SOME ASPECTS OF OVERHEAD ACCOUNTING
FOR

INCOME MEASUREMENT AND COST CONTROL

BY

WILLIAM LEONARD FERRARA

A THESIS

Submitted to School for Advanced Graduate Studies of
Michigan State University of Agriculture and
Applied Science in Partial Fulfillment
of the Requirements for the degree
of

DOCTOR OF PHILOSOPHY

Department of Accounting and Financial Administration

1959

 

 

ACKNOWLE DGEME NTS

The author wishes to express his sincere thanks to
Dr. B. C. Lemke for guidance and valuable suggestions,
especially in the early stages of this writing.

Grateful. acknowledgement is also due to Dr. G. M.

Jones who gave unselfishly of his time and made many valuable
suggestions. The writer is also indebted to Dr. J. D. Edwards
for his advice and continuing aid in facilitating completion
of this study.

Each of the author's guidance committee members,

Drs. R. Simonds, K. Boedecker, T. Standt, and H. Brainard,
has made suggestions and contributions for which he is
grateful.

Special thanks are due to the public and industrial
accountants who were kind enough to share some of their
knowledge, opinions, practices and experiences with the
author.

This work is dedicated to my wife, Carol Ann, and my
Children, Stephen, Paul, and Janeen Marie who provided the

encouragement. the incentive and the devotion necessary to

ComPlete th is s tudy .

WILLIAM LEONARD FERRARA
Candidate for the degree of

Doctor of PhilOSOphy
Final examination: June 5, 1959, 2 p. m.

Dissertation: Some Aspects of Overhead Accounting for
Income Measurement and Cost Control

Outline of Studies:

Degree‘ Major Minor Granted
B . S . C Accounting Economics , June, 1952
Industrial
Management
.M.I\. Accounting Economics March, 1954
Ph . D . Accounting Economics. December, 1959
Finance,
Industrial
, Management

Biograph ica l I terns:

Born: September 5, 1930, Chicago, Illinois
Undergraduate Studies, De Paul University, 1948-52
graduate Studies, Michigan State University, 1952-1959.
Passed Uniform CPA Examination, May, 1953

\
Graduate assistant, Michigan State
University, 1952-1955.
Junior and Senior Accountant, Harris.
Reames, and Ambrose, Certified Public
Accountants, Lansing, Michigan, 1955-1957.
Instructor, Michigan State University,
1957—1959.

Exper-ience:

 

Membership: Beta Alpha Psi
American Institute of Certified Public
Accountants
Illinois Society of Certified Public
Accountants
American Accounting Association

iv

SOME ASPECTS OF OVERHEAD ACCOUNTING
FOR

INCOME MEASUREMENT AND COST CONTROL

by

WILLIAM LEONARD FERRARA

AN ABSTR.CT

Submitted to the School for Advanced Graduate Studies
of Michigan State University of Agriculture and
Applied Science in partial fulfillment of

the requirements for the degree of

DOCTOR OF PHILOSOPHY

Department of Accounting and Financial Administration

U.)

195

Approved

 

William L. Ferrara

The income measurement and cost control aspects of
accounting for manufacturing overhead costs have yet to be
fully developed. Concepts applicable only to other cost
finding purposes have been adopted for income measurement.

Control of manufacturing overhead costs is viewed as pro—

ceeding from ex post analyses of the variances of standard

costing and flexible budgeting.
Costing concepts historically developed for sales
price determination and cost control have been accepted with
little, if any, mofidication for income measurement. The
normal capacity concept and the idea that unit costs should

not be allowed to fluctuate with volume are remnants of the

early emphasis on price determination and cost control.

Use of the normal capacity concept brought forth the

direct costing controversy. Attempts to defend traditional

accounting on the basis of a cycle capacity concept or a
Practical capacity concept failed to recognize the inherent

limitations of all three capacity concepts when they are

used to measure income.

To measure income properly, overhead should be

Categorized and allocated as follows:

vi

William L. Ferrara

 

 

Category Bases of Allocation
Costs applicable to fixed Units of production or
assets (depreciation, insurance an approximation thereto
and taxes) which is the cycle

capacity concept
Indivisible costs inputs or Actual output
chunk costs (the semi-variable
costs which are absolutely
necessary for all outputs
within a range of outputs)
Other overhead costs Actual output
(primarily the costs to
Operate fixed assets)

The unit of production basis for allocating fixed
asset costs isthe only basis consistent with the expected
use (useful life) of fixed assets. Allocation of "chunk
costs" on the basis of actual output is the only method
consistent with the fact that "chunk costs" are absolutely
rmcessary'costs for any output within the range that ”chunk
cmsts“ can serve. On the above bases unit costs may vary
Wiflixnalume and the generally assumed utility of a fixed—
variable breakdown for cost allocation is rejected.

IVithin the realm of cost control the fact that many
mm-of-1jgue conditions can and will be eliminated long before

variances are accumulated must be recognized. Control of

overhead costs starts with preventive cost control, continues

vii

William L. Ferrara

znth visual observation and ends with variance accumulations.
Iueventive cost control attempts to stop waste before it
sfiarts. Visual Observation by workers and supervisors stops
wane before it starts or as soon as it is detected. Variance

cmumulations detect wastes which have evaded visual obser—
wfijon and show the profit impact of waste.

The traditional approach to cost control is ex post

hithat variances are analyzed to determine root causes
Vfiuch must be eliminated. Such analyses are not only too
lauafOr truly effective cost control; their approach is
entirely inappropriate, for they ask the question, what must
is £12 3931? (after we find out what went wrong). The only
(nestion consistent with the residual position of variance
reports is what has already been done? to eliminate the

causes of out-of-line performance.

viii

TABLE OF CONTENTS

CHAPTER PAGE

I. INTRODUCTION . . . . . . . . . . . . . . . . I

II. ADAPTATION OF OVERHEAD COSTING TO

INCOME MEASUREMENT AND COST CONTROL:

A FUNCTIONAL APPROACH TO THE DEVELOPMENT

OF OVERHEAD COSTING . . . . . . . . . . . . 8
Introduction . . . . . . . . . . . . . . 8
General . . . . . . . . . . . . . . . . 8

Early Emphasis on price determination
and waste elimination . . . . . . . . . 9
The birth of overhead . . . . . . . . . 12

Influence of Price Determination on the

Content of Overhead . . . . . . . . . . 17
General . . . . . . . . . . . . . . . . 17
Thomas Battersby and overhead . . . . . . 18

The Whitesmiths of Taunton and overhead . 20
The Texts of the '80's and '90's . . . . 22
Literature and practice of the '80's

and 90's . . . . . . . . . . . . . . . 30
The Increate of competition:

A. Hamilton Church and the content of

overhead. . . . . . . . . . . . . . . . 31

CHAPTER

Rise of cost control and changing
sales price ideology . . . . . . .
Summary . . . . . . . . . . . . . . . .
The Rising Influence of Cost Control: A
Hamilton Church and His Supplementary
Rate . . . . . . . . . . . . . . . .
Description of the supplementary rate .
Limitations of the supplementary rate .
The prime critic - John Whitmore . .
Church's defense and the demise of a
pricing concept . . . . . . . . . .
Summary . . . . . . . . . . . . . . .
The Sequel to the Supplementary Rate
The ideas of H. L. Gantt . . . . . . .
General . . . . . . . . . . . . . . .
Factors Influencing Gantt
Sales price determination . . . .
Measurement of operating efficiency

The social problems concerning labor

and capital . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . .
capacity measurement . . . . . .

IT“? normal overhead concept . . . . . . . .

PAGE

39

42

43

43

46

48

51

55

56

56

59

61

64

65

66

66

(REQTER
General . . . . . . . . . . . . . .
. Early literature . . . . . . . .

Contemporary literature

Summary . . . . . . . . . . . . . . .
The cYcle overhead concept . . . . .
General . . . . . . . . . . . . . . .
Early literature . . . . . . . . .
Some early objectors . . . . . . . . .

Contemporary literature

Summary . . . . . . . . . . . . . .
The practical capacity concept . . . . .
General . . . . . . . . . . . . .

Church, Whitmore, and Gantt and
practical capacity . . . . . . .
Other writers and practitioners and
practical capacity . . . . . . .
Some special problems
Categories of machines or capacity
Categories of idle capacity . . . .
Influence of standard costing
on capacity measures . . . . .
Summary . . . . . . . . . . . . . .

sumary: The sequel to the supplementary
rate . ; . . . . . . . . . . . .

PAGE

66

67

71

74

76

76

76

82

84

88

90

90

91

92

94

99

102

104

106

CHAPTER. PAGE
Cost Control and the Development of
Overhead Costing . . . . . . . . . . . 113
General . . . . . . . . . . . . . . . 113

Idle capacity costs and efficiency

measures . . . . . . . . . . . . . . 114
Standard costing ideology . . . . . . . 116
The responsibility idea . . . . . . . 125
Summary . . . . . . . . . . . . . . . . 128

Income Measurement and the Development

of Overhead Costing . . . . . . . . . . 129
General . . . . . . . . . . . . . . . . 129
Early writings . . . . . . . . . . . . 129

Breakdown of commercial and manufacturing
overhead . . . . . . . . . . . . . . 132
Exclusion of imputed interest from
manufacturing overhead . . . . . . . 135
The supplementary rate and its
sequel . . . . . . . . . . . . . . . 139

A. Hamilton Church and income measurement 140

Development of overhead allocation . . 141
Summary . . . . . . . . . . . . . . . 148
III. INDUSTRIAL OPERATION AND OVERHEAD COSTS:

THE VIEWPOINT OF ECONOMICS . . . . . . . 150

PAGE

Introduction . . . . . . . . . . . . . . . 150
General . . . . . . . . . . . . . . . . 150
Income measurement and cost control . . . 152

Variable Costs and VOlume variation . . . 154
General I. . . . . . . . . . . . . . . . 154
Statistical cost studies . . . . . . . . 156
Controversy over marginalism . . . . . 158

Fixed Costs and VOlume variation . . . . . 162
General . . . . . . . . . . . . . . . . 162
Fixed costs and economic waste . . . . 163
Fixed costs and competition . . . . . . 170

General . . . . . . . . . . . . . . . 170
Public utility industries . . . . . . 171

Non—public utility industries . . . . 174
Summary . . . . . . . . . . . . . . . . . . 179

IV. INDUSTRIAL OPERATIONS AND OVERHEAD COSTS:

THE VIEWPOINT OF MANAGEMENT . . . . . . . 182
General . . . . . . . . . . . . . . . . . . 182
Financial Accounting As a Management Tool . 185
Summarized data . . . . . . . . . . . . . 186
Long-run assumption . . . . . . . . . . . 186
Outsider orientation . . . . . . . . . . 188

,Measure of economic progress . . . . . . 190

CHAPTER PAGE
Cost Accounting As a Management Tool . . . 191
Extention of financial accounting . . . 192
Historical costs versus predetermined
costs . . . .p. . . . . . . . . . . . 193
Responsibility accounting . . . . . . . 199

Other aspects of cost accounting

Pricing . . . . . . . . . . . . . . . 206
Decision making , . . . . . . . . . . 214
Beware of oversimplification . . . . 218
Fixed Overhead Costs and Management . . . 224
Summary . . . . . . . . . . . . . . . . . 226

V. THE MODERN APPROACH TO OVERHEAD COSTING AND
INCOME MEASUREMENT AND THE NEED FOR

RECONSIDERATION OF BASIC IDEOLOGICAL \

FOUNDATIONS . . . . . . . . . . . . . . . . 228
General . . . . . . . . . . . . . . . . 228
Direct Costing: Origins . . . . . . . . . 229
Direct Costing: The Period of Refinement . 235

Early emphasis: eliminate the normal

overhead concept . . . . . . . . . . . 235
Switch in emphasis

Approach of the economic

marginalist . . . . . . . . . . . 238

CWWTER PAGE

Approach of the break—even

enthusiast . . . . . . . . . . 239

The perfect argument . . . . . . 240

The Case of the Defense . . . . . . . . . 243
General . . . . . . . . . . . . . . . . 243
Idle capacity as a defense . . . . . . . 246
Recognizing limitations of marginalism . 253
An Improved Approach . . . . . . . . . . . 259
General . . . . . . . . . . . . . . . . 259

Overhead cost segregation for income
measurement . . . . . . . . . . . . . 265
Idle capacity costs and income
measurement . . . . . . . . . . . . . 273
Some objecticns considered . . . . . . 286
The misguided marginalist and break-
even enthusiast . . . . . . . . . . . 292
Summary . . . . . . . . . . . . . . . . 301
VI. THE MODERN APPROACH TO OVERHEAD COSTING
AND COST CONTROL AND THE NEED FOR AN
INTEGRATED AND CONTINUOUS APPROACH . . . 304
Traditional Cost Control . . . . . . . . . 304
Operating Controls In The Factory: Physical

Standards . . . . . . . . . . . . . . . 308

CHMMER
General . . . . . . . . . . .
Direct materials . . . . . . .
Direct labor . . . . . . . . . . . . . .
Overhead . . . . .

The Integrated and Continuous Approach .
Limitations of traditional cost
- control . . . . i . . . . . .
Limitations of physical standards
Hierarchical ranking and the integration

of cost and physical standards . . .

Illustrations of the Integrated and
Continuous Approach . . . .
Genera1-.
Direct materials
Direct labor
Overhead . . . . . . .
Summary . . . . . . . . . . . . . .

\HI. SUMMARY.AND CONCLUSIONS

BIBLIOGRAPHY.................

PAGE

308

309

312

314

316

316

318

322

332

332

338

351

361

378

383

398

LIST OF ILLUSTRATIONS

ILLUSTRATION

1.

10.

The PrOblen Posed by Fixed Manufacturing
Overhead Costs . . . . . . . . . . . . .
Quantified Illustration of Capacity
Concepts . . . . . . . . . . . . . . . .
Three Dimensional Break—even Chart . .
The Traditional and The Recommended Methods
of Allocating Overhead Costs . . . . .
Unit of Production Depreciation . . . . .
Depreciation Costs Under Normal or Cycle
Capacity . . . . . . . . . . . . .
Summary of Control Over Material Usage
Summary of Control Over Labor Usage
Summary of Control Over Overhead Costs
Summary of Control Over operating Department
Overhead Costs Related to the Operation of

'Equipment and Facilities . . . . . . . .

PAGE

108

109

257

272

287

288

340

353

363

376

CHAPTER I
INTRODUCTION

Manufacturing overhead1 is the source of many accounting
problems. The significance of this statement is readily
understood when the heterogeneous nature of manufacturing
overhead is considered. It is nothing more than a gigantic
"catch all" category. Accepted definitions admit this when
they state that manufacturing overhead includes all manu—
facturing costs except direct labor and direct materials or
all those manufacturing costs which cannot be traced to a
Particular production order. In other words, manufacturing
overhead is neither direct labor nor direct materials, and
direct labor and direct materials are those costs which can
be traced to a particular production order. Perhaps another
disconcerting feature of the "catch all" nature of manufacturing
overhead is that the above definition is often modified to
inchide all those costs not worth tracing to a particular

Pmduction order .

K

1
Manufacturing overhead is sometimes referred to as

ove . . . .
rhead, manufacturing burden, burden, indirect manufacturing
expenses’ and even oncost.

