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Appendix C.



1. Direct material consists of all material which appears in the finished product in commercially measurable quantities. It includes raw materials, such as crude rubber or iron ore; semi-finished materials, such as pig-iron; finished parts, such as carburettors or rubber tyres used in the manufacture of automobiles, or, in short, everything which goes into the finished product of a particular company but which is not manufactured in its own plants. Direct material does not include factory supplies which do not appear in the finished product. Direct material costs include the invoice price of materials purchased, plus Customs duties and transportation charges to the factory. Sometimes a handling charge is also included, but this is not altogether logical. Since the handling of materials within a plant is a necessary part of the process of conversion, such charges should be classed as conversion costs. The distribution of direct material costs to the units of product manufactured usually involves little difficulty. To find the cost of material in a given article, it is necessary simply to measure the quantity required in manufacturing it and to multiply this amount by the delivered cost of the material. Special problems arise in the case of joint products and by-products, but these are too technical for consideration here. Cost accounting methods have been developed which provide for a reasonable allocation of material costs in such cases.


2. The cost of conversion includes two principal elements; direct labour and factory overhead expense. Direct labour is labour expended directly on the product itself and is distinguished from other labour which is necessary in the operation of a plant but which does not apply to specific units of product. The cost of direct labour for any unit of product may usually be determined easily by the use of time records which show the time spent by each worker on each article or on each order.

3. Factory overhead expenses cannot be allocated with such precision, since by definition this group includes only those costs of factory operation which do not relate to specific units of product. Typical factory overhead expenses are superintendence, indirect labour (janitors, watchmen, etc.), supplies, heat, light and power, insurance, property taxes, depreciation, repairs and maintenance, and a share of the general administrative expense of the organisation. The allocation of these expenses to the different factory departments and finally to the product itself constitutes the most difficult problem of cost accounting. For a more detailed presentation of these methods, the reader is referred to standard works on cost accounting. For present purposes, it is sufficient to note that cost accounting methods have been developed whereby any manufacturing concern which wishes to do so may make a reasonably accurate computation of the unit cost of its product. In the United States, at least, considerable progress has been made toward the determination of standard costs designed to show what an article ought to cost. These standards are carefully set by means of time and motion studies and the like, and are used as a means of discovering inefficiencies and unfavourable variations in actual costs. This refinement in method indicates that factory cost accounting has reached a high stage of development in some companies and can be depended upon, if properly used, to supply reliable cost data.

4. One characteristic of factory overhead expenses must, however, be considered here. Most of these expenses are rather fixed in character — that is, they do not vary in proportion to changes in the volume of production. Superintendence, depreciation, insurance, property taxes and certain other expenses are likely to remain almost constant, even though the volume of production is materially decreased. As a result, in periods of slack production the overhead cost per unit of product will be exceptionally high; or, to say the same thing in different words, a substantial amount of unabsorbed overhead will remain. This unabsorbed overhead — i.e., the overhead not applied to product — represents the cost of idle plant capacity. If the entire overhead for a given period were applied to the product actually manufactured during that period, the effect would be to add the costs of abnormal idle capacity to the normal costs of production, thereby causing a marked increase in unit costs at the very time when business activity is low and when sales prices are likely to be falling. If all of the overhead is not absorbed in this manner, however, the losses from abnormal idle capacity must themselves be allocated to some division or divisions of the enterprise. Since it is customary in many industries to charge only normal or average overhead costs to the units of product manufactured, we shall proceed on the assumption that this method is to be followed.

5. The disposition of the abnormal idle capacity losses which appear under this method will depend on which of two conflicting theories is adopted. It may be argued that these losses are due to the failure of the sales department to sell in sufficient volume and that they should be charged against the several sales branches. This theory logically requires that sales budgets be prepared showing how much each branch would have to sell in order to obtain the necessary total volume, and that the costs of abnormal idle capacity be prorated among them according to the differences between the actual sales and the budgeted sales of each branch. This method, however, would always load the heaviest losses upon the branches least able to bear them. The allocation of abnormal idle capacity costs in accordance with actual sales volume would meet this difficulty, but it would be practically equivalent to adding these costs to the unit cost of production.

