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STRATEGIC MANAGEMENT

AND COSTING SYSTEMS


12
At the end of the chapter, you should be able to:

• Understand the process of the activity-based


Analysis
• Identify the usual statistical control techniques
applied in quality management.
• Determine the effects of learning curve with the
total labor costs.
• Apply strategic profitability analysis.
• Prepare the journal entries using the backflush
costing system in its different trigger points.
• Understand the theory of constraints and relate
it with throughput accounting.
• Explain customer profitability analysis.
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 522

Introduction

The development and use of new managerial policies and models have dramatically changed the costing systems used to
generate, the more accurate, detailed, and timely informations. A tabular relationship of some of the new management
models and management accounting techniques is as follows:

Cost and management accounting


Management model techniques
• Just-in-time philosophy • Backflush costing
• Theory of constraints • Throughput accounting
• Activity-based accounting • Activity-based costing
• Human resources development • Learning curve theory
• Balanced scorecard • Strategic profitability analysis
• Life-cycle analysis • Life-cycle costing
• Continuous improvement • Kaizen costing

Activity-based costing (ABC)

It’s an overhead allocation issue….

The issue of activity-based costing (ABC) lies on how factory overhead and other indirect expenses are allocated among
two or more products. Traditionally, factory overhead is predominantly and conveniently allocated based on direct labor
costs or direct labor hours. This is because under an intensive labor-oriented production environment, direct labor costs
comprise a significant portion of total manufacturing costs.

Again the pervasive introduction of technology has changed the way production processes are done. Labor has become
an insignificant portion of total production costs. The changes made in the production process have redefined meanings in
accumulating costs and classifying production costs. It was found out that many of the factory overhead accounts are not
significantly related to direct labor. As costs are accumulated not with their relationship with the product but based on their
relationship with the process and the activities in a process. It was observed that factory overhead costs are incurred or
not incurred based on activity drivers. An activity driver (i.e., cost driver) causes costs to change (e.g., increase or
decrease) or not to change. Examples of activity drivers are number of batches, setups, material moves, production
orders, number of produces, design changes, design hours, square footage occupied and many more.

Activity (or cost) drivers are identified per batch, product or plant levels. Each level has its own set of activities and costs.
The costs include materials, direct labor and factory overhead. Materials and labor are easily identified and is therefore
directly assigned to a product and in a process. Factory overhead is an indirect cost, not directly identified with a product
or process and should be therefore allocated among products.
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 523

Sample problem 1. Activity-based costing-1

To illustrate the main difference between traditional costing and activity-based costing, consider that Dianne Company
produces two products with the following related production data:

Product 1 Product 2
Prime costs P 120 P 200
Production in units 20,000 80,000
Direct labor hours 6,000 hrs 14,000 hrs
Set-up time 900 hrs 100 hrs
Factory overhead, P8,000,000

Determine the unit costs under the traditional costing (TC) and activity-based costing (ABC) models.

Solutions /Discussions:

 Under the traditional costing method, the factory overhead is allocated based on direct labor hours. Under the
ABC method, the factory overhead’s cost driver is the set-up time.

 The overhead allocation rates are:

Overhead rate (TC) = P8M/ 20,000 DLH =P400 per DLH


Overhead rate (ABC) = P8M/ 1,000 set-up hours =P8, 000 per set-up hour

 The total unit costs under the two methods are calculated below (DLH = direct labor hours, SUH = set-up
hours):

Product 1 Product 2

TC ABC TC ABC
Prime costs P 120 P 120 P 120 P120
Factory overhead
[(6,000 DLH x P400)/ 20,000] 120
[(14,000 DLH x P400)/80,000] 70
[(900 SUH/20,000)] 360
[(100 SUH x P8,000)/80,000] 10
Total unit costs P 240 P 480 P 270 P 210

Production
ABC unit costs is
Unit sales price tends to
Resulting to
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 524

 Activity (or cost) drivers are identified per batch, product or plant levels. Each level has its own set of activities
and costs. The costs include materials, direct labor and factory overhead. Materials and labor are easily
identified and is therefore directly assigned to a product and in a process. Factory overhead is an indirect cost,
not directly identified with a product or process and should be therefore allocated among products.

 The unit costs computed under the ABC method are ore reliable than that computed under the traditional
costing method. In short, the traditional costing unit costs are misstated which leads to an erroneous decision of
setting unit sales price.

