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CHAPTER III

SEPARATE DETERMINATION OF SELLING PROFIT AND MANUFACTURING PROFIT.

42. In accounting and tax literature, there are occasional references to a so-called sales or selling profit which is distinguished from a manufacturing profit. Although these vague concepts are never defined, they rest apparently on the obvious fact that the profits of a manufacturing enterprise arise from the manufacture and the sale of goods. It is tacitly assumed that this profit can be divided between, or ascribed to, one or the other of the processes from which it is derived, but it is almost as futile to attempt to allocate profits to the different functions of a business concern on grounds of pure theory as it is to try to discover how much of the cutting is done by each blade of a pair of shears.1 Both blades are essential, but no more so than the two functions of manufacturing and selling in an industrial enterprise. Profits do not arise from manufacturing alone. Despite these theoretical difficulties, profits can be divided in most instances by resorting to methods used in dealings between independent enterprises.

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43. The typical manufacturing concern performs two primary functions, production and distribution. It would perhaps be more accurate to say that a manufacturing business consists of a trading business and a service business combined. A grist mill to which farmers take their grain to be ground into flour for their own use is clearly a service business, similar in many respects to a public utility. A concern engaged solely in buying and selling wheat is clearly a trading business. The profits of the mill and of the trading concern may be easily determined, and no particular problem of allocation arises. Difficulties begin, however, when the grist mill and the trading concern are merged into a flour mill which buys wheat and sells flour. There is no exact method by which the profits earned by grinding wheat into flour can be specifically separated from the profits earned in the process of marketing.

44. Continuing the illustration, the cycle of operations consists of the purchase of wheat, the grinding into flour, and the sale of the flour. Translated into terms of cost, these operations respectively include the cost of materials, conversion cost and distribution cost. Contrary to the usual ideas on the subject, the purchase of basic materials is really a trading function rather than a manufacturing function. If the cost of such materials is deducted from the selling price of the finished product, the remaining figure is the amount of gross revenue available to meet the cost of two distinct services, production and distribution, and to provide profits for the concern as a whole.

45. When the functions of manufacturing and selling take place at establishments in different countries, the proper determination of the taxable income of each establishment requires a system of branch accounting with the following primary objectives:

46. The second of these objectives, it should be noted, is a modification or qualification of the first. In dealings between independent concerns it is, of course, quite common for one of them to earn a profit and for the other to suffer a loss with respect to the same lot of merchandise. It is possible that the different branches of a single concern should be treated in this respect exactly as independent businesses, but it seems a bit severe, and perhaps impractical, to attempt to tax a profit which is more than offset by a loss sustained by some other branch on the same goods. Attempts to tax unreal profits of this character are likely to cause taxpayers in self-defence to seek methods of evasion or avoidance.

47. In the chapters which follow four general methods will be discussed in the light of these criteria:

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