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.