2

One factor which has had an ever—increasing tendency
micomplicate overhead accounting and also to make it more
significant has been the combined relative and absolute in—
crease in the amount of manufacturing overhead. This
increase has been and will continue to be caused by techno—
]rmical development or automation wherein direct forms of
labor are replaced by machinery. Another factor has been
the relative increase of fringe benefits in the total wage
bill. In both cases a direct or traceable item of manu—
ihcturing cost is replaced by an indirect item. In many
instances the items causing the relative and absolute increase
in.manufacturing overhead are items that do not vary within
vdde ranges of production volume.

Among the many problems emanating from overhead
accounting are two that have received wide attention in
recent years. These are the problems related to income
measurement and cost control. In the case of income
measurement, accountants have not recognized the true
rational foundations and origins of cost accounting for
overhead costs in general, and for fixed overhead costs in
particular. TOO many have unthinkingly adopted for income
measurement purposes concepts applicable to other cost

finding purposes, or have warped the concepts in such a way

(A)

that their quantification has questionable utility for
cuiginally intended functions or for income measurement pur—
poses. Such a situation presents a fundamental challenge to
13m integrity of financial statements.

In the case of cost control, especially with regard
‘Uioverhead costs, accountants have never really constructed
maintegrated system that illustrates the prOper position of
aumounting accumulations. Many have frustrated cost control
kmrwrapping it up in the double entry framework. Many others
have added to the variance accumulations of double entry such
finngs as periodic reports of controllable costs by respon—
sibility centers, as well as periodic reports of spoilage,
labor efficiency and even machine efficiency. This all seems
adequate until it is realized that most of the cost
axmumulators and report gatherers visualize control as
starting with the report and an analysis of variances between
aumual and expected performance. Their point of departure
is an intensive analysis of variances in order to determine
root causes which must be eliminated. Such a report is not
onLy too late for truly effective cost control, but its
approach is entirely inappropriate, for it asks the question
'wmat must w; 82 g9w?", after we take the precious time to

analyze what went wrong in the first place. The appropriate

4

cumstion is "what has been done?”lto eliminate those factors
ghfing rise to out—Of—line performance.

This more appropriate question has grown out of the
vniter's personal dissatisfaction with the traditional
approach to cost control which places too much reliance on
adier—the—fact cost accumulations. To be effective, control
nmst eliminate out—of-line conditions before they occur or
mssoon as possible after they occur. Cost accumulations are
guepared too late to be of effective use in cost control.
Asvdll be illustrated later, many of the factors giving
rise to out-of—line performance can be and are eliminated
long before cost data are accumulated. Thus it will be seen
that the role of cOst accumulations in a cost control system
differs considerably from the assigned role in the traditional
amproach to cost control. Cost control will be portrayed as
endhng rather than starting with the accumulation of
variances between actual and expected costs.

131 conjunction with the above expressed needs the
Objectives of this dissertation will be

(1) to provide a more reasoned approach to overhead

costing and income measurement with special
emphasis on the fixed element of overhead cost,

and

(2) to present a meaningful approach to the position
caf overhead cost accumulations in a cost control

system.

These objectives may seem somewhat unrelated, but as
vullbe shown they are tightly interwoven in terms of their
rusunjcal development as well as their theoretical and
prmfifical application. They are, in effect, hardly separable.

Source data for this study includes the rather large
sane Of literature included in such publications as the

lhtnxml Association of Cost Accountants Yearbooks and

 

fififletins, The Journal of Accountancy and The Accounting
flgflgw. Particularly appropriate literature in the fields
Ofifinancial and production management as well as economics
hasalso been considered. In addition, in order to add the
fnushing touch of current applications, the writer's limited
emmmience in the field of public accounting has been
buiressed by interviews with outstanding practitioners
hlprofessional accounting as well as by some interviews with
fidustrial accountants.

FOllowing this introduction, there will be six
mkhtional chapters. In Chapter Two the adaptation of
(nerhead costing to the purposes of income measurement and
cost control will be considered. In effect, this will be a
hummional approach to the development of overhead costing
iflUch will attempt to illustrate the major factors in—

fluencing the growth and refinements in overhead costing.

6

Among the major factors to be covered will be the influence
of price determination and efficiency measures On overhead
costing, the very significant contributions of Alexander
Hamilton Church and their ultimate development into the
measures of wasted and utilized capacity as well as standard
costing. All of this material will then be related to in—
come measurement, cost control and the development of
overhead costing.

Chapters Three and Four will cover the significant
implications of industrial operations and overhead costs
from the viewpoints of economics and management. These
Pages on economics in and of themselves have great
Significance, especially in light of some current ideas con—
cerning the accountant's concepts of income measurement as
they are related to overhead costing. A pragmatic approach
is the essence of the chapter on management's point of view.
The utility of both financial and cost accounting is con—
sidered with special emphasis on overhead costing.

In the light of these exploratory chapters, chapter
Five will consider the modern approach to overhead costing
and income measurement as well as related controversies.
This will be terminated with a more reasoned approach to in-

come measurement which will recognize the true rational

foundations of the conflicting ideologies. Chapter Six
will consider the modern approach to overhead costing and
cost control, and its limitations. This will be terminated
with an attempt to put forth a reasoned analysis of the
function and place of cost accumulations in cost control,
particularly overhead cost control.

Chapter Seven will summarize this study, “Some
Aspects of Overhead Accounting For Income Measurement and
Cost Control, " with a, restatement of significant factors
and present certain conclusions that seem justified by the
study. These conclusions will have definite implications

for public, industrial and academic accountants.

CHAPTER II

ADAPTATION OF OVERHEAD COSTING TO INCOME MEASUREMENT
AND COST CONTROL: A FUNCTIONAL APPROACH TO THE

DEVELOPMENT OF OVERHEAD COSTING*

Introduction

General

Cost accounting, like many other fields of endeavor,
evolved to meet felt needs. This is especially true of cost
accounting development in the period of most active industrial
growth, that is, around the turn of the nineteenth century.

It is even more true of accounting for overhead costs, which

only began to assume importance in the latter part of the

nineteenth century .

tMany ofothe items to be discussed in this chapter
anacovered in more detail by S. Paul Garner, Evolution_gf
.Q§$.Accounting:£g 1925 (Tuscaloosa, Alabama: University of
Ahmama Press, l954),4l6 pp. and David Solomons "The
Historical Development of Costing" in David Solomons (ed.)
§3§udies _j_._n Costing (London: Sweet and Maxwell, Ltd., 1952),
1:52, inlooth cases the approach is much different from that
taken here. Garner seems to take as his point of departure
income measurement while Solomons seems to emphasize a
densiOn—nufl<ing or incremental approach. This chapter will
consider the functional approach or those factors which gave
rise to the development and refinements of overhead costing.

9

The reasons underlying these more modern developments
incpsting are essentially related to the determination of
seUJng prices, and to broad measures of efficiency deSIgned
tolmlp identify and eliminate waste. The matter of inven~
toqrvaluation and income measurement seemed to have very
liUfle to do with cost accounting developments in this early
penpd.l In a sense one could say that inventory valuation
andincome measurement accepted or followed whatever figures

wenaderived for other cost finding purposes.

Qyfly Emphasis on Price Determination and Waste Elimination
In order to illustrate in an introductory manner the
{nessures bearing on cost accounting, the following comments
inc made. One early student of the subject of costing wrote
nithe prize essay of the Union of Chartered Accountant

Ekudent Societies of Great Britain in a competition con—

ducted in 1905:

Cost Accounts, as such, may fairly be con-
sidered of comparatively recent origin, and their
existence has been necessitated by the growing com—
plexities of manufacturing. The development of the
factory system, the immense improvements in machinery
and general manufacturing methods, and the great in—
crease in the intensity of competition caused by the

1For an exactly opposite point of view see Raymond
Pu Marple, "Direct Costing and the Uses of Cost Data," The
Accounting Review, XXX (July,l955), 430.

 

’5

10

ever—improving transit facilities between differenE
countries and different parts of the same country.

He added that the requirements of data needed in
emumating gave rise to a need for costing, since the rule-
ofthumb method was found to be quite useless in those
aflhirs of any magnitude or complexity.

One essential point in Pedder's remarks concerns the
hmreasing intensity of competitiOn which forced a more
mmtematic and scientific approach to estimating, the other
mmential point. The estimating referred to is obviOusly
Mflated to the problem of setting selling prices so as not
.tolose sales on the basis of improperly—prepared or faulty
bub or to takelosses by overbidding.

David Solomons, one of the few cost accounting hiS*
mnians, expressed essentially the same idea when he spoke of
the increasing scale and complexity of industry, the
mechanization of all industry, the development of railroads
\dflth brought overhead into prominence, and the rise of the
«necutive divorced from operations, whiCh focused attention

2 , .
S. Pedder, "Cost Accounts: their Advantages and their

Relation to Business Results," The Accountang, XXXII
(April 29, 1905L,518.

3Ibid.,519.

ll

oncontrol.4 In addition to these items Solomons addedzi
Perhaps the most important factor, however,
leading to a growth of interest in costing, was the
increased difficulty of price fixing-in the
engineering industry. '

The importance of estimating, Solomons pointed out,
wmsdueto the increasing intensity of competition in the
Enter part of the nineteenth century wherein the rough
amiready methods of setting selling prices on the basis of
pnMe costs plus a percentage to cover all overheads and
{unfit were no longer adequate. More careful and systematic
“words were necessary for improved price estimates. After
ghflng a number of historical references concerning the
sewing of prices and cost accounting, Solomons concluded
Hum costing for price determination was the praCtical reason
immind the increasingly accelerated interest in costing.

A. C. Littleton, perhaps the foremost of all accounting
1Ustorians, also stresses the Same factors when speaking of
the genesis of cost accounting. He stated with reference to

the rise of the factory system that:

4

David Solomons, "The Historical Development of
Ckmting" included in David Solomons (ed.) Studies in Costing
(Londonz'Sweet and Maxwell, Ltd., 1952), 18-19.

5Ibid.,l9.

6
Ibid.,l9-20

12

The resulting cost problem was in reality
a price prOblem related to calculating the pro—
fit and bidding for work in competition.

In addition he said:
As competition grew keener, the interest

of management in the analysis of costs and

expenses increased. The search for indications

of waste and of unprofitable products, for the

means of increasing unit productivity and so on

is still unceasing.8

Garner, a contemporary authority on cost accounting
Insany has the same point of view. He describes American
bushmssmen around 1898 as natural Opportunists who began to
amHEciate the necessity of accurate costing in order to set
seNing prices and to keep those selling prices low by means

ofincreased efficiency and waste elimination via cost

rmhmtion and cost control programs.

The Birth of Overhead

\

All of the previously-quoted sources refer to a rise
Ofinterest in cost accounting during the last quarter of

theruneteenth century and the early part of the twentieth.

7
A. C. Littleton, Accounting Evolution to 1900 (New
Yoflh The American Institute Publishing Co., Inc., l933),321.

8
Ibid..322.

 

9Garner, op. cit.,208-9.

l3
fiUs was especially true of the attention given to overhead.
'Nm factory system itself brought on some problems concerning
ownhead, due to the fact that the owners of capital had to
pnwide not only the facilities within which to produce,

‘

1mm often the facilities with which to produce. Littleton

stated this as follows:

Increased capital investment in fixed plant
made necessary additional attention to adequate
plant—expense analyses; there were maintenance
charges, running expenses for light, heat and
power,,several varieties of superintendence and
the like, in ever-expanding detail as production

became departmentalized and integrated. In a
word, "overhead" was born. .10

Littleton added, though, that many of the special
nfifinements of cost accounting with regard to selling prices
axiwaste elimination came in the twentieth century. This
vms true "since they were associated with mass production by
Um use of large investments in power machinery—-a condition
rmt Characteristic of the nineteenth century".

The same point of View was also expressed by the

aMnent economist J. M. Clark when he considered the possible

Mmact of fixed costs upon industry in general, as a result

loLittleton, op. cit., 321—2.

llIbid, , 322.

of the substitution of machinery for labor. His relevant
comments were:

However, this fact did not have its full
effect until the largest mechanical unit of all,
the railroad-—had reached maturity and had had
its transforming effect on industry, making
possible the fullest development of mechanical
production in other lines by enabling the output
of mammoth plants to find a market. There resulted
the struggle for world—markets, cut—throat com—

petition, discrimination, the modern forms of
the business cycle and the growth of monopoly.

12

It is not difficult at all to pinpoint chronologically
thusdevelopment (in the importance of overhead as an element
ofcmst) to the period surrounding the turn of the century.
In1869 the Union Pacific and Central Pacific met to form
theiflrst transcontinental railroad system in this country.
Tmebkmthern Pacific reached Portland, Oregon in 1883. The
Souflmun Pacific in 1881 connected New Orleans and San
Frmxusco. In 1893 the Atchison, Topeka, and Santa Fe
remflmd San Diego from Kansas City and the Great Northern
IGMflmd Seattle from St. Paul. Mass production demanded a
SYSUmlof transportation stretching across continents, and

sudla system was not ready until the latter part of the

nimfieenth century in North America or Europe. Other sections

x

12JOhn M. Clark, §tudies in the Economics of Overhead

EEEE “flucago: the University of Chicago Press, 1923) 9.

 

15

ofiflm world were behind the transportation develOpments in

13 so that when one emphasizes the

NOrdmAmerica and EurOpe,

liuflature of the United States and England, the two greatest

inmunrial nations of those and even more modern times,

stamflhg with the period at the turn of the 19th century,

a very fine perspective of the deveIOpment of overhead

comung is Obtained. On occasion, though, it will be both

nmxmsary and informative to go back a little further in this

fmuxional approach to the development of overhead costing.
The remainder of this chapter will be divided into

four parts, viz. ,

l) the influence of price determination on the
content of overhead

2) the "supplementary rate" of A. Hamilton Church
and the sequel to the "supplementary rate"

3) cost control and the development of overhead
costing

4) income measurement and the development of overhead

 

costing
l3 , , . .
Some comparative railroad mileage statistics for
1913are as follows: EurOpe 216.393

North America (including
U. 8., Canada, and Mexico) 303,046
Central America and South

America 53,271
Asia 67,591
Africa 27,693
Australasia 22,136

Smnte: The New International Encyclopedia! Second edition, Vol. 19,
(NmVYOrk: Dodd, Mead and Company, l930).489.

 

 

16

Sales price determination will be portrayed as it
should be, the most important factor in the early development
of overhead costing. Alexander Hamilton Church will be
given the recognition he deserves as the originator of the
"supplementary rate" which ultimately develOped into those
capacity measures utilized for income measurement. The
develOpment of overhead costing as it relates to cost
control and income measurement actually constitutes a summary
of the first two parts of this chapter, but in addition
other factors will be considered in order to lay the foun—

dation for the remainder of this dissertation.

17

Influence of Price Determination
On the Content of Overhead

General

Early overhead costing practice was essentially re—
]atmitr>the determination of selling prices. Manufacturers
vmreinterested primarily in direct material and labor cost.
Ownmead was considered only in terms of that broad per-
cmfiage Which, when added to direct costs, was to yield the
ssUing price or "hoped for” selling price. Ordinarily there
wasno distinction made between the various elements of
ownhead. .Manufacturing overhead, commercial overhead, and
"mxmd for" profits were all lumped together in one per-
centage figure.l4

Increasingly competitive conditions in industry
resumed a more scientific method of price determination.
thmms and practitioners began to draw a distinction between
““eTnies of overhead and also to discuss refinements in
Umxmflhods of allocating overhead to production.

