107. The previous chapters have dealt chiefly with the problem of allocating profits to sales branches of foreign enterprises. Much of the material will apply directly or indirectly to the problems which arise in accounting for the profits of other types of branches. The problem of allocation, however, must now be considered from the point of view of the manufacturing establishment. The special problems of purchasing, processing and other types of branches will also be discussed.


108. When the buying establishments and the sales branches of a company have introduced methods of accounting which provide for a proper allocation of profit to these units, the profits of the manufacturing branch or division are almost automatically determined. The difference between the prices paid for materials furnished, either by purchasing branches or by independent suppliers, and the prices fixed for goods transferred to sales branches constitutes the margin out of which the manufacturing division must pay the costs of conversion and secure its profit. The methods of arriving at intra-company transfer prices and the difficulties involved have already been discussed and need not be repeated. Some aspects of the relationship between the manufacturing division and the sales branches, however, must be restudied from the point of view of the manufacturing establishment. In preceding chapters we have studied principally the relationships between a single sales branch and the manufacturing establishment, usually the home office, which supplies the merchandise. It is now necessary to consider the manufacturing division in its relationships with all branches. The first question which arises is whether or not uniform prices must be charged to all sales branches. Then, if uniform prices are not required, the extent to which price discriminations among branches are permissible must be considered. This brings up the problem of dumping.

109. The argument in favour of uniform prices is that the same amount of manufacturing effort goes into an article sold by one branch at a loss that goes into an identical article sold by some other branch at a profit. From the manufacturing point of view this is correct, but the fact remains that uniform prices in transactions between independent concerns are the exception rather than the rule, and many of the factors which make for price discrimination between independents enter also into the relationships between a home office and its branches. Although the same amount of productive effort may go into each article, a manufacturing plant or division may find it desirable on occasion to accept prices which are equal to, or even less than, the cost of production. The advantage to be gained from sales at or below cost arises from the fact that production cost usually contains a considerable proportion of fixed overhead expenses which must be paid whether the plant operates at a higher or lower percentage of capacity. Where the percentage of overhead expense is relatively high, there is a powerful urge to keep the plant operating as nearly as possible at normal capacity. Otherwise, the costs of unused capacity are likely to preclude the possibility of profit. In the attempt to obtain the necessary volume of business, a sales branch may be opened in a country in which the competitive situation, the tariff, or other factors make it apparent from the beginning that no profits in the ordinary sense of the word can be expected. The purpose of the branch is simply to obtain a volume of business which will help absorb overhead. In billing merchandise to such a branch the factory price, if it included full cost and normal profit, might conceivably exceed the ultimate selling price of the branch.


110. The question of uniform or discriminatory1 prices from the factory to sales branches raises the familiar dumping argument which runs somewhat as follows. A company manufactures a product which it sells largely in the domestic market, but since it cannot obtain a sufficient volume of business from domestic sales to keep its plants operating at capacity, it sells abroad at marked price concessions, sometimes at less than cost. As a result of this dumping in the foreign market an additional amount of overhead expense is absorbed and the total profits of the company are increased. Up to this point the facts presented are undeniably correct. The conclusion is drawn, however, that the increase in profits caused by dumping represents a profit which should be allocated to the country in which the goods are dumped and taxed as income there. This conclusion, in my opinion, is untenable.


111. The objection to the conclusion is that it confuses differential gains with profits. The differential gain attributable to a branch is the difference between the total profit (or loss) of the company with the branch in operation and the total profit (or loss) which would have been earned without the branch in question. This differential gain, if it could be accurately calculated, would, except by the merest coincidence, be quite different from the commercial profit of the branch. And tax laws, it should be noted, apply to business profit or income as ordinarily defined, not to some vague concept of differential gain.

112. The nature of the differential gain which arises from dumping may be more easily explained by the use of a hypothetical case. Suppose a company manufactures in one country and sells one-tenth of its product through each of ten sales branches located in ten different countries. Costs and prices are assumed to be uniform at all sales branches. Assume further that the total profit earned by the whole company is $100,000 and that, if any one of the branches were not operated, the company would earn exactly nothing. The elimination of any branch, in other words, would reduce the total profit by $100,000. This amount, then, is the differential gain ascribable to each branch, but if each of the ten countries should levy an income-tax on this amount, the company would be taxed on $1,000,000 of “income” even though it earned only $100,000. And this does not include a tax on the manufacturing establishment, the differential gain of which would be hard to estimate.

