Jerome Lee Nicholson.

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the labor cost in the first example. The average wage per
hour found by dividing $16,000 by 56,000 is only 28 4-7
cents per hour, and therefore the output of any man
whose pay is more than 28 4-7 cents per hour has to bear
more of the indirect expense in the first method than in
the second.

This makes it perfectly clear why ''there should be a
marked uniformity as to product, wages, and time of
operation" in the direct labor cost method. Evidently,
differences in any of these factors tend to throw the
costs out of true, unless it can be shown that there are
corresponding differences in the direct costs. And this
has to be shown in each particular case; for there is no
essential reason why, as between two men working side
by side, the output of the higher-priced man should incur
more indirect expense than the other. Consideration
will show that, on the whole, indirect expense is more a
function of time than of labor cost. If the items that
make up indirect expense are examined one by one, as
interest, depreciation, light, heat, power, supervision, etc.,
it must be seen at once that the majority, though not all
of them, accumulate according to time, and have but an
incidental connection with the rate of wages.

The conclusion is clear that, other conditions being
equal, the labor hour method is applicable to a wider
field than the labor cost method. Certain limitations re-
main, viz.: The labor should be a dominant factor, and,


for the most part, the product should be uniform. Where
machines are used, the same precautions must be taken as
in the case of direct labor cost, except that the wages of
the operators may be disregarded.

(3) Direct Labor and Material Cost

Under this method of expense distribution, the cost
of material is recognized as one of the factors that give
rise to indirect expense. The principle and plan of
operation are exactly the same as described in the direct
labor cost method, if "prime cost" is substituted for "direct
labor cost."

The limitations described there all apply in this case,
with the additional condition that the material cost and
labor cost should be nearly equal. This method is seldom
found in practice, and then almost always as an averaging
method, to prorate the general expenses over the whole
product. In such cases it must meet the objection to
that class of methods as a whole.

If the method is used out of its special field, where
the necessary uniform conditions do not exist, the re-
sults are quite unreliable.

(4) New Pay Rate

The "New Pay Rate" is still another way of utilizing
the principle of direct labor cost in expense distribution.
It is essentially a departmental method, and is rarely used
for any other purpose.

Under this plan the indirect expenses connected with
any operating department are first determined; and to
these is added the department's share of the general
operating expenses, which is determined on any basis
that seems best. Next, the percentage of expense to
labor cost is determined as in the first method; but, in-



stead of this rate being- added to the total labor cost, it
is applied to the employee's wage per hour. For instance,
if the indirect expenses were 621^ per cent of the direct
lal)or cost, and a workman's pay was 32 cents per hour,
the new pay rate as applied to the product would be 32
cents plus 62^ per cent of 32 cents, or 52 cents per hour.
If the man worked five hours on any one article, that
article would be charged with five times 52 cents, or
$2.60 for labor and indirect expense. By adding the
material cost to this, the total cost is shown.

The principle involved, and the conditions of its appli-
cation, have already been sufficiently discussed under the
direct labor cost method. The only advantage of the
new pay rate lies in the ease with which the expenses
are prorated over the product. Once the rate is deter-
mined, it is a very simple matter to apply it to every
article or order.

For finding costs it is just as accurate as the direct
labor cost method and no more; but as a method it fails
to present the data necessary to analyze costs properly.
It collects charges in totals; and, in order to attain sim-
plicity, neglects the proper classification and arrangement.
However practical it may be in some cases, this last con-
sideration disqualifies it as a part of any complete cost

(5) Old Machine Rate

All machine rates are based on the principle that in-
direct expenses accrue according to the number of hours
machines are in operation. There is considerable difference
in the methods employed by the different forms of machine
rate in collecting and applying the charges to the product.
The simplest is the "Old Machine Rate."

Under this method, the amount of indirect expense


for a certain period is divided by the number of hours the
machines have been in operation during that period, and
the rate per hour is appHed to the product, according to
the number of hours it has been in process, as its share
of the overhead. In common with all other general
methods, it will produce accurate results only when the
conditions are substantially uniform. The machines
should be alike as to cost, power, floor space, etc.; and
this practically limits its scope to departmental dis-
tribution. When such conditions exist in a department,
the old machine rate is both convenient and accurate, and
will naturally be selected in preference to more com-
plicated methods.

In departments where bench work is combined with
machine work the method breaks down, because it makes
no provision for anything outside of machine-made
products. For the same reason it is almost never suit-
able for distributing general operating expenses.

(6) New Machine Rate

The "New Machine Rate" represents the modern ap-
plication of the machine rate principle to complex con-
ditions. It connects or welds three principles or ideas
into one working system.

