Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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balance itself is of no great logical significance. Properly
it is not profits, but merely the sales less some, but not all,
of the cost or expense of making the sales. Nevertheless
there are advantages in making a comparison of cost and
selling price as these figures lend themselves conveniently
to statistical results. A merchant generally bases his sell-
ing price on the cost price, either adding a given percent-
age, or by fixing it so that difference between cost and
selling price is a percentage of the latter. Thus, where
merchandise is bought at $1.20 a yard, the price may be
fixed so as to yield, say, 25 per cent. " profit," or other-
wise expressed so that 20 per cent, of the selling price will
be gross profit, that is, at $1.50. Basing the selling price
thus on the prime cost is almost a necessity, for the trad-
ing expenses are not known when the price is fixed, while
the cost is easily ascertained through the invoices. The
keeping of the accounts thus somewhat parallel with actual
business processes has practical advantages. But a glance


at the various forms used by accountants shows at once
that practice is far from uniform.

If items other than the direct costs are to be included
in the Trading Account the criterion by which selection
is to be made offers new difficulty. The one frequently
followed is to include only those expenses which are at
least roughly proportionate to the amount of goods sold.
But this line of division is most vague, and custom, while
including wages of salesmen and commissions to travelers,
excludes the wages of bookkeepers, which equally may vary
with the amount of business transacted.

3. "What constitutes selling price is another problem,
for at times it is difficult to determine whether a given
charge is a deduction from the selling price or a part
either of the selling or of the general administrative ex-
penses. The discounts allowed on sales come under this
class of doubtful items. Custom seems to favor deducting
from the sales the trade discounts, that is, those deduc-
tions conventionally allowed to dealers from the nominal
selling price. On the other hand, the discount allowed
for an early payment of the account, according to Lisle,
should not be deducted from sales, but be treated as is
interest and discount paid the bank, that is, as a cost of
obtaining the needed working capital. Thus it results that
the difference between the nominal selling price and that
actually received may appear in either one of three sections
of the Profit and Loss statement; in the first as a deduc-
tion from sales, in the second as a selling expense, or in a
subsequent one as the cost of borrowed capital.

4. Of greater theoretical, but of less practical interest
is the location of taxes. This is shown clearly in the case
of railroads. Some roads, as for instance the Southern
Railway and the Illinois Central, treat taxes as being co-
ordinate with Operating Expenses and deduct them from
Gross Earnings. Others treat them as fixed charges, simi-


lar to interest, and deduct them from the Net rather than
from the Gross Earnings. The revised form proposed by
the Interstate Commerce Commission makes a special divi-
sion for taxes, as is shown in form 111, and still other
accountants argue that taxes should be treated as part of
the Net Profits.

It is impossible to say that any one of these views is
absolute and exclusive. Perhaps even the system of taxa-
tion may influence the decision as to the proper treatment
of taxes in accounts. A strong argument can be made in
favor of the view that taxes are really a part of profits
and not a deduction from earnings to be made before
determining profits. In so far as the stockholder is con-
cerned it turns on two facts: whether the taxation of the
road exempts the stockholders from other taxation; and
whether the capitalist would escape taxation on other in-
vestments. If the stockholder has his dividends lessened
by the taxes paid, but in all probability would pay no
taxes were his funds invested, say, in bonds or mortgages,
the taxes are, from his point of view, in no sense a distri-
bution of profits. But where there is an income tax uni-
formly enforced, and the payment of taxes by the road
works merely as a stoppage of that part of the income, it
is not illogical to consider the tax as a distribution of part
of the Net Profits derived from operating the road.