As competitive pressures increased there came to be
a gradual shift or blending of price determination and cost

ccmimlin overhead costing. Overhead costing came to be

k

14 .
Garner, 0 . c1t., 122.

18

:mflated to more scientific allocation schemes intent on
lnnlding up selling prices and measures of manufacturing
effnflency. The following pages are designed to illustrate

theemrly influence of price determination on the content of

overhead .

Thomas Battersby and Overhead

In his discussion of a text written by Thomas
BaUmmsby in 1878,15 Professor Garner, without any apparent
inUHWion of stressing the point, illustrated quite clearly
thatsales price determination was the paramount consideration
incwerhead allocation.l6 Garner discussed the six different‘
medmfls of costing Battersby had seen used in his public
acmxmting practice. In none of the methods was a dis—
thmtnxxmade between manufacturing overhead and selling
andadministrative overhead.

The relevant remarks classified according to the

mnhmiused are as follows (italics all mine):

(1). . . Twenty-five percent of the preceding total
was added on for profit, as well as 25% profit on all

_.-‘~_______.
15

Thomas Battersby, The Perfect Double Entry Bookkeeper,
(Manchester: 1878)

6
Garner, op. cit., 70-76.

19

materials used. To the total Battersby added the
cost of materials in order to arrive at the sellipg

price.

(2). . . Then 25 percent of the total was added on
for indirect expenses and profit, as well as the

usual 25 percent for profit on materials purchased.
All these sums plus the cost of the materials used

gave the selling_price.

 

(3) . . . In the third method the wages paid to
workers were added to a percentage of wages for the
use of tools and other expenses. To this total was

added the profit to arrive at the selling_prige.

(4) . . . In the fourth method all the tools were
rated according to the purchase price and the power
required to work them, plus the workman's wages, and
every workman is rated at the wages paid him, apd
a_percentage for indirect expense and_prg§it is addpd
on the total and on materials purchased, whigh gives
the sellingdprice.

(5) . . . The fifth method was purely arbitrary. A
so-called 'rate' was fixed by some responsible person
in the organization based upon the purchase price of
the tools and lathes used. These rates then were
'used as selling prices, both for contract work and

jobbing work.‘

I

(6) . . . The sixth method was used where piecework
was employed. The total cost of materials was added
to the piece—rate wages paid to employees. Then a
percentage was added for the use of tools as well as
minor charges. Onto this total anotherppercentage
was added for theprofit.l7

In criticizing these methods, Battersby said, in
afikct, that the rates used were based on opinion and

assumption, and their advocates "hoped that the percentages

l7fi1xid,,taken from Thomas Battersby, op. cit.,34.

 

2O
amirates employed would be sufficient to cover the overhead

18 After his criticism Battersby

itamaand a profit as well."
remmmmnded his own method, about which Garner said, "These
data [prime costs] were in turn to be transferred to a
pnnmte cost ledger where certain percentages for overhead
dmrmfisand profits were to be added on, giving the selling
pnue and gross profit on each job.”19

There is no denying that Battersby made some con—
trflnmion to the literature and practice of allocating
cweflmed costs, but his goal was not inventory valuation.

Hissnml was price determination, as was also true of the

meflmfis he criticized.
The Whitesmiths of Taunton and Overhead

In a study of early New England silverware pro—

chmtnxflo the same conclusions can be reached regarding the

 

emmumis on price determination. The study of Reed and
x
18
Garner, op. cit., 72.
19Ibid., 73.
20

. George S. Gibb, The Whitesmiths 9}: W, A
EEEEEX pf Reed and Barton. 1824-1943 (Cambridge, Massachusetts:
Harvard University Press, 1943) 419 PP.

 

 

 

21

Barflx1by George S. Gibb is quite informative in this
mmpafi; When discussing the company's price policy from
1837to 1859 Gibb wrote as follows:
In general, the pricing practice followed by
the company consisted of a rule—of-thumb policy,
having reference on the one hand to direct costs of

manufacture, and on the other to the bargaining
position of the buyer.21

In other words, overhead costs were to be included in
vmaUnmr percentage above the direct costs of manufacture
(mannials and labor) the company could bargain out of its
cmsUmmrs. The bargaining position of the company was usu-
alhzvery good, since it sold highly popular branded
merchandise .

In the discussion of accounting procedures in the
Petkfl from 1860 to 1900, the connection between cost
acunmting and price determination is brought out in a very
1MCidmanner. Gibb described the relevant procedures as
fOllows: ,

To the intense annoyance of his salesmen and
some of the foremen, George Brabrook, who supervised
the costing, habitually placed a value on the metal
used far above either the current market price or
the price the company had paid for it. The inflated

cost resulting from such a practice, Brabrook felt
was an excellent cushion against the inevitable cuts

21
Ibid., 159.

22

in the price of the finished article forced on him
by the company salesmen and competitive action.

Gibb added that in order to arrive at a selling price
whnflicovered direct costs, overhead and profit, Brabrook
vmuhitake the prime or direct cost of an article and double
it. Furthermore Brabrook considered manufacturing overhead,
amiadministrative and selling costs as one composite called

overhead.23

The Texts of the '80's and '90's

 

As to the latter part of the nineteenth century,

A.CL Littleton stated that there were three notable books

, 24 .
on<xmt accounting which deserved mention. These were

thekmmks of Garcke and Fells, G. P. Norton, and J. S.

Iewnazs Both Garcke and Fells and G. P. Norton drew a

22 ‘
Ibid..267.

23Ibid-o 267“9o

24Littleton, op. cit.,340.
25
Emil Garcke and J. M. Fells, Factogy Accounts,

Ummkm: Crosby Lockwood and Son, 1887).264 pp. George P.
NONxm, Textile Manufacturers Bookkeeping, (London: Simpkin,
Manfimll, Hamilton, Kent, and Co., Ltd., 1889),300 pp,
iL 5.1ewis, The Commercial Organization pf Factories,
(hymen:‘E. and F. N. Spon, 1896),540 pp. '

 

 

 

 

23
dnfljhction between manufacturing overhead and selling and
admuustrative overhead. In both cases selling and
admhustrative overhead were not considered product costs
butvmme charged directly to profit and loss. Garcke and
Eelhsstated that the best firms priced their inventory at
cmstcnfproduction, including only manufacturing overhead,
amisaid that the practice of including a percentage for
'%sfiflfl¢shment charges" (selling and administrative
exmymes) "can not be too Strongly condemned."26 Their
IPamXUng included the fact that there was no relationship
beufimn production and selling and administrative expenses,
butthat in fact, such expenses were quite fixed with regard
tOPI‘Oduction, and therefore profits could be manipulated by

thesflhmle means of producing to stock or reducing inven—

tories,27

The above comments by Garcke and Fells could easily
lemione to believe that their objective was the measurement
0f.flmome. On the other hand there is other evidence which

SUTfiwts that the major objectives of separating manufacturing

26
Garcke and Fells, (Fourth edition, 1893), pp. cit., 122.

27See Chapter V on "Direct Costing--Origins" pp.229—35.

24

andcxxmnercial overhead were price determination and the
measurement of efficiency. For instance, they state:
The establishment expense . . . and interest on
capital should not, however, in any case form part
of the cost of production. There is no advantage in
distributing these items over the various transactions
or articles produced. They do not vary proportionately
mdth the volume of business . . . To distribute the
charges over the articles manufactured would, there—
fore, have the effect of disproportionately reducing
the cost of production with every increase, and the
reverse with every diminution of business. Such a

result is greatly to be deprecated, as tending neither

to economy of management nor to accuracy in estimating
for contracts.28

The problem in this case for Garcke and Fells is
thm:sales results in terms of volume should have no effect
ontme cost figures utilized to measure manufacturing
efficiency (economy of management), nor on the cost figures
utLHzed for price setting (estimating for contracts). A
unnzcost figure which fluctuates up and down due to the
,indhmion of the relatively fixed commercial overhead could
nottm used as an overall measure of manufacturing efficiency.
Theemphasis on selling price is revealed again when Garcke
WM Rflls added the comments that the principals of an
ameqnise could always judge the proper percentage of gross
.fmoflns upon costs that was needed to cover fixed commercial

\

2.
73 8Garcke and Fells, (Fourth edition, 1893), pp. cit.,

25

cnmrhead and interest on capital.29

In 1922 Garcke and Fells clearly showed their
ammasis on price determination. In this case they were
tmdng to defend their policy of excluding commercial over—
lmadznxiinterest from the cost of production. They
awMtted that these items were costs of production in a
wnku sense, but from the standpoint of price setting
hfimld not be regarded as items in the cost of production
ofparticular commodities insofar as it regulates prices."3O
Attmis time Garcke and Fells demonstrated their position
abmflxmely when they said it was sufficient to know only the
coaxsof direct labor and direct material when other costs
vmrecnfa more or less fixed nature.31 Thus, when Garcke and
Fans allocated manufacturing overhead to units produced,
tmgyvmre assuming that such costs were variable.

After a study of all these comments it is quite clear

t

thatChrcke and Fells were well aware of the effect of

thmubry valuation on income measurement, but the figures

 

\
29Ibid.
30

Ibid.,(Seventh edition, 1922), footnote on page 119.

31
Ibid,,(Fourth edition, 1923).

26
that they utilized were intended primarily for other pur—
poses. Basically, price determination, in the out-of—pocket
cost sense, was the true rational foundation of the cost
figures utilized. A secondary consideration was measuring
efficiency (economy of management), which they felt could
not be done except on a variable cost basis.

G. P. Norton, like Garcke and Fells, also drew a
distinction between manufacturing overhead‘and commercial
overhead. The reasons behind the distinction are not as
clear as in the case of Garcke and Fells, but there is
enough evidence to indicate that Norton was not too interested
in uSing cost figures as a basis for valuing inventories and
therefore for income measurement. For inventory valuation
Norton recommended a net selling price concept. Inventories
were to be valued at selling price minus costs yet to be
incurred in the disposition" of the articles. Illustrative of
Norton's recognition of the relationship between inventory
valuation and income measurement is the fact that he drew
a distinction between goods made to order and goods made
for stock, and recommended a deduction for profit from the

net selling price if the goods were not made to order. 32

3
aflorton, (Third edition, 1894), pp. p_i__§., 259-260.

27

At least Norton didn't seem to use inventory valuation
as the reason for separating manufacturing and commercial
overhead. The distinction was apparently related to an
intense interest in the hnalysis of manufacturing costs and
the measurement of manufacturing efficiency. Evidence of
Norton's intense interest in manufacturing costs was his
refusal to analyze commercial overhead on the grounds that
such costs were not connected with the departments of manu—
facture.33 Evidence of Norton's use of manufacturing costs
(exclusive of commercial overhead) for measuring manufacturing
efficiency is illustrated by his recommendation that product
costs within a plant ought to be compared periodically with
What it would cost to have the same work done by a competitor.
The comparison did yield an overall measure of plant
efficiency or the ability to produce competitively.3

As for J. S. Lewis, all the available evidence points
to the conclusion that he was not too interested in income
measurement. Lewis' work seemed to have the dual objectives
of price determination and of ascertainment of a measure of
manufacturing efficiency.

33
Ibid.’220.

34Ibid” 219-22.

28

Littleton said that there was much evidence in
ides' work to lead him to believe that Lewis used overhead
alhxmtions only for jOb estimating or sales price deter—
rMhation purposes.35 Garner, in reviewing Lewis' work,
qurently missed Lewis' emphasis on price determination,
fin he criticized Lewis severely not only when he ”was
raflun careless in making the distinction between manu-
fmfimring burden, on the one hand, and selling and office
eXpenses on the other hand“, but also when Lewis failed to
cany’his distinction through the books.36 On this point
Gamer said of Lewis' treatment of selling and office

expenses:

When it came to their treatment in the cost
accounting books, however, Lewis considered it
proper to divide the entire total over the orders
finished during the period. Thus, in the last
analyses, his distinction was rather superficial;
that is to say, he really did not have an under—
standing of their fundamental nature.3

Garner's frame of reference was strictly ”double
entrY"Eir1d.the related problems of inventory valuation and

x

35
Littleton, pp. cit., 353. Littleton is most likely
raferring to pages 174—9 in Lewis' book.

6Garner, pp. cit., 125.

37
Ibid., 126.

 

29
incmmameasurement. His criticism of Lewis was reasonable
(way fixm1this point of view, which was completely different
frmnlewis' price—setting approach. Lewis was clearly not
inanested in income measurement, as is demonstrated by his
belnfifthat it mattered little if all commercial overhead
wenacharged to profit and loss or allocated to products,
"fortme mere purposes of commercial bookkeeping ."38

Lewis' interest in obtaining a measure of manufacturing
effnfiency'was evident when he said it was necessary to draw

a dhnjnction between manufacturing and commercial overhead

simxathe commercial side of the business

' ° °may be adversely affected by conditions,
the result of commercial blunders, which have

nothing to do with the direct costs of production.
The relative manufacturing efficiency of two rival
firms may be precisely similar, but the commercial
efficiency of one hopelessly behind that of the
other.39

 

Thus when J. S. Lewis wrote on cost accounting his
emphasis was on sales price determination and when he spoke
Ofchstinguishing between commercial and manufacturing over-
rleadhis emphasis was on a measure of manufacturing efficiency.
\

38

Lewis, pp. cit., 174.

. 9Garner, op. cit., 126. (quoting in part from
Lewis. 92. cit., 179.)

30
Ryand large then, it appears that the authors of the three
tadbooks quoted here were interested first of all in price
muermination, secondly in manufacturing efficiency, and

laMHy'(if at all) in income measurement.

Literature and Practice of the '80's and '90's

 

Other examples of this emphasis on price determination
arethe presentations of George L. Fowler and H. M. Lane
atnmetings of the American Society of Mechanical Engineers.
Ebwhn showed very clearly that his only purpose in cost
fnmhng was as a guide to selling price, in which he con—
simned general and administrative and manufacturing overhead
ascme cost category, i.e., overhead.4O

The same is true of Mr. Lane's presentation, but
Lamfis comments are much more significant since they were
based on a survey of industry practice. He noted that many
0fthe firms surveyed included office expenses in burden,
andmentioned that to shOp cost was added a percentage to

COVeradministrative and selling costs. Then he revealed

hfliexact intentions (to build up to a selling price) when

40
George L. Fowler, "Estimating the Cost of Foundry
WQNL" Transactions pf the American Society pf Mechanical
Emyneers, IX (May,1888 Meeting), 393.

 

 

31

he stated,

This, then is the minimum selling price, the
price of bare existence without profit, and to
which finally a further additioglis made, depending
upon circumstances, for profit.

In the discussion that followed, Oberlin Smith, a
pnmunent member of the Society, agreed with Mr. Lane's
pmmentation but made one correction when he referred to the
cxmt as "including commercial expenses (where they are not

. . "42 . .
mKeSSive or remarkable in any way.) _ This comment is
ceflminly quite revealing with regard to the intentions of
thethen-existing cost accumulators, that is, build up cost
fhmues to determine a selling price, but do not include
amxumal costs if prices are to be acceptable to buyers.