113. Let us now suppose that an eleventh branch is organised and that it sells the same quantity of merchandise as each of the other branches, but at a much lower price. The eleventh branch, in other words, is organised for the purpose of dumping, and, as a result of the increased volume of business, profits rise to $150,000. The differential gain ascribable to the new branch is $50,000, but did it make that much profit? To maintain that this $50,000 is profit of the eleventh branch would create the absurd situation of ten branches selling at regular prices and earning only $100,000 altogether, while an eleventh branch selling one-tenth as much merchandise at much lower prices would be credited with a profit of $50,000! What actually happens is that the new branch makes it possible for the company to effect a saving. If the dumped merchandise is sold at cost … i.e., at normal production cost plus distribution cost — it is apparent that the eleventh branch relieves the other ten branches of $50,000 of overhead expense which they would otherwise be compelled to bear. This $50,000 of overhead is made up of expenses which would have been incurred oven if the capacity required to supply the additional branch were not used at all. The additional profit, therefore, is due to the more efficient use of the company’s facilities for production and distribution, and not to the activity of any one branch. The benefit derived from the opening of the additional branch is in the nature of a saving, not a profit in the accounting sense of the word. If any profit at all is to be allocated to the branch which does the dumping, it cannot properly exceed the amount obtained by the following computation. First, allocate a part of the $150,000 of net profit, say $90,000 to the manufacturing division; then find for each branch the margin of selling prices over direct costs — this will give the amount of revenue available for overhead and profit; finally, distribute the profit to branches as a percentage of the margin above direct costs. By this method the branch engaged in dumping could hardly receive more than $5,000 of the total profit. As the result of a general apportionment, this allocation may be reasonable enough, but there is a grave question whether any so-called profit of this kind should be or can be recognised in the accounts. From an accounting point of view, the safer procedure would be to follow the general rule that no profit is realised unless a sale is made at more than cost.

114. Since a branch which sells at or below cost cannot properly be said to earn a profit, the levying of an income-tax upon it can be justified only on grounds of national policy. Excellent reasons may exist for attempting to discourage the practice of dumping, but the income-tax would seem to be a very ineffective weapon. Under no reasonable system of allocation could a very large profit be ascribed to a branch selling at cost or less, and the amount of tax which could be levied would, therefore, be small. A tariff, however, acts in direct opposition to dumping. Since a tariff applies directly to every unit of the product imported, it would be far more effective than a tax on net income. In fact, as soon as the tariff becomes equal to the difference between the dumping price and the direct costs applicable to the merchandise imported, dumping necessarily ceases.

115. In any discussion of this subject, it must be remembered that dumping is hard to define, and it is difficult to distinguish between losses due to dumping and those due to the development of a new market.


116. Buying establishments range in size and scope from mere purchasing agencies to large organisations which buy, assemble, sort, grade, and store some basic raw material for later use in manufacturing operations by other units of an enterprise. It is at once apparent that the large buying establishments which perform the functions of grading, storing, etc., are more closely related to processing establishments than they are to the small agencies which simply purchase goods for direct shipment to plants abroad. Some of the larger establishments may even do some preliminary processing in preparing materials for shipment.

117. The differences in function here represented call for corresponding differences in the accounts and they raise an important question regarding the point at which profits must be presumed to accrue to buying establishments. In both business and accounting practice it is an accepted rule that profits do not arise from purchasing. The necessity and importance of the purchasing function in the profit-making scheme are recognised, but no profit is ordinarily assigned to purchasing even though the savings effected may be substantial.

