3. If interest is to be charged, how shall the offsetting credit be handled on the books?
4. The introduction in production costs of a more or less constant element tends to obscure fluctuations in actual cost due to causes which may be corrected, and thereby partly defeats the very purpose of cost-keeping.
5. As the business world is accustomed to consider interest and dividends as of the same nature, namely, as a return on capital invested, to treat interest as a cost of operation would produce financial statements which are misleading.
With regard to the rate of interest, three different theoretical rates have been suggested: (1) a so-called “pure” interest rate, i.e., one yielded by the safest investment; (2) the rate at which money might be borrowed for the particular type of industry; and (3) a rate sufficient to attract permanent investment in the enterprise. From the practical standpoint of results there are serious objections to all these suggestions. As it is beyond the scope of this chapter to discuss this phase of the question, the interested student is referred to the numerous writers who deal with the question.
Problem of Charging Interest on Books
Where interest is treated as a manufacturing cost, the booking of it raises a perplexing accounting problem. The charge has to be made to some factory expense account, while the credit must be carried over to possibly a financial management income account. If the entire output of the factory were sold out by the close of the fiscal period and no product was in process of manufacture at that time, the result of booking interest in this way, so far as net profit is concerned, would be nil. It would be like taking money out of one pocket and putting it in another. This situation, however, is never met at the close of the fiscal period. Almost invariably some finished stock is on hand and goods are in process of manufacture. Where interest is added, the result is to inflate the value at which the goods must be carried on the inventory—a very undesirable procedure from an accounting and financial viewpoint. By such means it is conceivable that a factory might be made to show a handsome profit even before any of the product had been sold.
Considering both the ends to be attained by, and the defects and disadvantages of, the inclusion of interest as an item of factory cost, its exclusion seems best. In this connection it is to be noted that all government contracts on a “cost-plus” basis do not allow the inclusion of interest as one of the cost items. Furthermore, all the ends aimed at by its inclusion may be secured almost if not equally as well by statistical records, thus eliminating the objections to the bringing of interest as an item of cost onto the financial records.
Unrealized Profits
A similar problem to the above is the practice of charging a manufacturing profit to the selling department. The practice is prevalent in some concerns, of transferring the output of the factory to the selling department at a value above the cost to manufacture. The purpose of such a transfer is to show on the books the profit arising from the policy of manufacturing the product instead of buying it on the open market. The value at which the product is transferred from the factory to the selling department is usually the wholesale market value, though it may be at a fixed per cent above the cost of manufacture. The effect of this is, of course, to limit definitely the showing of factory profit. Where the compensation or the efficiency of the factory management is measured by the savings effected over the wholesale market price of the output, there is perhaps some practical advantage in the allowance of a manufacturing profit.
The main objection to charging the factory output to the selling department at any price other than cost is that such a policy introduces an element of unrealized profit. This objection is not serious if, at the time the books are closed for the purpose of showing results for the fiscal period, the unrealized profit is eliminated from the stock-in-trade inventory. So far as the profits on the portion of the output which has been sold are concerned, the net result is the same. The effect is to diminish the profit of the selling department by the amount of profit allowed to the factory. To bring assets onto the books at inflated values is, however, always objectionable, both because of the temptation to inflate profits by valuing the goods for the inventory at an inflated figure, and also because of the ease with which the adjustment of such items may be overlooked or forgotten at the close of the fiscal period. Where the adjustment is made with care, correct results can be shown as well by the one method as by the other. The adjustment needed applies only to the inventory of goods remaining unsold at the close of the period, which adjustment is usually shown by means of a valuation reserve account, by means of which the book value of the inventory is brought down to the factory cost value.