Part 9
=2. True Cost──What Is It?= Without trespassing on the general subject of cost accounts, it is quite essential to clearly establish at the very outset what constitutes _true cost_. It would be difficult to conceive of a manufacturer to─day who would simply take the value of wages paid and material used for a cost price, and to this amount add the usual percentage of profit he desires to make on his output, and sell at that price. It would be folly to attempt business on any such basis. No business can be conducted without expense, and yet, in the case just cited, the manufacturer has simply ignored it. Suppose the expense of conducting his business exceeds the percentage he added for profit, what then? He soon finds he has made a serious error in figuring his cost, and the item omitted is the cause of his business losses. His selling price was based on less than the true cost of his product and it is noted he has made no provision, in making up his cost price, for covering the expense of operating his factory, his offices, and general expense, including insurance and taxes. It is apparent then that this matter of _expense_ has a very important bearing on the cost, in fact is a part of it, and must be carefully considered in making up the cost records. The factor of expense is frequently found to be greater than the direct labor cost itself, and a successful manufacturer must know how much expense his costs should absorb and how to figure it. The sales from his product must more than pay for the direct cost to manufacture and all the expenses of his factory besides, and if his sales are not sufficient to pay for both there is no profit. This expense, then, is an indirect charge to the cost of production, and must be included in it before the selling price can be established. Many a manufacturer has been ruined by not properly handling his manufacturing expense, and the necessity for its careful consideration cannot be emphasized too strongly.
Mr. Clinton E. Woods, one of our leading authorities in factory organization and accounting, very clearly states that expense and "overhead" charges must be absorbed into the cost of production as much as labor and material, by which operation expense is really converted into an asset.
True cost includes first, _direct labor_; second, _material_; and third, _expense_. The last item will admit of further subdivision and originates from two different sources: First, the expense of operating the work─shop or factory itself; and second, the general expense of offices and administration.
The cost of production, therefore, resolves itself into the following elements:
Direct labor $ Material Factory expense ──────── Factory cost General expense ──────── Manufacturing cost
=3. Selling Expense.= _Selling expense_, oftentimes spoken of as _commercial expense_, has no bearing on cost price. The correctness of this position is easily shown. Two manufacturers, competitors in the same line of production, both operating up─to─date plants with the finest equipment, may produce at the same cost. The expense necessary to market the product from one factory may be so excessive as to cause one concern to lose business to their competitors who can sell their output at less expense, while the actual cost to manufacture may be identical in both shops. Again, while one manufacturer, who can produce at a low cost but carries a heavy selling expense, may conduct his business at a loss, his next door rival in trade may not be able to manufacture as economically but can sell his product with less expense, and thereby carry on a profitable business. In the two instances cited, the key to the losses of one manufacturer and to the profits of the other is in the expense of selling, and not in the cost of production.
In a large plant with an elaborate, well─organized, and expensive sales division, where the dividing line between the commercial and production expense is clear cut, these two expense accounts should be kept entirely separate; the commercial being charged off to _Loss_ and _Gain_ direct, while the latter only should be merged into manufacturing cost.
In a small plant, where the selling division is conducted through the general office at an expense so small as not to affect the cost of administration over what would be necessary for manufacturing purposes only, or where there is difficulty in separating the selling from the manufacturing expense, the two are often combined as general expense and pro─rated as one account into production costs.
Theoretically, selling expense is not a charge to production, but the dividing line between this view and the practical one in most cases is a very fine one, and in the interest of simplification instead of elaboration, the commercial will be treated in this presentation of the subject as a part of the general expense, and will be considered in detail later.
=4. Expense Based on Cost Price or Selling Price.= Having shown that expense is of necessity an item which must enter into true cost, the question at once arises as to what it is related. Is the amount of expense to be borne by any article of production based on its cost or its selling price? While it is noted that some accountants claim the latter should be the basis for calculation, the consensus of opinion seems decidedly in favor of the cost price as the correct one, and there seems to be good argument for the stand thus taken:
(a) Inasmuch as the selling price cannot be established until the cost price has been ascertained, which is to include the expense, it is apparent that the expense must be calculated from data already in hand; either the direct labor or material cost. The selling price is established after, and contingent on, the cost price, not the reverse.