5. Of much greater importance is the treatment of
depreciation. In a preceding chapter it was shown that
depreciation, despite conflicting usage and authority, is a
charge which should invariably be made. Here the ques-
tion is as to the section of the Profit and Loss Account
using the title in its broadest sense in which depreciation
should appear. Almost all possible combinations are found
even in the relatively few accounts in which depreciation
shows at all. In some few cases it is subtracted from
Gross Earnings, and thus, like expenses, is prior to the


determination of Net Earnings. This is done for instance
by the National Biscuit Company. By some, for instance
the Chicago City Railway Company, it is even distinctly
included among the expenses., Much more frequently it
is subtracted from Net Earnings, in which place it may
rank along with dividends or may be regarded as one of
the fixed charges; since in many accounts fixed charges,
depreciation, dividends, and reserves are all together sub-
tracted from " Net Earnings " without any intermediate
balancing to indicate how much of the net earnings are at
the same time " Net Profits." An example of this treat-
ment is found in the accounts of the International Mercan-
tile Marine Company. In still other companies the deduc-
tion is clearly made from what is called Net Profits, that
is, it is deducted, together with dividends, from the balance
remaining after fixed charges have been met. This is done
by the Republic Iron and Steel Company. And finally
the Diamond Match and numerous other companies sub-
tract depreciation from the surplus after the dividends
have been paid. Depreciation charges are thus variously
regarded as partaking of the nature of expense, of fixed
charges, of profits reserved or placed in a surplus. In
railroads depreciation has almost never been specifically
allowed. The recent ruling of the Interstate Commerce
Committee referred to above demands, however, that it be
included, at least so far as equipment is concerned, among
the operating expenses.

Those who have followed the argument of this treatise
will agree that it is a radical error to treat depreciation as
anything else than a deduction to be made before profits
are ascertained, and that, allowing for variations in the
use of terms, it must inexorably appear in the Income Ac-
count before the balance called Net Income is reached.
But so far as shown by the published accounts only about
one third of the corporations making any allowance for de-


preciation deduct it before obtaining the sum which by
whatever name it is called is apparently available for
dividends. The strong position taken by the Interstate
Commerce Commission is theoretically correct, for depre-
ciation is really an expense. In the formal statements of
manufacturing concerns depreciation of the plant should
appear in the Manufacturing Account, the depreciation of
office and store equipment in the Trading Account rather
than among the fixed charges as a deduction from Net,

Even to treat depreciation as a fixed charge, though
that is a great improvement over regarding it as an
optional disposition of profits, is illogical. Depreciation
represents an expense not only preceding profit to the
stockholders as such, but prior also to the earnings on
the invested capital as a whole, whether that capital is
represented by bonds or stock. Whether a road costing
$100,000,000 is financed by issuing $100,000,000 stock, or
by issuing only half that sum in stock and an equal amount
in bonds, the invested capital (using capital in the eco-
nomic, not in the accounting, sense) is the same, and the
earnings of that investment should appear the same in the
Income Account. No change of form of capitalization
affects these earnings. Interest charges may increase, but
the earnings ceteris paribus remain unchanged. But not so
with depreciation. A smaller charge shows indeed larger
apparent earnings, but such a showing is false and decep-
tive. Depreciation, therefore, is not logically to be treated
as coordinate with interest charges.

It is even more erroneous to treat the fixed charges-
as superior to depreciation. Unquestionably there is an
insistence about interest charges which appeals to the
directors in a way in which a charge erroneously called a
"mere bookkeeping charge " is not regarded. But the
compulsion to make a payment has nothing to say regard-


ing the position of the charge in the Income Account.
Needed repairs may, perhaps, be deferred for years, while
the payment of a collateral note is imperative and un-
avoidable. But the inclusion of repairs among expenses
is never even questioned, while the payment of a note has
no place whatever in the Income Account, does not in the
least affect the determination of profits. A sound system
of accounting will therefore not make depreciation subse-
quent to fixed charges merely because of the imperative
nature of the latter payments.

Finally placing depreciation charges after net profits
is not only incorrect in theory, but tends to the vicious
policy of making the amount of depreciation depend on
the amount of profits and of omitting it altogether when
there are no net profits against which it may be charged.


