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Fourthly, that to include interest in costs of every
operation results in concealing from those in charge of the
business the exact effect of two of the important factors
involved in profits — namely, the amount of capital em-
ployed and the time for which it is employed — and conse-
quently the actual return on the investment necessary to
produce it which is yielded by any particular article.

Whilst perhaps the point is not material in a discussion
of the theory involved, it may be pointed out that there is
a strong objection on the ground of policy to the inclusion
of interest as a part of the cost, particularly in the case of
public service corporations. In fact, this objection is so
pronounced that some banks stipulate in agreements with
borrowers that inventories must be taken upon a basis that
excludes interest on capital invested.

If any interest rate is to be assumed it can only be a rate
which represents a fair compensation for the use of the capi-


tal. If the selling price or rate yields a profit over and above
the cost of material and labor, a fair return on the capital
employed and fair compensation for management, it would
seem that to the extent of this profit the price charged is
excessive, at least where the manufacture is not conducted
under some patent or other special process for which a
further compensation may fairly be exacted. This is not a
conclusion that a manufacturing or public service corpora-
tion whose prices or rates are attacked can afford to admit,
more especially as those attacking the rates are not bound
by the interest rate adopted, as the corporation might be.

While, however, so far as the general accounts of a
business are concerned, it must be held that interest is not a
proper element in the cost of product, there is an undoubted
demand, and even necessity, for some supplementary statis-
tical accounting which will give effect to the principal ele-
ments involved in the earning of profits. The factors
involved in profits are the following :

(i) The labor, material and expense cost of a
unit of each class of article.

(2) Facilities used in manufacture, such as land,
buildings, machinery, tools, stocks on hand, and
other working capital, all segregated between the
different classes of articles.

(3) The time during which such facilities are
in use for a unit of each class.

(4) The selling price of each unit of each class.

If these elements be known, comparisons can be made
between different articles produced in the same factory or
between the same articles produced in different factories, as
to the amount of fixed capital employed in different pro-
cesses and the time for which it is employed; as to the


amount of working capital constantly maintained and used ;
and as to the effect of further expenditures on additions
and improvements with a view to cheapening cost of pro-
duction. Only the first of the above four factors should
enter into the general accounting books and form the basis
of inventory valuations and so of the actual profits earned;
the remaining factors should be dealt with only in sub-
sidiary statistical records. The difference between the sum
of all selling prices (4) and of all costs (i) will agree with
the gross profit in the accounting books ; and a comparison
of this figure with the total capital employed, including not
only fixed but circulating capital necessary for manufactur-
ing purposes, w'ill give the rate of return yielded by all
classes of articles. The cause of any variation in this rate-
of return, as compared with a previous period, or of the
varying rates of return on different articles in the same
factory, or of the same articles in different factories, will be
obtained from the detail figures. Such variations may be
due either to (i) higher or lower cost of labor, material
and expense; (2) greater or smaller amount of facilities
used; (3) longer or shorter time during which these facili-
ties are used; and (4) lower or higher selling price. If
interest at an arbitrary rate is included throughout in labor,
material and expense costs it means that the fluctuations in
profit due to the first three of these variations are merged
into one and cannot without considerable labor again be
segregated. The best measure of factors (2) and (3)
would seem to be the value of the facilities used, multiplied
by the fraction of the year during which they were used
and divided by 100, which product would be equivalent to
interest at i % per annum ; the actual margin between sell-
ing price and cost of labor, material and expense divided
by this product w-ould thus be the actual rate of return
yielded by any particular class of articles, the average of



such yields corres]Joncling to the yield shown by the prin-
cipal accounting records.

Unused facilities would under this system appear as a
factor in reducing profits either by lack of sufficient busi-
ness to employ them or by excess facilities in one portion of
the plant as compared with another. The product factor
corresponding to these unused facilities would form part
of the divisor in obtaining the average yield.

Comparative costs of separate operations will be
reached by a consideration not only of the actual labor,
material and expense cost in different periods or in separate
factories, but also by a comparison of these costs with the
facilities employed. Thus the estimated savings to be
efifected in any operation by additional expenditures on con-
struction account should be found reflected in the reduced
cost of these operations.

Such a plan as that here suggested gives proper weight
to all the factors entering into profits, without introducing
any arbitrary rate of interest; it will be no more com-
plicated in its working than are cost systems which are
in constant use; and its complications will vary with the
number of different articles produced for which separate
costs are required.


Discussions of interest in its relation to cost will be
found in the following publications :
"Factory Accounts," Garcke and Fells, page 140.
"Commercial Organization of Factories," Spencer, page 150.
"Factory Costs," F. E. Webner, pages 149 to 155.
"Cost Keeping and Management Engineering," Gillette

and Dana, pages 141 and 142.
"Factory Organization and Administration," Diemer, page



"Cost Accounts," Hawkins, page 109.