 Under the activity-based costing method, the unit cost of low-volume products is lower while the unit cost of
high volume products tends to be higher. This is the effect of “peanut-butter costing “. In this costing system
when the indirect costs are spread over a grater number of units produced, the unit cost becomes lower. While
if the production is lower, the unit costs gets higher.

 This is in direct contrast with the traditional costing where unit costs are still higher when production is higher,
and unit costs are lower when production is lower.

 This miscasting (e.g., understatement or overstatement) does not give the business an advantage to allocate
factory overhead based on traditional (or convenience-based) costing. Accuracy which is the underlying
premise of activity0based costing should substitute convenience (which is the justification of traditional costing)
to produce and provide more reliable, precise, and meaningful information for more progressive decisions.

To illustrate further the applications of activity-based costing, let us consider the next illustration presented in the next
page.
525 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12

Sample Problem 2. Activity-based costing and traditional costing

Deming Corporation now employs a full-cost system and has been applying its manufacturing overhead on the basis of
machine hours. The corporation plans using 50,000 direct labor hours and 30,000 machine hours in the coming year. The
following data shows the manufacturing overhead that is budgeted as follows:

Budgeted Budgeted
Activity Cost Driver Activity Cost
Materials handling No. of parts handled 6,000,000 P 720,000
Setup costs No. of setups 750 315,000
Machining costs Machine hours 30,000 540,000
Quality control No. of batches 500 225,000
Total manufacturing overhead costs P1,800,000

Costs, sales, and production data for one of the organization’s products for the coming year are as follows:

Prime costs:
Direct materials cost per unit P 4.40
Direct labor cost per nit (.05 DLH $ P 15/DLH) 0.75
Total prime costs P 5.15

Sales and production costs:


Expected sales 20,000 units
Batch size 5,000 units
Setups 2 per batch
Total parts per finished unit 8 parts
Machine hours required 80 MH per batch

Determine the cost per unit for the product for the coming year using the traditional costing and the activity-based costing
methods.

Solutions / Discussions:

 The unit cost under the traditional costing method is computed as follows:

Overhead rate per machine hour (P1, 800,000 / 30,000 MH) P 60


Overhead rate per unit (P60/MH x 80 MH / 5,000 units) P 0.96
Prime costs 5.15
Total unit cost (traditional costing) P 6.11
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 526

 The unit cost under the ABC model is calculated as follows:

 The budgeted overhead rates per cost drivers are:

Activity OH Rate/Cost Driver


Materials handling (P720, 000 / 6 million parts) P 0.12 per part
Setup costs (P315, 000 / 750 setups) P 420 per setup
Machining costs (P540,000 / 30,000 MH) P 18 per MH

 The budgeted unit costs are:

Factory overhead per unit:


Materials handling (P 0.12 per part x 5 parts) P0.600
Setup costs (P420 per setup x 2 / 5,000 units) 0.168
Machining costs (P18 per MH x 20 MH / 5,000 units0 0.288
Quality control (P420 per batch / 5,000 units) 0.084 P 1.14
Prime costs per unit 5.15
Total unit costs (activity-based costing) P 6.29

The ABC process

ABC assigns costs to activities rather than to organizational units. The ABC process may be summarized as follows:

 Set-up the ABC system. This is done through the establishment of the activity-based management (ABM) system
which serves as the linkage of product costing and the continuous improvement of processes. Process
improvements start from process value analysis which is a comprehensive understanding of how an organization
generates its output by mapping out its activities in the process. Thereupon, activities are classified as value-
adding or non-valued-adding activities.

 Identify the resource drivers. These are factors that cause changes in the costs of an activity. Costs are
accumulated for an activity-based system where the flow of resource consumption is observed.

 Identify the activity drivers. Activities are classified according to their relation to a particular activity driver known
as driver analysis. It is an analysis that emphasizes the search for

• The cause-and-effect relationship between an activity and its consumption of resources, and
• An activity and the demands made on it by a cost pool.

Activity drivers are grouped as shown on the next page:


527 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12

Process levels Activity drivers

Unit level direct labor hours, direct labor pesos, machine hours,
unit of output

Batch level setup time, number of batches, material moves,


orders processed, number of receipts, weight of
material handled, number of inspections, or number
of production orders

Product level design time, testing time, number of engineering


change orders, number of categories of parts, design
changes, or number of products

Facility level square footage occupied, or any of those mentioned


in the three levels

 Group similar or homogenous activities in relation to specific activity driver.