6. The other theory with respect to abnormal idle capacity costs is that they are due to the over-expansion of plant and are the measure of the loss due to the adoption of this policy. Since major questions of policy of this kind must be decided by the general management, even though they may be influenced by an over-optimistic sales department, it might appear that these losses should be charged against the real centre of management of a company. Two policies are usually open to a concern. It may elect to manufacture the product which it sells or to purchase it from others. Or it may manufacture part and purchase part. Since losses from abnormal idle plant capacity could not appear if the product were purchased from others, it seems logical to conclude that such losses, when they do appear, must be ascribed to the policy of manufacturing in the company’s own plants. This would be true even though the real centre of management were at the headquarters of the sales division and the manufacturing plant located elsewhere. In order to determine the net advantage or disadvantage resulting from the decision to manufacture in its own plants, a company would have to assign idle capacity costs to the manufacturing function, and it will be assumed that this is the proper procedure to follow in allocating profits for tax purposes. All methods of branch accounting which make use of a sales commission or an independent factory price produce this result. It is the result, moreover, which would be obtained by ordinary methods of accounting for independent concerns. When goods are distributed through independent dealers, it is the manufacturer who must bear abnormal idle capacity costs. All further references to conversion cost or production cost will, therefore, rest on the assumption that these costs include only a normal or average amount of overhead and not unusual allowances to cover the cost of abnormal idle capacity.


7. Distribution cost includes all expenses which relate directly or indirectly to the product from the time it leaves the factory door until it has been sold and the proceeds collected. In general, the function of distribution consists chiefly of activities of four types:


8. The costs applicable to each of these types of activity fall into three groups:


9. In order to reduce the zone of uncertainty which is present in all apportionments, a definite effort should be made to place expenses in the first two groups, keeping the third at a minimum. A careful analysis will often reveal expenses which are usually classed as indirect but which may be handled as semi-direct.

10. For the purpose of making a correct allocation of profit to branches, it is essential that all costs of distribution be analysed:

11. The making of such allocations is exceedingly complex and far beyond the scope of the present enquiry. In order to make a satisfactory allocation of distribution costs to branches and to products, a concern might, however, proceed somewhat as follows:

12. (1) Classify all operating expenses of the enterprise into three groups:

13. (2) Apportion administrative and financial expenses to production and distribution.

14. (3) Separate the total cost of distribution into:

15. A concern which has a substantial export business will usually have an export department against which all expenses relating to foreign branches may be charged. In separating the costs of domestic and export business, an apportionment of the expenses of general sales management including a share of the general administrative expense, will be necessary.

16. (4) Divide the expenses relating to export business into:

17. (5) Allocate to products exported the internal handling charges and supervisory expenses of the export department (expenses included in 4 (b) above) and treat them as charges to be paid by the manufacturing branch or division out of the price obtained from the sales branch.

18. Expenses of this character take the place of the selling expenses which would be necessary if goods were to be sold to independent dealers. Such costs might, therefore, be presumed to be covered by independent factory prices charged to a sales branch. If sales branches are charged at a constructed factory price, these expenses should be added as an element of cost in order to bring the constructed price as nearly as possible into line with market or dealer prices.

19. (6) Allocate all branch operating expenses, including those mentioned in 4 (a) above, to the products handled by the branch.

20. The bases to be used in making allocations of distribution cost to products depend so largely upon conditions within each organisation that they cannot be discussed here. As a matter of fact, methods of allocating distribution costs are in such an embryonic stage of development that much further work will be necessary before any generally accepted procedure will emerge. After all the costs of production have been allocated on some reasonable basis, however, the accounts will show the profit realised by the enterprise on each line of product handled by each sales branch. The profit so determined will not be an exact or absolute amount, but it will be sufficiently accurate to serve as a basis for decisions of business policy and it should, therefore, be considered satisfactory for tax purposes.

21. After a concern has made detailed allocations of distribution costs to products sold during a number of periods, it should be possible to set standards for distribution activities. If carefully worked out, these standards will show how much it ought to cost to distribute each product and these ideal or standard costs may be used in lieu of the actual allocations. The use of standard costs greatly simplifies the accounting for the different lines of product and, at the same time, gives a running comparison between actual distribution costs in total and the amount which should have been spent as shown by the standards.

22. The allocation of distribution costs to the product handled by each branch completes the work of expense analysis. It should now be possible to prepare a complete statement for each line of product handled by each branch showing sales by the branch, the production cost (materials plus conversion cost) and the distribution cost of the goods sold. The excess of sales over production and distribution costs is the net profit of the enterprise on the particular line of goods handled by the particular branch. This net profit is the result of manufacturing in one country and selling in another, and a reasonable method must be found for dividing it between the two functions. In the absence of an independently determined price, this division may be accomplished by constructing a factory price or by apportionment. Methods for effecting this division are discussed in Chapters VI and VIl of this report.

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