Just-in-time operations and backflush accounting

The just-in-time (JIT) approach to conducting the activities of an organisation is often incorrectly considered to relate solely to the manufacturing environment. In fact, just-in-time is a very broad philosophy that emphasises simplification and continuously reducing waste in each and every area of business activity. This implies that the application of the just-in-time philosophy is best directed towards an organisation in its entirety. While this is undeniably true, this article will focus on summarising the features of the just-in-time approach together with an explanation of backflush accounting, which has been developed in order to support just-in-time operations.

The main aims of just-in-time are aligned with those of total quality management (TQM). The primary focus is on the elimination of waste and non-value added activities, and the production of goods which possess 'zero defects'. In a similar vein to TQM, the just-in-time philosophy focuses on the customer - on-time delivery of products on every occasion is critical.

It has been suggested that the explanation for the development in Japan of JIT is down to the country's economic circumstances. Operating from a small, geographically isolated nation - with little in the way of natural resources and with scarce land space - Japanese manufacturers were at a relative disadvantage compared with some of their western competitors. JIT evolved as a response to these resource constraints. Where the management of an organisation is considering the implementation of a just-in-time philosophy they need to give detailed consideration to the following:

• Employee involvement should be actively encouraged. This will help to reduce levels of reluctance to participate in change management programmes that will be crucial to the successful transition to just-in-time operations. The successful operation of just-in-time requires that workers possess a flexibility of both attitude and aptitude. Workers may be individually responsible for ensuring adherence to prescribed quality levels and manufacturing may be organised in such a way that individual roles will change significantly.
• The fundamental requirement to ensure that the level of quality satisfies the customer.
• A constant focus on the simplification of products and processes in order to maximise the utilisation of available resources.
• The creation of a uniform factory load which will enable the speed of manufacture to mirror the demand of customers.
• The minimisation of set-up times as no value is added at this point in the manufacturing process.
• The factory layout to be adopted. The majority of factories operating just-in-time manufacturing operations have adopted a U-shaped layout of machinery. This layout facilitates the flow of components, thereby minimising transportation activities while maximising efficiency.
• The operation of a 'pull' system which produces products for the time when they are required by customers. This is a complete change from traditional 'push' through production which can hardly be described as being customer-focused!
• The fundamental need for excellent relationships with suppliers, putting emphasis on flexibility and good communication channels.

Just-in-time manufacturing enables purchasing, production, and sales to occur in quick succession with stock being maintained at minimum levels. The absence of stock renders decisions regarding cost-flow assumptions (such as weighted average or first-in, first-out) or stock costing methods (such as absorption or marginal costing) unimportant. This is because all of the manufacturing costs attributable to a period flow directly into cost of goods sold. Job costing is simplified by the rapid conversion of direct materials into finished goods that are then sold immediately.

Traditional and standard costing systems track costs as products pass from raw materials, to work in progress, to finished goods, and finally to sales. Such systems are called 'sequential tracking systems' because the accounting system entries occur in the same order as purchases and production. Where management attempts to track direct material and labour time to individual operations and products, then sequential tracking can prove to be very costly. The implementation of a just-in-time philosophy will cause a change in the role of the management accountant. This is because traditional management accounting techniques are rendered inappropriate due to their incompatibility for use in conjunction with just-in-time operations. For example, traditional variance analysis focuses on maximising capacity utilisation while attempting to minimise costs.

The minimisation of costs will always remain an important consideration. However, the focus has shifted to value appreciation while attempting to minimise costs. Management is therefore required to provide financial and non-financial information regarding supplier performance, on-time deliveries, cycle times, and the number of defective items manufactured.

Backflush accounting

These new requirements for management information have necessitated changes in the processes and accounting methods in order to enable the provision of such information. This explains the growth in the application of backflush accounting systems that are used to support just-in-time operations. Backflush accounting focuses on the output of an organisation and then works backwards when allocating costs between cost of goods sold and inventories. It can be argued that backflush accounting simplifies costing since it ignores both labour variances and work-in-progress. While in a true just-in-time environment there would be no work-in-progress at all, there will, in practice, be a small amount of work-in-progress in the system at any point in time.

This amount, however, is likely to be negligible in quantity and therefore not material in terms of value. Thus, a backflush accounting system simplifies the accounting records by avoiding the need to follow the movement of materials and work-in-progress through the manufacturing process within the organisation. The backflush accounting system is likely to involve the maintenance of a raw materials and work-in-progress account together with a finished goods account. The use of standard costs and variances is likely to be incorporated into the accounting entries. Transfers from raw materials and work-in-progress account to finished goods (or cost of sales) will probably be made at standard cost. The difference between the actual inputs and the standard charges from the raw materials and work-in-progress account will be recorded as a residual variance which will be recorded in the profit and loss account. Thus, it is essential that standard costs are a good surrogate for actual costs if large variances are to be avoided.

Backflush accounting is ideally suited to a just-in-time philosophy and is employed where the overall cycle time is relatively short and inventory levels are low. Naturally, management will still be eager to ascertain the cause of any variances which arise from the inefficient usage of materials, labour, and overheads. However, investigations are far more likely to be undertaken using non-financial performance indicators as opposed to detailed cost variances.

The following example illustrates the preparation of accounts using a system of backflush accounting under two variants. 'Trigger points' determine when entries are recorded in the accounting system. Variant 1 (Table 1) has two trigger points, variant 2 (Table 3) has only one. Wallace plc manufactures a single product called the 'Grommit'. The transactions for the month of March 2004 were as follows:

There were no opening inventories of raw materials, work-in-progress or finished goods at 1 March 2004. The standard and actual cost per unit of output is $36 ($20 materials and conversion costs of $16, of which labour comprises $6.40).

Variant 1

• Trigger point 1: The purchase of raw materials
• Trigger point 2: The manufacture of finished goods.

Table 2 shows the ledger accounts in respect of the above transactions. The inventory balances as at 31 March 2004 are:

The balance of £8,000 on the conversion costs account would be debited to the profit and loss account.

Variant 2
This is the most simple variant of backflush accounting which has only one trigger point that we shall assume is the completion of a 'Grommit'. Conversion costs are debited as the actual costs are incurred by Wallace plc. The accounting entries under this variant are shown in Table 3.

At the end of March 2004 there will be a balance of $72,000 in the finished goods inventory account (2,000 Grommits at $36). As far as raw materials are concerned then $20,000 of raw materials have been purchased but are yet to be converted into Grommits (ie finished goods), and therefore will not have been recorded in the internal costing system of Wallace plc. Consequently, this amount will not be incorporated within the value of inventory at the end of March 2004.

The variants illustrated above eliminate the need to record movements in work-in-progress. Proponents of backflush accounting argue that, in situations where inventory levels remain low, the preponderance of manufacturing costs will form part of cost of sales. This is as opposed to being deferred into inventory. As a consequence, there is little benefit in tracking the costs of stock movements through work-in-progress, cost of sales, and finished goods inventory. Here lies the considerable benefit of the application of backflush accounting in that its application greatly reduces the volume of accounting transactions which would be recorded in a conventional costing system. In keeping with a just-in-time philosophy the recording of such transactions can be regarded as a non-value added activity.

Reference
Drury, C Management and Cost Accounting 5th edition (Thompson Learning Press, 2000)

Shane Johnson is examiner for Paper P5