BROAKER, F. and CHAPMAN, R. M. The American Accountants'
Manual, I, pp. 131-148. New York, 1897.

CHAMPNESS, C. H. Form and Arrangement of Profit and Loss
Accounts. Accountant, XXIII, 1904.

LISLE, G. Accounting in Theory and Practice, pp. 55-63. Edin-
burgh, 1906.

Manufacturers' Accounts. Article hi Encyclopedia of Account-
ing, V, pp. 1-5.

Profit and Loss Account. Article, Ibid., V, p. 366.

Revenue Accounts and Balance Sheets. Encyclopedia of Account-
ing, VIII, pp. 249-326. [Contains an interesting collection of
Revenue Accounts of British companies.]



THE desire to distinguish between the elements of profit
due to industrial and commercial activities respectively led
to the formulation of the Manufacturing and Trading Ac-
counts. The stress of modern business and the keenness
of competition make necessary a more minute analysis and
a closer estimate. Not only must it be known what are the
manufacturing costs as a whole, but these must be so ana-
lyzed as to indicate the cost of each commodity, of each
process employed in production, even of each part, minute
though it be, of which the commodity is composed. Sys-
tems designed to secure such information are known as
Cost Accounts.

The attention given to such investigations is of recent
origin. The first reference to its desirability is said to be
that of Charles Babbage in his " Economy of Manufac-
ture," published in 1832, but half a century elapsed be-
fore factory managers began on any extended scale to
introduce systems of Cost Accounts. Since then increased
attention has been given to the subject, particularly under
the influence of engineers, to whom, rather than to pro-
fessional accountants, the credit of inaugurating and de-
veloping cost accounting is perhaps due.

More specifically the purposes of cost accounting are
as follows :

1. To indicate the probable actual cost of production
so as to enable the manufacturer to determine the price at
which he can profitably sell. This is particularly impor-



tant in engineering work where so much is done on con-
tracts rather than by producing stock goods for the open
market. Thus, for instance, a system of cost accounts,
accurately kept, should enable a shipbuilder to give an
estimate of the cost of constructing a vessel which would
be something more than guesswork.

2. Identical in principle is the value of cost accounts
in indicating whether the manufacturer shall produce
goods for the open market where the price is already
fixed by competition. Without such information manu-
facturers have undoubtedly continued to produce and sell
certain lines of goods which, at least to them, were un-
remunerative and a source of loss. Perhaps the market
price is fixed by some competitor whose peculiar advantage
in production gives profits at prices unremunerative to less
favored rivals; or perhaps the price is due to ignorance
on the part of the competitors who are themselves selling
at a loss while fancying that they are making profits. A
clear understanding as to whether the manufacturer can
produce so as to realize a fair profit at current prices is
of advantage not merely to the individual, but also to
society, as it serves to prevent the misdirection of capital
and the great loss which occurs when readjustment be-
comes necessary.

3. Cost Accounts have a further advantage in deter-
mining the advisability of introducing a new process, or
of substituting machine for hand labor. They have shown,
for instance, that it is profitable to run a drill so rapidly
as to wear it out in a single day, although at a slower
speed it would have drilled twice as many holes before de-
struction. They show at what prices of machinery and of
skilled labor it is profitable to substitute an automatic
machine in a process which can interchangeably be per-
formed by a skilled laborer on a less costly machine. Thus
throughout the industrial process Cost Accounts substitute


facts and intelligence for the rule of thumb and blind

4. Finally, Cost Accounts furnish a convenient method
for checking the efficiency of factory management. If it
appears that the cost of producing a given form of pinion
has increased, it enables the manager at once to locate the
cause. It may be that the change is unavoidable, due to-
higher cost of raw material or higher wages. But, on the
other hand, investigation may show carelessness on the part
of the foreman, and ill-advised redisposition of labor, or
wastefulness in the handling of material evils which are
already far on the way toward correction when once their
existence is shown. Slight losses of this kind may well
escape attention if only general results are studied ; or the
losses in one department may easily be offset but by no
means canceled by a new economy elsewhere. The sub-
division of accounts makes it more easy to detect changes,,
and gives a constant incentive to foremen and superin-
tendents to reduce costs.