 Estimate costs based on their cost-driver or activity-driver.

The ABC process is included in the system of activity-based management (ABM). This system serves as a linkage of
product costing and continuous improvement of processes which encompasses driver analysis, activity analysis, and
performance measurement.

ABC has its advantages and limitations, as presented below:

BENEFITS COSTS

Accuracy. Overhead is accumulated based on Costly to implement.


multiple cost pools related to activities instead of in a
single pool. Product costing does not conform with GAAP.
Example, ABC may classify research as product cost,
Continuous improvement. Activities are and plant depreciation, insurance or taxes as period
continuously mapped, analyzed, and studied in costs.
relation to a particular cost object thereby assisting in
identifying non-value adding activities. These
advantages result to a better cost control and more
efficient operations.

ABC is most applicable to those organizations with products or services that


 Vary significantly in volume, diversity of activities, and complexity of operations;
 Relatively high overhead costs; or
 Operations that have undergone major technological or design changes.
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 528

Product-life cycle costing

Traditionally, costs of units produced are computed based on the costs of materials, labor and overhead. The production
costs are accumulated based on job-order costing and process costing. This model is now considered too shortsighted,
not comprehensive, erratic and does not provide decision makers the overall and accurate picture of the entire costing
process. Consequently, if the computed cost is incorrect, sales price tends to be incorrect. To address the weaknesses of
the traditional coating systems and to capture the new ways of managing, the life-cycle costing was developed.

Life cycle-costing estimates and determines the total cost of a product over its life cycle. A product life cycle has five (5)
stages, namely: pre-infancy (or start-up stage), growth stage, expansion stage, and maturity/decline stage, as shown
below:

Growth rate Product life-cycle


Time

Pre-infancy Infancy Growth Expansion Maturity/ Decline

The product life-cycle costing is related to quality –based business cycle premise on the proposition that quality starts
from “effective listening to customers”. It commences from research and development, to design engineering, production,
marketing, channels of distribution, and customer services. This process is shown below.

Quality-based Business Cycle

Production

Design engineering Marketing

Research and Channels of


Development distribution
Customer
Services
529 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12

This new business cycle has four (4) groupings of costs: upward costs (e.g., research and development and design
engineering), production costs, downward costs (e.g., marketing and channels of distribution), and post-sales services
costs (e.g., customer services). Recent studies have shown that about 80 % of the total business cycle costs are already
locked-in even before the very first unit of product is produced. This pushes the issue that product costing should not be
confined within the production costs but should include all costs of doing business from research and development to
customer services. In this approach, strategic costing should be more reliable and accurate leading to better strategic
pricing and operating performance.

Life-cycle costing gets the average unit cost over the entire life span of a product. This would give managers an idea on
the long-term sales price of a product. As product costing fine tunes the business costs strategically, product pricing may
be made equally throughout the product life, or product pricing may be higher during the initial years of product life and
gradually decreases as the product nears its maturity and decline. Or, still, product pricing may be initially set at a lower
price and gradually increases as the product approaches growth and expansion. On top of all these, life-cycle costing is
also affected by the introduction of new technology or processes even before a product reaches its maturity stage. This
situation also calls for consideration in strategic pricing.

Sample problem 3. Life-cycle costing

Rene Corporation is introducing a new model in one of its product lines. This model is expected to have a 3-year product
life and would incur the following costs and production (M = millions):

Upstream costs (e.g., research and development product design) P20 M


Production costs 40 M
Downstream costs (e.g., marketing and channel of distribution) 20 M
After-sales services costs 10 M
Total product costs P 90 M

Estimated production in units:


Infancy period 1M
Growth period 4M
Expansion period 8M
Maturity period 2M
Total 15 M

Required: Determine The strategic sales price over the life of the model if:

1. Unit sales price is set at 200% of the total product costs.


2. unit sales price is set at 150% in the first year, 400% in the second year, and 120% in the third year.
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 530

Solutions / Discussions:
1. The life-cycle unit cost is P6.00 (eg, P90M / 15M). The unit sales price is P12.00 (eg, P6 x 200%).
2. The sales price are:
First year P6 x 150% P 9.00
Second year P6 x 200% 24.00
Third year P6 x 120% 7.20

Statistical Control Techniques and Other Quantitative Techniques

Statistical control techniques are operations research models used to map up processes, monitor and evaluate quality
indicators, and provide intelligent alternative solutions. Statistical control techniques are numerical reports expressed in
statistical terms and presentations used to predict and monitor activities towards a more efficient and more effective
operations. These techniques include lines (eg, regression line, line graph, etc.), graphs (eg, bar graph, histograph, etc.),
dispersion or deviations (eg, such as those expressed in x-graph, r-graph, etc.), and other related analysis that are
conveniently used to identify and describe patterns and potential problems in the business operations.