(b) Again, the selling price may vary according to the demands of trade; different prices to different classes of customers, as well as the wholesale and retail prices for the same article. In either case, the cost price is the same and is not influenced one way or the other by the selling price. The selling price may fluctuate while the cost price remains positive and stationary.
(c) While the selling price is theoretically based on cost, it is often fixed by the trade, or regulated to meet competition regardless of cost, and the expense accounts are found to continue about the same each month whether the selling price is high or low.
(d) In times of depression, or when business is slack, it is common practice to "mark down" the selling price and increase the amount of sales at a smaller percentage of profit.
(e) It is difficult to see wherein there would be any difference in the expense of manufacturing an article which sells at $110.00 over what it would be were the price but $100.00, yet there would be if the selling price were used as a basis.
Other reasons will suggest themselves, but these just referred to are quite sufficient to show that the selling price is too erratic and that expense will be found more reliable when figured at cost price, which method has, therefore, been adopted as the best practice.
=5. Expense Based on Cost of Labor or Material.= Having decided that expense should be reduced in some manner from the direct cost price rather than the selling price, it is remembered that we still have two items of cost to choose from: The labor cost and that of the material. There are those who maintain that the material cost is the correct starting point for calculations, but there are few manufacturers, if any, who do this.
An attempt has been made to use the combined total of labor cost and material, but this method is hardly worthy of serious consideration. The best practice points almost without argument to the labor cost as the true basis of expense; this is not only the logical conclusion but common sense:
(a) It is easy to see that the elements which go to make up the expense of operating a factory──foremen, sub─foremen, supervision, shop clerks, toolkeepers and grinders, helpers, the up─keep of tools and machines, lighting, etc.──are all closely related and largely dependent upon the number of men employed. Reduce the number employed and it will be seen at once that some of the above mentioned items of expense can be cut; less supervision is required and the wear and tear on tools and machinery is also reduced. It is difficult to see wherein any difference in cost of the material used would of itself cause any increase or decrease in the factory expense or even be influenced by it. It is quite contingent on the labor.
(b) That the cost of the material is not a reliable basis for calculating expense can be quite satisfactorily demonstrated. If the cost of an article is, say, labor $25.00, material $50.00, with expense to be figured at 50% on material, or $25.00, it is seen at once that the manufacturing cost would be:
Labor $25.00 Material 50.00 Expense 25.00 ──────── Cost $100.00
Suppose this article were duplicated under the same identical conditions and cost, using only this time material that cost $60.00. It is a fair proposition that the total cost would be but $10.00 more than in the first instance, or $110.00. But if the percentage is added on the material as before, it is found that the expense this time is $30.00, which would make the cost appear thus:
Labor $25.00 Material 60.00 Expense 30.00 ──────── Cost $115.00
It is now noted that the cost figures $15.00 more than in the first instance, while we are quite ready to admit it should be but $10.00, the only difference being in the cost of the material.
=6. Conclusions.= Having established the fact that the expense is a legitimate charge to the cost of production, we are now quite safe in laying down for our foundation the proposition that expense is contingent on, and should be figured from, the direct labor value of the cost price.
METHODS OF DISTRIBUTION
=7.= Time is continually bringing improvements; old methods once thought practical and satisfactory are replaced by more efficient ones to meet the exacting conditions of to─day. Examine a _Practical Bookkeeping─Manufacturer's Edition_ of thirty or forty years ago and you will probably find nothing on this subject of _expense distribution_, while to─day it is one of the most important and most discussed of any in factory accounting in general, and cost accounting in particular. Since that time different methods of handling expense have been devised, some with more or less merit. It will be the intent of this section to consider at some length three of the most frequently used of these methods, endeavoring to find one which will, in the most equitable manner, distribute into production the operating expense of a factory with the least amount of detail and unnecessary figuring on the part of the accountant; and at the same time prove satisfactory from the manufacturer's standpoint.