The discussion of Cost Accounting is rendered more
difficult by the rather vague and varying terminology em-
ployed. There are many different costs depending on the
point of view. The terms used to designate these differing
costs Prime Cost, Factory Cost, Total Cost, etc. are not
uniformly defined either by economists or accountants. This
may be illustrated by the case of a factory which desires to
learn the cost of producing, say, a pair of shoes. To pro-
duce this the following factors are involved: (1) The raw
material used. (2) The wages of the laborers directly em-
ployed in making the shoes. (3) The expenses of operating
the factory as a whole which are not particularly assigned
to this pair of shoes, as for instance the wages of watchmen,
the repairs on the building, the cost of the power used for
various purposes, etc. (4) The expenses of the establish-
ment outside of the factory. (5) More questionably the


normal rate of profit, whether separated or not from the
normal rate of interest on invested capital. In a broad
sense profit is a necessary cost of the permanent continu-
ance of the industry ; for, if normal profits are not secured,
new factories will not be started, and an adjustment of
prices will be ultimately secured whereby profits as well
as wages will be covered by the selling price.

By some writers the first and second items mentioned
above are collectively called Prime Cost, while the first
three items together make up Factory Cost. Other writers
use Prime Cost to indicate the same as Factory Cost just
defined, and these employ no specific term to indicate the
sum of the cost of material and labor directly employed.
The sum of the first four items is sometimes called Total
Cost, sometimes " Cost to make and sell." Accountants
universally exclude profits from cost, but use as a compre-
hensive term, including all five items enumerated above,
the phrase " Selling Price." In addition to these differ-
ences in terminology there is divergence in regard to the
treatment of certain particular items, such as interest, rent,
taxes, etc., involving the principles discussed in Chapters
IV and XV.

"Without attempting to decide between the various
usages, each of which has the support of high authority,
and no one of which therefore can be declared wrong, the
real problem may be faced, namely: What share of the
total expenses, covering as they do the production of vari-
ous commodities, is to be assigned to the cost of some one
commodity, or to some single process? As to the first two
items, w y ages and material, there is no doubt as to the prin-
ciple and little difficulty in practice. The material actu-
ally used and the wages of laborers directly employed in
producing the given commodity are obviously an integral
part of the cost of producing that article. The connection
is so clear that the use of the phrase Prime Cost seems ia


a measure to be justified in describing these two funda-
mental and easily ascertainable elements of cost.

The first point of difficulty comes in attempting to dis-
tribute the indirect factory costs among the various com-
modities produced. Various principles are used, among
which may be mentioned the following:

1. The indirect factory expenses, which include such
items as wages of workmen employed in general labor such
as watchmen, cleaners, firemen, etc., the wages of foremen
and superintendents, light, heat, rent, and repairs of fac-
tory and its equipment, depreciation, etc., are apportioned
among the various jobs or processes in the proportion
which in some particular exists between the given job and
the total operations of the factory. But the basis on which
the comparison is made is variously chosen, and it may
rest either on

a. The direct wages paid.

&. The hours of labor spent.

c. The material used. *

d. The direct wages paid plus the cost of material.
(Prime Cost.)

e. The units of product.

Other bases may also be taken, and one of them, the
Machine Rate, is reserved for further discussion, but the
five mentioned above are those most generally used.

Taking, as purely arbitrary figures, those given below
in Form 114, it is seen that each of the methods may pro*
duee quite different results, the figure in the last column
indicating the amount of the total 'indirect factory ex-
penses of $12,000 to be apportioned to the particular job
on each of the five bases of distribution mentioned.

