74. If independently determined commission rates or dealers’ prices cannot be obtained, inter-branch prices may be constructed by means of a careful analysis of internal data and applied in lieu of the independent dealer’s price described in the previous chapter. This is the cost approach. It requires a complete system of cost accounting, not only for factory operations, but also for administrative and selling activities. Since only the barest outline of cost accounting methods can be given here, the reader who wishes a more complete discussion is referred to an extensive literature on factory cost accounting,1 and to the beginnings of a literature on the analysis of distribution costs.2

note note

75. The operating expenses of an industrial enterprise may be grouped in three broad classes — namely, direct material costs, conversion costs and distribution costs. Operating income consists almost entirely of income from sales. The net operating profit which we are attempting to allocate is obtained by deducting the sum of the three classes of expense from sales, as shown in the following condensed statement:

Sales  xxxxx 
Cost of materials in goods sold  x 
Conversion cost of goods sold  x 
Distribution cost of goods sold  x 
Net operating profit3 (or net profit on sales)  xxx 

76. It should be possible to prepare a statement of this kind, not only for the business as a whole and for each branch, but also for each line of product manufactured and sold. As a matter of fact, it should be possible to obtain these figures for each lot of merchandise handled. In order to accomplish this result a complete departmentalisation of the accounts and a careful analysis of all costs by lines of product are necessary. Many industrial enterprises have accounting records which supply all this information with respect to material and conversion costs, but only a few make adequate analyses of distribution costs. Until distribution cost accounting methods are more fully developed and more generally used, the amount of distribution cost applicable to a given line of product will remain rather nebulous. In the meanwhile, one is compelled to accept rather rough approximations.

77. The division of all operating expenses into two classes is somewhat unusual. The more common practice is to divide them into production costs (material costs plus conversion costs), selling expenses and general administrative expenses. Selling expenses, however, constitute only a part of the cost of distribution and this part, naturally, is less significant than the whole. General administrative expenses may be placed in a separate class on the theory that administration is a distinct function, but many of the items commonly grouped under this head relate rather definitely to production or distribution, and the others may be apportioned. The function of administration, after all, is simply to co-ordinate and direct the production and sale of goods. The costs of administration can be allocated to branches with much greater assurance if they are first divided between production and distribution. The portion which applies to production then follows the product, and only the remaining portion has to be considered in relation to sales branches. Some concerns may find it inconvenient to follow this dual classification, but it offers the most logical approach to the problem of allocation. Since any presentation of methods of expense analysis must necessarily be rather complicated and technical, and since some of the suggested methods are controversial, the discussion of them has been placed in Appendix B. In the further consideration of the problem of constructing a factory price from internal data, it will be assumed that an adequate cost system is in use.


78. The joint profit resulting from the manufacture of goods in one country and their sale by a branch in another may be divided by constructing an inter-branch billing price which will fall between the cost of manufacture and the final selling price. A factory price of this kind may be constructed by adding to cost an allowance for manufacturing profit. This allowance may take the form of a fixed rate of return on investment in manufacturing facilities or a fixed percentage on cost. Among corporations which use factory prices in billing to sales branches, a common procedure seems to be to add an allowance for interest on the investment in manufacturing facilities, and to consider all remaining profit as belonging to the sales division, but this is hardly the method that an independent manufacturer would follow.

79. In constructing a factory price by this method, it is necessary first to decide upon a reasonable rate of return on the investment in manufacturing. There is no generally recognised rate which can be applied, but it ought to be somewhat in excess of ordinary interest; from 7 to 9 per cent, perhaps. The rate would have to be higher than ordinary interest in order to justify the investment, but it should not be higher than is necessary to obtain capital. The ideal rate is the one which would be just sufficient to induce an independent capitalist to make the investment in manufacturing facilities under an agreement with a sales company to market a reasonable volume of the product. A reasonable rate may usually be computed by considering the profit requirements of the company. These include interest on indebtedness, preferred and common dividends and an allowance for income-tax. The sum of such items may first be apportioned to manufacturing and selling in the ratio of the investment in production to the investment in distribution. Then some allowance should be made for necessary additions to surplus in each division, usually a small amount in the manufacturing division, say from 1 to 3 per cent. This allowance, plus a proportionate share of the interest, dividend and tax requirements, indicates the minimum profit which the manufacturing division ought to earn if the enterprise is to prosper.

80. The required manufacturing profit thus estimated may now be expressed as a percentage of the manufacturing investment and applied to the total investment of each department in the plant. By this method, each department is charged with its proportionate share of the required profit. This charge must now be distributed to the various lots or units of product handled in the department. The distribution to the product may be made according to direct labour cost, direct labour hours, or machine hours, or by other methods, but, whatever the method, it is important to base the computations on average or normal operating capacity. For example, if the profit requirement assigned to a given department were $1,000 per month, the direct labour hours per month at maximum capacity, 10,000, and the average direct labour hours per month, 6,000, the profit requirement per direct labour hour would be 1,000 divided by 6,000, or $16{\textstyle{2 \over 3}}$ cents, not 1,000 divided by 10,000, or 10 cents. After the hourly rate of $16{\textstyle{2 \over 3}}$ cents has been established, each product would be charged $16{\textstyle{2 \over 3}}$ cents for every hour of direct labour applied to it in the given department. This method of distribution — the same that is used in distributing overhead expenses — makes it certain that each product will be charged with a reasonable amount of profit.

