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.