Ehe Increase of Competition: A. Hamilton Church
gpdpthe Content of Overhead

The prOblem that faced manufacturers around the turn
0fthe century was the necessity of developing a more
schxmific means of price setting. Overall percentages,

\
41
H. M. Lane, "A Method of Shop Accounting to Determine
Shop COSt and Minimum Selling Price, " Transactions 93: the

flfigggfllsociety pf Mechanical Engineers, XVIII (May, 1897
M“‘=‘“-'11n<21) . 894.

42
Ibid., 896.

32
based on Opinion and assumption and applied to prime costs,
were not at all adequate. It was time for a more scientific
allocation of all costs beyond prime costs. This made
necessary the distinction between manufacturing and commercial
overhead, not for the purpose of inventory valuation, but,
as a means of recognizing that different types of costs had
to be allocated differently, in order to build up to a
selling price more responsive to contemporary market con—
ditions. In addition, the factors of efficiency and waste
detection and elimination began to assume some importance.

As usual, necessity brought on the scene a person
who fitted the times. This was Alexander Hamilton Church,
an English electrical engineer, who came to America around
the turn of the century. While in England Mr. Church had
been associated with J. Slater Lewis, previously referred to

as the author of The Commercial Organization p__f_ Factories.43

 

1“ 1901 Mr. Church wrote a series of articles for the
ELIN-{wing Magazine on "The Proper Distribution of Expense
Burden" which immediately attracted the attention of the
engineering and accounting world. So great was the demand
for rePrints that the entire series of articles was reprinted
\.____

43
Page 22, sup_r_a_.

33

iJihmok form in 1908 as part of the Engineering Magazine's

 

 

Works Management Lib rary.

Mr. Church's contributions were many, and most of
them will be discussed in this chapter. For the present his
ideas on the elements of production cost are of most
interest. According to Church, cost of production consisted
ofthree great divisions: (1) direct wages and materials,

UH manufacturing overhead, and (3) general and commercial

overhead . 44

Church was aware of the distinction between manu-
faduuing and commercial overhead, but he still insisted on
flflEading commercial overhead to products. The reasons be—
hhfiiChurch's ideas will be discussed after it is shown how
weLLhe recognized the distinction between manufacturing and
cmmmrcial overhead and the need for scientific allocation
0f eElCh category of overhead.

In his chapter on the apportionment of office and

sEUing expense Mr. Church stated.

In addition to the charges actually incurred
in production, there is a large section of expenses
incurred in advertising, warehousing, packing, trans—
Porting, and conducting the commercial processes

\

A. Hamilton Church, The Proper Distribution pf

W Eprden (New York: The Engineering Magazine Company,
. 23.

34
incident to selling the finished product. Thppp
expenses should not on any account be mingled with
those due toproduction.ZP5 italics mine.

In addition to recognizing the distinction between
cxmt elements, Church also realized that the method of
alkxmtin91manufacturing or commercial overhead costs must
:nxmgnize individual differences in cost incurrence so as to
avofliaveraging the differences when allocating either
category of costs to units produced.

When speaking of manufacturing overhead allocation,
(munflldid a magnificent job of recognizing the limitations
ofthe then current methods of allocating overhead. He
thaipmesented his ”Scientific Machine Rate," wherein he
kmemusthe shop into "small shops” or "production centers”,
t0\flflch are allocated all costs possible, which then are
alkxmted to production going through each "small shop" on
thehmsis of machine-hours in each "small shop”. All charges
nOtallocable to production centers are the subject of the
"Swwflementary rate" which will be discussed later.

Church said of this method, "instead of turning our
mmrgmw to cover up the natural differences between these

I
Prmhmtion centers' and make an average of them, we devote

\W

4SIbid., 99.

 

35

our attention to giving the fullest play to this dif—

46
ference. . ."

There is no claim here that Church was the first to
remxnflze more scientific means of allocating overhead. All
(fimrch did was to put together in remarkable fashion a
demnfitmion and criticism of the then prevalent means of
aLkmeting overhead (percentage of wages plan, hourly burden
plan and machine rate plan) and put forth his own method as
a fundamenta l improvement . 47

Church, when speaking of allocating selling and
gauual expenses to products, again considered the differences
incxmt incurrence. He referred to selling expenses applicable
dmurto certain products (e.g., advertising), as well as to
Prmhxms requiring very little if any selling effort. Withw
Ontcflmstion, Church did his best to apportion all costs to
prmhmms, and in doing so he recognized and emphasized
duffiuences in cost incurrence or those factors which gave

rise to cost elemental"8

\“

46Ibid., 43.

47 ,
Ibid., Chapter 2.

48Ibid., Chapter 6.

36

As for the reasons behind Church's insistence on a
Imus scientific allocation of costs, one thing appears
antain: Church had very little interest in inventory

49
wfluation and income measurement. His major reasons for
dwaallocations were waste detection and efficiency measure—
mau;as well as selling prices.

In regard to waste detection and efficiency measures,
hereferred to proper allocations of commercial overhead

. . , 50
SMwung the best class of buSiness to eprOit, and the
.. . , 51 . . .
elumnation of unprofitable products and waste in distri-
bution.

Church's comments as to why a firm will spend its
moneW'freely on such things as plate glass and mahogany for
itscfifices, and will shrink from the expense of getting to
kmmzwhat is going on in)its shops, are very indicative of
thejflPOrtance Church placed on waste elimination.

\ /

See the section entitled “A. Hamilton Church and
Inmmm Measurement" in this Chapter, pp. 140-1.

Ibid., 104

Ibid., 111
52

Ibid , lOO.

37

The true answer probably is that one is a
familiar and conventional item of expenditure,
and the other is 'something new'. One is an
Obvious and tangible asset, the other an easy
subject of criticism for the irate shareholder
who remarks, 'they have nothing of this kind of
thing at so and so's'. To spend money today for
the sake of saving a much larger amount at some
future period, . . .demands some moral courage;
but to expend money for the purpose of raisipg
efficiency, detecting waste, and preventiqg loss
demands strongpjudgment and confidence as well. 3
[:ital ics minQ‘]

 

As for the selling price ideology imbedded in his
thhflung, Church seemed to emphasize the allocation of all
cosUsin.order to determine the profit on a sale.54 He
rmxgnized very explicitly the factor of competition in price
determination55 so that his comments with reference to profit
Onéisale must be related primarily to the decision to
{Homxm and to the elimination of waste,and secondarily to
thenmtter of influencing price if at all possible. The

aflfimt of sales price determination was most clearly revealed

whenChurch spoke of "the most serious canons of modern

 

thmny and practice, viz.: that whatever else is done, pypgy
53
Ibid., 11.
54Ibid., 24.

55Ibid., 101. Church's explicit recognition of
Cmmmtition was:"It is not often that the price obtained
fcDITan article is otherwise than ruled by the state of
the market."

38

ddHar of charges must be burdened onto some item of work.“56

 

In Church's original work the preceding comment is
mxzas clearly worked into selling price ideology as in his
laUnrworks. In 1917 he illustrated his attachment to
prhxadetermination when speaking of unutilized capacity
costs:

In an armour-making plant, for example, the
wasted manufacturing capacity due to no work may

be very high. Yet it is very desirable to express

this loss as a percentage of actual cost, and in

fact make it a part of such cost, pecause it has 7
to be recovered in the selling price of the armour.5

 

Church's 1901 writings mark a kind of turning point
inthe practice of cost accounting; they were unique in
mmurrespects. His primary interest was in increasing
effunency and eliminating waste as has been illustrated.
Evaivuth this intent, Church still seemed to be attached to
dmzdoctrine of utilizing cost data to build up a selling
Prue, even though he recognized explicitly that competition,
rider than cost, set selling prices in most instances.
Gmrdivms building up to new ideas, but he still retained
mmnlfeatures of an earlier period of cost accounting.

56gpgg., 113.

57A. Hamilton Church, Manufacturing Costs and Accounts
(New York: McGraw—Hill Book Co.‘, Inc., 1917), 352.

 

39

The Increase of Competition: Rise of Cost Control app
Changing Sales Price Ideology

The emphasis on setting selling prices seemed to be
loshmjits importance in comparison with the problems
anxounding cost reduction and control brought on by in—

crmnnng competition. This idea is illustrated perfectly

bytme 1912 comment of B. A. Franklin:

It is also a fact, that, except in the case
of monopolies or special articles, and frequently
even in their case, the price is fixed by
competition or a figure that will stimulate
demand. . . As a matter of fact the selling price
often fixes the cost, since many an article is
definitely made to sell at a prefixed figure.

The main value in the knowledge of unit costs in
most plants is not to fix the selling price,then,
but to lggd to methods of cost reduction and

control.

Of course it must not be forgotten that increased
mmmetition brings on problems in price setting also,
Pnflflems concerning the element of fixed costs and the use
Ofcmt-of-pocket costs only, for purposes of price setting
or b idd ing .

The point was recognized by Mr. Franklin in 1912 when

Tm wrote:

58
B. A. Franklin, "Cost Methods That Give the Executive
(kmtrol of His Business--VI,The Vexing Question of Expense,"
IE5 Engineering Magazine, XLIII (June, 1912), 424.

40

this leads to the fact that when discovery

of net losses in certain articles is made it does
not always increase total profits to discontinue
their manufacture. . . This will always be so
where the loss on an article is less than the
general expense burden it bears. 9

S. Pedder in his prize—winning essay of 190560
dimnmmed the same idea. Still earlier reference to this
ideatmmer very competitive conditions in the British steel
inmnury indicates how accounting data had to be manipulated

tormmt the needs of the times. T. S. Ashton, in a commentary

cm m11833 report entitled Committee on Manufactures, wrote:

 

In times of bad trade works were continued
so long as the selling price of the iron would
cover even a little more than prime costs'of
production-~raw materials and labour. Competition
in sales was consequently felt to be harmful, and
there was a strong incentive for iron masters o
combine with the object of maintaining prices.

Even though Mr. Ashton's comment does not reveal
trmaincremental pricing, it does recognize the problem of
fhwfl costs in an elementary way and their special reference

tOpricing decisions. Another interesting aspect of Ashton's

59Ibid.

60Pedder, 92. cit., 519.

61
T. S. Ashton, lron and Steel ip Egg Industrial
Bfiwnution (Manchester, England: Manchester University Press,

1951). 164.

 

 

41
cxmment is related to the fact that excessive competition
waszflfli;to be harmful, which led members of the iron and
stmfl_industry to combine with the object of maintaining
pnues. Circumstances just like these were prime movers
‘uNmrd uniform cost accounting systems within various
. . 62 .
inmnHXies. This is just another aspect of the way sales
_prnxadetermination has influenced the growth of cost
accounting.

To complete this discussion of a changing sales
Prnxaideology, the words of George 0. May are quite

. 63 . . .
appnxniate. In an article written on cost accounting
forthe 13th edition of the Encyclopedia Britannica (1926),
Mr.hhy listed as the first object of cost accounting the

64

Fmefiflmation of a sound basis for selling policy. He

elaborated on this point:

Sales may therefore be advantageous, even
though they do not reimburse direct costs and a

62Franklin, 92. 935., 584.

63Mr. May came to the United States from England in
1898and has been associated with Price Waterhouse and Co.
amipractically every significant development in American
accounting since that time.

64George 0. May, "Cost Accounting", Twenty—Five Years
if Asgountim Responsibility 1911-1936 (New York: The
AITlerican Institute Publishing Co., Inc., 1936), 364.

 

42
rateable proportion of Overhead expenses. The
cost accountant should therefore do all in his
power, especially where profit margins are
narrow, to segregate overhead costs, to analyze
them and to interpret them to the executive, so

as to ensure that they will be given due, but
not undue weight in the formulation of policies.

65
Competition then brought on the accounting scene
anmch more sophisticated approach to price determination,

mswell as the need for cost reduction by means of identi-

2fitation and elimination of waste or excessive costs.
Summary

For purposes of waste identification and price
deanmunation a need for distinguishing between manufacturing
andcommercial overheads became absolutely necessary. This
wSEESESpecially true for cost reduction and control purposes
vmemaeach category of overhead (commercial or manufacturing)
hadtobe further subdivided into categories appropriate
tOtme analyses and comparisons which are necessary ingredients
OfanYcost reduction and control scheme.

»As for price setting under competitive circumstances,

a $Mmle percentage which hopefully included all costs above
pan costs plus a profit was no longer adequate. Entrepreneurs

6591a, 368.

43
huerested in building up selling prices or "hOped for"
seudng prices on the basis of cost had to be more precise
axmt the cost elements. Incremental pricing, also brought
miby competition, or perhaps by excessive competition, gave
iflse to a more searching analysis of overhead costs.

The early history of overhead costing was closely
asmxnated with the determination of selling prices. The
1mmt section will show how the "supplementary rate" of
Ahmander Hamilton Church, in conjunction with the related
mxmepts of idle capacity and normal capacity, preserve in
Aument accounting principles and practice a strong relation—
shuibetween unit cost figures and sales price determination.

The Rising Influence of Cost Control:
A. Hamilton Church and His Supplementary Rate

- pescription of the Supplementary Rate

 

In his original 1901 work, Church put forth the
Smxflementary rate as one of the distinguishing features of
hisnmthod of overhead expense distribution. Church's system
inwflwed breaking the factory down into "small shOps" or
"production centers", which was in line with his idea of
nmknxyevery effort to narrow the individual items of

oveflmmd down to definite points of incidence. For each

44
subduction center an overhead rate was determined on the
Inmis of maximum operating machine hours and estimated costs.
hiother words, Church's scientific machine rate assumed
tflmt each production center would operate full—time, or

. . 66
atnexamum capaCity, throughout the month.
In terms of traditional debit and credit the system

wmfld.accumu1ate data as shown in the following “T" account.

Manufacturinngverhead

 

Debits gredits

Actual Actual Machine \
Manufacturing Hours Multiplied

Overhead by the Estimated

Costs Rate

 

There would always be a debit balance67 in this
mxmunt for two.reasons. In the first place, the credits
'aretmsed on an estimated rate per production center set
atfimximwm capacity, which is rarely if ever achieved. This
nemusthat on the debit side all capacity costs are shown.

whileOnthe credit side only the costs of capacity utilized

Church, The Proper Distribution pf Expense Burden,
9P» 31;, 85.

 

 

7Possibilities for credit balances would be a very
mauuial error in overestimating expenses or underestimating
CaPam-ties; or a large increase in the value of money via a
Pruxalevel change, in cases where those in authority would
refiflm to revise the machine rates.

45
are allowed as an offset, which leaves a debit balance of
mutilized capacity. Secondly, the actual costs include
cnmrhead elements not included in the machine rates. These
anathe truly general burden charges which cannot be broken
wwm into production centers. The residual debit balance
wasthe subject of the supplementary rate, which Church
LKilized to spread the debit balance to each job that went
fluough the shop in the period involved. Therefore Church
demnibed the supplementary rate in the following fashion:

This represents: (1) a proportion of the
really general charges of the shop; and (2) an
averaged distribution of the idle hours of any or
all the machines in the shop.68
The supplementary rate was determined by taking the

pnndously mentioned debit balance and apreading it over

prmhmtion on the basis of machine hours actually expended

or'somewhat less accurately (according to Church), on the

bmfls of dollar amounts already distributed by the regular
69

HBdUhe rates. Since the general charges were part of

Um SIlpplementary rate, there was presumably a minimum

 

 

S"‘F’Plementary rate at all times. The rate did vary from
.__‘p~________
68
Church, The Proper Distribution pf Expense Burden,
3)" SE'I 59.