Doubtless in actual practice the divergence in results
reached by the different methods would not be so great,
as in the figures given below. But it is clear that unless
all work is of a practically uniform character the costs



obtained must vary according to the basis of distribution
selected. Unfortunately for scientific accuracy it is impos-
.sible to pick out any one of the methods named as being
logically correct or uniformly accurate. The first one,
which distributes factory expenses in proportion to direct
wages paid, is probably more frequently used than any of
the others. It is, however, obviously incorrect where there
is great divergence in rates of wages paid, or where there
is a difference in the degree in which automatic machinery
is used in the various processes. But it is simple of appli-
cation, and this fact in itself probably explains its more
general use.

FORM 114.


In Entire

On this


>(a) Wages paid



$50 00

(5) Hours of labor



80 00

(c) Material used. .



37 50

(d) Wages plus Material



45 00

(e) Units produced




Distribution in proportion to hours rather than to cost,
of labor is favored on the ground that much of the indi-
rect cost, such as foremen's wages, light, heat, etc., is de-
pendent on the hours of work, and that other general
charges, such as rent, depreciation, etc., have a direct rela-
tion to time. But its critics point out the fact that it
makes the same charge upon the labor of a boy running
a fifty-dollar machine that it does on that of a man with
a thousand-dollar machine, " the grotesqueness of which
procedure will not be enlarged upon." Apportionment of
indirect factory expenses on the basis either of material
or of the sum of wages plus material has the obvious ob-
jection that there does not seem to be any logical connec-
tion between an increase in the cost of material used and


an added charge for indirect factory costs. Apportion-
ment in proportion to the units of product may be most
convenient of application in certain kinds of production,
and is frequently used in foundry practice, the ease with
which this system is used being held to more than offset
any theoretical objection on the ground of the absence of
strict logical accuracy.

The foregoing methods have all considered wages and
material as the only charges directly apportionable to the
particular product or operation, and have made all the
indirect charges a function of labor or material. A dif-
ferent conception is one which recognizes to a greater or
less degree that in modern factory production there is a
third element of eost, namely, that of the machinery em-
ployed. This theory has had various applications. In
some it has merely determined the direct cost of the ma-
chinery, including depreciation, repairs, and interest, and
from this obtained an hour-rate by dividing the total of
such costs by the assumed number of hours which the
machine runs. This method, of course, merely gives an
apportionment of part of the indirect expenses of the fac-
tory and leaves probably the larger part still to be allo-
cated. Furthermore, it does not give correct results where
the machinery is idle for part of the time, for the rate
charged is on the basis of the machine running the assumed
number of hours. Sometimes the method has involved
dividing all the indirect expenses by the total number of
hours which the machines run, v or are supposed to run,
thus obtaining a uniform hour-rate without differentiation
between different classes of machines. This is similar to
dividing the indirect expenses according to the hours of
labor spent on the particular operation, the difference
being that in one case the hours of labor, in the other the
hours of machine operation, are taken as the basis of dis-


The obvious objection here is that many of the indirect
expenses have no more to do with the cost of running the
machines than they have to do with wages or the cost of
material. For instance, in a factory in which all the work
was done by hand there would still be indirect charges
covering the cost of the factory itself, the watchmen, light
and fuel necessary for keeping the building warm in win-
ter. These certainly cannot be machine costs, where no
machinery is used, and part of similar expenses in a mod-
ern factory equally relate to labor rather than to machin-
ery. Or again some of the indirect expenses relate to the
material used, as, for instance, the additional watchmen
required where the material is costly and portable and
hence easily stolen. Probably the indirect expenses of an
establishment for polishing diamonds have no great rela-
tionship to the use of machinery.

In the more improved methods of obtaining machine
rates the attempt is to determine not merely part, but all
of the charges which attach to the running of a given
machine, and to make an hour-rate which correctly dis-
tributes all such expenses. In other words it is an exten<

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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 22 of 27)