SOME PRINCIPLES OF COST ACCOUNTING.*

BY ERNEST RECKITT, C. P. A.

In the choice of a subject, I have been influenced not only by the growing demand on the part of manufacturers for intelligent men in their cost departments, but also by the necessity of a greater appreciation of correct principles in the application of "costs." Many business men have unfortunately lost faith in the benefits to be derived from maintaining a cost department, and it has been my experience that usually in such cases the failure of the system has been due to illogical methods and a failure to bring the information which should be prepared by this department in concise form before the superintendent and general manager. Thus, it is no uncommon thing to find the total factory expense apportioned on the basis of the prime cost of the complete machines, instead of determining the factory expense of each department and apportioning same on the parts manufactured by that department. Where the factory output consists of a variety of machines and where the factory expense of some departments is much heavier than in others, it will be readily seen that the latter plan is the only one which could give accurate results.

Before entering upon the discussion of what constitutes factory or manufacturing cost, it is advisable that you should have a clear understanding of certain of its features, and the first that I will call your attention to is that of Rental.

The actual ownership of a plant, that is, the real estate, buildings, boilers and engines, is not essential in order to manufacture. Not only can plants be rented, but the power, light and heat can be purchased from outside sources. * Reproduced from Journal of Accountancy.

Therefore, if a manufacturer decides to invest the whole or part of his surplus capital in real estate, plant, etc., and erect his own power, light and heat plant, he is actually engaging in other enterprises not absolutely essential to the manufacture of the articles he sells. As an illustration, we may suppose a concern, that for the sake of convenience we will call the Smith Mfg. Co., having a capital of $150,000.00, whose net profits amount to $30,000.00, and who pay an annual rental of $9,000.00 to a Mr. Brown on property valued at $100,000.00. It is fair to assume that Mr. Brown pays out in taxes, insurance and repairs the sum of, we will say, $2,000.00 a year and makes a reserve for depreciation at the rate of 2 per cent per annum or $2,000.00, leaving a net available profit to himself of $5,000.00, or 5 per cent on his investment of $100,000.00.

The question arises whether it would be a good investment for the Smith Mfg. Co. to own its own real estate and plant, or whether it would be wiser to continue to rent. If they purchase the premises for $100,000.00 out of their earnings, they will then have an invested capital of $250,000.00, producing profits amounting to $35,000.00 per annum or 14 per cent on their invested capital, while prior to that time their profits amounted to 20 per cent on a capital of $150,000.00. Hence it will be seen that it would be folly to sink $100,000.00 in the purchase of a plant, unless their profits produced more money than they could advantageously use in increasing their business, or unless it was considered that the purchase of the plant was a good conservative investment. But the $100,000.00 so invested could have been used to purchase bonds or other safe securities and their regular and legitimate business would have gone on just the same. It is, therefore clear, that if a company, private firm or individual owns its own plant, it should consider it as a matter quite outside of the investment in the manufacturing business, and should charge the latter with rent, so that the true percentage

of profit on the articles manufactured can be arrived at. Furthermore, in nearly all factories it is found necessary to establish departments, one department manufacturing one part of the mechanism or articles dealt in, while another department carries out other operations. Each department should be charged with its proper proportion of rent, and this same plan is sometimes carried still further by charging each machine with its proportion of rental charges. Thus the cost of operating a large steam hammer in respect to space occupied would be very much larger than that of a small drill used in conjunction with special tools.

To determine the rental chargeable by a concern owning its own real estate and plant, it is necessary to open in the general ledger an account to be termed Real Estate Operating Account, and to charge this account with the following items:

(1) Real Estate Taxes,

(2) Fire Insurance on Buildings,
(3) Repairs to Buildings,

(4) Depreciation on Buildings,

(5) Interest at 5 per cent or 6 per cent per annum on the amount invested in Real Estate and Buildings,

-and to credit this account and charge the various departments each with its proportionate amount which in the aggregate will equal the total debits. To make this clearer I have drawn up the following statement as illustrating a Real Estate Operating Account:

interest at 5 per cent on the investment in real estate and buildings should be credited to a real estate profit and loss account.

The next item of factory cost that requires comment is depreciation. It is not my object to treat fully of depreciation, as to do so would demand a lengthy paper on this subject alone, but merely to point out its importance. Depreciation may be said to be the gradual diminution in value, due to wear and tear, obsolescence, or other causes, of what are termed fixed assets, such as leases, patents, buildings, machinery, etc. I believe it was John Mann, C. A., of Glasgow, who said that the application of the principles involved by the term depreciation is merely an acknowledgement of that universal law that nothing around us is eternal, and that sooner or later everything must succumb to the destructive forces of the elements or to change of conditions.

Closely allied to depreciation is the item of extraordinary repairs. We will suppose that a factory has been built and new boilers, engines and machinery installed. It is reasonable to expect that during the first year the repairs will be exceedingly light; during the second year, somewhat heavier; during the third year, still greater; until it may be the fourth year and after, before the repairs to the machinery appear to cost approximately the same each year. Yet it is only fair that the first and second years' business should be chargeable with a part of the repairs made during succeeding years, as it is the wear and tear of these years that has largely been instrumental in causing the outlay in the third and fourth years. For this reason it is proper and conservative to charge the first and second years with an estimated amount to cover repairs to be made in the future and to credit a reserve account which in later years may be used to lessen the charge to profit and loss for this form of outlay.

While it is perhaps scarcely within the scope of this

article, I would state that no factory accounts are complete without a system, preferably a card system, for recording all the machinery in stock. There should be a card for each machine, filed in the case in such a manner that its location in the factory can be immediately determined. If the machine be moved from one room to another the card is similarly changed to another sub-division in the case. Each machine should be numbered, the corresponding number being entered on the card, in addition to which the card should show:

(1) Description of machine.

(2) Date of Purchase.
(3) From Whom.

(4) Original Cost.

(5) Freight Paid and Cost of Installment.

(6) Amount of Depreciation Written Off Each Year. (7) Date Scrapped.

On the other side, the card should record cost of all repairs made, so that a complete history of each machine can be obtained by the factory superintendent. When the repairs to the machine pass beyond a certain point, this fact can be ascertained, and a decision reached as to whether or not it would be cheaper to send the machine to the scrap heap.

Having dealt with some features of factory costs which require more careful study than such items as cost of material and labor, we may safely pass on to the subject of what constitutes factory cost and of other definitions of terms used in this connection.

The terminology of this subject is in a very chaotic condition, this being due largely to the fact that the science of factory costs is hardly out of its swaddling clothes. Though many systems of factory costs have been brought up to a high state of perfection, they are isolated, and though many valuable articles as well as books have been written, each person has pursued this investigation along