Jerome Lee Nicholson.

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Items Composing the Indirect Expenses

The following list shows some of the more constant
items which compose the indirect expenses. The classifica-
tion will vary in almost every factory, but the items listed
almost invariably appear.

Indirect material





Freight and express inward,

when not charges to direct

material cost

Depreciation \
^Maintenance \.
c Repairs

Indirect labor

Power or power plant

Experimental work



Small tools

Over, short and damage

Rent, Taxes and Insurance

When rent is paid, it is generally distributed over the
different departments on the basis of floor space occupied.

Taxes are a part of the general operating expenses, as
they are independent of department value.

Insurance, on the other hand, is partly distributed over
the plant as a w^hole, and partly over each department
according to its value.

Depreciation, Maintenance and Repairs

Depreciation, maintenance and repairs are distributed


between the plant as a whole and its departments, depend-
ing on where the expenses are incurred.

The loss of value due to depreciation is undoubtedly
the most difficult of all expenses to reduce to accurate
figT-U'es, because there are so many elements to be taken into
consideration. For instance, the general nature of the
e(iuipment. the length of service to be expected, the amount
of use per day or month, the kind of business, the amount
spent for maintenance and repairs, and the likelihood of
new methods and machinery, are a few of the more impor-
tant influences that determine the actual amount.

The discussion of depreciation, as a whole, must be left
to special books on that subject. The province of the pres-
ent volume extends only to the manner of its treatment in
cost finding; and here depreciation is usually disposed of
by distributing the cost of the equipment of a plant over the
product it turns out during a period of time estimated as
the life of the equipment.

There are two general ways of arriving at the entries
for depreciation :

(i) Periodical revaluation of all the property, the differ-
ence between any two consecutive valuations representing
the depreciation for the period. This would seem to be the
most accurate plan ; but practice has shown that such re-
valuation is at best an estimate, which must be based on
two factors, condition and earning power. The gain in
accuracy, if any, is not enough to justify the difficulty and
trouble of the physical revaluation, except at long intervals.

(2) A more common method is to estimate the life of a
machine or building, and then write off a certain per cent
of its value each year.

Two cautions in particular must be observed in writing
off valuations by the per cent method. First, the estimates
should be reviewed at intervals, and corrections made for


apparent errors. In case of doubt as to the proper rate, it
is considered better policy to choose the higher of the rates
considered, as any mistake is better corrected by restoring
values where they belong than by charging the Profit and
Loss account.

The second caution relates to the ground covered by
single calculations of depreciation. The same per cent
must not be extended to cover complex groups. If a single
per cent were used on the whole plant, the result would be
quite untrustworthy, since the true rate of depreciation
varies in different parts, depending on the nature and cost
of machines, amount of idle time, and other conditions. To
be accurate, each element of equipment should have its own
depreciation rate.

Power Costs

The power costs are somewhat complex, especially
where a factory produces its own power. The power plant
is regarded as a department by itself, and bears its own
assignment of direct, as well as certain indirect, expenses.
If the power plant furnishes heat and light to the factory,
the cost of these items must be subtracted from the total
power cost, to gtt the net power cost applying to produc-
tion centers. To obtain accuracy, it is generally necessary
to segregate and distribute the power costs as a direct
charge to each department or machine. The net power cost
is usually distributed in the ratio of use, thus making each
machine or department bear its share of unutilized power,
or power lost in transmission.

The calculation of the power actually consumed by any
machine or department is a mechanical problem. There are
special machines for the purpose, such as dynamometers
for steam-driven machinery, and wattmeters or power
factor indicators for machines using electricity.




Small Tools

The value to be set on tools made in the plant should
include all the elements of cost that enter into their manu-
facture. It may be stated as a general principle that the
cost of any equipment manufactured by the plant itself
must include its share of the indirect expenses as well as
the labor and material cost. For the same reason, installa-
tion charges would be treated as a part of the cost of a

If special dies or tools are bought or made for a par-
ticular order, the total cost is charged against that order,
unless they are retained after its completion, and an allow-
ance made, either on their scrap value, or on the possibility
of their being of some future use.

Experimental Work

When the expenses of the experimental department
arise from work directed on the current product, the cost
becomes properly an item of indirect expense ; but when the
expense results from work on products or processes that
are to be used at a future time, the correct method is to
make a deferred charge of it, which will not be absorbed
until the results of the experimental work are in actual
operation. In practice, however, such expenses are usually
absorbed in current indirect expense, and are not treated as
deferred charges unless they are large enough to affect the
cost calculations perceptibly.

Machines and appliances that are perfected through
experiment do not come under the same head, but should be
considered as assets, their theoretical value being the sum
of all the elements of cost that have been incurred on their
behalf during the course of the experiments.