(i) It employs the machine rate principle, as

(2) It recognizes and provides for the differ-
ences in indirect expenses that arise from differ-
ent kinds of machines.

(3) It is specifically devised to absorb, as direct
charges, all the indirect expenses that can be asso-
ciated directly or indirectly with the operation of
any machine or process.


In installing the new machine rate, the department
is taken as the unit whenever possible; but if a depart-
ment includes different machines or processes, a further
subdivision of charges must be made inside the depart-
ment itself. The essential point is to reduce the unit to
processes of the same kind, or to the machines used in
such processes, even if this carries it down to the single

The object in view is to collect the various charges
against each machine or process in such a way as to know
what it actually costs to run the machine per hour; i. e.,
what the hourly machine rate is when the operations or
processes have been classified, and the charges have been
made, each item being considered by itself. In making
up the charge per hour only the actual number of opera-
ting hours for the cost period is considered.

In making up the machine rate, the labor cost is ob-
tained from the time reports, as is also the actual number
of operating hours.

Circumstances must determine whether the material
cost should enter into the machine rate or not. If the
materials operated on vary in grade or price, the rate is
made up of the other expenses, and the material cost not
included until after the process cost for each article or
order is calculated.

The depreciation per hour is found by dividing the
cost of the machine by the total estimated number of
working hours in the life of the machine.

Most of the floor space charges, and those resting
on the value of the machine, as interest, insurance, etc.,
are steady, or annual, charges, and accumulate whether
the machine is idle or not. These charges for the cost
period are made a part of the machine rate by being
divided by the number of actual working hours. If there


is very much idle time on the part of a single machine, it
may be best to make the annual charges for such machine
a part of the department indirect, and so spread the cost
over the department, instead of centering it on the small
amount of product actually going through the machine.

Power charges must be determined by taking an in-
dication of power. Allowance for horse-power lost in
transmission may be made if there are marked inequali-
ties, or if great exactness is desired. If no such allowance
is called for, the first step in determining power charges is
to calculate the total horse-power hours of all machines as
actually operated. Multiplying the horse-power of a machine
by the number of hours the machine is operated gives the
horse-power hours for that machine; and the total for the
plant is found by adding the results for each machine. The
power generated at the engine but not indicated in the
above total is simply considered as unutilized power, the
cost of which is borne pro rata by all the machines. The
total power charge of the power department of the plant
is then divided by the total horse-power hours, which gives
the cost of power per horse-power hour. Multiplying this
by the horse-power hours of each machine gives the machine
power cost per hour for actual operating time.

After all the charges possible have been made directly,
the residue of indirect expenses must be considered. There
are two classes of these — expenses that can be identified
with certain departments, and general operating expenses
for the plant as a whole.

First, the general operating expenses are distributed
over the departments. Second, each department adds to
this share of the general expense its own departmental
indirect expense, and proceeds to distribute the total over
its own product, the method depending on the basis of
the cost system.


If the departmental costs are based on a unit of meas-
ure, as the ton or gallon, the total indirect expense of
the department is divided by the total output, giving the
rate per unit, and the rate so obtained is distributed
among the machines or processes by multiplying the
number of units of product operated on by the rate per

If the costs are based on time, the departmental ex-
pense is divided by the total number of machine-operating
hours; and this rate is added to the direct rate already
established, which gives the complete or final rate per
hour with which to charge the product of that depart-

In special cases, the department indirect may be dis-
tributed over the machines or processes on the basis of
labor cost or labor hours, the justification lying in the

It may be well now to review the method as outlined.

(i) All expenses which can possibly be charged
direct to machines or processes are so charged.

(2) The general operating expenses are dis-
tributed over the departments as units, and be-
come a part of the several departmental indirect

(3) The total departmental indirect expenses
are distributed over the machines or processes of
the department.

(4) Combining the charges of i and 3, the total
machine rate is determined.

Suppose an article now to pass through several de-
partments or processes. Multiply the number of hours
it is operated on in each process by the machine rate for



that process, and the cost of the various processes so
calculated will, when added together, give the total
process cost.

If the material cost constitutes a part of the machine
rate, this result is also the final factory cost; if not, the
material cost must be added to the process cost to get
the final result.

The scope of the new machine rate method should be
clear from the foregoing description. It can be used when
all operations are performed by machines, but it cannot
be applied to general bench work and miscellaneous forms
of hand labor.

(7) Fixed Machine Rate M

The "Fixed Machine Rate" is characterized by three
special features:

(i) The rate itself is an estimate, and is made
in advance.

(2) The rate is estimated on the basis that
every machine in the shop will run full time.

(3) All charges unabsorbed by the estimated
fixed rate are distributed through a supplementary
rate, the special feature in this being its relation to
idle time.

