Cyclopedia of Commerce, Accountancy, Business Administration, v. 02 (of 10)

by American School of Correspondence

PERCENTAGE METHOD EXEMPLIFIED

11. Before proceeding to show in detail the method to be pursued in arriving at the various percentages to be used in distributing expense by the percentage method, it may be well at the outset to clearly understand what constitutes productive labor and expense, or non-productive labor, for it is on the former that all calculations are based.

12. Productive Labor. The wages paid to the workmen for labor spent on productive work which is offered by the manufacturer for sale, and from which the business derives its regular revenue, is properly classed as productive labor. In other words, the amount of productive labor is commensurate with the productive output.

It is frequently asked whether labor spent on plant extensions or new equipment, when made for one's own use, may be considered productive labor and should carry its share of the expense in its distribution. Most assuredly, yes. If this same work were performed to be sold again in trade it would be considered productive labor and the expense would be added. The reverse is also true; if it were purchased from another manufacturer he would treat it as productive labor, and include expense in his cost and selling price, and the purchaser would have to pay for it, and would carry same in his ledger, in his plant or equipment accounts, and on his balance sheet as an asset. The only difference, if any, is in making new equipment himself, in which case it goes on his books at the cost price to him, thereby saving the manufacturer's profit he would have to pay if he purchased it. Is it, then, any less productive labor because a manufacturer prefers to make his plant extensions or new machinery, himself, instead of buying? It does not appear so; it certainly is productive labor.

13. Non-Productive Labor. All other labor, not distinctly productive as just outlined, must be classed as non-productive. This includes clerks and offices, foremen, assistants, watchmen, repairs and renewals, small tools, etc., and all the many expense men not working on product but necessary to keep the plant in repair and operation. Non-productive labor is a question of keeping the factory organization and management up to concert pitch, and is not regulated by the quantity of production.

Inter-department work in a plant often raises an interesting question. Shall labor expended by one department on repairs for another department receive credit for same as productive labor? The foreman of the department often claims that the repairs his men are doing for another department are just as much production, so far as he is concerned, as though his men were building a machine for sale, and should shoulder part of his expense. In a certain sense, all labor is productive, and from a selfish point of view, the foreman's argument is a fair one. But from the broader view of the manufacturer, all such inter-department repairs, or similar work, are a part of the operating expense of the plant, and are necessary for the up-keep of the equipment; they are not made for sale, as is a production order, and must be carried as expense—non-productive labor.

14. Expense and Production Cost Ledgers. Without digressing from our general subject, it may not be out of place at this point to call attention to a most convenient method of keeping cost records. Inasmuch as the cost of production must absorb the expense costs of manufacturing, it will be found advantageous to keep these two classes of accounts in separate binders, putting all the non-productive labor cost records in one binder, calling it Expense Ledger No. 1, and all the productive labor in Production Ledger No. 2. When the expense distribution is to be figured, it will be noted that all the entries will be made in Ledger No. 2, while Ledger No. 1 furnishes the amount and details of expense to be distributed.

15. Period for Comparisons. Having shown that our percentages of distribution are based on the relationship of total expenses to total of productive labor, the first step in our calculation is to draw off from our ledgers a statement of each for the same period as a basis for comparison.

Fig. 1. Private Ledger Labor Account

Inasmuch as there is generally found to be some item of extraordinary expense that appears each month, comparisons made on conditions shown by one month's operations are apt to be found abnormal, while a comparison made on results of operations extending over six months or more will give an average nearer the true condition of the plant's activities than one made on results shown by a shorter period.

16. Pay-Rolls Dissected. For our first statement, let us examine the pay-rolls and find out what portion may be classed as non-productive labor and what as productive labor, both by departments and in totals, our examination of same to cover a period of six months as just suggested.

For the sake of illustration, let us take a plant with a weekly pay-roll of about $10,000. Ordinarily there will be four pay-rolls each month, but in order to provide for thirteen rolls quarterly, it will be necessary every third month to have the labor account cover five weeks instead of four. Turning to our Private Ledger, we find our labor account appears as shown in Fig. 1.

