BASIS OF EXPENSE DISTRIBUTION
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.