Goods Made to Order
Where the factory works only on order, conditions as to profit-taking are somewhat changed. Here, the sale has already been made for delivery of the product at some future time, named or left indefinite. While, of course, cancellation of the order is always possible before date of delivery and acceptance, inasmuch as here we have under consideration a special product made to individual specifications and not a stock or standardized article, cancellation of the contract is not probable without incurrence of damages or even being held to specific performance. Under these circumstances it is apparent that, within reasonable limits, a portion of the profit may be taken up in the current period, which has, of course, done a portion of the work and therefore earned a portion of the profit, if there is one. This last contingency is, of course, the crux of the whole problem. If a portion of the profit is taken, this necessitates a predetermination of profit on the whole contract, an estimate of the portion of the contract completed, and adequate provision for unforeseen difficulties in completing the work. Where conditions are such that these things can be done with any degree of certainty, there is not only no objection to taking up a portion of the profit for the current period, but it is the only way in which profits may be allocated to the period earning them and so stabilized somewhat as between periods. As has been said already a number of times, the summary of results at the close of regular periods is in many cases based on estimate, which in the final analysis is merely the expression of an opinion. If the estimates are made with due care, in the light of all available information and probable contingencies, and without intent to deceive or defraud, more than that cannot be asked of any concern.
The practical application of this principle requires consideration. In some few cases the volume of product passing through the factory will be fairly constant as between periods. Where this is so—and frequent tests should be made to establish it—it would be a useless expenditure of effort to make the estimates necessary for determining profits on uncompleted work. The same situation is met with also in concerns where the unit of work is small. Here the effort, entailed in making the estimate is more than offset by any advantage gained thereby. If the product is somewhat standardized, it may be possible as a result of past experience to make a rough estimate on the basis of the volume of work in progress instead of by means of an examination of the conditions of each contract. Such a policy is fraught with many pitfalls and, as a usual thing, does not commend itself to conservative management; speculative conditions are too many.
Profits on Long-Term Contracts
Where the unit of work is large, conditions are somewhat different, however. The necessary estimates are not based on so many uncertainties, and, oftentimes, financial considerations and an equitable treatment of stockholders demand the determination of profits on work in progress. Thus, one contract extending over a number of years may occupy the entire attention and facilities of a concern. To withhold profits if earned, until the completion of the contract might work a real injustice. Such contracts are usually financed by means of periodic payments on account, based on a careful estimate by the supervising engineer or architect of the portion completed on such dates. As these estimates are sufficiently accurate on which to base payment of contract price, they can be allowed to serve as the basis for a determination of profits after liberal reserves for contingencies are made.
The nature and terms of the contract itself will usually indicate the method of estimating the profit. If the price agreed upon is for the contract as a whole, then extraordinary care must be exercised in estimating the portion completed and almost a seer’s prevision of the requirements to complete is needed. If, on the other hand, the contract is broken into smaller units on which price is based and there is no guarantee as to the number of units in the contract, profit may be taken on the number of units completed. Thus, a contract calling for excavation of earth or other material may be taken at a named price per cubic yard. The building of a canal, the driving of a tunnel, the construction of a dam and reservoir, are frequently handled on this or a similar basis. So, also, the use of a concern’s equipment and organization on a per diem basis. Under these conditions each fiscal period can safely take its profits or losses with little regard for the uncompleted portion of the work. Contracts taken on a so-called “cost plus” basis, i.e., at cost plus a definitely agreed upon per cent of profit, may have their profits determined without consideration of the uncompleted portion.
Profit on Goods Awaiting Delivery
Similar to the problem of profits on work in progress is that of profits on goods awaiting delivery. The goods have been sold, are completed, and may even be prepared for shipment. All that remains is delivery and that cannot be effected until the date agreed upon. In some lines of trade this method of sale is a time-honored and even necessary custom. The practice is found in some kinds of clothing industries, woolen manufactures, farm implements, etc. Here because the product is a standard product, cancellations take place and are usually allowed right up to, and in some instances beyond, the date of shipment. Because of this trade practice, profits should never be taken until delivery has been effected. To a similar or even greater extent than with work in progress, costs and expenses are under this principle incurred and charged in one period and the profit is taken in another period which is not thus charged with the cost of getting the income.
Two methods of handling the difficulty are met. The one operates on the expectation that the volume of such orders awaiting delivery is fairly constant as between periods; hence, the income from goods of this sort delivered during the current period is charged with the costs and expenses of goods to be delivered in future periods. This is the rule-of-thumb method to be used where accurate allocation of costs is neither necessary nor justified by results.
The other and more accurate method consists of deferring the costs and expenses properly applicable to the deferred income. But the difficulty of determining just what expenses are so applicable often causes this method to break down, giving less accurate and dependable results than the first. The roseate optimism of the average proprietor or manager as to his own business almost always results in a too liberal estimate of the portion of expense to be applied against the deferred income. In treating this problem of profits in connection with contracts and the length of the cost period ([Chapter XIII]), the principle was stated that such goods should be included in the inventory at cost. This results in deferring the main item of cost, but omitting the further costs of selling and administration which belong to all sales effort made and to the progress of the order up to the point of delivery. While theoretically these should be deferred, practically the estimate of the amount to be deferred should lean on the side of too little rather than too much. Where, as stated above, the volume of this kind of trade is fairly constant, the rule-of-thumb method first stated gives more satisfactory and safer results.