Over, Short and Damage

Wastes of material, shrinkage in weight, defective work,
etc., are charged to Over, Short and Damage account.
After this account has been credited with the value received
for any disposition of the items charged, the balance
becomes a part of the indirect expenses.


Interest, as an expense, is generally treated according to
its origin, as follows :

( 1 ) Interest on mortgages, as a part of the rent

(2) Interest on buildings and land values, as one
of the general operating expenses.

(3) Interest on the value of different machines
or equipment of different manufacturing depart-
ments, as a charge to the product of these machines
or departments.

Production Costs and Selling Costs

A clear distinction must be made between production
costs and selling costs. The latter include the selling ex-
penses, such as advertising, commissions, salaries, etc.,
which are necessary elements in determining the price for
which an article may sell, but have no direct bearing on the
cost of producing the article itself. The cost of production
ends when the finished stock is ready for sale.

Administrative Expenses

The expenses that arise from advertising, commissions,
salaries of officers, etc., are known as commercial, or selling
and administrative expenses.

•See Chapter III, "Interest in Its Relation to Cost,"









Sp2 J < t5 ^

*^ 1

QC fcj








The segregation of administrative expenses, as a dis-
tinct class, is sometimes a matter of convenience. In the
majority of cases the time of the administrative force is
spent in supervising the selHng organization, in solving
problems of production, and in looking after the finances of
the business. Therefore, administrative expense is partly
a production cost, and partly a selling cost. The purposes
of cost finding are best served by separating expenses of
such a nature from those expenses which arise from pro-
duction proper and its direct supervision.

Relation of Cost Elements to Selling Price

The sum of the direct material and labor cost is known
as the "Prime Cost." This, combined with the indirect
expenses, gives the final "Factory Cost." The total of the
selling and administrative expenses, plus the factory cost,
shows the cost of making and marketing the article; and
this total — plus the profit — gives the actual selling price.

This relation of the different elements may be illustrated
by the diagram on the preceding page, which, in the light
of what has been said, is self-explanatory.



Should Interest be Included in Cost?

As there is a difference of opinion among accountants
as to treating interest as a cost of production, the views
of two writers of prominence are quoted at length in the
present chapter, and reference is made to a number of
articles on this subject. The question is of great im-
portance, and therefore the views set forth in this chapter
should be considered carefully, and the articles referred
to should also be consulted before a final decision is made.

The author's own position is that whatever expense is
necessary to operate a plant must be charged against
the cost of the product, if true costs are to be obtained;
and as it is just as necessary to have buildings, grounds
and machinery as it is to have workmen for manufacturing
a product, these factors should be considered in ascer-
taining costs, especially where the values of these elements
vary in relation to different articles manufactured.

To make this clear, suppose that a factory is pro-
ducing several articles of different kinds, some of w^hich
necessitate the use of expensive machinery or equipment,
while others are largely the product of hand labor, or
cheap machinery. If the different values invested are not
taken into consideration, the indirect expenses as dis-
tributed will not show the true variation that exists in
the costs. The unequal burden, resulting from the differ-



ences in investment, is clearly an essential factor; and
since this burden is a direct result of using the producing
equipment, it seems that it should be considered as one
of the elements of cost.

Of course, if the equipment is uniform, or if all the
output passes alike through all the processes, there is no
essential difference between including the interest as a
cost and leaving it for a later supplementary calculation.
Since, however, in either case, the amount invested must
be considered in determining the selling price, the ques-
tion still remains as to what method or base of calcula-
tion should be used. It may be interest on values, or
some arbitrary charge based on time or other conditions
of manufacturing.

The difference of opinion then centers on what is the
best method of applying this charge to the cost; that is,
whether it should be included among the regular cost
items and become a part of the accounting system, or
only be added to the cost in a statistical report.

From another standpoint the objection is raised against
including interest cost as a part of the accounting system,
that banks in many cases will not accept the valuation
of an inventory which includes interest as part of the
cost of the product.

Interest as a Charge against Costs

The following article on "Interest on Investment in
Equipment,"* by William Morse Cole, Assistant Pro-
fessor of Accounting in Harvard University, presents the
view that interest is properly a cost item, and should be
so treated:

Though it is common to speak of cost accounting
as if it were different in nature from other kinds of ac-

*"Journal of Accountancy," April, 1913.


counting, virtually all accounting worthy of the name has
for a prime purpose the determination of cost. Account-
ing should serve as a guide in three ways: In fixing
prices so that they shall be adjusted properly to costs; in
eliminating waste of material, of labor, and of burden
charges; and in determining what had best be undertaken
in the establishment itself and what had best be purchased
or ordered outside. Since these three purposes are the
recognized fundamental purposes of cost accounting, it
is necessarily true that whether an enterprise is con-
cerned with manufacturing, distribution, or service, its
accounting should be, in a sense, cost accounting.

