(1) Basis of Expense Distribution.
(2) Methods of Expense Distribution.
(3) Percentage Method Exemplified.
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.