118. At all buying establishments for which this view is accepted, the accounts should be kept on a cost basis. All buying expenses should be computed and then charged against the other branches or divisions of the business for which purchases are made. In so far as possible, the direct expenses applicable to each purchase or to the purchases for each branch should be determined and charged directly either as an addition to invoices for goods or as a separate charge. Some of the expenses will, of course, have to be distributed by apportionment. As a matter of fact, it may be more convenient to distribute all expenses by this method. This may be done by adding a standard charge or a fixed percentage to the amount of each invoice. At the end of the year, any difference between the amounts thus charged and the actual buying expenses could be pro-rated among the branches served, presumably in proportion to the value of goods purchased for each. Keeping accounts by these methods for buying establishments to which no profit is assigned offers no difficulties.

119. As these establishments take on more varied and more important functions, a point is finally reached at which it becomes necessary to allocate to them a share in the profits. If buying establishments could be arranged in the order of their relative importance in their respective enterprises, there would be a continuous series beginning with the purchasing agency, consisting of a purchasing agent and stenographer, and ending with a buying organisation whose operation constitutes the principal business of the undertaking. A buying organisation of the latter type clearly deserves credit for most of the profits of the business, but the exact point in the series at which profits are held to arise will depend upon the law of the country in which an establishment is located.

120. There are two general methods by which profits may be allocated to buying establishments. One is by means of commissions or fees; the other, by billing all goods purchased for other branches at market prices which are presumably in excess of cost. The one rests on the theory that the purchasing branch is being paid for services rendered; the other, on the assumption that the buying establishment is trading on its own account. Since a branch which simply buys for direct shipment abroad is in no sense trading on its own account, the first of these methods should be used if the law requires that some profit be allocated to such branches. The rate would be that currently charged by brokers or commission agents who make purchases for independent concerns.

121. The accounts of the larger establishments may be based on either method. If in the exporting country there are customary fees or rates for the various services of buying, sorting, grading, packing, storing, and the like, these may be conveniently used in placing purchasing branches on a commercial basis. If the home office or other branches are charged the regular commercial rates for all services rendered, the books of the purchasing branch will show the profit which an independent brokerage or commission house would have earned on a similar volume of business. The reasonableness and the convenience of this method strongly favour its use wherever it is applicable.

122. The commission method, however, does not fully recognise the gains which may arise from skill in buying. There is no method by which such gains can be accurately measured, but an approximation can be made by treating the buying establishment as a trading business engaged in both buying and selling. In the country of export there are likely to be definite quoted prices for the graded commodity ready for export and other prices in the interior for the ungraded product. If the buying establishment “sells” the commodity to other branches of the company at the market price on the date of export, the difference between this price and the sum of all the costs of buying, grading, etc., will represent the remuneration of the purchasing branch for services rendered and the gains attributable to skill in buying. By skilful buying, for example, it may obtain quantities of the commodity which will grade higher than the average and thereby make a so-called buying profit.

123. This would be the ideal method for allocating profit to buying establishments were it not for the fluctuations in market prices which are almost certain to occur while a commodity is in process of preparation or in storage at the branch. If during this period the market price should fall abruptly, the purchasing branch would bill the commodity at less than actual cost, thereby showing a large book loss with probably no taxable income from which to deduct it. The company abroad, at the same time, would receive the goods at less than cost, and its books would show an apparent profit which was not actually realised by the organisation. The distortion of profits would be even worse if the commodity were hedged by the home office on the date of the original purchase, since under these conditions the home office would not only obtain the commodity at less than cost but it would also show a substantial profit on its hedge. Actually, the gain on the hedge would probably be about equal to the loss on the commodity, and, if the hedge were perfect, the company would neither gain nor lose on the two transactions taken together. On the other hand, if market prices had increased materially, the branch would have shown a large profit not in the least due to skill in purchasing, while the home office, in addition to paying the full market price for the commodity, would have lost heavily on its hedge. Clearly, if hedging is practised, the losses and gains on transactions in the commodity itself must appear in the accounts of the establishment which places the hedges. This matter of hedging in international trade deserves more attention than it has received from tax officials and accounts. The problem would be simple enough if each transaction in a commodity were matched by a reciprocal transaction on a futures market, but such is not the case. A concern will hedge its total position, it may delay the placing of hedges, and it will shift its future contracts from one month to another as market conditions change. All this is necessary for successful hedging, but it raises some difficult accounting and tax questions unless the hedges happen to be placed in a futures market in the importing country. This is likely to be done when possible, but goods are frequently shipped to countries in which no futures market exists.