It is now seen at a glance that the total pay-roll for six months is $266,155.00. It is now necessary to know the split-up of the above figures into productive and non-productive labor by departments, and this is easily obtained. By reverting to the pay-sheets, can be found the total pay-rolls for each department during the above period, and from Ledger No. 1 can be found the portion of these same rolls that were classed as non-productive labor, and the balance will be found entered in Production Ledger No. 2, the sum total of which will in each case balance with the totals in the Private Ledger. Every dollar of labor is accounted for in either one or the other of the two cost ledgers. Having done this, the labor statement resolves itself into something like the following:

PAY-ROLL DISTRIBUTION

Jan. 1 to June 30, 1908

		Non-Productive Labor		Productive Labor		Total Pay-Roll
Dept.	A-Offices	$9,828	00			$ 9,828	00
	B-Store	2,180	00			2180	00
	C-Power	4,524	00			4,524	00
	D-Yard	9,316	00			9,316	00
	E	9,971	00	104,409	00	114,380	00
	F	7,082	00	31,429	00	38,511	00
	G	1,749	00	5,528	00	7,277	00
	H	2,488	00	10,659	00	13,147	00
	I
	J
	K
	Etc.
	Totals	58,021	79	208,133	21	266,155	00
		21	8%	78	2%

The above figures are all that are needed so far as the labor end of the comparison is concerned. In fact, the non-productive labor is not necessary and is shown here merely as a matter of interest, as are also the proportionate percentages of each division to the total pay-roll, for it will be remembered that the productive labor is the figure used in all costs on which the expense is calculated.

17. Departmental Expenses. Against the amount of productive labor for each department shown in the statement just made, place the total expenses for the same departments. This is readily found by again referring to the Private Ledger, where the amount of Operating Expense, Department E, for the same months the pay-rolls were tabulated, appears as in Fig. 2. The expenses of all the other departments should be similarly treated.

Fig. 2. Private Ledger Operating Expense Account

18. General Expense. The general expense of a plant, for the sake of convenience as well as information, is kept usually in considerable detail, different ledger accounts being opened to carry the various subdivisions of expense. The use of a General Expense Account in the ledger is not recommended, for its very name has the earmarks of a general dumping ground for all miscellaneous items, and is often found a convenient place to hide expense, trusting it will there be lost sight of and thereby escape observation.

The combined total of these various expense accounts is the total general expense, a part of which each productive job is to carry. As they now appear in the ledger as separate accounts, Executive, Office, Store, Power, Yard, Taxes, Insurance, Printing and Stationery, Telephone and Telegraph, Postage, etc., it will be seen that each account is in itself but a part of the amount to be distributed, and, to better show this combined total, these individual accounts should be closed out monthly and brought together in another account, called General Expense Distribution. This is done by journal entry.

	Dr.								Cr.
	$10,293	28		General	Expense Distribution
					Executive Salaries
					Insurance
					Taxes
					Depreciation
					Freight
					Express
					Cartage
					Printing and Stationery
					Telephone and Telegraph
					Traveling Expense
					Postage
					Legal
					Water
					Advertising
					Etc.
					Operating Expense Dept.	A
					"	B
					"	C
					"	D			$10,293	28

These accounts are now balanced out and combined in total in the Distribution Account. The Distribution Account is now examined to ascertain the total general expense for the same six months previously used, and the Private Ledger shows it to be $67,840.00, Fig. 3.

19. Power. While the cost of operating the power-house is unquestionably a legitimate charge to the operating expense of each department according to quantity used, it is noted that, by the journal entry just made, the cost of same is closed into General Expense Distribution.

In a plant operating a central power station with electrically driven machinery, the power used in each shop can be metered and accurately known, in which case, each shop can be charged with the amount actually used. To do this requires considerable extra expense, and although it is done in many works, most plants do not consider the expense worth the results, and are inclined to treat all power as general expense rather than departmental.

In a plant driven by shafting and belting, the power consumed cannot be registered or recorded, and the power required only estimated from tests made as often as desired. Although there may be a heavy draft on the power-house at certain times, when all the machinery is in operation, there are frequently times when but few machines are running and the power required is down, although there is no way of recording it.

It is, therefore, extremely difficult to arrive at the actual power used during a month, and for this reason most plants do not attempt its calculation, and are quite ready to charge its cost off as a whole to general expense. To departmentalize it, means extra expense with no benefit gained—except to engineering science.