=8. The Man─Hour Rate Method.= This method, once quite popular, is now but little used, and it is doubtful if it can be found in operation in many up─to─date plants at the present time. The name of the method suggests its intent, which was to distribute factory expense over the various production job orders according to the amount of time spent by the workmen at an hourly rate. This rate is easily calculated, and was established by dividing the total expense for any period by the total number of hours spent on productive work for the same period, reducing the rate of distribution to so much per hour. If 100 hours of labor were spent on a productive job, the cost of the wages paid the workman for this time was not considered, the expense to be borne by the job being figured at the hourly rate for the 100 hours. It will be seen that this is hardly an equitable arrangement, and to rectify a serious defect in the method, some adjustment must be made:
(a) The inability to fix a standard for the efficiency of the labor lays the man─hour rate open to criticism. Could this be done, this method would in many cases prove a very equitable way of distributing expense. It will, however, be seen at once that as it is, a skilled workman carries no more expense than an apprentice boy, and if both work on a productive job a full week, the expense in either case is the same regardless of the wages paid. This is hardly a fair proposition. Either the apprentice's time must be accepted as standard and the skilled workman considered twice as efficient in work─hours, or _vice versâ_. To do this would lead to endless complications, yet the quantity and quality of the output between these two classes of labor should be considered and adjusted in some way so that the injustice done the manufacturing cost may be corrected. But this is not an easy matter to regulate, and means extra work on the part of the cost clerks in recording the time spent on job work and adjusting these inequalities in the labor.
(b) The man─hour rate requires that the hours worked be carefully recorded and totaled, as well as the cost. Many concerns with heavy pay─rolls to be apportioned over a large number of job orders, ignore the footing of the long columns of hours and fractions, and use only the totals of labor cost, which are of course necessary for entry in the commercial books. It is obvious that in doing this an immense amount of clerical labor is saved. The man─hour method requires that both hours and labor cost should be recorded and totaled──a double operation and duplication of work, which, unless it can be simplified, should be avoided, as it means time and unnecessary expense.
=9. Machine─Hour Rate Method.= This machine─rate plan of distributing expense was designed to meet the needs of a shop where the product is largely the result of a machine or tool operation, rather than the labor of the mechanic himself. It somewhat resembles the man─hour plan in that the rate of distributing expense is reduced to an hourly rate for the time the machine is working on the job instead of the time of the operator. Each machine is intended to have its own rate.
The method of arriving at the machine rate is easily understood, and reduces itself to the item of depreciation on the original cost price of the machine with its shafting, belting, tools, and installation cost figured at, say, 5%, the power to operate machine at an estimated cost per horse─power, ordinary repairs, divided by the number of hours the machine is estimated to be in operation for the same period; this will give the hourly rate of cost to operate. Some mechanical engineers advocate including in the above cost, interest on the investment at 6%, also insurance and taxes; and by others, the value of the floor space occupied by the machine is also included; but in all these latter points referred to, engineers greatly differ in opinion, and it is generally decided by each manufacturer for himself according to his own ideas.
On the question of the value of machine rates there is probably more argument by mechanical engineers and accountants than on any question in factory accounting; in fact, engineers themselves are very far apart in their opinions and do not seem to agree among themselves. Accountants generally are inclined to take a somewhat different view of the situation from our mechanical friends. While it is admitted there is good argument for both positions, it is to be remembered that we are considering the question of machine rates as a means of distributing the expense account, and it seems to be the prevailing opinion among accountants that as such it is found wanting. While, theoretically, it is undoubtedly the correct solution of the problem, it is more often found in practice to be a case of a "distribution that does not distribute," and for this reason is not used by the very class of factories and machine works for which it was designed and intended to benefit.
Let us consider in detail a few of the objections that may be raised to the machine─rate method:
(a) It will be noticed there are other expenses in the shop than that of operating the machines and not covered at all by the machine expense. Machine rates are absolutely worthless for bench labor and the assembling room, for these two must also share in carrying the shop burden. Not to do so would be manifestly unfair. It is therefore necessary that a second distribution must be made entirely different in its calculation, to handle this undistributed expense not covered by the machine rates, which means two different operations for the same shop.
This necessitates two different time records to be kept, one card for each machine showing jobs worked on and hours idle, and another time card for the workman. Is is easy to appreciate that this double operation greatly increases the clerical work in the shop, besides two sets of entries by the cost clerks, and more detail for all concerned. If a method can be found which requires but one time record to be kept, this double process can be done away with and the duplication of work avoided.