81. After all manufacturing expenses and the required manufacturing profit have been distributed to the product, an inter-branch billing price may be computed by simple addition as shown below:

Cost of materials  x 
Conversion cost: 
Direct labour  x 
Factory overhead  x 
Manufacturing profit  x 
Factory price  xxxx 
Handling charges — Export Dept.  x 
Billing price to foreign branch  xxxxx 

82. The use of this price will provide a reasonable return on the investment in manufacturing when the plant is operating at average capacity. A somewhat higher return will be earned when the volume of business is above average, but this will be offset by much lower earnings in periods of subnormal activity. Under this method of pricing, there is more danger that a manufacturing division will fail to earn a reasonable return on its investment than there is that it will earn an excessive return.

83. A simpler version of the method just described is to determine the manufacturing profit by adding a fixed percentage to production cost. Unless the percentage to be added is carefully computed, however, results are likely to be arbitrary. Moreover, the inclusion of material costs in the base on which profits are computed is likely to cause a distortion of profit due to fluctuations in material prices. About the only advantage in using a fixed percentage of this kind is that it simplifies the accounting, especially in computing the amount of unrealised profit to be eliminated from branch inventories.

84. The method of constructing a factory price1 by adding a fixed percentage or a fixed amount of manufacturing profit to cost is only fairly successful in accomplishing the objectives established in Chapter II. The method of pricing at cost plus a fixed and limited profit is not often used in dealings between independent concerns. It places the manufacturing division in a preferred position so far as the earning of interest on investment is concerned, but prevents it from participating in higher profits. It definitely assumes that manufacturing is a subordinate function so far as the earning of profit is concerned. Prices fixed in this manner, however, are probably about what a relatively small manufacturer would get if he sold his entire output to a large organisation which could easily do its own manufacturing. If the manufacturing function is thus relatively less important than selling in the profit-making scheme, prices fixed on a cost-plus basis may correspond roughly to those which would apply to the transactions of independent concerns under similar conditions.


85. The cost-plus basis, however, like all methods which involve inter-branch pricing in excess of cost, raises the problem of unrealised profit in inventories. If this profit is not to be taxed, it must be eliminated by the methods described in Chapter V.2 Some difficulty may be met in computing the amount to be eliminated, but a satisfactory approximation can always be made.


86. No method which is based upon cost analysis can meet the third requirement mentioned in Chapter III3—namely, that profits be allocated by the use of data which can be verified in the country in which the branch is located. The profits of manufacturing branches may be readily verified where the cost-plus basis is used, but in order to test the reasonableness of an inter-branch billing price, the tax authorities in the country in which a sales branch is located would have to enquire into foreign production costs. In spite of these objections, the method has much to commend it. From the internal point of view, it is much the easiest way of constructing an inter-branch price. It is fairly definite, easily understood, and in rather common use. Where prices so constructed are used for tax purposes, however, the authorities will have to accept the taxpayers’ declarations of costs, or they will have to rely on comparative figures and external data to test the reasonableness of prices. Detailed enquiry into cost accounts kept at a foreign plant will ordinarily be impossible.


87. From a practical point of view, the chief advantage of using a factory price constructed on a cost-plus basis is that it does not depend on an analysis of distribution costs. Many concerns keep adequate records of production costs, but only a few have devoted the same attention to distribution costs. Since all methods of allocation hereafter discussed require an analysis of distribution as well as production cost, they can, at the present time, be applied by relatively few concerns. The cost-plus basis, however, may be used by many concerns without a radical change in their accounting methods.


88. In constructing a factory price by the methods just described, the manufacturing profit was determined without regard to the amount of profit left for the sales division. Whether there were a sales loss or a large selling profit, the manufacturing profit would remain the same. This is a one-sided, though very convenient, approach to the problem. It would be more logical and, at the same time, more difficult to consider both aspects of the problem simultaneously as an independent buyer and seller would do. The “willing buyer, willing seller” test is the one criterion which can be generally applied in judging the reasonableness of any intra-company price. This criterion unfortunately is so vague and indefinite that it almost begs the question. Some progress can be made, however, toward the establishment of objective standards which will indicate approximately the price which should result from a process of bargaining between a willing buyer and a willing seller who are well informed as to costs and prices. In other words, in the absence of a real market price, an attempt may be made to construct one which might reasonably apply.