6
91bid., 60-61.

11'

46
'UUs minimum and in doing so it became according to Church
'8 useful barometer of conditions".70 The change in the
rate was due to variations in "commercial efficiency"
(state of trade) or, in other words, the utilization of
awnlable capacity strictly in terms of changes in production
wflume (capacity utilized). In addition, manufacturing
eificiency also affected the rate by mean of utilizing too
nmnylnachine hours in producing certain commodities or per—

lmps utilizing fewer machine hours than expected.
Limitations of the Supplementary Rate

If, as claimed by Church, the supplementary rate
waste become a "barometer of conditions" in the shop it had
mabe COnsidered a very general barometer, if anything, for
itSfluctuations up and down represented a number of factors
Whnfixcould be present in a wide variety of combinations.
flmme factors are as follows:

1) price level changes in the truly general

burden as well as real increases or de-
creases in the general burden.

2) the general burden which certainly was a

combination of fixed and variable costs,
and thus even with these costs alone the

~\__—

70
Ibid., 113.

47

supplementary rate would vary on the basis
of changes in production volume.

3) price level changes in the cost factors making
up the machine rates.

4) excessive or wasteful use of facilities.

5) exceptionally good use of facilities (exact
opposite of 4)

6) changes in volume based solely on differences
between the maximum capacity utilized in
setting machine rates and the actual capacity
utilized in terms of sales volume.

With all this in mind, it is quite obvious that
duuch's supplementary rate represents a ”hodge—podge" of
mameactors, and it is quite difficult to see how it could
rqflesent a fruitful ”barometer of conditions“. Church
adMited possible variations in the supplementary rate on
thb‘ - 71

e 3818 of items 4, 5, and 6 above, but he strongly
enli . , 72 . ,

i>aSlzed item 6. The mixture of these items (4, 5, and 6)
dimvt.seem to bother Church and it is not too difficult to
fimne out why. All of them (4, 5, and 6) involve efficiency
O3r9fficient utilization of capacity and in a true sense
rePI'ESent a "barometer of conditions“in the shop which ought

tote separated from other shop costs. Many people today

\—
71
lbid., 81.

72
Ibid., 80.

48
wouhilike to break down these portions of the supplementary
raUainto a volume variance and an efficiency variance, but
munch was content with the combination, although he admitted
that analysis of the combination might be useful.

In the new method, the state of trade or
the general efficiency of management affect the
supplementary rate alone, and a similar cost at
two different periods might, if analyzed, show
that what had been gained in method had been
neutralized by a fall in the volume of trade
by a muddled condition of shOp organization.

or

’73

Mr. Church did not mention items 1, 2, and 3, above
eidun because he didn't recognize them as problems, or he

feh:that their effect if any, would be immaterial.

O

The Prime Critic—~John Whitmore

 

The supplementary rate was well received as a real
mhmnce in the field of costing, but Church had one major
crude. John Whitmore took Church to task, not for isolating
theidle and misused capacity, but for taking this element
amiallocating it to production. Church and Whitmore appear
tolmve been in agreement as to the major purpose of their
effints, i. e., the identification and elimination of waste.
mWrst position in this respect was described fully in the

lastsection of this study; as for Whitmore's similar

K

73
Ibid., 81.

 

49

position, it was stated as follows:

The fundamental principle is always the

same namely, the principle of making a record

sufficiently full to constitute a clear accounting

for the factory expenditure; and the object of

the accounts is always the same, namely, to

eliminate waste from the operations. This then

may be said to be the purpose of all factory

accounting: to produce records in which waste

shall be plainly shown as waste.

Both Whitmore and Church were essentially in
mneement on the content of the supplementary rate with one
WUOI exception. Whitmore wanted to consider only idle
capacity; He did not want to include in his cost of idle
caPacity'the so-called truly general overhead which could
notsensibly be associated with individual production cen-
ters. Iflost important of all, Whitmore wanted to put the
lumts<3f idle capacity in a separate and conspicuous account
VTactory Capacity Idle"L and to treat this account as an
ex ens - - ' 75

P e or loss in the period it was accumulated.
Treating idle capacity costs as a loss is the real

dtfikrence between the positions of Church and Whitmore.

CWHTh Used the idle capacity costs plus the truly general

 

 

.\\———

Ma1y John Whitmore, "Factory Accounting As Applied to

24: me Sh°PS'" The Journal 91:: Accountancy. 11 (August, 1906),
75

Ibid., 257 and 31.

.w flufiuilflzl

SO
cwerhead as the subject of the supplementary rate which
allocated idle capacity costs to production. With Whitmore
tmere was no supplementary rate, but only a dollar amount
of Nile capacity costs which Whitmore wanted to treat as a
losszrather than a part of product cost.

Whitmore actually made quite clear the reasons for

Ins difference of opinion when he praised Church's scientific
rmmhine rate for leading to the exact statement of unused
cmmcity; Specific identification of unused capacity,
mebelieved, would lead ultimately to the utilization of

flum capacity by bringing into play two forces, viz.,

EU reiieving cost prices of a burden that does not
belong to them, thereby creating better con—
ditions commercially”

E4 and next by bringing into plain view the cost
of idle factory capacity, and making it possible
to trace its causes and to fix responsibility
for it and to secure earnest and well-directed

“efforts to remedy fig76
‘ f
Whitmore's reasons, then, for isolating the cost of

1dlecaPacity were to direct attention to it so that the
pHXESSeS tending toward its elimination might be instituted,
as“ell as to remove it from those cost figures used to

e . . .

Standsh selling prices. Church and Whitmore agreed on the

\—

7
6Ibid., 258.

51

primacy of waste elimination as such, but disagreed as to its
implementation. Whitmore's insistence on a unit cost free
of.ndle capacity costs was a turning point in the use of

cost figures for price determination purposes.

I

Churrh's Defense and The Demise of A Pricing Concept

In 1910 Church tried to defend his supplementary
rate, stating that idle capacity costs were distributed
<mmr production only because the significance of idle
cmpacity could be more easily recognized "than if it were
leftams an undistributed debit balance." Furthermore, he
Ummght the distribution brought the idle capacity to the
mnice of officials who had no access to the accounts.77

Church, in 1910, was trying to defend himself against
Mr.Whitmore's attack on his supplementary rate. The defense
considered only the implementation of ways and means to
idmujfy and eleminate waste. Church wanted to identify
waanby increasing unit costs through the application of
thesuPPlementary rate. Whitmore, however, wanted the costs
Ofidle capacity to be identified as a dollar figure deducted
hithe income statement.

\

77
Church, Production Factors, 0

 

z u . 733$!”

52

There is probably good reason to accept the sincerity

of Mr. Church's position, since it is already apparent that

hisrnajor emphasis was on identifying and eliminating waste.
Ontflua other hand, there is substantial evidence that Church

was:hnfluenced by the "selling price ideology" of the
runeteenmh century, 1. e., that whatever else is done, gyery
. , 78
mfllar of charges must be burdened onto some item of work.
In 1930 Church, in effect, admitted his attachment
Ubthe early sales price doctrine when he wrote, “At the time

fixquestion, nearly twenty years ago, the idea of separating

vested capacity (idle time) from.true cost of jobs was

mmirely'new and unfamiliar. . ."79' Therefore he believed

Umt it would not be desirable to depart from established

'WEQE.‘Which called for allocating all costs to units pro-

dllCEd- In addition to these comments Church also said in

l9fllthat he was quite surprised at the criticism leveled
xwinst the supplementary rate and the general recognition
thm:the costs of idle capacity were no part of true cost
and sh ° 80

OUld therefore be charged to profit and loss.

78

Church, The Proper Distribution pf Expense Burden,
99' 914 113.

79
Church, Overhead Expense, pp. 915., 383.

80 .
Ibid., 383.

 

53

One objectionable feature of Church's 1930 statements
is that.he referred to a period 20 years before 1930 which
nwans his comments must be judged (if Church's memory was
accurate in 1930) in the light of Church's later works,81

notliis earliest work.82 In his later works Church did

indicate that he believed.idle_capacity costs_were not part

83
Qijuaua_ggsts, but he did not establish this point in his

earliest work (1901 - The Proper Distribution 9f Expense
mnden) which was the subject of Mr. Whitmore's criticisms.
‘What probably happened was that Mr. Church slowly but
muely began to recognize Mr. Whitmore's criticisms, and at
Hm anne time began to lose his attachment to the selling
{Mice ideology which existed in his formative years. The
dwnge has almost complete by 1930,84 but in 1931 it was

1mmt certainly complete, for then Church referred to over-

hemias the cost of production preparedness, not of production.

“\—
81
See Footnotes 77 and 83.
82 -
See Footnote 78.
83

Alexander Hamilton Church, "The Meaning of Scientific
Management," The Engineering Magazine, XLI (April, 1911), 101.
84
flat See Footnotes 80 and 81. The point at issue here is
oftreVen though admitting the supplementary rate is no part
armmfe cost, Church immediately utilizes a selling price
ent (l930)to justify the use of the supplementary rate

(p'384). Note that Professor Garner (pp. cit., 243) considers

54
The cost of production preparedness could be used or wasted,
Tm believed, if utilized it became part of the product cost,
and if unutilized it became a direct charge to income as a
fonn of waste. In 1931 Church didn't even mention the

85
supplementary rate.

In conjunction with Church's original attachment to
the<>ld selling price principle that all costs had to be
recovered or included in selling prices, it is interesting
u>note that Whitmore used sales price determination as one
dfhis reasons for not spreading idle capacity costs over

Pmflucts. It is hard to imagine any other explanation for

nus statement:

This it does first by relieving cost prices
of a burden that does not belong to them, thereby

86
creating immediately a better condition commercially.

N

this change in view on the part of Church as basically
asample matter involving the double entry framework wherein
thesubJect of the supplementary rate becomes a cost of pro—

dm“3(a balance sheet item) or a loss (an income statement
item .

 

85
d . A. Hamilton Church, “Overhead——The Cost of Pro—
fixilon Preparedness," Factory and Industrial Management,
XXXI (January,1931), 4o.

86

She Whitmore, "Factory Accounting As Applied to Machine
1:33.93. _c_i_t_., 258. Garner (92. gi_t_., 219) and Brummet
$L£m2£§., 19) both seem to be under the impression that
pan;0re agreed with Church in making idle capacity cost a
of product costs via the supplementary rate.

'~ .v

55

Whitmore thus was one of the first, if not the first, to
consider elimination of idle capacity from product costs on

thelaasis of its inapplicability to the determination of a

fair and commercially feasible price.

Summary

The ”supplementary rate“ of Alexander Hamilton Church
flmused attention on the problems of idle capacity costs,
evmiiflnough Church's supplementary rate included costs
odmr than idle capacity costs. The major use of the ”rate"
mas as a "barometer of efficiency" in that changes in the
'Tate" supposedly indicated similar changes in efficiency.
Actually, the "rate" was a very crude measure of
efficiency at best in that there were a number of factors,
hmluding commercial efficiency (sales volume) and technical
Efffiflency, that could occur in an infinite number of combi—
naflflnS. When Whitmore came along, he pointed out that he
wasinterested only in the costs of idle capacity. He
‘nfihEd to show this waste as waste in order that steps might
betaken to eliminate it. Whitmore then, changed the
'banmfiter—of—efficiency" idea to a dollar measure of waste.

In order to show the waste more clearly Whitmore

d' .
Minot want to allocate it to production (via the supplementary

rate). nor in addition, did he want the waste to be included
in product costs used as a basis for price determination.
This idea was fundamentally new and showed clearly a change
frmn a system wherein all costs were utilized to build up
selling prices, to a system which emphasized an efficient
cost, without such waste, as the foundation of a fair and
cmmmarcially feasible price. Whitmore's idea of costs for
sales price determination is quite prominent in the overhead
mmemes usually associated with H. L. Gantt and many others.

'flm next section will consider these concepts in detail.

The Sequel to the Supplementary Rate

The Ideas of H. L. Gantt

Genera 1

Church‘s supplementary rate not only stirred up a
sneat deal of controversy, but it also shifted a number of
paxfle into new lines of thought concerning the treatment
Ofidle capacity costs. Idle capacity came to be considered
asa-measure of unutilized fixed costs of equipment and its
Inkeep, or else as a measure of unutilized overhead costs,
asamung that only variable overhead costs vary directly
WithProduction, which is in effect the same idea.

Prominent among these people was H. L. Gantt, who

57

in 1915 expressed the opinion that:

When a plan is operating at less than its
full capacity, it is quite evident that the
expense of maintaining a certain portion of
the plant in idleness must be borne somehow.
The old theory that it must be borne as a part
of the cost of the articles produced is rapidly
giving way to the theory that it is a business

expense and not chargeable to the articles pro—
duced.

In the same year he stated his general principle

CWKEIrning the relation between production and fixed costs-

The indirect expense chargeable to the out—
put of a factory bears the same ratio to the
indirect expense necessary to run the factory at
normal capacity, as the output in question bears
to the normal output of the factory.

Gantt was certainly not the first one to express
fimse \uews, but he was undoubtedly the best—known and most
hkely'to be listened to in business circles at that time.
.Rmn MHUtmore actually expressed Gantt's general principle
hil906, when he quantified idle time in terms of the
(hiference between the time each machine was used and the

tmm or hours used to measure the capacity of each machine.

\fi.

87
Ifibf't 'H. L. Gantt, "The Effect of Idle Time on Costs and
80.1 S.’ Annals g; the American Academy Q: Politigal and
~$flfli Science, xLI (September, 1915), 87.

88 .
(kmts " H. L. Gantt, "The Relation Between Production and

' Transactions 9f the American Society of Meghgnigal

rs. XXXVII (June, 1915 Meeting) 112.

 

En inee

firJ
.. f w. -.

58

The idle time was multipled by the machine rate and, in
effect, produced the same answer Gantt did for the cost of
idle capacity.89 In 1908 P. J. Darlington expressed the
same thought when he emphasized the expense character of
idle capacity costs.

C. H. Scovell, in an article published in 1914,
agreed'Wholeheartedly, He believed the scientific machine
hour rate was the greatest coSting advance in a generation
since it yielded more precision in burden accounting, in
addition to having the ability to make an "accurate measure"
of loss due to slack production or interrupted operation.91

An interesting side—issue at this point is that
(mutt apparently had not developed this point of view in his
earlier years. In 1897 at the annual meeting of the
Mmuican Society of Mechanical Engineers Gantt made no men—
tnxiof the issue of idle time in a discussion of a
Sumation in which it most certainly fitted, that is, how to
\fi—

89

Whitmore, 92. cit., 28.

90
P. J. Darlington, "The Fundamental Principles of

2:11;“ Organization and Management, " The Engineering Magazine:
V (April, 1908). 65.

Clinton H. Scovell, "Cost Accounting Practice With
Acmg Reference to the Machine Hour Rate," The Journal 9:
M. XVII (January, 1914), 13-27.