Fig. 3. Expense Distribution Account in Private Ledger

20. Productive Labor and Expense Compared. Having now dissected the pay-rolls and drawn off the departmental and general expense accounts, it is but a matter of bringing these two statements together to produce the final results. It will be remembered that all that is necessary to know is the rate between the two, therefore place them side by side, item for item, as already shown:

		Productive Labor		Expense		% Expense to Prod. Labor
General				$67,840	00		32.6
Department	E	$104,409	00	22,731	00	21.8
"	F	31,429	00	5,419	00	17.3
"	G	5,528	00	2,465	00	44.6
"	H	10,659	00	3,174	00	29.8
"	I
"	J
	Etc.						26.5
Total		$208,133	24	$122,985	00		59.1

The percentage columns shown give us what may be considered a very close figure as to what are the actual factory conditions of operating expense and productive labor, and the relationship of the former to the latter. These results are all the more reliable because they are based on actual figures taken from the books of the company, thereby eliminating all estimating and the basing of important calculations on guesses and assumptions, which later generally prove to be far from the real facts in the case. The above results, gathered from six months' operation of the plant, are a fair statement of what the same expenses will be found to be in the long run, although if it is desired to go into the matter still deeper, the same tabulation may be made covering a year, with practically the same results.

What do the above figures show?

(a) That the total operating expenses of the plant are 59.1% of its productive labor, of which amount, 32.6%, is necessary to cover the general expenses, and 26.5%, the average for all shop operations.

(b) That the expense of operating the different productive departments vary according to conditions. That while Department E's expense is found to be 21.8% of its productive labor, that for Department F is found to be but 17.3%; each department having its own rate based on its own actual figures.

(c) Since, as already shown, each department must shoulder its own expense and its share of the general expense, it is seen from results just shown that for every dollar spent on productive work in Department E, 21.8 cents must be added to cover its own operating expense, and 32.6 cents as its share of the general plant expense, and that every dollar spent on production here cost $1.544. This has been covered in detail under heading, True Cost.

21. How to Use Percentages. Let us continue the use of the same figures. It is apparent that, if to the cost of each productive order worked on in Department E during the period of six months just considered—all of which is shown in detail in Production Ledger No. 2, the sum total of whose labor cost is $104,409.00—21.8% is added, the amount thus added will be $22,731.00 (the actual figure is a trifle more), which is just the amount of Department E's expense shown in the Private Ledger and found in detail in Expense Ledger No. 1.

Again, if to the cost of each productive order worked on by any and all departments in the plant during this same period—the sum total of whose labor cost is found to be $208,133.21 and which is shown in detail by the individual cost sheets in Production Ledger No. 2—32.6% is added, the amount thus added will be $67,840.00 (actual figure is a few dollars more), which is just the amount of total expense shown by the Distribution Account in the Private Ledger.

It is now a simple proposition. Having found our average ratio of expense to productive labor for each department, and also for general expense covering a period of six months' operations, we can begin to distribute the expenses of succeeding months on the same basis with the same results.

In closing up the Production Ledger at the end of each month preparatory to drawing off a monthly summary of all the totals therein to obtain the total cost of production for the month for entry through the journal into the Private Ledger, it is simply necessary to enter on each cost-sheet, in columns provided for that particular purpose, two items of expense, one for department expense and one for general expense. In the case of Department E, just cited, the expense for the department is to be calculated at 21.8%, and the general expense item at 32.6%.

22. Even Percentages May Be Used. In a large plant with an elaborate system of manufacturing job orders worked on daily with perhaps hundreds of cost-sheets on which an expense calculation must be made, the use of percentages with three figures may require more time in figuring than desirable, in which case an even percentage may be used. Instead of 21.8 for Department E use 22, and for general expense, instead of 32.6 use 33. This means that under usual conditions, more expense would be added to production than shown by the expense accounts, and the Private Ledger would show whether there had been an over-distribution or an under-distribution in each department's account after the distribution had been made. Turning to Private Ledger Account, Department E, while it is shown that, for January, the expense that should have been distributed, if done exactly, would have been $3,697.33 (had the productive labor for the same month been, say, $17,095.45), the amount added to production by using 22% would have been $3,761.00, an over-distribution of $63.67. To adjust this overdraft in figuring the next month, use 21%, the idea being to have the ledger accounts as nearly balanced out as possible. Should the general expense rate prove more than sufficient when 33% is used, reduce it or increase it to meet the fluctuations of the expense, with the thought always in mind to keep all balances as small as possible, and to make as nearly a perfect distribution as figures will permit.