The other quantitative techniques include Gantt Chart, PERT/CPM, Pareto’s Law, regression analysis, fish-bone analysis,
linear and dynamic programming, and learning curve theory. Gantt Chart is used to trace project schedules and activities
as to their sequence, parallel undertakings, and time of completion. PERT/CPM is used in estimating a project (or
process) completion time and activity costs using probabilistic principles. Pareto’s Law is the 80-20 rule, which states, for
example, that 80% of the problems in a particular process is contributed by 20% of the total activities, or vice-versa.
Pareto’s Law is applicable in every conceivable business process and in all fields of managing such as human resources,
financial management, marketing management, warehousing, logistics, legal department, accounting department, etc.

Learning curve theory

Productivity Rate
Learning Curve Theory

One of the applications of Pareto’s Law is the


learning curve theory which states that pro-
ductivity rate marginally increases as emplo-
yees gain experience in his work. Normally,
efficiency increases by an average of 20% for
every doubling .

0 Time
531 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12

There are two models used in the learning curve theory, the Wright Model and Crawford Model. The Wright Model states
that each time the cumulative quantity of output doubles, the cumulative (or moving) average time to produce per unit
decreases by a certain percentage. The decrease I percentage to produce an additional unit is 20%. This rate changes
across industries between 60% and 85%.

The Crawford model (i.e., incremental-unit-time learning model) predicts the time required to produce the last units
requires getting the total of each unit’s time to compute cumulative total time and cumulative average time per unit.

Sample problem 4. Learning curve theory applications: cumulative average time

To illustrate the learning curve theory using the Wright model, let us assume a 20% learning rate, and a worker initially
needs 20 hours to produce the first unit. The average direct labor cost is P30. analyze the effects of the learning curve
theory.

Solutions / Discussions:

 The learning curve theory has the following effects:

a b C(axb) d E(cxd) F(e/a)

Units Moving average Estimated total DL cost Total DL Average DL cost


Labor hours per unit hours to produce per hour cost per unit
the units

1 20.00 20.00 P 30.00 P 600 P 600


2 (20 x 80%) 16.00 32.00 30.00 960 480
4 (16 x 80%) 12.80 51.20 30.00 1,536 384
8 (12.80 x 80%) 10.24 81.92 30.00 2.458 307
16 (10.24 x 80%) 8.19 131.04 30.00 3,931 246
32 ( 8.19 x 80%) 6.55 209.60 30.00 6,288 197

 Take note, as the number of units produced doubles, the average labor hours per unit decreases (i.e, from 20 hours
to 16 hours, to 12.8 hours, to 10.24 hours, etc.).

 Also note that the average direct labor cost per unit decreases by 20% as number of output doubles (e.g., P600 x
80% - P480; P 480 x 80% - P384, etc.).

 Learning curve rate may be determined as follows:


a. Based on average DLH per unit
Learning curve rate = 16 hrs / 20 hrs = 80%

b. Based on average DL cost per unit


Learning curve rate = P480 / P600 = 80%
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 532

Strategic Profitability Analysis

The application of the balanced scorecard as discussed in chapter 3 brings an extended analysis of profitability.

 Evaluating the success of a strategy

Under the balanced scorecard philosophy, evaluating the success of a strategy involves the use of the Strategic
Profitability Analysis (SPA). It dissects the change in profit into growth factor, price-recovery factor, and productivity factor.
An example of such strategic analysis is given below:

Sample Problem 5. Strategic Profitability Analysis

Consider the following income statements of BS Company for the years ended 2006 and 2007:

Amount %
2006 2007 Change Change
Revenues P 16,000,000 P 22,000,000 P 6,000,000 10 %
Materials (9,600,000) ( 10,648,000) (1,048,000)
Direct labor (4,000,000) (6,072,000) (2,072,000)
Other expenses (2,000,000) (2,000,000) -
Profit P 400,000 P 3,280,000 P 2,880,000

An analysis of related data are as follows:


