Accounting theory and practice, Volume 2 (of 3)

by Roy B. Kester

It may be objected that, in the case of large contracts, perhaps running over a period of years, many unforeseen things may happen to wipe out any seeming profits on the completed portion, and that conservatism would demand that no profits be taken until the contract is completed or in a sufficiently advanced stage as to be reasonably sure of results. In such a case it frequently happens, however, that not only are stockholders impatient of delay, but very serious injustice may result to any who might be forced to give up their holdings before the completion of the contract. Moreover, a fair method of making payment on the contract is usually in force, the sale price often being on the basis of units of work accomplished, so that the contingencies giving rise to the objection mentioned are greatly minimized. Thus, some contracts may be on a fixed price per cubic yard of earth removed, per unit of goods manufactured, or other similar basis for periodic payment, a certain per cent being retained as a guarantee for the satisfactory completion of the whole. Again, where the price is for a lump sum, engineers representing the contracting parties may agree on the amount completed and periodical payment may be made on that basis.

This topic of uncompleted contracts will come up again for treatment when considering the profit and loss summary for the year. It is sufficient to note here that some share of the profit on the completed portion of a contract may be taken as indicated above, in which case the inventory problem may be disposed of either by adding the amount of estimated profit to the cost value of the uncompleted contract, or by treating the payments made as sales.

Contracts and Length of Cost Period

In some lines of business, orders are booked several months ahead of delivery date, the factory operations depending somewhat closely on the contracts entered into. During the period of manufacture there may be few deliveries of the product, and therefore no actual profit. Obviously, the easiest method of handling such a situation is to make the fiscal period long enough to include the greater part of the deliveries, and so leave the inventory comparatively free of goods in process. Where this method is adopted, there is no serious objection to valuing the goods still in process at the close of the period so as to take a fair portion of the profit, although conservative practice usually values them at cost. The difference in the amount of profit under the two methods is insignificant under the condition named. Under other conditions valuation at cost is the rule.

Valuation of Scrap

Raw materials are never completely used up in manufacture; portions too small for the main product, corners, odd-shaped pieces, defective pieces, etc., are usually thrown into scrap. This scrap is frequently utilized in the manufacture of side lines if a market can be developed; otherwise it may be valueless. The problem of the valuation not only of the scrap but of any product that may be made from it presents some interesting features. If the entire cost of the raw material is charged to the main product, the scrap material used in the side line costs nothing, and to charge anything for it, either on the basis of cost or some arbitrary estimate, would result in inflation. Furthermore, the cost figures of a side line which is not charged for material might at some time be made the basis for a bid on a contract too large to be filled entirely out of scrap material, and so result in a loss. On the other hand, if the main product is charged only for the material actually consumed, and the side line is compelled to bear the cost value of the material it consumes, the cost of the side line may so increase that it cannot be marketed at a profit. The lowered cost of the main product might lead, in the face of keen competition, to the cutting of its price below real cost, unless, of course, all the scrap is being utilized in the side line which is also being sold at a profit. If such is the case, the valuation of the main product, the side line, and the scrap should be on a cost basis. This is not usually the case, however. No basis for valuation can be found which will prove entirely satisfactory under all circumstances.

In the light of the conditions involved, particularly as to whether there is a constant market for the utilization of all the scrap material in the manufacture of the side line, each concern must adopt whatever policy best suits its peculiar needs. At all times the application of materials costs to the product should provide an intelligent basis for entering into future contracts. A blind use of cost figures frequently invites disaster. In cases where scrap is not utilized in a side line, it has only scrap value. The thing to guard against is the double charge for the same material, i.e., a charge to the main product and also to the side line, resulting in an inflation of values.

Inventory-Taking

There remains, as a corollary to the problem of valuation, a consideration of the method of taking the inventory, for if the count is wrong the most careful valuation per unit will not give true total value. In connection with the count of the inventory, two fundamental rules must be observed. These are: (1) make sure that everything, i.e., all stock-in-trade, belonging to the business is included; and (2) be careful that there is no duplication of count nor inclusion of any stock belonging to others.

In accordance with the first fundamental rule, care should be exercised to include all goods out for sale in other markets—these to be valued at full cost in those markets—and all goods not yet received into stock but belonging to the business. These latter include goods invoiced but not received, and goods received but not unloaded prior to the close of the period.