Special

 

59
set a burden rate fOr a tool running only one tenth of the

time.92

Factors Influencing Gantt: Sales Price Determination
Mr. Gantt and his contemporaries seem to have been

influenced in their ideas by three considerations:

1. The necessity for arriving at selling prices.

2. PrOblems concerning the measurement of operating
efficiency.

3. The social prdblems concerning labor and capital.

In 1915 Mr. Gantt criticized the widely-held view
'what the product of a factory, however small, must bear
..93 . .
Hm total expense, however large, as being responSIble
flu much of the confusion about costs which led to unsound
luminess policies. The fact that he was referring to
Enicing decisions was made quite clear when he said
Our cost systems, as generally operated at
present, show under such conditions that our
‘costs are high and, if business is very bad, they
usually show us a cost far greater than the amount
we can get for the goods. In other words, our

present systems of cost acggunting go to pieces
When they are most needed.

\\
92
Lane, 99. cit., 897.
93
C H. L. Gantt, "The Relation Between Production and
Osts," 5&3. ci ., 113.’
94
l2;g.. 110

60
Sir Arthur Lowes Dickinson, eminent English accountant,
was also concerned about the then prevailing point of view
when he wrote that idle capacity costs must be provided for,
but that it would be better to charge them to profit and
loss in order not to inflate product costs which might lead
to further restriction of production ". . .on the ground
that product can no longer be sold at a profit."95
All of these men seemed to be aiming to destroy the
concept described by Alexander Hamilton Church in his
earlier years (and later abandoned) as one of the most

serious canons of "modern theory and practice", that is,

vmatever else is done, "every dollar 92 charges must be

 

96
Efiflened onto some item of work." There is also very little

dmmt that Mr. Church's final capitulation to the new view97

wmsan indication of his inability to withstand the more

fimceful arguments of his contemporaries.

It is interesting to note, again, that Church used
hisidea of absorbing idle capacity costs in products to

\—
95
amiAb Sir Arthur Lowes Dickinson, "The Construction, Use,
use of Cost Accounts," The Journal 9; Accountancy,
m" (July. 1927), 10.
96
See Footnote 78.

 

97 '
See FootnotesB4 and 85.

61

promote the sales price doctrine of his youth, that is, sales
must cover all costs. On the other hand, Gantt and the
others considered in this section used the idea of a profit
and loss charge for unused capacity costs to determine a
fairer and more realistically competitive price. This change
should pinpoint one major effect of competition on cost
accounting theory and practice, that is, the change from

full cost pricing to compétitive cost pricing.

Factors Influencing Gantt: Measurement of Operating Efficiengy
The View of overhead which emphasizes the measurement
Cfi'operational efficiency is an outgrowth of the "scientific
management" movement. In this case the treatment of idle
facility costs is exactly the same as when a competitive
Fmice setting standard is paramount. Only the basic purpose
Inderlying the treatment is different. Gantt published his
bem:statement on idle facility cosfisand measuring operating
eflfi£iency only a few years after the articles quoted in the
anmeding section. To him, production costs should vary
mfly aS‘methods. wages, cost of raw materials and efficiency
ofc’Peration change. Costs of production should be separated

f .
romcaPltal charges, special repairs, and cost f idle

m.

 

 

"Under such conditions, with a definite method and

62
known wage rates and cost of raw materials, the cost of the
manufactured article is an indication of the efficiency with
vflflch the methodsof manufacture were operated."98 G. Charter
Harrison agreed when in 1919, he said that combining the
costs of production and the costs of idleness ". . .absolutely
kills the value of cost statements considered as indices of
Operating efficiencyfl9

An earlier similar statement by William E. McHenry

is so revealing that it must be quoted. McHenry wrote that

ordinary cost systems are:

a combined result of the cost of doing those

things which they ought 39 have done, plus the cost
of doing those things which they ought g9; 39 hgyg
done, and worse still, with algég mixture of the
cost 2: not doing anything!!! ‘

 

 

Gantt and Harrison are quite clear in their desire to
EseParate idle facility costs from other manufacturing costs
hlorder to utilize the actual costs of manufacturing as a
I“erasure of operating efficiency. Thereby it is possible to
\—

98
H. O. Gantt, "The Basis of Manufacturing Costs,"

 

 

lEEEEEIQI Management, LIII (June, 1917), 369.
99
I d G. Charter Harrison, "Cost Accounting in the 'New
nrmtrial Day'," Industrial Management. LVIII (December,
1919). 443
100
The William E. McHenry, "Is Your Cost System Scientific,”

W Magazine, LI (August, 1916), 678.

c.

’ 63
compare the actual costs of producing units in one period
with snnilar costs in another period in order to see if
progress has or has not been made. On the other hand,
McHenry, even though stressing idle facility costs, seemed
to want to go further and break the actual costs of manu—
facturing into costs that were prOperly incurred and costs
that were improperly incurred, i. e., the costs of inefficiency
or waste in production. One point is clear, though; all of
these men were interested in having idle capacity costs
identified very plainly so that managerial attention would
be directed toward a large item of expense that should and
could be reduced.

Church was essentially in agreement with these men in
trYing to measure efficiency. The major difference was that
munch combined in one category the costs of idle capacity,
mmm of the costs of manufacturing inefficiencies (he did
run consider that machine hours could be saved or wasted),-
amithe general overhead, but he admitted that breakdowns
ofthe supplementary rate would be fruitful.101 There is no
dmflt that these men added to the structure for which Church

lanithe Cornerstone.

ai~§__________
101 .
See Footnote 74.

64

Factors Influencing Gantt: The Social Problems Concerning
Labor and Capital

The last consideration which influenced Mr. Gantt
was the social prdblem concerning labor and capital. He
believed idle plant was an executive—caused waste and, like
idle labor, did not deserve to be paid for by the consumer.
The loading of idle plant costs on products produced he felt
to be fundamentally false. "It is based on the theory that
invested money must return profit, or interest, whether it is
used productively or not."102

Mr. Gantt further mentioned his fear about the
rapidly rising industrial unrest and said:

It is on this account that I say that a
recognitioncfifthe expense of idleness and the
allocation of this expense to those who are
regponsible for it, is the most important
economic fact that has been brought to the
gttention of the business world for many years.103
Problems concerning the conflict between labor and

Capital seem to permeate Mr. Gantt's cost accounting dis—

mumions. Perhaps all of his conclusions on idle facility

____‘__________
10
th 2H. L. Gantt, "Influence of Executives," Annals gf
\e mail My g_f_ Political and Social Science,
(September, 1919), 259.
103
Ibid., 262.

‘7

65
costs were the result of the labor-capital conflict.
Illustrative of Gantt's concern about these social issues
are his concluding remarks to the American Society of
NEchanical Engineers on the subject of "Production and Costs".
This address in 1915 was Mr. Gantt's first on the subject
of idle facility costs. He concluded that all efforts should
be directed towards worthwhile or beneficial actions to
help promote industrial tranquility.104 He added, with

specific reference to cost accounting:

a combination of properly directed efficiency
and proper cost methods are absolutely essential

to the solution of our industrial problems, and the
hopeful thing about the newer ideas of cost keeping
is that they point the way of measuring not only
the efficiency of the workman but that of the
manager and of the financier.105

$mmary

Gantt's ideas have come down to the present day in two
major fonns. The first group includes those factors which
Camern measures of operating efficiency, and waste identi—

fnmtion and elimination. This group will be considered

laufl'in this chapter under the title, "Cost Control and

fluaDevelopment of Overhead Costing." The second group
X
104 ' .
CO H H. L. Gantt. "The Relation Between Production and
Sts' 92. c t., 128.
10
lbid.

.
-—-¥"-' '

66
includes those factors concerning the measurement of capacity
which is the key to the determination of utilized and unutilized
capacity for purposes of income measurement. Capacity measure-

ment is to be considered in the next section of this chapter.
Capacity Measurement

The methods of meaSuring capacity, for segregating
utilized and unutilized capacity costs, fall into three
categories:

(1) the normal overhead concept——based fundamentally
on selling price ideology. -

(2) the cycle overhead concept——based on the selling
Price idea of the normal overhead concept and some added
features of income measurement.

‘7 (3) the practical capacity concept——based on the
or{ginal capacity ideas of Church, Whitmore, and Gantt-—
whN31 yields the idle capacity measure in its purest form.

The last two seem to be the minority.poSitions, and

Hwy Will be treated as exceptions to the more prevalent

rlonmal overhead concept" in the f01lowing pages.

The Normal Overhead Concept

Ge
46.er

The normal overhead concept is an outgrowth of the

Sel'
llng Price ideology, which states in effect that the

67
cost of idle capacity should not be included in those cost
figures utilized as the foundation of selling prices. Another
influence on overhead theorizing which seems to have been
quite important was the incidence of depression. The writings
on the normal overhead concept were quite prominent in the
early 1920's and again during the 1930's, a time when the
spectre of depression hovered like a grey shadow over the
United States and most of the international commercial

world.

Early Literature

C. B. Williams recognized all of these influences in
two appropriately-titled articles published in 1921.106 He
shmmed how the abnormal year 1920 pointed up the problem of
"h§Posing of overhead during below—normal production, and
advOcatedthat the business cycle be used as the basis for
€u10cating overhead by defining "normal period" as including
a cmmplete cycle of normal, below normal, and above normal
mmivity. He believed that doing this would result in an
hmmme statement showing normal profits plus or minus over-

or . . . .
under-capaCIty gains or losses. Williams also considered

an! .' _ ‘
Cycle treatment of overhead, pOInting out the limitations

\—
1065
See Footnotes 107 and 108.

___1'

 

68

of months and years as accounting periods, and the possibility
in some circumstances of treating an underabsorbed overhead
as a deferred charge to be offset by overabsorbed overhead
in future periods. He did not make any mention of deferred
credit treatment for gyggabsorbed overhead.107

In his second article, six months later, Williams
dropped the cycle concept: instead he spoke of "true cost"
as the cost obtained under a normal volume of production
Which considered quite specifically under—and over—normal
Production. Underabsorbed overhead produced a special idle
caPacity expense, while overabsorbed overhead produced a
Special gain derived from more intensive use of fixed cost
inPuts. Williams then completed the normal overhead concept
Pattern by invoking the normal cost concept and its relation
to lorig—term pricing as a major advantage.108

In 1922 Stanley Fitch presented the same conclusions

' . 109 .
mtWO articles. Jordan and Harris also agreed, in their

\—.

107
mxmi .C. B Williams, "Treatment of Overhead When Pro—

OH 18 Below Normal," The Journal 9; Accountancy, XXXI

WY: 1921), 336—42.

108 . .

‘erh1 C. B. Williams, "Treatment of Costs During Periods of
9 volumes of Production," The_gournal of Accountancy,

II (November, 1921), 321-33. '—

 

9
Stanley CL H. Fitch, "Deflation in Relation to Cost

ACCOunt in u
g, The Journal of Accountancy, XXXIII (January, 1922),

l~ll, ._____.__ ___

 

I

.____..

4

69
text published in 1920.
Burden rates should be standard or normal,

1. e., they should bebased on burden costs which

occur when production is standard or normal.

Furthermore proper selling prices cannot be

fixed without standard burden rates. The price,

no doubt, would be too high or too low. The

use of a standard or average rate, however, is 110

equitable for both estimating and cost purposes.

In 1925, at the Annual Meeting of the National
Asmociation of Cost Accountants, a vote was taken of favored
Hmthods of determining capacity for purposes of overhead
allocation. Of the 59 people in attendance, 50 were in favor
CK capacity determined on the basis of a cycle of sales
fbrecasts so that all burden would be absorbed over the
CYcle. Those voting admitted that they would be including,
lmder their suggestion, the costs of idleness in product
costs. and they used to support their opinions the argu—
Hmnts (usual at that time) for sales price determination.
Eflght participants were in favor of using a practical

erating capacity, that is, maximum theoretical capacity

Imnus estimated unavoidable delays.

 

 

\
Mnm Stanley G. H. Fitch,'"Present-day PrOblems in Industrial
I‘louhting," The Journal gf Accountancy, XXXIV (July. 1922).

110

\I. - .
(New York. P. Jordon and Gould L. Harris, Cost Accounting

The Ronald Press Co., 1920), 222.

 

70

Only one person voted for the use of expected actual pro—

duction for the year for purposes of allocating overhead.lll

During the 1930's, another depression period, the
same use of a normal capacity concept was considered, with
a special tiein to the long-run average basic price. J. H.
March wrote that one of the foremost objectives of standard

costs was to indicate a normal cost as a guide in setting

sales prices.112 Wyman P. Fiske in effect agreed with

this, for he stated that normal idle time (seasonal and
cyclical) should be included in product costs. He based
his conclusions on the "economic principle of normal prices"

and held that prices must include normal idleness in order

t0 insure business continuity.113

Charles Reitel also agreed when he wrote:

In other words, our expected normal capacity
should be an interpretation of our sales over quite
a long-time: trend, and if our sales expectancy
represents 80 per cent or 75 per cent of our plant
capacity, I vote for that rather than the maximum

3

.‘__________*__

1
“1 Discussion, "Some Debatable Points in Cost Accounting
eonYo",§ational Association pf Cost Accountants'Yearbook,
£225. 187-3,

Shall {1:2 H. March, "In Establishing The Budget for Burden
DWERe Ornm_' CapaCIty Be Set For Each Department by 1) Giving
OutRegar'd to the Capacities of Related Departments; or 2) With-
attmegzrxi to Other Departments; or 3) With All Departments Set
Accountaame Arbitrary Level?, " National Association 9; Cost
~“‘*~~5!E§'Yearbook 1946, 176.

13
“UNman P. Fiske, "Accounting for Unused Facilit
, 3

N'A-C
M-Aulletin, XIII. Sec. 1. (November 15. 1931)
¥

ies",
63.

71

plant capacity as Set up by our equipment and our
buiidings.1l4

Finally, C. E. Knoeppel, a contemporary of most of
the authorities thus far mentioned, was quite lucid about
how sales price determination was the key to the normal
overhead concept when he wrote:

The idea behind this device at that time

“Esthat a true cost from which a really competitive

price could be determined would be at a normal or

average use of the plant facilities, and that any
variations in volume above or below this normal

or average point influenced the profit and loss

account and not the cost of theproduct.115
antemporary Literature

The idea of normal capacity which caught on in de-
pression periods has come down even to the present day, as
is indicated by the following comments.

Ellis Sowell, in his doctoral dissertation, concluded

that‘tnormal capacity was the predominant capacity measure at

. 116
He the he completed his study (1944). Major sources

114
Charles Reitell, "The Standard Cost Plan for the

 

 

 

 

Saca Company," National Association g: Cost Accountants'Year—
4¥$:£22l, 43.

115
Prof‘ C. E Knoeppel and Edgar E. Seybold, Managjngrfnr
-ei£ (Neerbrk: McGraw—Hill Book Co., Inc., 1937), 176.

116
and -Ellis Mast Sowell, The Evolution 9f the Theories
\

 

“HM g_f_ Standard Costs, Unpublished Ph.D. disser—
n, The University of Texas, 1944, 294.

9

72
of data leading him to this conclusion were two studies
conducted.by the National Association of Cost Accountants.

In both cases normal capacity was the predominant capacity

measure among over four hundred companies contacted.117

The emphasis on cost and long—run selling prices hung
on persistently. In 1944 L. W. Downie stated;

Cost estimates are normally the foundation of
selling prices and unless normal capacity is used as
as basis, the price structure must necessarily be on
a false foundation that will tend eventually to des—
troy industry.