89. The minimum price which a manufacturer can accept must be somewhat in excess of the total direct costs applicable to the commodity in question. These costs consist chiefly of direct material, direct labour, commissions on sales, etc. He would not care to sell unless he could recover at least a part of his overhead. On the other hand, the maximum price which a dealer can pay is determined by the probable selling price of the goods and the direct costs of handling and marketing them. The margin between the dealer’s purchase price and his probable selling price should be at least sufficient to cover his direct costs. The direct costs of the dealer include transportation charges, Customs duties, salesmen’s commissions, direct handling charges, etc. Sometimes the margin between the lowest price a manufacturer can accept and the highest price a dealer can pay is so narrow that a sale is impossible unless the manufacturer is willing to make a marked concession in favour of some particular territory or section of his market. Selling abroad at such prices is known as dumping and requires special consideration. The fact that a manufacturer may be willing to sell in a foreign market at more than his direct costs, but less than his full costs of production and distribution indicates the wide range which may exist in prices fixed by agreement between independent parties.

90. Under normal conditions, however, it may be assumed that the price will be fixed at a point which will permit both parties:

91. It may be assumed further that any profit in excess of the amount necessary to pay interest on the investments will be divided between the parties roughly in accordance with their relative contributions toward producing it. These relative contributions cannot be measured exactly, but if the manufacturer by extensive advertising in the territory or by other methods has created a goodwill for his product, he should be able to obtain the larger portion of the profit in excess of ordinary interest. The dealer, however, is likely to obtain this profit if he has done the advertising, and if the goodwill is in his name. With these assumptions as a basis, it is possible to work out a method of estimating or budgeting by which to construct a price which a willing buyer and a willing seller might be expected to reach under similar circumstances. Some form of budgeting is necessary because the factors which govern independent parties in price negotiations are probable future costs and selling prices, not past costs and prices.

92. Using the figures for actual past costs and prices as guides, an estimate can be prepared showing the probable volume of sales and probable selling prices at a given sales branch, or at all sales branches if a uniform inter-branch price is to be fixed. An estimate of the probable cost of materials may next be made and deducted from the proposed selling prices in order to ascertain the amount of probable revenue available for conversion cost, distribution cost and profit. Probable direct costs of conversion and probable direct branch expenses applicable to the goods in question may be ascertained, and reasonable allowances for factory overhead and branch overhead on the expected volume of business may be estimated. The deduction of these expenses leaves the expected profit on the goods under consideration.

93. Even if all of the estimates have been accurately and carefully made, there still remains the problem of dividing the expected profit. This profit may be divided by making an allowance for interest on branch investments and apportioning the remainder in accordance with the relative importance of the functions of manufacturing and selling in the particular business, or the whole profit may be apportioned by the method outlined in the following chapter. This method will not be presented in detail here, but, briefly, it involves the apportionment of profit, in this case expected profit, in the ratio of the conversion cost to the distribution cost applicable to the specific goods under consideration.

94. When the expected or budgeted profit has been thus apportioned, the inter-branch billing price can be readily determined. It will be equal to the estimated cost of materials, plus normal conversion cost, plus the budgeted manufacturing profit, plus a charge to cover export department expenses for merchandise handling and general supervision. When the finished product is shipped to the branch it will be charged at the price thus fixed, and this will constitute the first entry to be made on the formal books of account. All the work heretofore described has been analytical in nature. It has furnished a basis for budgeting and controlling the various activities of the business and for constructing a factory price. That price is now used and recorded on the books for the first time.

95. The advantage of a price fixed in this manner is that, within the limits of its own accuracy, it measures the relative efficiency of manufacturing and selling. If the manufacturing division operates with more than average efficiency, its actual profit will exceed the anticipated profit by the amount of the savings effected. It will, on the other hand, be penalised for excessive manufacturing costs. The sales division likewise will be rewarded for selling at higher prices or for reducing the cost of distribution, and it will be penalised for excessive distribution cost and for price concessions. Under actual operating conditions, however, the sales and factory prices and the expense budgets will have to be adjusted from time to time to compensate for market changes in the cost of materials or labour and for important changes in the competitive situation.

96. The procedure here outlined for constructing an inter-branch billing price can be used only by the management of a company; it is manifestly unavailable to tax officials because they could not possibly obtain the necessary data. They can, however, apply general tests which will indicate roughly whether the results obtained by the company’s methods are reasonable — that is, whether the prices used might reasonably apply as between a willing buyer and a willing seller. If the margin between the billed price to the branch and the selling price of the goods is so narrow as to eliminate the possibility of profit on a reasonable volume of business, or if this margin is markedly lower than that realised by independent dealers in similar lines, there is an indication of over-pricing. This becomes almost a certainty when the total profit on the goods is high. Note that the reference here is to gross profit on sales and not to net profits. A branch which has an adequate margin of gross profit may show a net operating loss due to a small volume of business or to extraordinary expenses, but such a loss should not be construed as an indication of over-pricing. Over-pricing is indicated only when the spread between the inter-company billing price and the ultimate selling price is so narrow as to preclude the possibility of adequate profit, even on a satisfactory volume of business. Very narrow profit margins for sales branches may be justified, however, when the total profit of the company on the goods handled is small or non-existent. In the final analysis a fair market price cannot be “constructed”. A detailed budget may provide the facts, but they must be interpreted and applied in accordance with the judgment of individuals familiar with conditions in the industry.