(b) The principal factor in the calculation of the machine rate, in fact, the real key to a successful calculation, is in establishing a standard of work─hours for each machine. It is noted that the higher the standard, the lower will be the rate, and the lower the hours operated, the higher will be the rate; in other words, when the machine is idle in excess of the standard, the rate changes. In some shops where the output is a stable product, always in demand, and the machine in continuous operation, a good estimate may be made, but in most shops a machine is frequently idle on account of "no work" or "laid up" for repairs the same as is its operator. The practice in most shops is such that it is extremely difficult to estimate ahead what the work─hours of a machine will be, and it resolves itself generally into an intelligent guess with two estimators far apart in their estimates, yet a satisfactory distribution requires a standard which will work out in figures close to the actual facts.
Who can successfully estimate ahead for any time the activity of each machine in a large factory? Our factory engineers are at wide variance on this point. One authority says "full time," 300 days a year, is the proper basis for calculation. It would seem as if this were rather an unusual position to take; it apparently being his belief that the time idle would be offset by the time the machine was operated overtime, or else he expected the machinery once put in motion to neither shut down, nor break down. Either appears to be rather a dangerous assumption on which to base a careful calculation for rate of distribution.
Another engineer says 80% of a full day will be found to be the maximum, and further adds: "It will doubtless fall much below that figure." One naturally asks "How much lower?" There is quite a large field of figures to choose from between an 80% activity and a dead standstill for the machine.
It is quite unnecessary to attempt to demonstrate at length that the work─hour standard may be a very elastic figure, and it is often found that after distribution has been made, the results are very unsatisfactory and the machine rates used have proved "way off."
(c) Again, having settled on the work─hour standard, other adjustments appear necessary to equitably handle the machine rate question. For instance, two machines may be of the same book valuation and in cost of operation practically alike, yet one may be far more efficient than the other and possibly turn out two or three times as much work. This condition is constantly found in different shops, and whether or not the two machines should carry the same rate, and, if not, how this inequality shall be adjusted, forms a very interesting question for discussion.
(d) It is noted that the essentials in the calculation of machine rates are all based on estimates which may or may not prove correct; that positive book figures are lacking; and that the calculations are made on assumptions. One of the best professional opinions noted is that expressed by one of our leading accountants, who, commenting on the question of machine rates, observes that "it begins with estimating and is estimating all the way through." This appears to be rather severe criticism, yet one has but to give the subject careful consideration to note that it quite correctly sums up the situation in a few words.
As previously stated, the machine─rate method is without doubt theoretically correct, but, until the subject has been more thoroughly elucidated and worked out in all its details to fit shop conditions and furnish a satisfactory means of distributing expense, it is doubtful if it will be used to any great extent. This method certainly requires an elaboration of system and detail, with questionable results, and with many serious objections apparent; it seems pertinent, therefore, to ask the question "Is it worth while; cannot something better be devised?"
=10. The Percent Method.= A third plan of distribution, commonly referred to as the _percentage method_, differs from the two already outlined, in which the time employed was the basis of operation, in that the rate of distribution is a percentage on the direct labor cost of the product, which is, of course, commensurate with the amount of time expended. In the first division of our subject, it was shown that expense figured on direct labor would prove the most reliable.
This method is based on the principle that the production of each department of a plant should shoulder its own expense, and also a share of the general expense. In other words, the cost of the output from the _Blacksmith Department_, for instance, would be the total productive labor of the department, plus the material used, plus the operating expense of the department, plus its share of the general expense of the whole plant. It is only necessary, then, to establish the relation between the productive labor and the expense, and express the same in a percentage. It is immaterial how many departments or processes there may be in the factory; this relation should be found in each case, based on its own productive labor and expense, each department having its own percentage ascertained from its own actual conditions; no estimating about it. The expense, then, is figured on the labor cost. If, in the _Blacksmith Department_ already referred to, it is found that the expense at which the department is operated is one─fourth of its total productive pay─roll for the same period, it is at once apparent that if to the labor cost of every productive job, 25% is added for shop expense, the total of these expense items added will equal the total expense of the department. In other words, the shop expense is split up and added to each job in proportion to the labor expended on it.
The general expense is handled the same way. If the total general expense is found to be one─third of the total productive labor in the plant, it is likewise apparent that, if to the labor of every productive job, 33⅓% is added to cover general expense, the sum total of these percentage items added will equal the total general expense of the plant.