It is suggested that where these percentages come close to 16⅔, 20, 25, 33⅓, etc., that these figures may be used to advantage. By so doing the expense calculations can be figured mentally and very rapidly, and generally without interfering with a satisfactory distribution. If, however, the overlap each month increases, these should be modified to bring closer results.

23. Journal Entry for Distribution. While it is not the intention in the consideration of this subject of Expense Distribution to depart therefrom into the general field of cost accounts and cost records, it is assumed that on whatever form of cost-sheet used, provision will be made for the proper recording of the three elements of cost: labor, material, and expense, the latter in two items. Inasmuch as only totals should be carried into the Private Ledger, it is only necessary for drawing off the amounts on the individual sheets in Production Ledger No. 2 to provide summary sheets with sufficient money columns to accommodate, among other credits, all items for each department's expense and also for general expense. This, when done and totaled, will give the total cost of production for the month, made up of the following items:

(a) Labor—amount of which should check total of productive labor shown by the dissection of the monthly pay-roll.

(b) Material—amount of which represents withdrawals from stores during month.

(c) Departmental Expense—each separate, representing the amount of expense actually distributed and thrown into production.

(d) General Expense—representing the total amount actually distributed and absorbed by production.

This done, our journal entry will be:

Debit Production. (This may be subdivided into as many accounts as desired.)
	Credit	Labor.
		Material.
			Expense Dept.	E
			"	F
			"	G
			"	H
			"	I
			Gen'l Exp. Distribution.

24. Expense Ledger. The totals from the Expense Ledger should also be drawn off in a similar manner, and the same items will appear as those shown in the Production Ledger, except that no expense will be added, for it will be remembered that the entries in the Expense Ledger constitute the very items which are transferred to the Production Ledger through the percentage added.

The journal entry for this ledger will be:

Debit Expense Dept.	A
"	B
"	C
"	D
"	E
"	Etc.
		Credit	Labor.
			Material.

25. Results of Distribution. Having posted the journal, turn again to the Private Ledger and note what has taken place. It is found that the two items of labor posted have just balanced out the Labor Account, and every dollar of pay-roll has been accounted for somewhere, either into expense or into production. It it also found that all the debits in the shop-expense accounts have originated in Expense Ledger No. 1, and the credits have originated in the Production Ledger. The various subdivisions of general expense have been consolidated in one Distribution Account, which has also been disposed of through the Production Ledger. What once appeared as an expense cost has now been wiped out, absorbed by production and converted into an asset, just as Mr. Clinton E. Woods, previously quoted, states it should be. A glance at the trial balance reveals scarcely a trace of expense, the small undistributed balances only remaining.

26. Undistributed Balances. Under any method of distributing expense on a pro-rata basis, it is apparent there will be small balances left, representing either an over-distribution or an under-distribution, as already explained. These may be treated in either one of two ways. If the product manufactured has been practically completed during the year, and but little carried over into the next year to be finished, these balances can be charged off and become a part of the Loss and Gain account for the year in which they were created, and the new year begun with a "clean score."

If the product, however, consists of large contract work but partially finished when the year closes, the work on same continuing for some time into the new year, these balances may be also carried over to be worked out in succeeding monthly distributions as the work continues. When this latter method is chosen, of course it will be necessary that these balances be taken into consideration when preparing the Balance Sheet.

27. In Conclusion. While it is realized that the Percentage Method is not perfect in all its details, yet it is quite generally admitted to be the best means that has yet been devised for distributing expenses. A manufacturer using it may be assured that his costs thus figured are correctly shown, from the fact that this method is used and recommended by our highest technical authorities in accounting. From the practical side, it appeals to the manufacturer who is more interested in successful manufacturing than he is in the science of accounts, by the simplicity of the method and economy with which it is operated. The same amount of time spent in planning economies and devising means for cheapening the cost of production that is often spent in lengthy attempts at fine figuring, which, when finished, prove unsatisfactory, will be productive of far better results. Any method which eliminates the unnecessary and simplifies the essentials cannot help but prove attractive both to the successful manufacturer and the progressive accountant.