In practice, the fixed machine rate is employed in vari-
ous forms, and with sometimes quite essential differences.
For instance, it is sometimes used departmentally, and
sometimes it covers the whole machine production of a
plant, each machine having its own rate, and there being
no class of expenses recognized as departmental. Again,
the rate may be considered as a single rate covering all
forms of expense, or it may be constructed as a total


rate composed of component rates, each rate representing
the estimate for a certain class of expenses. The par-
ticular method chosen, in conjunction with the conditions
of manufacture, will affect the accuracy of the results to
a considerable degree.

We will first consider it as a single rate. The esti-
mate is made either by a careful analysis of all the ele-
ments of expense, or by referring to the results of past
experience. In the latter case the average results of a
period of years are generally taken. In either case it is
supposed to include all production expenses incident to
the operation of each machine.

The total expense assigned to each machine is then
divided by the maximum number of operating hours for
any chosen period to find the machine rate per hour; i. e.,
the estimated cost of running the machine one hour. This
rate is then charged against the machine, irrespective of
the actual cost per hour, or the actual time of operation.

The sum of all the rates or machine charges in any
department is charged against that department in the de-
partmental expense account, or, if no departments are
considered, the total of all estimates is charged against
a general factory expense account. Whatever difference
appears between the estimated charges and the actual ex-
penses for the period is adjusted over the factory through
a supplementary rate, which may be applied department-
ally or over each machine separately.

If all the machines run full time, it is obvious that all
the charges as estimated will be absorbed into the product;
but this is very rarely the case. Besides the idleness due
to dull times, there are often machines that, because of
great capacity or peculiar product, are used only a frac-
tion of the whole time. The question arises as to what
to do with the charges written against a machine for


the time that it is idle, which seem to apply to nothing.
If they are added to the cost of the product, they in-
crease it out of all proportion. For example, if a ma-
chine were busy only one day in a week, the product made
that day would, under such a rule, have to bear the ex-
penses of the whole week, including charges that do not
apply to it in any possible way. The result would be in-
accurate on the face of it.

To avoid such an evident fallacy, the costs, as deter-
mined by applying the rate to actual running time, are
subtracted from the estimated cost to find the amount
still unabsorbed. This is considered as an indirect ex-
pense estimated but not actually incurred, so it is sub-
tracted from the departmental, or from the general factory
expense account, as the case may be, in order to make the
proper adjustment.

This principle in itself is wrong. The plan of deduct-
ing the rate of idle machines from the general expenses
implies that there are no direct expenses connected with
the machines when they are not working. But this is
not true; for interest, insurance, floor space charges, and
certain other items go on just the same.

Evidently, the fixed rate will be unsatisfactory unless
provision is made for the fixed or annual charges that
accrue whether the machines are idle or not; and these
charges must be distinguished from the charges arising
out of actual operation, which may be designated as
operating charges. Of course, allowances may be made
afterwards by adjusting the supplementary rate, but this
would be a direct contradiction to the principles and pur-
poses of the method itself.

To avoid these difficulties, separate fixed rates may
be calculated for the dififerent classes of expense, and the
total of these rates regarded as the maximum rate for


operating time. For instance, one rate may stand for
the operating charges only, while another may represent
the annual charges assignable to any particular machine
or department. A third rate could be fixed to include a
pro rata share of the estimated general operating ex-
penses. If it is desired to analyze the expenses accord-
ing to rates, the total rate could be divided into as many
component rates as desired.

Allowances for idle time would now be made as fol-
lows: The maximum number of operating hours is multi-
plied by the total rate for each machine, which gives the
total amount charged against that machine. The sum
of all these charges constitutes the total estimated fac-
tory charge. The number of idle hours for each machine
is then multiplied by the "operating expense rate" only,
which represents the expense charged against the ma-
chine but not actually incurred. When the sum of all
allowances for idle time is subtracted from the total esti-
mated factory charge, the result is the net estimate of all
charges. The difference between the net estimate and the
actual expense is then adjusted through the supplemen-
tary rate.

In such case the supplementary rate becomes far more
important, because it is no longer limited only to ad-
justing mistakes in the estimates, but also becomes the
indicator of idleness in the factory, and provides the
means for distributing the resulting burden over the whole
product manufactured. The supplementary rate, which
distributes these expenses, reflects in actual figures the
fact that idleness in one part of a plant is a burden on the
rest of it.

The "Fixed Rate" as a method is adapted only to
shops where the greater part of the work is done by ma-
chines. The drawbacks are that it is primarily an esti-


mate at best, and that it is too rigid to reflect all the
fluctuating phases of actual production.

