finished goods and finally to sales. In other words, material costs are charged to WIP when materials are issued to production, direct labour and overhead costs are charged in a similar way as the cost is incurred or very soon after.
If a production system such as JIT is used, sequentially tracking means that all entries are made at almost the same moment and so a different accounting system can be used. In backflush accounting, costs are calculated and charged when the product is sold, or when it is transferred to the finished goods store.
Backflush costing is ‘a more simplified costing system for allocating costs between stocks and cost of goods sold…… The purpose of this is to eliminate detailed accounting transactions. Rather than tracking the movement of materials through the production process, a backflush costing system focuses first on the output of the organisation and then works backwards when allocating cost between costs of goods sold and stocks, with no separate
accounting for WIP.’ (Drury)
Backflush costing and standard costs
Budgeted or standard costs are used to work backwards to ‘flush’ out manufacturing costs for the units produced. (Hence the rather unattractive name for the system!) The application of standard costs to finished goods units, or to units sold, is used in order to calculate cost of goods sold, thereby simplifying the costing system and creating savings in administrative effort. In a true backflush accounting system, records of materials used and work in progress are not required as material cost can be calculated from either finished goods or goods sold.
When backflush costing is appropriate
Backflush costing is appropriate for organisations trying to keep inventories to the very minimum. In such circumstances, the recording of every little increase in inventory value, as each nut and bolt is added, is simply an expensive and non-value-added activity that should be eliminated.
Possible problems with backflush costing
The successful operation of backflush costing rests upon predictable levels of efficiency and stable material prices and usage. In other words there should be insignificant cost variances.
- It is only appropriate for JIT operations where production and sales volumes are approximately equal.
- Some people claim that it should not be used for external reporting If, however, inventories are low or are practically unchanged from one accounting period to the next, operating income and inventory valuations derived from backflush accounting will not be materially different from the results using conventional systems. Hence, in such circumstances, backflush accounting is acceptable for external financial reporting.
- It is vital that adequate production controls exist so that cost control during the production process is maintained.
Advantages of backflush costing
- It is much simpler, as there is no separate accounting for WIP.
- The number of accounting entries should be greatly reduced, as are the supporting vouchers, documents and so on.
- The system should discourage managers from producing simply for inventory since working on material does not add value until the final product is completed or sold.
Backflush costing and modern database/warehouse accounting
- With modern barcode readers and ordering systems, stock control and accounting can be built into modern ERP (enterprise resource planning) and accounting database systems such as SAP or Oracle. From the authorisation of the initial request/order, no further special voucher entries are required.
- Stock/WIP/FG are automatically taken care of in this type of accounting and so there is no saving here.
- The number of accounting entries are not affected.
- BUT the system can be instructed to produce “backflush costing” reports to discourage managers from producing simply for inventory since working on material does not add value until the final product is completed or sold.
CHAPTER ROUNDUP
- Costing systems have evolved to reflect a manufacturing philosophy that is based on the need to achieve competitive advantage.
− Flexibility and the ability to respond quickly to customer demands are vital.
− Product life cycles are shorter and products must be brought to the market quickly. − New technology has been introduced.
- Just-in-time is an approach to operations planning and control based on the idea that goods and services should be produced only when they are needed, and neither too early (so that inventories build up) nor too late (so that the customer has to wait).
- Backflush costing is suitable for use in a JIT environment. Costs are attached to output only, thereby simplifying the costing system.