At the 1946 annual meeting of the National Association
CE Cost Accountants, H. T. McAnly came to the same con—
. 119 , .
cluelon. Verne Breitenbucher at the 1946 meeting also
agreed; he related the normal capacity idea to a business
CYcle and said the fixed element of overhead costs should be

absorbed on the basis of "this average normal or standard

117
N.A.C.A. Research Study "Practice in Applying Over—

lmad and.Calculating Normal Capacity," N.A.C.A. Bulletin

XIX. Sec. 3.(April 1, 1938), 917-32. '
N.A.C.A. Research Study, "Accounting for Excess

Labor Costs and Overhead Under Conditions of Increased Pro-

1:221:11". n,A,C,A. Bulletin, XXII, Sec. 3. (August 15, 1941),

 

118
L. W. Downie, "Normal Capacity and Its Uses",

N.
M. Bulletin’XXVI, Sec. l.(September 1, 1944), 5.
1419

 

FOrI> . H. T. McAnly, "Putting Cost Accounting to Work——
ASSOCFOff-t Determination and Inventory Valuation," National
111.3333122 22 Cost Accountants'Yearbook 1946, 133.

73

volume," and his reason for saying this seemed to be ". ..no

company can expect to recover in the selling price the excess

cost due to the retention of idle capacity."120

The 1948 standard cost research series of the National
Association of Cost Accountants shows without doubt that the
normal overhead concept was predominant in a study of 72
industrial concerns. This predominance was revealed in the
following quotation from the National Association of Cost
Accountants published study report.

The Standard overhead rate is usually based

upon a volume of production which is intended to

provide for recovery of overhead costs over a

period of years. Used for costing production it

avoids the disturbing effect of fluctuations in

production volume which tend to increase unit costs
in periods of low activity and to decrease unit

costs in periods of high activity.

T. R. Torian, writing in 1951, also was in favor of
the.norhe1 capacity concept which he defined as the level of

Mfiivity whidh, over a long period of time, tends to effect

abalance between production and sales. "It serves as a

X

120
Wolt Verne Breitenbucher, "Putting Cost Accounting to
I“"F‘OI‘Cost Control,” National Association 9; Cost

W‘ Yearbook 1946, 105.

 

121
Yoflp 52— §E§£QE£Q.QQ§E§ Are Being Used Currently (New
. Natiional Association of Cost Accountants, 1950), 60.

Lg!

74

measure of the general activity level which has been, or is

expected to be, the average or norm for the company."122

Summary

Even though the normal capacity concept had its roots
in the "supplementary rate”, it involves a decidedly different
point of view. The supplementary rate had as its objective
the measurement of waste or inefficiency. The same objective
led to the modifications of John Whitmore, H. L. Gantt, and
others. The capacity measure utilized was a theoretical
meimum.with or-without allowances for unavoidable delays.

In such cases, especially where allowances for unavoidable
deLays were made, a fairly accurate measure of idle capacity
was Obtained. In addition, according to Whitmore and Gantt,
sales prices were to be based only on capacity actually
IKilized, a factor which both of these men considered quite
in1POrtant.

The normal capacity approach does not yield a measure
QEidle capacity and it is based on a long-run average basic
Rfice COncept. The reasoning behind this seems to be wrapped
“Pin a depression psychology, wherein the cost figures

ut"
ilizeci for long-range pricing are not to be influenced by

\—

122
f0r1; Thomas R. Torian, "Measuring Activity and Capacity

161, he Buclget," N.A.C.A. Bulletin, XXXIII. Sec. l.(October, 1951),

the seasonal or cyclical nature of business conditions.

Normal capacity treatment doesn't yield a measure of idle
capacity, since it is based on a policy wherein all over—
head is to be recovered in selling prices over a long period
of time. In such a case the difference between utilized
capacity and normal capacity represents either costs re-
covered in this period and not to be recovered in the future
haverabsorbed fixed overhead), or costs not recovered in
this period which are to be recovered in future periods
huuierabsorbed fixed burden). This is not admitted by the
abnocates of normal capacity, except insofar as they admit
that11a basic long—run average selling price is the key to
their’.normal capacity concept. Most of the advocates of
noI‘ma]. capacity like to think of over— or under-absorbed
tmrden as a special gain or loss due to volume being in
amass; of or less than normal. It is unfortunate that this
'13 truee, for it presents a situation wherein academic and
pr-‘."‘3tiC=ing accountants do not understand the true rational
fimmdathDns and practical implications of some of their
aMflied, Cxost'keeping. The only treatment of overabsorbed
and underabsorbed overhead that ' ' ' —

is conSIStent with the long
rmisell-ilag price foundation of the normal ca '

pac1ty concept

is the
(asiferred charge and deferred credit treatment used

76

under the cycle capacity concept.

The Cycle Overhead Concept

General

In a sense the cycle overhead concept is the normal
overhead concept carried to its logical conclusion. The
difference between the two is that those favoring the normal
overhead concept base their ideas primarily on a long—range
average basic price concept, while those favoring the cycle
mmncept base their ideas primarily on a cycle concept of
inccnne measurement which springs from three factors:

1) a feeling that the business cycle is more

appropriate than a year for purposes of income

measurement.

2) the sales price ideas inherent in the normal
overhead concept.

3) a crude semblance of financial policies attempting
to provide for lean years in the years of plenty.

1&11 of these factors are not specifically mentioned
by Uuasee advocating the cycle concept, but there is no doubt
t
1latall of these factors are at least implicit in most of

the dis Cussions .

E .
arl L1 terature

one of the earliest mentions of these ideas occurred

in 19 .
01 111 an article by David Cowan. Cowan, after

if,

"'t—“e—A’fl

77

discussing the then current methods of allocating ”oncost"
(the English equivalent of overhead) recommended an hourly
allocation basis and further added the cycle concept as

follows:

If this hour factor correctly represents the
variations during a representative cycle of years,
in these years of good trade, this account should
show a credit balance and in bad years, a debit

balance.1

By this he simply meant that his overhead rate would
be laased on an average for a cycle of years and that in
axjve—average years costs at the estimated hourly rate would
be 1J1 excess of actual costs. This excess was due simply to
Uua;fact that the cycle scheme would not allow decreasing
unit 1:osts, recognizing that the fixed element of overhead
“38 SEDread over more units. -In "T“ account form the results

would appear as follows:

______________
123
Wh David Cowan, "With Special Reference to Oncost
at 153 should Include: Its Allocations and Recovery," Th2

Wt. XXVII (November 16, 1901), 1251.
thdtk) An even earlier reference to the cycle problem is
Work" Y George L. Fowler, "Estimating the Cost of Foundry

En inéeT\ransactions _c_>_f_ the American Society 9__f_ Mechanical
m, Ix (May, 1888 Meeting), 390-397. In this address
mflmasi (Des refer to brisk, dull, and fair business but his
new-381: is not on the cycle overhead concept, but on the
mxmndi 3? for utilizing a different measure of capacity
(“fier t;:€! on whether business is brisk, dull or fair in

Eit all overhead costs might be assigned to product.

 

 

78

Manufacturing Overhead

 

Actual Applied Overhead Costs
Overhead (BaSed on Actual Hours
Costs multiplied by a cost

per hour absorbing the
fixed cost element not
in terms of actual vol-
ume but in terms of
average cycle volume).

 

In years of below-average volume the account would
shcnv a debit balance due to not recognizing increasing unit
costs on the basis of spreading fixed overhead costs over
fewer‘units.

Cowan actually doesn't follow through on the cycle
conceqat, for he suggests that business wouldn't allow a
débit laalance in the account to be treated as a deferred
(margfi (in effect an asset) in the balance sheet, and there-
flue Enach balances would be "cleared off as they arise by
Credit (derived-from Profit and Loss."124 In the case of

medit loalances (deferred credits) he states that they

should be allowed to remain therein as an equaliser of

Profits "125

.in,future years of bad trade.

\

124
Cowan, 9p. cit., 1252.

Ibid.

79

Cowan's final statements seem to be heavily influenced
by the ingrained conversatism characteristic of many
accountants. He states, in effect, that debit balances
should be treated as losses (reduce income) even though he
admits that good theory (in terms of the cycle concept)
'would demand a deferred charge treatment. On the other hand,
he Mmmld never consider credit balances as gains (increase
iJucome) although he admits their use as an equalizer of pro—
fits. In this case Cowan apparently returns to his cycle
mmncept, but'at the same time there is an implication of
unWilJJngness to face the facts concerning poor years
(equalizing profits).

Gersham Smith in 1909 brought into the cycle concept
the sauna sales price idea which is inherent in normal over—
.Tmad, He wrote about a buffer.working into the machine rate
‘3 COVner unforeseen expenses, and also to provide "a reserve
innOITnaltimes which could be drawn on in subnormal times,
and thus to keep the expense rate fairly even and not to
increase it as would otherwise be necessary at a time when
Costs can least afford the additional burden."126 In
addition to the ion - ' '

g run sales price foundation for overhead

\—

126
Gersham Smith, "Distributidn of Indirect Costs by

the _
(JunMachlne“H°ur MathOdW . The W Magazine. XXXVII
8‘ 1909), 391.

80
cost absorption, Smith also brings in the idea of providing
for the lean years.

Smith's idea of providing for lean years out of the
profits of good years doesn't seem to make much sense un—
less it is considered as a remnant of early thought on
financial statement preparation. Early financial statements
were prepared only to illustrate dividend—paying ability.
The provision for lean years is simply a matter of intro-
ducing an income figure averaged for each of the years of the
business cycle, so that stockholders would not demand or
expect excessive dividends in good years. The extra assets
earned in good years, but hidden by the averaging process,
are then available for dividends in poor years. The averaging
process also provides for those unforseen factors involved
in the vicissitudes of everyday business life.127

Gantt in his 1915 address to the American Society of
Mechanical Engineers also mentioned the cycle concept, but
he immediately expressed his dislike for it. He favored
the measurement of idle capacity costs, not the averaging of
such czosts over products produced.128 At least two persons

\—

127
A 1i Clinton H. Scovell, Cost Accounting and Burden
Cation (New York: D. Appleton and Co., 1916), 185-6.

128
C08,: 'H. L. Gantt, "The Relation Between Production and

S H
' 9.2. cit., 117.

81

Keppeler Hall,

129
recommended the cycle overhead concept in general terms.

in Gantt's audience disagreed with him. One,

The other, Ralph Flanders, stated his reasoning in very

forceful terms, as follows:

We are forced, unfortunately, to reckon with
cycles of boom and depression as one of the con-
ditions of doing business and this condition is
therefore a regular factor in the cost of pro—
duction, and should be so treated. . .There is
nothing like having all unavoidable expense firmly
imbedded in the cost figures, instead of rattling
around loose in the ledger.13

In this case Flanders gives the perfect argument for
usirng a business cycle as the period over which to measure
huxmne, and even though monthly or annual reports are issued
he iruiicates that the cycle should be preserved as the basis
0f inuzome measurement via the cycle overhead concept. Per-
haPS IPIanders was more specific as a supporter of the cycle
cmnceEJt when he stated the difference between his ideas and
those §>f Gantt. With respect to this he said:

The main difference between the two plans is

‘that with the average rate the burden of carrying

-idle equipment and organization through the dull

tlimes is distributed into the cost of work in good

tiimes, while the proportional rate takes it out of

‘tlle cost system entirely and charges it to profit
and loss . l 1

11:29

Ibid., 121
130

Ibid., 123
131

 

82

To Flanders, Gantt's system is not acceptable, for
he (Flanders) considers the cost of idle equipment and
organization as unavoidable costs resulting from business
cycles which are equally unavoidable. In a sense the
position of both men could be reconciled if it were
recognized that Flanders was interested in income measure—
ment, while Gantt was interested primarily in industrial
tranquility gained through identification and elimination
of wastes which were not to be included in costs utilized
as a foundation for selling prices. In addition, Gantt's
measure of idle capacity was based on practical capacity
(i.e. . theoretical maximum less unavoidable delays), while
Flanders' system produced under- and over—absorbed overhead
based on an average or cycle capacity which had absolutely
no relation to measures of idle capacity. In fact, the
pI‘aCtiCal capacity basis would rarely, if ever, produce an

over-absorbed burden, if handled properly.132

My Obj ectors

Tqiere were some early objectors to the cycle overhead
COn
Cgpt - Among them was William E. McHenry, who subscribed
l\“__~‘§“_____;
132
See Footnote 146.

 

83

to the Gantt position, and stated with reference to a

comparison of the two ideas that the proportional plan of
including in production costs only that portion of overhead

costs actually used had been before the public for several

years:

Yet it seems to be so little understood that
I have heard practical men, as well as professional
accountants, advocate a system whereby certain
percentages, determined from averages of several
years, are used, so that under full running con—
ditions a credit is established in the expense
fund upon which lean years may draw without
increasing the cost. And they also contend that
this is substantially the same as the principle

for which we are fighting!!!

The principle in McHenry's mind was that waste should

be recognized as waste and "that IT cosrs SOMETHING TO DO

NOTHING."134 The editor of The Accountant also objected to

the cynsle concept but for a different reason. He wrote,

It should be borne in mind that the goal to be
aimed at is not to level out all the results of a
,year or a series of years, so as to make them as
ianiform as possible, but to bring prominently before
‘the notice of those responsible the actual facts, by
110 means the least important of which would be that
VVith a full factory the cost of production is far
14283 than when the factory is half empty. This, how—
eVer, is a point which of necessity is glossed over
145 the standing expenses are to be averaged over the

‘\_'__

133
McHenry, op. cit., 686.
1:3
4mm” 678.

84

output of a comparatively long period.135

In this case the editor was certainly not in favor
(pf the cycle concept, but he was not yet considering the
cxancept of idle capacity except in the broad sense of
iJicreases and decreases in product costs depending on volume

'variations. His comments came before the many criticisms of

Cflhirch's supplementary rate.

Contemporary Literature

Among the earliest of the contemporary writers who

might.be considered is G. Charter Harrison. He presented a

136
very cmmcise but at the same time confused point of view

mxmxarning the cycle concept. He spoke first of segregating

theicost of idleness from cost of production for purposes of

meMMJring efficiency; He quantifies the cost of idleness
bYtRfl<ing the ratio of utilized to total plant capacity

and aPplying it to fixed manufacturing costs.

Iflith the utility and quantification of idle capacity

costs apparently settled, Harrison states

As regards this the author's opinion is that
the conservative and sensible policy to follow is
to remember during the fat years that lean years
are sure to follow, and to set aside out of the

i._____‘______
13

(J Editorial, "Cost Accounts," The Accountant, XXXII
“he 17. 1905), 729.

mkmld 136G» Charter Harrison, Standard Costs (New York: The
Press Co., 1930), 260-266.

 

85

profits of the prosperous years a reserve to which to
charge the cost of idleness during periods of de—
pression. It is just as inevitable that there will
be periods of business stagnation as it is that
equipment will ultimately have to be renewed and

it should seem equally correct to provide a reserve
for the former as for the latter.137

Thus far Harrison was speaking of measuring wasted
capacity in the same sense as Gantt (practical capacity)
ibut the wasted capacity was to be charged to reserves for
nileness created from large profits of prosperous years.
Finally, Harrison confused the issue entirely by switching
to a cycle overhead concept based purely on income measure—
ment: ideology. His exact words are as follows:

Now, if we consider earnings over periods of
years instead of by seasons or individual years, it
would be possible to eliminate largely the fluctuations
in profits owing to variations in the fixed charge
costs due to the peaks and valleys of production, and
to equalize these charges in a manner similar to that
followed by the steel manufacturer, who, instead of
charging the cost of relining furnaces to the cost
sheet of the month in which the work is done, sets up
a reserve for this expense by charging all production
at so much a ton.