Miscellaneous Methods

Various modifications and combinations of methods
for the distribution of expense have been devised to meet
special conditions in different lines of business. For the
most part they are "percentage" plans in some form or
other. It has been shown that accurate costs cannot be
obtained from an arbitrary percentage added to the prime
cost of the product, except in the most elementary con-
ditions, M^here there is only one class of product, and all
processes are the same. This, however, does not for-
bid the application of a percentage to the output of a
department for the distributing of purely departmental
expenses. In fact, the direct labor cost is a percentage
plan, only it is not an arbitrary percentage plan, since
it uses for a base one of the factors of production.

The departmental condition where an arbitrary per-
centage may be safely used for distribution of expense
must be judged by direct observation. In any case the
percentage method will fall short of the desired standard
in the matter of analyzing expense into the different items
of which it is composed.

In shops where the material constitutes much the
larger part of the prime cost, and where the processes are
uniform, experience has shown that the indirect expenses
may be distributed either on the tonnage basis, or per
hundred, on the number of articles.

In similar conditions, where the material does not
differ in grade or price to any considerable degree, or
where the business is really little more than assembling
finished parts bought in the market, the cost of the
material may be substituted for the quantity as the unit


of distribution. However, such special conditions rarely
exist in a business of much size.

There are also cases where the principle of the machine
rate is applied to the operator of the machine instead
of to the machine itself. It may be used where the wages
of the operators are difTerent, and where operators go
from one machine to another.

The same principle is sometimes extended to cover a
whole department; that is, a rate is made for the total
productive labor hours of all the men in the department.
It has been called the "Sold Hour" plan and was orig-
inally devised to apply to the printers' trade. It is
adapted to industries where any man in a department may
be called on to do any job coming to that department.



Since the prime object of cost systems and cost
methods is to increase efficiency, and since a knowledge
of wage systems is necessary for the designing of a proper
cost system, it is very necessary that the accountant be
familiar with the workings and advantages of the various
methods of paying wages.

The purpose here is to present and explain briefly the
different wage systems that are commonly recognized,
and to indicate certain advantages or difficulties con-
nected with their adaptation to conditions. No one
method can ever be recommended as the best; for each
has its own characteristics, which make it peculiarly
suited to some conditions, and at the same time impos-
sible in others.

The general methods or plans of paying wages are
known as:

(i) Day Rate

(2) Piece-work

(3) Differential (piece) Rate

(4) Premium

(5) Bonus

(6) "Stint" System

(7) Contract System

(8) Profit Sharing

(9) Stock Distributing




Each plan is subject to more or less modification.
There are, particularly, many forms of the premium and
bonus systems, some of which are known as the "Dif-
ferential Bonus," the "Gantt System," the "Santa Fe
System," etc.

(i) Day Rate

The "Day Rate" method groups several workmen in
a body, and pays each one a certain sum for a certain
number of hours' work, this amount depending partly on
the skill called for, partly on the locaHty in which the
plant is placed, and partly on the labor conditions exist-
ing at the time. This is the original elementary method;
and since all the other plans have been devised in an effort
to get away from it, it is natural to assume that there are
grave defects connected with its use.

Many of these can be traced back to a single general
cause, "lack of incentive." The workman has Httle or
nothing to gain by putting his heart in his work and
exerting himself. He is kept up to about a certain dead
level by the fear of losing his job, and that is all. Why
should he do more than the man next to him, when they
are both paid alike? This reasoning does not apply to
the one man in a thousand who goes ahead and by sheer
energy makes a place for himself "higher up"; but it
does apply to the great mass of workers. The result is
shown in both quantity and quality of output.

Still another objection to this plan comes from the
difBculty of finding labor costs, for a uniform labor cost
per week is nowhere near a uniform cost per article made.
The wages remain even, while the product varies from
day to day, and still more between man and man.

There are classes of labor, however, for which no other
kind of rate is applicable. Where the work is a pure


function of time, as in the case of firemen, watchmen, in-
spectors, etc., the natural rate is a time rate. Repair men,
inventors, and men who are planning and constructing
special machines, also come under a time rate, because of
the nature of their work. In general, indirect labor is
more suited for payment by time than direct labor.

(2) Piece-work

The "Piece-work" plan is a system of paying wages
on the basis of the amount of work done, the rate being
based on past experience or ascertained by test. Under
this plan the employer, after making what he considers
a fair estimate, sets the workmen's rate for the various
operations incident to the production of an article.

If the rate is fair, the entire arrangement looks so
equitable that it may be surprising to learn that in many

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Online LibraryJerome Lee NicholsonCost accounting, theory and practice → online text (page 4 of 19)