Let us examine these three aims in turn.

Prices must be fixed at such a point that they shall
at least cover (i) materials, or goods; (2) labor, or serv-
ice, and (3) expense burden, or what are commonly called
"Overhead Charges." Obviously, if the last of these is
not quite fully covered, the continuance of production or
service is not economically advisable (unless, of course,
the work serves other purposes than those which are im-
mediately connected with the initial enterprise). If,
again, the income provided by the price gives less than
a proper amount as interest on the investment — invest-
ment in the form of capital locked up in machinery,
facilities, material, or waiting product — the return is not
economically sufficient to make the enterprise self-
supporting. If this interest is not included in the expense
burden, therefore, it must be added later, somewdiere, be-
fore one can know whether the return is adequate to
make the enterprise self-supporting. Since one of the
purposes of accounting is to show whether the return is
adequate, the interest would seem necessarily to be in-
volved somewhere in the accounting.

Efficient management always attempts to eliminate as



much as possible of excess consumption of material, excess
expenditure of labor — both mental and muscular — and
excess investment in machinery, in other facilities, and in
supplies. The best guide for such elimination is an
analysis of these various elements, so that comparison
may be made between different methods and between
different managements. To use a simple illustration,
there may be a choice between two methods as follows:
Machinery at a cost of $35,000, materials at a cost of $5,
and labor at a cost of $20; or machinery at a cost of
$5,000, material at $5, and labor at $30. We may know,
perhaps, that the maintenance, insurance, and taxes on
the machinery while the article is in machine process
(that is, the share of maintenance, insurance, and taxes
chargeable on this particular production) will be $10 in
the first case, and $1.50 in the second case. These figures
give us with the expensive machinery a production-cost
of $35.00 (that is, $5 for material, $20 for labor, and $10
for maintenance, etc.), and of $36.50 ($5 for material, $30
for labor, and $1.50 for maintenance, etc.) with the less
expensive machinery. Taking no account of the interest,
therefore, the investment in the expensive machinery
appears worth while — if, at least, our production is so
large that a margin of $1.50 reduction in cost on each
article of product is worth while when set against the
possibly greater error in our estimate of depreciation, etc.
Yet we have clearly left out of account one element of the
problem, for until we know the length of time for which
these different equipments are involved in production, we
do not know whether interest on the greater capital in
the first case will more than eat up the margin of saving
over the second. If, for example, the machinery is em-
ployed a day in producing this article, even though we
use as low a rate of interest as 3 per cent, there is in the


expensive machinery an additional element of $3.50 in in-
terest for the one day involved (on a 300-day basis), but
there is an additional charge of only 50 cents in interest,
on the same ground, for the inexpensive machinery. This
difference in favor of the less expensive machinery turns
the scale of advantage; for the costs are now $38.50 com-
pared with $37. If, on the other hand, the machines were
employed in this production only one hour, on the basis
of a 9-hour day, the more expensive machinery with the
lower labor cost would be a more economical means of
production; for since the interest element is now only 39
cents, its total is $35.39, but the total for the other
machine, with interest of 6 cents, is $36.56. It is abso-
lutely essential, therefore, that interest be taken into
consideration in determining which of two methods of
production is more economical.

The same sort of consideration of interest is essential
in attempting to determine what we shall make in our
own establishment and what we shall order outside; for
if work at home involves investment in machinery, or
other facilities, so that we must get a return of $38.50
from our ultimate product or service, but we can pur-
chase the same product or service outside for $37, it is
obviously foolish to do the work at home — unless, in-
deed, our freedom from outside dependence is worth to
us more than the difference in cost, or unless we can find
no employment for our capital elsewhere at a rate as high
as that which we have used in our calculation.

No comparison is possible between different establish-
ments, between different periods in the same establishment,
or between different methods in the same establishment,
if capital investment in labor-saving or material-saving
machinery is neglected; for the very purpose of such in-
vestment is to save cost in other directions; and to neglect



the capital sacrifice made in saving other costs, is to
neglect in part the very aim of cost accounting.

Opponents of treating interest as a cost may admit
the need of knowing the figure of interest, but may deny
the desirability of showing it on the books. The function
of an accountant is to analyze a situation and learn the
facts; and the function of a bookkeeper is to record the
facts, which, if not recorded, will be forgotten. It seems,
therefore, as if it is the function of a cost accountant to
learn regarding interest the facts which will serve as a
guide in determining prices, in eliminating wastes, and
in determining what may best be undertaken; for one
cannot otherwise easily get a safe guidance in these par-
ticulars. It seems, too, as if it is the function of the
bookkeeper to record the results of such study, for surely
they will be forgotten if they are not recorded.