124. Our immediate problem, however, may be solved by having goods invoiced by the purchasing branch at the market price for the assembled and graded commodity on the date on which the raw commodity was originally purchased rather than at the market price on the date of shipment. The margin between original cost and the market price of the prepared commodity on the date of purchase should be large enough to pay the branch for the services of buying, grading, etc. In this margin would also appear the gains, if any, arising from the exercise of special skill in buying. The margin, however, would not ordinarily include an allowance for the costs of storage for any period of time between the date on which the commodity was ready for shipment and the actual shipping date. A fee for storage would, therefore, have to be added to the invoice price.

125. This method of invoicing at the market price on the date of purchase rather than the date of shipment removes all gains and losses on market fluctuations from the branch accounts and centralises them at the home office which presumably effects the hedges. If a company does not or cannot hedge its position, it is still proper that all market gains and losses should appear at the home office, or other importing branch, unless the buying establishment actually trades independently. If it buys only on orders from other branches, then it is obviously unfair to ascribe to it any market gains or losses which may happen to occur while the commodity is being prepared for shipment. Tax authorities may, of course, take the view that, if an increase in market value takes place while the commodity is still in the country, a taxable gain thereby arises. This view is hardly tenable, however, since the same rule would not apply to the purchases of independent concerns with no permanent establishment in the country. It is an accounting principle, moreover, that profit is not realised when goods appreciate in value. Such appreciation could properly be taxed as profit only if the purchasing branch were treated as an independent entity purchasing on its own account, not for others. Even then it could be taxed only when the goods were actually sold. If goods are to be priced at the market on the date of purchase, some difficulty will arise in identifying the different lots for the purpose of pricing them. Moreover, there might be wide differences in the prices charged to branches for shipments made on the same day. These difficulties could be avoided by using a weighted average market price for all shipments. This method of pricing, however, at its best is rather complicated.

126. To summarise, three general methods for handling the accounts of purchasing branches have been mentioned. These may be called the cost basis, the service basis, and the trading basis. Under the cost basis no profit whatever would accrue to a purchasing branch. Since it is a generally accepted rule that profits do not arise from purchasing, this method is to be preferred unless the other functions of the branch are important. If purchasing branches are regarded as service units which do earn profits, they may operate on a commercial basis by charging the regular fees which a brokerage or commission house, or a warehouse, would charge for similar services. The simplicity of this method commends its use if the cost method will not be accepted. Only in rare instances where skill in buying is an important factor should a purchasing branch be treated as a trading business. Complications in connection with hedging and with the treatment of market gains and losses generally make this method of handling inter-branch transactions unsatisfactory.


127. Processing establishments are, of course, engaged in manufacturing, but they will here be distinguished from manufacturing establishments by the fact that they do not perform the whole manufacturing process. They may be engaged in the preliminary work of preparing some raw material for use in later manufacturing operations, or in intermediate processing.

128. The establishments of each of these types have their own peculiar problems. Preliminary processing establishments, however, in many respects so closely resemble the more complex buying establishments that the same rules may be applied to both. Both are engaged in preparing a commodity for later use, one by assembling, grading and sorting it, the other by changing its form. The profits of preliminary processing establishments, therefore, may be determined on the basis of regular commercial fees for services rendered or by the use of current market prices for the commodity in a prepared state.

129. A different situation exists with respect to intermediate processing establishments because of the fact that they both receive material from and send it to other units of the same enterprise. As a rule, there is no independent price at either the beginning or the end of the process. If quoted market prices for the product, both before and after processing, are available, they can be used for inter-branch billing, thereby fixing definitely the margin available to the processing establishment for costs and profit. Or the prices obtained by independent processing plants for the same work may be used, if the quantities involved are comparable.