"Cost Keeping and Scientific Management," Evans, page 37.
I "Depreciation and Wasting Assets," Leake, pages 53 and 54.

Journal of Accountancy:

December, 1911, page 588, A. Lowes Dickinson.
April, 1913, page 236, A. Hamilton Church.
April, 191 3, page 240, W. B. Richards.
April, 1913, page 241, J. E. Sterrett.
May, 191 3, page 329, Edward L. Suffern,
May, 191 3, page 330, J. Lee Nicholson.
May, 191 3, page 334, J. Porter Joplin.
June, 1913, page 427, H. C. Miller.
June, 19 1 3, page 428, John R. Wildman.
June, 19 1 3, page 431, Herbert M. Temple.
June, 19 1 3, page 473, E. C. Gough.
July, 19 1 3, page 22, Arthur Berridge.
August, 191 3, page 145, Henry A. Denison (Court



Calculating Costs

The conditions of manufacture determine the basis on
which costs are calculated ; and according to these condi-
tions, costs are found either ( i ) on the order, job or article,
or (2) on the product or process, without relation to a par-
ticular order or article. The former method is known as
the "Special Order System," and the latter as the "Product

Applying Cost Charges

There are two general methods of applying the items of
cost, known as

(i) Productive labor method (hours or wages)
(2) Process method

In the first method, the labor and material are charged
directly to the order, article or product, and to these
charges is added a pro rata share of the indirect expenses,
based upon the amount or the time of the productive labor
consumed in the production of that order, article or
product. This gives the total cost.

Under the second method, the charges are made against
the process or operation, and after the total cost is ascer-
tained it is distributed over the product according to its


nature — i.e., on the basis of weight, measure or number, as
the case may be.

Machine Cost Method

A special type of the process method, particularly valu-
able when it can be used, is the "Machine Cost Method,"
which employs the same principle, but applies it to machines
or groups of machines. Its effectiveness is due to its ability
to absorb many of the usual indirect expenses, such as
power, heat, light, etc., as direct charges, thus lessening the
amount of indirect cost that must be distributed over the
product as a whole. The importance of this must not be
underestimated. The direct material and labor charges are
not. as a rule, difficult to compile or distribute, and can be
accurately determined ; but the proper distribution of indi-
rect expense is difficult ; and almost all the trouble and mis-
takes in finding costs are due to this fact. Any method that
provides for transforming a large part of these indirect
expenses into direct charges attacks the difficulty at its

Types of Systems

Four types of systems are founded on this double classi-
. fication — i.e., the special order system and the product
{system as bases for calculating costs, and the productive

labor method and process method for applying costs.
■ These typical systems may be designated as follows :

1(1) Special order system, using the productive
labor method.

(2) Special order system, using process or
machine cost method.

(3) Product system, using the productive labor



(4) Product system, using process or machine
cost method.

Cost finding for most phases of manufacturing may be
efifectively served by one of these four types; but in actual
practice it is comm.on to utiHze the features of two or more
of them in finding the costs in different parts of a plant.
Each type is susceptible of more or less modification to fit
special conditions, while still retaining its general charac-
istics. The success or failure of a cost system sometimes
largely depends on the recognition of these special condi-
tions, and the proper adaptation of the cost system or
systems to meet their needs.

Partial or incomplete cost systems are frequently de-
vised for particular purposes. In such cases, as a rule, the
object is to find the cost of certain lines of goods as a class,
without going into details for each production order or
article. A partial system of this kind is described in
Chapter XIII.

There are also in use systems or methods of estimating
costs and of verifying these estimates to a certain degree
of accuracy. These are not cost systems in the true sense
of the word, as they do not provide for finding actual costs;
but, nevertheless, they may be of considerable practical
value in small shops. In larger factories they often serve
to indicate where accurate cost methods should be installed.
These methods are described under the head of "Estimating
Cost Systems" in Chapter XII.

Analysis of Operations

Since one of the principal functions of a cost system is
to analyze the costs into their component parts, it follows
t1iat there must be a corresponding analysis of the manu-
facturing operations. This is accomplished by dividing the


factory more or less arbitrarily into operating departments
or production centers, the aim being to limit each depart-
ment, as far as possible, to simple and uniform operations.

The operating department plays a very important part
in making up and arranging the cost accounts. It furnishes
a center about which various expenses may be grouped, and
from which the indirect expenses may be distributed over
a limited field with a greater degree of accuracy. A dis-
tinction must be maintained between direct production de-
partments and indirect production departments. The latter
often have to carry their share of general operating ex-
penses until the cost incurred in them is distributed as a
burden on direct production.