Quantity sold 400,000 440,000 40,000 F 10 %
Unit sales price P40 P50 P10 F
Actual direct 800,000 lbs. 968,000 lbs.
Materials quantity
Actual direct P 12 P 11 P (1) F
materials price
DM productivity ( 400,000 / 0.50) 0.50
Measure
Standard DM ( 440,000 / 0.50) 880,000
Quantity based on
2006 data
DM growth Change (800,000- 880,000) 80,000 UF
DM productivity (968,000-880,000) 88,000 UF
Variance
Actual DLH 200,000 264,000 64,000
Actual DLR P 20 P 23 P 3 UF
DL productivity (400,000 / 200,000) 2 220,000
Measure
Standard DLH based ( 440,000 / 2)
On 2006 data
DL Growth Change (200,000- 220,000) 20,000 UF
DL Productivity (264,000-220,000) 44,000 UF
variance
Required: Account for the change in net profit in 2007 using the strategic profitability analysis.

533 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12

Solutions / Discussions:

 The change in profit accounted for by itemizing the effects of the growth factor, price recovery factor, and
productivity factor, as follows:

Growth factor
Sales growth factor 50,000 F x P40 P1,600,000 F
DM growth factor 80,000 UF x P12 960,000 UF
DL growth factor 20,000 UF x P20 400,000 UF P 240,000 F

Price-Recovery Factor
Sales price-recovery factor P10 F x 440,000 4,400,000 F
DM price-recovery factor P(1) F x 880,000 (880,000) F
DL price-recovery factor P3 UF x 220,000 660,000 UF 4,620,000 F

Productivity Factor
DM productivity factor 880,000 F x P11 968,000 UF
DL productivity factor 44,000 UF x P23 1,12,000 UF 1, 980,000 UF

Increase in profit P 2, 880,000 F

 The growth factor is computed as follows:


Sales growth factor = (Sales this year – Sales last year) x Unit sales price last year
DM growth factor = (Standard DM quantity this year – DM quantity last year) x Unit direct materials
price
DL growth factor = (Standard DL hours this year – DL hours last year) x Unit direct labor rate last
year

 The price-recovery factor is computed as follows:


Sales price-recovery factor = (USP this year – USP last year) x Actual quantity sold this year
DM price-recovery factor = (actual UDM price this year – Actual UDM price last year) x Standard
DM quantity this year
DL price-recovery factor = (actual UDL rate this year – Actual UDL rate last year) x Standard
DL hours this year

 Productivity factor
DM productivity factor = (actual DM quantity this year – Standard DM this year) x Standard
Unit DM price this year
DL productivity factor = (actual DL hours this year – Standard DL hours this year) x unit
DL rate this year
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 534

BACKFLUSH COSTING

JIT and Backflush Costing

The use of Just-in-time inventory system among small and medium-sized companies in the industrialized economies has
brought the development of backflush costing.

In just-in-time, the trigger point is traced from the date a customer made an order. From their, machines and men are
prepared, and materials are ordered. As materials are ordered, it is safe to assume that the same would be immediately
used in the production process. This means that no materials inventory, or only a little materials inventory, would be
maintained by the enterprise. And since machines are maintained on their top operating conditions, men at their best
possible performance, and having an error-free production processes, the materials are certain to be converted into
finished goods and delivered to customers. To do all of these things, the applications of technology would be inevitable.
This brings direct labor costs minimal and indirect to the product being produced. This makes direct labor cost more of a
fixed cost rather than a variable cost.

This new manufacturing set-up suggests that materials inventory and work-in-process inventory would be an insignificant
cost in the production process. Backflush costing records until after the events have taken place, then costs are worked
backwards to “flush” out the manufacturing costs. So the accounting question is: at what point in the production and sales
processes would material costs be summarized and recognized? The point where the materials costs are backflushed is
called the trigger point.

The trigger points

There are three events that trigger the records kept in many backflush accounting systems:

Trigger
point Events Comments

1 Sale of goods This is the true trigger point because satisfying customers initially happens
when the right goods are delivered or sold to them. The completion of
goods does not give value to the enterprise until and only when the goods
are delivered to the customers.

Completion of This is only a secondary trigger point in a true backflush coating system
2 production because the quality of the JIT system is measured on the date the goods
are delivered to the customers and not on the dare of production.
In a true JIT system where there are absolutely no raw materials held on
Purchase of materials hand, this trigger point is irrelevant. However, while companies have not yet
3 reached the dream of backflush environment, the use of the materials
purchases date and the date of sale or production would still be popular.