Possibly some persons admit that for such purposes
as those just discussed, interest must be considered, but
deny that it is a cost. Discussions of terminology are
quite as likely to be fruitless as fruitful. Any practical
value that they may have must lie in a possible better
common understanding of one another's meaning when
men use the terms in question. To-day the word "profit,"
which is the complement of "cost," is used in many senses.
Under many partnership agreements, salaries and interest
on investment are charged as expenses, and net profit is
the gain arising from proprietorship pure and simple —
from the circumstance of responsible ozuncrship, aside from
the salary of the manager as manager (not financially
responsible) and from the income of the capitalist as
capitalist (not personally responsible). The happy con-
junction of ownership and personal responsibility often
results in a gain not otherwise realizable; and that gain
is profit. When there is no provision for interest and



salaries, on the other hand, the term "profit" is com-
monly applied to the difference between the gross income
and the charges incurred for purchases and outsiders'
(non-partners') services; so that the profit shown is a
compound of return for proprietors' services, for interest
on partners' investments, and for the circumstance of re-
sponsible ownership. In corporation accounting, again,
salaries are always included in expenses, and the net in-
come is the return to the stockholders as owners of
capital. In common parlance, therefore, the word
"profits" means much or little. Knowing this, men al-
ways interpret it with a mental foot-note.

On the announcement of the figure of profits under
an agreement which makes no provision for interest, the
first mental act of anyone interested in the business is to
see what relation those profits bear to the capital — so as
to see what are the excess profits over a reasonable re-
turn on the investment. Instinctively, interest is a first
deduction — partly because it has a definite basis that cart
be figured, and partly because it is the one thing that
everyone counts on. One does not think of terminology;
one thinks only of the fact. Virtually everyone admits
that in partnership or other settlements the most satis-
factory agreement is one that provides for a definite in-
terest charge. This is mere practical convenience.
Though the accountant is not much concerned with the-
oretical economic distinctions, he is at least interested
when he sees that economists use a term in a sense that
happens to be, for his own practical purpose, most con-
venient to him. Professor F. W. Taussig, in his "Princi-
ples of Economics,"* a recently published and standard au-
thority used in many universities, says: "So much only
of a business man's income is to be regarded as profits

Vol. II, p. 179.



as is in excess of interest on the capital which he

We have seen that for analytical purposes, in study-
ing operations, practical necessity requires us at least to
consider interest in virtually all calculations when in-
vestment is involved; and we have seen that in financial
statements practical convenience is served by the treat-
ment of interest as a charge, or cost, rather than as a
residue, or profit. It seems reasonable, therefore, for ac-
countants to adopt a terminology that will serve their
own ends, will agree with the terminology of economists,
and will mislead no one. Business men are likely to be
misled in the future, as they have been in the past, by
statements of profit which assume that no cost is involved
in the use of capital.

Interest a Profit — Not a Cost

The following article, entitled "The Fallacy of Includ-
ing Interest and Rent as Part of Manufacturing Cost,"* by
A. Lowes Dickinson, C.P.A., presents the other side of the
question, viz : that all interest is fundamentally a profit and
not a cost.

The "fundamental objection to treating interest and rent
(which, except in so far as it includes compensation for
services rendered, is only a form of interest) as an integral
part of the cost of manufacture is that all interest is in
fact profit. The practical effects of this objection are as
follows :

First, that from an accounting standpoint costs are
used mainly to determine the valuation of inventories of
stocks on hand and that to include interest (that is, profit)
in such costs leads to inflation of these values and conse-
quent anticipation of profits not yet earned by the sale of

•"Journal of Accountancy," August, 1913.



Secondly, tliat it is impracticable to determine a rate of
interest on any but an arbitrary basis and tbat consequently
costs arrived at on such a basis have no real meaning and
may easily be misleading. For example — owners of a busi-
ness are earning profits equivalent to 12% on the capital
employed and decide to make certain extensions and im-
provements which will result in savings equivalent to 10%
on their cost ; they are in a position to raise the money by
an issue of bonds on a 5^% basis or of preferred stock on
a 7% basis. What rate of interest should be added as a
charge to cost accounts if such a principle is adopted?

Thirdly, that the common methods of including interest
in costs calculate such interest only on buildings, plant and
machinery and ignore the investment of working capital,
and frequently also the element of time during which the
capital facilities are required for each manufacturing

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Online LibraryJerome Lee NicholsonCost accounting, theory and practice → online text (page 2 of 19)