97. The three preceding chapters have been devoted to the discussion of methods for dividing the joint profit on the manufacture and sale of goods by the use of a sales commission, an independent factory price, or constructed factory price. Such methods aim to divide profits to accord with what each establishment would earn if it were an independent enterprise operating in a similar manner. If there is no such basis of comparison with independent enterprises, the method of fractional apportionment may be used. This basis requires that all goods be billed to branches at cost and that branch accounts be kept in such a way as to permit the determination of the distribution cost applicable to specific goods or lines of product handled. Accounts kept in this manner will reflect the total profit realised by the enterprise on the specific goods sold by a given branch, and it is this profit which must be apportioned.

98. Take the case of a company manufacturing any commodity in one country and selling exclusively through a permanent establishment in another. For the sake of simplicity, the countries may be assumed to be the United States of America and Canada, since both have dollar currencies which may be assumed to exchange at par. At the plant are kept all factory cost accounts, including materials, labour and overhead, and the accounts for the investment in the land, buildings and equipment of the factory, and inventories of materials and work in process. All selling-expense accounts, including salesmen’s salaries and commissions, advertising, etc., and all trade accounts receivable, finished goods inventories and land, buildings and equipment used in distribution are kept at the sales branch. Operating cash funds are kept as needed at each branch. The general administrative officers spend part of their time at each branch and their salaries and expenses are charged accordingly. Almost the only expenses to be apportioned are the directors’ fees and expenses and other general corporate expenses. Under such conditions, a clear-cut division of the business into its primary functions of production and distribution can be readily obtained.

99. By combining the accounts of the two branches of such a business, a statement in the following form could be obtained.

Operating Income Statement. 
Sales  125,000 
Less cost of materials  25,000 
Value added in manufacture  100,000 
Conversion costs  40,000 
Distribution costs  20,000 
Net operating profit  40,000 

The investment in production may be assumed to be $150,000 and the investment in distribution may be taken as $50,000.

100. The question now is how to divide the $40,000 of profit between the manufacturing branch in the United States and the sales branch in Canada. It might be apportioned according to the relative investment in each branch, in which case the manufacturing branch would be credited with $30,000 and the distributing branch with $10,000. Such a division, however, places far too much emphasis on the single factor of investment. Since earnings are at the rate of 20 per cent on total investment, the accidental circumstance of owning or renting the real estate at one or the other branch would materially affect the apportionment. Not over 8 per cent on the investment, or $16,000, can properly be apportioned on this basis. Another method would be to apportion the net profit of $40,000 in the ratio of conversion cost to distribution cost. This is more logical because it includes a number of factors, not merely the one factor of investment. Applied to the illustration, this method would assign two-thirds of the total profit $\left( {{{\$ 40,000} \over {\$ 60,000}} \times \$ 40,000} \right)$, or $26,667, to the manufacturing branch, and one-third $\left( {{{\$ 20,000} \over {\$ 60,000}} \times \$ 40,000} \right)$, or $13,333, to the sales branch.

101. This method deserves the most careful consideration. If its soundness can be substantiated it can be used either as a basis for constructing an appropriate factory price or as a method of apportionment which will give far better results than the general allocation fractions now commonly used. The logic behind the method is that profits are earned by the expenditure of effort, that different types of effort can be quantitatively measured and compared only in terms of money cost and that the relative amounts of production cost and distribution cost, therefore, reasonably reflect the relative importance of the two divisions of a manufacturing business and the appropriate share of each division in the net operating profit.

102. The management of every business faces the problem of budgeting the total expenditure. More may be spent on production and less on distribution, or vice versa. If too little is spent for production, the product will be inferior and, on that account, difficult to market. On the other hand, if too much is spent for production and too little for distribution, an excellent product may fail simply because it has not been brought to the attention of consumers by suitable advertising and selling methods. A certain balance between the two types of expenditure is essential and the management of each company is in the best position to know what the proportions should be. Although there are undoubtedly mistakes of judgment and differences in efficiency, it may be assumed in each case that the actual expenditures for production and distribution are in the correct proportions. This assumption is justified because there are no absolute measures either of efficiency or of wisdom in budgeting expenditures. Thus, in the illustration, it may be assumed that an expenditure of $40,000 for production and $20,000 for distribution gave the highest net return, and that the shifting of one dollar from production cost to distribution cost or vice versa would have resulted in a lower net return. If the management correctly diagnosed the situation, the highest net profit was obtained by devoting $66{\textstyle{2 \over 3}}$ per cent of the total expense1 to production and $33{\textstyle{1 \over 2}}$ per cent to distribution. It does not seem unreasonable to assume that these percentages represent the relative importance of the two primary functions.


103. The argument which has just been presented seems logical enough and it may well be that a statistical study of the expenses of a large number of business concerns would show that on the average the relative amounts of conversion cost and distribution cost do indicate the relative importance of the manufacturing and the selling functions. It must be admitted, however, that, in many individual instances, this is not true. The profits of one concern may be due to the control of some particularly efficient process of production or to a source of supply of raw materials of a peculiar quality. Or the profits may be due almost entirely to effective advertising and selling. Facts of this nature ought to be recognised in making an apportionment of profit between the manufacturing and selling functions, but no quantitative measure of such intangible factors can ordinarily be obtained. In staple and raw material industries, the concerns which show the higher profits are likely to be the low-cost producers. Since sales prices are determined by market quotations, there is little room for sales effort. At the opposite extreme are the manufacturers of patent medicines and some other branded, trade-marked or patented articles. Manufacturing cost in such industries may be of little significance; their success or failure is likely to depend primarily upon effective selling. The great majority of business enterprises fall between these two extremes. It will be found in general that conversion costs will be relatively high and distribution costs relatively low in those industries in which production is the essential function. The opposite condition will prevail in those businesses in which the marketing function is the more important. It cannot be said that the ratio of conversion cost to distribution cost gives an exact indication of the relative importance of the two functions, but it does provide a basis for measurement which is convenient and reasonable.

104. The essential features of the method of apportionment here proposed are:

105. The method here suggested differs from other apportionment methods in a number of respects. In the first place, it calls for the apportionment of joint profits from the manufacture and sale of specific goods. It does not involve the apportionment of the net profit of a whole enterprise. Since the apportionment relates to specific goods and not to total net profit, it is possible for one sales branch to show a profit while another shows a loss. The apportioned profits are therefore more likely to coincide with the profits which would be shown by the several branches if they were operated as autonomous units buying at regular commercial prices. Under the proposed formula an apportionment can be made without enquiring into the world-wide business of an enterprise. An analysis of the production and distribution costs of specific lots or lines of product, however, must be made.

106. The suggested basis for apportionment, although necessarily somewhat arbitrary, is believed to be reasonable. Further study along this line is desirable and may lead to greater refinement, but no final or definitive solution can be expected. All apportionments must be more or less arbitrary. Were this not true, a method of direct allocation could be found. The omission of the cost of materials from the apportionment fraction, however, produces much more reasonable results than could otherwise be obtained. If the cost of materials were included, an apportionment in the ratio of production cost to distribution cost would assign at least as much profit to a manufacturing plant which merely purchased parts and assembled them as it would to a plant which manufactured all its parts from basic raw materials. The inclusion of the cost of materials in an apportionment formula probably results in the allocation of too large a share of profit to the manufacturing division.