The following list gives the operating departments of a
plant manufacturing axles and springs:

Direct Production Departments




Drop Forge




Heavy Axle

Axle Box

Axle Nut


Light Axle Finishing

Commercial Assembly

Pleasure Auto

Pleasure Auto Assembly

Auto Parts

Chassis Assembly


Indirect Production Departments



Supervision and Inspection

Engineering and Draughting

Purchasing and Stores

Time and Cost


Axle Tool

Die Sinking

Auto Parts Tool

Yard and Local Transport

Accounts are kept for each department, and these
should show the cost for material and labor and the indirect
expense involved in its operations.

Material Costs

The cost of direct material is a matter of market price
at the time of purchase, plus the freight and yard charges
when these are included in the cost. Sometimes the raw
material is purchased in bulk, and has to be sorted and re-
valued according to grade, as in the case of feathers, to-
bacco, or wool in the grease. The material cost must then
be adjusted over the various grades, so as to equal the
original price.

Complications sometimes arise in the treatment of scrap
material used in making by-products. The custom is to
determine the per cent of the original material so used, and
consider its cost as the material cost of the by-product, this
being deducted from the cost of the primary product. If,
however, there is no way of determining the percentage of
the waste used, except at considerable expense, or if it
varies greatly in quantity and quality, its scrap value is


estimated ; and when the by-product is sold, the amount
received for it is usually entered under the head of sundry
income. When this last method is used no deduction is
made from the material cost for scrap value.

Labor Costs

The direct labor cost is often easier to determine than
the direct cost of material. In piece-work it is given di-
rectly on the product without further calculation, unless the
several costs of the parts are to be added to find the cost of
the whole. In time methods of payment it is only necessary
to show how much time each workman has put on the
product, and the value of that time in wages paid.

There are, however, in a few lines of manufacturing,
conditions where a workman may spend only from three to
five minutes on a single order or article. In such cases it is
not practicable to charge this direct labor specifically to the
individual order or article, and a plan must be arranged for
its distribution over the number of articles worked on dur-
ing a given time. In other words, the principle of the
process plan must be used for this particular class of labor.

In such cases an estimate of the cost involved in an
operation or process is quite often made, based on previous
experience or tests ; and these figures are then used as a basis
for applying the direct costs. If the conditions remain
exactly the same, the results may be fairly accurate.

Distribution of Indirect Expenses

The ideal cost system would make all indirect expense
apply to the related product in the same way as the direct
costs. This, however, is hardly ever possible. The prac-
tical or working ideal is to assign as many of the indirect
expenses as possible directly to the product to which they
relate, and so reduce the general indirect expenses to a


minimum. There is a close relation between the amount of
unassigned or general indirect expense and the accuracy of
the costs obtained.

The machine cost method was commended specifically
on this ground,* its principle being to gather all the ex-
penses possible "at the point of the tool," where they are
easily applied to the product operated on. The value of the
operating department as a similar agent has also been
pointed out, the idea there being to gather such indi-
rect expenses as pertained to any department, and dis-
tribute them over its own particular output.

However, when the best has been done, there is neces-
sarily a residue of expense that cannot be conceived of as
applying to any particular part of production. This is
sometimes distributed over the product as a whole, but the
best method is to distribute it first over the departments as
units, and then to have each department distribute its share
in its own way.

The method frequently followed, of distributing the in-
direct expense over the whole production by adding a cer-
tain percentage to the prime cost, implies the fixing of an
accurate rate, and is subject to very grave criticism unless
the output of the factory is unusually uniform both as to
nature and quantity. Ordinarily the indirect expense is not
the same for each class of article, as each involves differ-
ences in process peculiar to itself; and this throws the
method out of adjustment. The fault is very marked when
certain articles pass through only a few departments, Avhile
others have to go through the whole, or nearly the whole,
routine. The former then have to help bear the indirect
expenses of several departments in which they have never
been at all, while the latter are relieved of a burden that
properly applies to them. A manufacturer may easily be

•Page 47.



led into fatal errors of policy by depending upon costs so

Even at its best, this percentage plan does not provide
for an analysis of costs; and the organization and efficiency
value of more accurate expense distribution is given up
entirely for the sake of simplicity. It must be remembered
that each department has its own equipment, and possibly
differs from the other departments in capital invested, floor
space, power used, etc. Therefore, any method which does
not utilize this natural center for collecting and dis-
tributing expenses, fails to use its most efficient weapon.