535 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12

Sample Problem 6. Backflush costing- the trigger point is the date of sale

Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. It
uses backflush accounting and the following selected transactions occurred in one of its products in the month of
January 2009:

Raw materials purchases, 12,000 lbs. @ P10, P126,000.


Standard costs per unit:
Materials, 4 lbs. @ P10, P40.00
Conversion costs, P20.00
Production costs with 3,000 units
Direct materials used 11,400 lbs.
Conversion costs P62, 000

Required: Record the foregoing transactions assuming that materials are backflushed at the date the goods are
delivered to customers.

Solutions / Discussions:

 The transactions are to be recorded as follows:

Transactions Accounts Dr. Cr.


a. Raw materials purchases No entry

b. Incurrence of conversion
costs Conversion costs P62,000
Accounts payable, etc. P62,000

c. Finished goods completed No entry

d. Sale of goods to customers,


materials are backflushed Cost of goods sold 188,000
to cost of goods sold Conversion costs 62,000
Accounts payable 126,000

The backflushing of direct materials costs, and therefore the recording of the creditors account, is made at the date of
sale. No finished goods inventory is maintained. Conversion costs are recorded at the date of incurrence.

Sample Problem 7. Backflush costing-the trigger point is the date of production.


Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. It
uses backflush accounting and the following selected transactions occurred in one of its production I the month of
January 2009.

CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 536

Raw materials purchases, 12,000 lbs. @ P10, P126, 000.


Standard costs per unit:
Materials, 4 lbs. @ P10, P40.00
Conversion costs, P20.00
Production costs with 3,000 units
Direct materials used 11,400 lbs.
Conversion costs P62, 000
Sales, 3,000 units

Required: Record the foregoing transactions assuming that materials are backflushed at the date of completing
the goods produced.

Solutions / Discussions:

 The transactions are to be recorded as follows:

Transactions Accounts Dr. Cr.


a. Raw materials purchases No entry

b. Incurrence of conversion
costs Conversion costs P62,000
Accounts payable, etc. P62,000

c. Finished goods completed. Finished goods 126,000


Materials are backflushed Accounts payable 126,000
to finished goods

d. To close conversion costs to Cost of goods sold 62,000


cost of goods sold Conversion costs 62,000

e. Transfer of finished goods to Cost of goods sold 126,000


costs of goods sold Finished goods 126,000

The backflushing of direct materials costs, and also the recording of the creditors account, is made at the date of
completing the production. As such, finished goods inventory is maintained. Later, the finished goods inventory is also
backflushed to cost of goods sold. Conversion costs are recorded at the date of incurrence.

Sample Problem 8. Backflush costing-trigger points are materials purchases and point of sale
Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. It
uses Raw and In Process account to keep track of its materials and backflushed materials at the date goods are
completed. The following selected transactions occurred in one of its products in the month of January 2009:

537 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12

Raw materials purchases,


Direct materials 12,000 lbs. @ P10, P126,000
Indirect materials P4,400
Production costs with 3,000 units
Other conversion costs P62,000

Beginning and ending balances:

RIP FG
Beginning balance Direct materials 2,000 3,100
Conversion costs 900 1,200
Total 2,900 4,300
Ending balances Direct materials (1500) (4,200)
Conversion costs (600) (2,200)
Total 2100 6,300

Required: Record the foregoing transactions using the company’s backflush accounting system.

Solutions / Discussions:

The transactions are to be recorded as follows:

Transactions Accounts Dr. Cr.


a. Raw materials purchases Raw and in process 130,400
Accounts payable 130,400

b. Incurrence of conversion Conversion costs 62,000


costs Accounts payable, etc. 62,000

c. Finished goods completed No entry

d. Materials backflushed to Cost of goods sold 126,500


cost of goods sold as Raw and In process 126,500
follows:
DM, Beginning P 2,000
DM, Purchases 126,000
-DM, Ending 1.500
DM used( to be backflushed) P 126,500

e. To close conversion costs Cost of goods sold 62,000


to cost of goods sold Conversion costs 62,000

f. Adjustment to RIP account Cost of goods sold 300


on conversion costs 300
DM (900-600)

CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 538

In this version of backflush accounting, raw materials purchases are immediately recognized on the date of receipt. The
debit is made to the “Raw and in Process” account to impress that there is no materials stored in the warehouse,
however, still in the process of production. The cost of materials used is backflushed at the date of sale. There is no
finished goods inventory account to be maintained. Conversion costs are recorded at the date of incurrence.