130. In the absence of independent prices or rates, the amount earned by the processing branch must be computed from internal data. The amount to be credited to the processing branch should be the inward billing price plus a margin sufficient to cover the normal cost of conversion at the branch and an allowance for branch profit. The amount to be paid to the branch should be the amount which would justify the construction and operation of an independent processing plant to handle the same volume of business. An independent capitalist considering the construction of such a plant would want to know first what the volume of business would be and the amplitude of variations in demand. Large variations in the volume of goods to be processed at different periods would require the maintenance of a plant of sufficient capacity to handle the peak load, and this extra capacity would necessitate a larger allowance for overhead to cover the cost of idle time in seasons of low production. The variability in demand, in other words, would determine whether the plant would normally operate at 60, 70, 80, or some other per cent of its rated capacity. Before constructing a processing plant an independent capitalist would require some assurance of a payment for services rendered sufficient to cover the direct costs of operation, the overhead computed on normal capacity, and a reasonable profit on his investment. Direct costs, of which direct labour is the best example, can usually be computed without difficulty. Overhead can be estimated with reasonable accuracy if the probable volume of business is known. The margin required for profit will depend on the volume of business handled and the risk involved. In determining a reasonable rate of return for the processing establishment, it would be wise to give some weight to the rate earned by the enterprise as a whole.

131. The required profit, as thus estimated, divided by the average annual production in units will give the necessary profit per unit, or if divided by the normal conversion cost for a year, it will give the necessary rate of profit expressed as a percentage of the processing cost. The profit per unit so determined when added to the processing cost per unit should give a reasonable price per unit for the service rendered. It would be difficult to fix independently both inward and outward billing prices for an intermediate processing establishment, but it is not so difficult to determine a margin or price for services rendered which will in normal times allocate a reasonable profit to the branch. Other methods, if desired, can be used. All accounts might be kept on a cost basis through the whole series of processes and the total profit on the goods processed, separately determined. This final net profit could then be apportioned between production and distribution, and the manufacturing profit thus determined could be allocated to the different processing establishments in proportion to the work done by each. Or inward and outward prices might be fixed by company executives on the basis of careful estimates. Unless the intermediate processing establishment is one of the major units of the enterprise, however, these more difficult methods should be avoided. In large complex enterprises it is both logical and convenient to allocate a profit to minor operating units measured by compensation for services rendered and to make the real centre of management the residual claimant for all remaining profit.


132. Because of tariff regulations, transportation costs, or other considerations, large industrial enterprises have opened so-called assembly plants in many countries. These plants usually import a substantial proportion of finished parts, manufacture other parts themselves, and assemble the two classes of parts to produce a finished product, such as an automobile. The assembly plant may also have charge of sales in the country in which it is located and sometimes in neighbouring countries. The difficulty of working out an accounting system by which profits can be allocated to such branches on a reasonable and consistent basis should be at once apparent.

133. In the first place, it is clear that there can be no recognised market price for finished parts transferred to an assembly plant, and the commission basis obviously will not apply. There may be independent factory prices for finished parts, but parts sold to dealers for repair purposes are usually higher priced than parts used in an original assembly. The parts required for assembling an automobile, for example, sell separately for much more than the assembled car. Furthermore, the parts transferred may be only partly finished. A logical method of allocating profit to such branches would be, first, to separate the manufacturing profit from the selling profit and to assign the latter to the sales branch, whether at the assembly plant or elsewhere. The manufacturing profit should then be apportioned between the assembly plant and the foreign manufacturing division in proportion to the amount of work done by each. The relative amount of work done may be measured by ascertaining the proportion of the total conversion cost which was incurred at each plant, or the list prices of all parts handled may be added together and the proportion which the value of parts manufactured at each plant bears to the total value at list price may be used to determine the relative amount of work performed. This method obviously cannot be used if partly finished parts are transferred. The use of such methods are not beyond the range of possibility, but a carefully designed system of cost accounting would be necessary. Such a system, naturally, would have to be worked out by the companies themselves. In the meanwhile, joint profits arising from partial manufacture in one country, and completion, assembly and sale in another will have to be apportioned on an expense or other convenient basis. The problem is one which requires a special study of the industries concerned. It cannot be solved in any general or theoretical way. If it is possible to establish the reasonable charge which an independent enterprise would make for performing services such as the assembly plant renders, this would seem a simple solution.