Supposing the departmental method to have been
adopted, there still remains the most vexatious problem
of all — upon what basis shall the indirect expenses be
distributed within the department so as to charge each
order or article with the portion that properly belongs to
it? To illustrate, let us suppose that high-priced and low-
priced men work side by side, or that there are machines
of very different size and value operated by men who
draw the same wages, or that the operations involve about
equal parts of machine work and work by hand — all of
which are quite ordinary conditions. Shall the basis of
expense distribution be the cost of labor or the time spent
on the work? Does the cost of material enter in as a
factor? Is a machine rate possible or practical? If so,
just what ground can it cover? These are some of the
questions which must be answ-ered, and answered cor-
rectly, if the cost results are to be accurate.

No one method of distributing indirect expense can
be considered as orthodox for all cases. Everything de-
pends on the particular existing conditions. The purpose
here is to describe the standard methods, stating their
underlying principles, and indicating the conditions where
each is effective.



There are seven methods of distributing indirect ex-
penses which may be considered as more or less standard.
A study of methods found elsewhere under other names
will show that they are more or less modifications or
combinations of these seven. It is suggested that under
some circumstances one of these methods may be found
valuable to distribute the general operating expenses over
the departments, while another method may be used more
advantageously in the department itself to apply the ex-
pense to the product.

The methods are:

(i) Direct Labor Cost

(2) Direct Labor Hours

(3) Direct Labor and Material Cost

(4) New Pay Rate

(5) Old Machine Rate

(6) New Machine Rate

(7) Fixed Machine Rate

(i) Direct Labor Cost

This method is based on the principle that indirect
expenses are incurred in proportion to the amount of
labor involved, this amount being measured by the labor




To operate the plan, the total cost of direct labor
charged to the product for a definite period is ascer-
tained, together with the total indirect expenses for the
same period. The total indirect expense is divided by the
total labor cost; and this shows what per cent the indirect
expense is of the total productive labor. The amount
of indirect expense assigned to any article is then found
by multiplying the labor cost of the article by the rate.
Adding the amount of the indirect expenses to the prime
cost gives the total or factory cost. The same principle
applies in finding the factory cost of any job, production
order, or process.

To illustrate, suppose that the pay-rolls for a certain
cost period show payments of $16,000 for direct labor,
and that the indirect expenses for the same period are
$14,000. These indirect expenses are 87^ per cent of
the direct labor cost. Now, if a man worked on an article
5 hours at 32 cents an hour, and the cost of material was
60 cents, the total cost would be $0.60, plus $1.60, plus
87 /^ per cent of $1.60, or $3.60.

The simplicity of this method is a great point in its
favor, but at the same time offers a temptation to em-
ploy the method too widely. The point to consider is
how far the particular conditions are in accord with the
principle of the method. To fit the case perfectly, the
labor should be the dominant element in the manufac-
turing process, and there should be a marked uniformity
as to product, wages, and time of operation. These con-
ditions rarely exist throughout a factory, but are not un-
common in single departments. The limits within which
the method may be advantageously applied are therefore
fairly well defined.

When the direct labor method is employed, special
care must be exercised, if there are machines, to see that



they are uniform as to cost and running expenses, or, if
not, that there is a corresponding difference between the
wages paid to the operators. The method is less accurate,
and even misleading, if these uniformities do not exist.
For instance, if a low-priced man is operating an ex-
pensive automatic machine, and a high-priced man is
working at a cheap machine where skill amounts to more
than running expense, the charges for indirect expense
will not only be inaccurate, but will be actually reversed.

When the residue of unabsorbed general operating ex-
penses is small, the direct labor method is often used to
prorate it over the departments, first, because the data
on which to base the distribution are easily obtained, and
second, because any resulting errors, when divided up
over all the output of all the departments, will hardly
be appreciable. Only an examination of the circumstances
in the case can determine whether theoretical accuracy
may be safely put aside for the sake of practical results.

(2) Direct Labor Hours

The principle of this method is the same as that just
described, except that the amount of labor is measured
by time and not cost. That is to say, the indirect ex-
penses of a plant are considered to be in keeping with the
number of employees engaged, and the hours they work,
rather than with the wages they receive.

The plan is to divide the total indirect expense for some
definite period by the number of productive labor hours
in that same period, in order to find the amount per hour
to be added to the prime cost of the product. Using the
example given before, suppose the number of working
hours for direct labor to be 56.000, and the indirect ex-
pense to be $14,000 as before. $14,000 divided by 56,000
gives an indirect expense per hour of 25 cents. In pro-


ducing the single article previously discussed, the other
conditions remaining the same, the total would be 60
cents for material, plus $1.60 for labor, plus 5x25 cents
for overhead, equaling $3.45.

An analysis of the difference between the two costs
will provide the best basis of comparison between the
methods. The critical point is the 32 cents per hour of

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Online LibraryJerome Lee NicholsonCost accounting, theory and practice → online text (page 3 of 19)