Sample Problem 9. Backflush costing-the trigger points are materials purchases and point of production

Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. It uses Raw
and In process account to keep track of its materials and backflushed materials at the date goods are completed. The
following selected transactions occurred in one of its products in the month of January 2007:

Raw materials purchases,


Direct materials 12,000 lbs. @ P10, P126,000.
Indirect materials P4,400
Production costs with 3,000 units
Other conversion costs P62,000

Beginning and ending balances:

RIP FG
Beginning balance Direct materials 2,000 3,100
Conversion costs 900 1,200
Total 2,900 4,300
Ending balances Direct materials (1500) (4,200)
Conversion costs (600) (2,200)
Total 2100 6,300
Required: Record the foregoing transactions using the company’s backflush accounting system.

Solutions / Discussions:

Transactions are to be recorded as follows:

Transactions Accounts Dr. Cr.


a. Raw materials purchases Raw and In process P130,400
Accounts payable P130,400

b. Incurrence of conversion Conversion costs 62,000


Costs Accounts payable, etc. 62,000

539 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12

c. Finished goods completed Finished goods 126,500


Materials to be backflushed Raw and in process 126,500
Is computed as follows:
DM, Beginning P 2,000
DM, Purchases 126,000
-DM, Ending 1.500
DM used ( to be backflushed) P 126,500

d. To close conversion costs Cost of goods sold 62,000


to cost of goods sold Conversion costs 62,000

e. Transfer of Finished goods


to cost of goods sold,
computed as follows:
FG, Beginning P 3,100
+ Materials backflushed 126,500
-FG, ending 1,500
FG transferred to CGS P128, 100

f. Adjustment on RIP and FG Finished goods 1,000


balances on conversion costs Cost of goods sold 700
DM (900-600) Raw and in process 300
DL (1200-2200)

In this version of backflush accounting, raw materials purchases are also immediately recognized on the date of receipt.
The debit is made to the “Raw and in process” account to impress that there is no materials stored in the warehouse,
however, still in process of production. The cost of materials used is backflushed at the date of completing the production.
Finished goods inventory account is maintained and is later transferred to the cost of goods sold account. Conversion
costs are recorded at the date of incurrence.
Standard costing and backflush accounting

Standard costing may be used in the backflush accounting. If used, the variance between the actual conversion costs are
to be closed to the cost of materials and conversion costs.

CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 540

Throughput Accounting

The Theory of Constraints (TOC)

The concept behind the theory of constraints was first formulated and developed by Goldratt and Cox (1986) in their book,
The Goal. In 1990 Goldratt refined the concepts and eventually gave it the name the “Theory of Constraints”.

The theory focuses on constraints or bottlenecks which hinder speedy production. This binding constraint in the
production process dictates the pace of the manufacturing throughput rate. The idea is to remove or unclog the bottleneck
to accelerate the production process from the point of procuring materials up to the point of delivering the goods to the
customers.

The theory of constraints has a five-step procedure as follows:


1. Identifying constraints 4. Increasing the capacity of the binding constraints
2. Exploiting the binding constraints 5. Repeating the process when new binding constraints are identified.
3. Subordinating everything else to the
Decisions made in the second step.

There could be as many bottlenecks that could be found in the production processes. The bottlenecks could be in terms of
machine hours, direct labor hours, materials availability, market capacity, financial constraints and priorities, talents and
technology. These bottlenecks impede the capacity of the enterprise to produce more goods and services. In case the
market could still accommodate, the constraints or the bottlenecks should be managed with an aim of allowing the
production process to produce goods up to where they could meet customer demands. This means that if the present
bottleneck is machine hours, then efforts should be made to speed up the production process in the use of machine either
by re-lay-outing the production process, training men to be more skilled, acquiring more durable materials, or acquisition
of more machines. In the process, creativity, innovations, and systems improvements would come into play. The
processes of eliminating or unclogging the bottleneck should be made using the overriding criterion of benefit-cost
analysis as the guiding principle.

Once the most constraining bottleneck is remedied, then another most constraining bottleneck that principally hinders the
potential of the production process would be identified. This would then be remedied, and the cycle goes on until the
maximum capacity of the plant is attained. In such case, the overall plant becomes the bottleneck in responding to
customer demands.