In the short space of five pages139 Harrison switched

fumia \Nasted capacity measure based on practical capacity

.i‘____________
137
Ibid., 261.
138 ,
Ibid., 264.
139

Ibid., 260-265.

86
:for‘purposes of measuring efficiencies to a cycle overhead
cxancept for the purpose of recognizing income measurement
as; related to a business cycle. In between his consider-
a1:ion of these extremes, Harrison combined his wasted
cfiapacity measure with a profit equalization reserve. These
'vievm are hardly compatible unless they can be made com—
patible by the statement that different costs are used for
différent purposes. Different uses of cost data were not
rmuitioned by Harrison. In fact, after his statement on the
cycleeconcept, Harrison immediately reverted to a discussion
«Muzerning the separation of costs of production and costs
Of idleness. He never again considered the cycle concept.
On the heels of Harrison's work came an article by
J-CI. Beldon, a member of the cost accounting committee of
theNational Electrical Manufacturers Association,‘WhiCh
remwmnended a cycle type of treatment for overhead costs.
Behkni stated the views of the committee as follows:
the factor of variation in business today was
so great that it really would not give a true

picture of conditions and results to close out these

unabsorbed and overabsorbed overheads to profit and
loss each year.1

\
140
N.A.C.A.

-——-i Bulletin, XII, Sec. l.(July 15, 1931), 1829.

I

 

 

 

J. C. Beldon, "What Executives Need From Accountants,"

 

87

Beldon's comments seemed to be prompted by a de-

pressions psychology rather than strong theoretical foundations.

unie fact that his comments were written in the midst of
depression (1931) no doubt influenced his and the committees'
opinion.

-Howard E. Cooper spoke of the cycle concept in 1933

strictly in terms of income measurement, as did Downie in

41
1944.1 Downie, though, changed his mind when he spoke of

the difficulty of calculating the cyclical average, and
stated that all variances should be included as specific

items inthe cost of goods sold section in the income state-

ment. This he called the conservative approach which he

142
felt would reflect a proper balance sheet at all times.

An interesting point in Downie's approach is that
he made quite clear the relation of the cycle concept to
selling prices when he spoke of normal or cyclical overhead

repreSenting all the burden costs with which production should

be Charged. His reason was that the averaged overhead costs

\h

Howard E. Cooper, "Some Controversial Phases of

Standard Costs," N.A.C.A. Bulletin, xv. Sec. 1. (September 15'
1933), 100.

L. W. Downie, pp. cit., 9.

14
2Ibid.

 

.7..- "W

88
.represent all the burden costs that the sales depart—

ment could sell."143

Mauriello, in 1954, also used the cycle concept as a
scalution to the ”direct costing" assertion that "absorption
cx:sting" was afflicted with the nonsensical problems of
Exroduction volume affecting income.144

Theodore Lang, a prominent cost accounting authority
summmarized the cycle concept fairly well when he wrote of
lengthening the time period for which the overhead rate
was calculated. This lengthening, he said, gave an average

rate “mich smoothed thexnonaviolent fluctuations in costs

due t£>seasona1 and cyclical causes. He added, in a comment

whicfli actually covered the normal and cycle capacity concepts,

that "this new idea carried the definite implication that

acuual costs were not real, that the true cost of the product

involved overhead at normal capacity."145

Eflflsryg

As in the case of the normal capacity concept, the

 

__~‘_§_________
143
Ibid., 9.
144 . .. - - - -
C Joseph A. Mauriello, Convertibility of Direct and
onwartional Costing," N.A.C.A. Bulletin,xxxv, Sec. l.(March,
145

N. .
—JL21§. Bulletin, XXVIII, Sec. 1.(Ju1y 15, 1947), 1388.

Theodore Lang, "Concepts of Cost, Past and Present,"

-.‘.

if“.

 

 

89
cycle overhead concept involves a decidedly different point
of view from that employed in the supplementary rate. The
supplementary rate, even with the modifications of Gantt
and Whitmore, was intended to focus attention on waste or
inefficiency. This is not true of the cycle capacity con-
cept.

The cycle capacity concept has wrapped up in it the
sales price ideology‘of the normal capacity concept as well
as some crude semblance of dividend policy related to
averaging income over the cycle in such a way that the extra
profits of good yearslwill be hidden and held over for the
lean years. In addition to these ideas, however, the primary
motive of the cycle concept must be considered—~that is, the
idea that the business cycle. is more appropriate than a year
for purposes of income measurement. Even though monthly,
quarterly, or annual statements are prepared, the cycle con—
cept would be preserved via the absorption or averaging of
fixed costs over the Cycle.

The difference between capacity utilized and maximum
caPaCity with or without allowance for unavoidable delay
does result in-a fair measure of idle capacity costs or waste,
b“ the difference between capacity utilized and a cyclical

normal" capacity represents something entirely different.

90
In fact, under the cycle capacity concept there can be no
idle capacity; in the sense of a loss, in that fluctuations
in volume are expected or unavoidable. Underabsorbed fixed
overhead represents a deferred charge or cost applicable
to the future while underabsorbed fixed overhead represents

a deferred credit or provision for future costs.

The Practical Capacity Concept
General

Allocating overhead to product on the basis of
practical capacity is actually the logical outgrowth of the
"supplementary rate". In this case a true measure of un-
utilized capacity is determined, for practical capacity
represents maximum attainable output in strict physical terms
Without the recognition of the sales factor which is found
in the normal or the cycle capacity concept.

The difference between maximum attainable output and
aCtHall output pinpoints the costs of unutilized capacity.
The a'Ctual dollar amount of unutilized capacity costs is
dete‘l‘fmzlned by taking the ratio of utilized to practical
Capacity and applying it to fixed costs. An approximation
of this calculation is made when fixed and variable costs

are included in one overhead rate based on practical capacity.

91

If it is assumed that variable costs are directly variable
Vvith output there should be no quantitative difference between
the amounts determined by both methods.

An important consideration in the case of practical
capacity is that it would not allow the possibility of a

' 146

credit volume variance. . This is true, since practical
capacity is maximum attainable capacity in a strict physical
sense, and a credit volume variance demands in the case of
practical. capacity a volume higher than maximum attainable
capacity--an impossible situation. The credit volume variance
is a necessary part of normal or cycle overhead or any over—

head measurement base which is less than practical capacity.

Chu

 

rch, WhitmoreL and Gantt and Practical Capacity

Church, as previously mentioned, worked with the idea
0f maximum capacity under the most favorable circumstances.147
It Could be insisted that Church's mention of the most

\
146
the One exception to this would be a situation wherein
o uhavoidable delay computation included in the determination
an Practical capacity was in excess of the amount needed in
tey Period for such things as employees personal time, main-
nance and other expected downtime.

147

Church, The Proper Distribution 9; Expense Burden,
9321;” 85.

 

92
.favorable circumstances is the same thing as the unavoidable
(ielay allowed for in practical capacity. On the other hand
'unost favorable conditions" could be taken to mean an "ideal"
(:apacity which did not allow for unavoidable delays. It
(does seem, though, that Church was really in favor of
practical capacity.

Whitmore, however, was clearly in favor of practical
capacity, for he wrote of full capacity under normal work
cxnuditions with allowances for unavoidable lost time.148
Gantlzalso seemed to favor practical capacity, for there is
m: other reasonable interpretation of his usual comments
about the factory running at full or normal capacity and the

. _ 149
waste due to idle facilities.

993%: writers and Practitioners and Practice Capacity

At the 1924 National Association of Cost Accountants
A“mail-Meeting in a discussion concerning debatable points
in<3k5t accounting there were some who spoke in favor of
praCtiCLal capacity and stated that commercial conditions

\—

148
Whitmore, "Factory Accounting As Applied to Machine
22. cit., 439.

149 .
. Gantt, "The Relation Between Production and Costs,”
QE-Clt, 117.

I“. '

Shops ' II

93
. . . 150
should never affect capac1ty determination. At the same
meeting Howard Knapp, when speaking in favor of practical
capacity, said that expected output is not to be considered
. . . . 151
in determining capac1ty, and then added:
When burden rates are planned on the basis
of probably business obtainable, the accounting
does not determine the cost of unused space and
equipment, a mostlggportant item in any state-
ment of earnings.
Knapp's comments point out that only practical
capacity measures the cost of unutilized facilities. This
_ .- . . 153
mmne pOint is made quite clear by Frank B. Wolfe in 1927.
After 1927 practical capacity doesn't seem to have been
considered too much in cost accounting literature. This is
Pethaps due to the fact that the greatest business depression

hlliistory came upon the scene and gave great impetus to the

nonmal overhead concept, which seems to have become the

Discussion, "Some Debatable Points in Cost
Accountzing Theory," National Association 9; Cost Accountants'
Yearbook, 1924, 266-9.

151

 

St C. Howard Knapp, "Variation From Predetermined
Asandérds of Burden in Manufacturing Costs," National
tJflfifiéiigygg.é§ Cost Accountants'Yearbook, 1924, 210.

152

 

Ibid., 217.

duct Frank 8' Wolfe, "Providing a Check on Unused Pro-
Ind ion capacity; Accounting for the Cost of Idle Plant,"
M Management, LXXIV (November, 1927), 305-9,

 

 

94
predominant form of capacity measure utilized for allocating

overhead costs.

_§ome Special Problems: Categories of Machines or Capacity
Church and Whitmore, in addition to working with
practical capacity, also considered machines purchased for
occasional or special use. Church's relevant comments were
as follows:
The idleness of a machine may or may not be
considered as the fault of that machine, if, for

instance, a machine was found to be idle nineteen-
twentieths of its time, this might be due to one of

two causes. Either the process was rare but
essential or the machine itself was largely super—
fluous.

He stated further that in the first case the special
mmfliine purchased for occasional but essential use should
hams a charge for use that is quite high since all the
charges for its upkeep and presence were incurred solely
fortflne sake of the occasional use. In other words, expected
usage Exrovided the means of allocating such costs to pro—
mxmiori. In the second case he believed that the retention
Oftme Inachine was primarily a matter of accommodation (peak
loads), .in which case the shop as a whole should bear the
burden and not the unlucky piece of work that happened to be

\

Church, The Proper Distribution pf Expense Burden,

\‘I 55.

 

«+143?

95

put on the machine at any time. In other words, Church felt
that these idle time costs were unavoidable and therefore

applicable to the whole shop for whose benefit the machines

155
were kept in the first place.

A slight modification in reasoning would have made
Church's position much more tenable. The necessary change
is that the products or specific processes for which the
second category of machines was kept as an accommodation

should be charged with the idle time, not the shop as a

Whole.

Whitmore, when he considered specific items of equip—

ment, divided machines into three classes, viz.,

[H machines of full efficiency, whose use is general
and whose full capacity should under proper conditions

be constantly used.

[2 machines of full efficiency, installed for special
and occasional use, and not upon a calculation of
continuous operation.

Bjmachines which are not of the highest efficiency,
‘but which are maintained and used when other machines
which could do the work more economically are busy. 56

\

155
Ibid.

#156
Malr Whitmore, "Factory Accounting As Applied to
C me Shops," 92. cit., 438.

96

For the first class of machines Whitmore recommended
a practical capacity basis, for the second class he re—
commended expected use, and for the third class he also

recommended practical capacity, for he said,

their use is certainly worth no more than
the hourly rate so determined, and probably even

on this basis the work is expensively done [for the

reason that these are not the most efficient machines];

and 2nd, the actual cost of keeping such machines

in the shop cannot be too plainly shown.157

In effect Church and Whitmore agreed on the capacity
loasis appropriate to each of the three classes. The only
clifference lay in their original controversy as to whether
‘thea idle capacity of group three should or should not become
a Ewart of product cost. Church's reasoning for allocating
the .idle time costs to product does not seem to be his
usueil sales price idea and appears much superior to Whitmore's
reasuoning. Accurate cost keeping seems to be the basis of
ChUITfli's reasoning, in the sense that machines kept for
purpCMses of accommodating peak loads or breakdowns of other ‘
-nmchiaies are absolutely necessary, and represent unavoidable

Costs cu'a form of insurance which could hardly be categorized

as WaSte.

Both of these men had one critic, Andrew Murdoch.

97

Murdoch believed the classifications put forth would involve

a hair-splitting procedure which ”would destroy much of the
usefulness of the records of idle machines for purposes of
comparison."158 He believed the only way to get an accurate
figure for idle capacity costs was to use a practical
capacity figure for all facilities. In a strict sense Murdoch
‘Mas correct. However, he was not considering, as were Church
.and.Whitmore, the special nature of the machine purchased for
<occasional use, whose costs had to be assigned to the special
<3r occasional use for which it was purchased. An accurate
cmast could not have been determined in any other way, even

thcnagh Murdoch had a point concerning the measurement of

idles capacity costs or a loss that could be eliminated with

added volume .

Two very interesting points are implicit in the

cc>mments of Church and Whitmore on categories of machines.

They are

1) Capacity consists of machinery and other facilities;
or,all fixed costs are related to long—lived asset

acquisitions.159

\—

158
Co Andrew A. Murdoch, "The PrOper Treatment of Machine
StsACriticism and a Theory,” The Journal 9; Accountancy,

In (December, 1906), 127.

159
This also seems to be assumed in the normal and

c
ycle <Dverhead concepts.

98

2) Machines are ordinarily purchased for their
physical output potential rather than their
expected use in producing saleable output.

Church and Whitmore probably emphasized machines as
the equivalent of capacity because they used the machine—hour
rate for overhead allocation. However, the emphasis on
Inachines yields the assumption that all fixed costs are
related to fixed assets. Such an assumption fails to
recognize that many fixed cost elements are fixed only within
«certain volume ranges and are unrelated to fixed assets in
luany'cases. Costs fixed within certain volume ranges in—
<i1ude supervisory salaries, factory service department costs,
armi practically all the clerical costs incurred by and for
the: factory. These fixed costs, which are unrelated to
fixed assets, can be eliminated if volume drops below the
levtal for which they are necessary. Thus, when volume of
outip'ut drops, idle capacity costs are not as great as Church,
Whitnnore, Gantt and others would lead their listeners to
believe. In addition, if a unit—of—output basis for
depr'E’H'Jiation is used rather than the straight—line method,
160

Idle <2apacity costs would be even less.

The second assumption implicit in the practical

\

160
This point is considered further in Chapter Five

11 n
nder An Improved Approach", pp. 273-86.

99

capacity concept is that machinery and equipment is ordinarily
purchased for its physical output potential rather than its
expected use in the production of merchandise and thus the
production of income. Church and Whitmore were engineering-
oriented and thought primarily of physical output potential.
They seemed to forget that all capital expenditures are

rnade with future sales expectations in mind. In addition,
Church, Whitmore and many others failed to recognize that
"useful life" (sales expectations) is the basis for de—
EPreciating fixed assets rather than a concept similar to

161
"Efliysical life" (physical output potential).

§_1ne Special Problems: Categgries of Idle Capacity

Thus far in this consideration of unutilized capacity
theirs has been no mention of the many categories or causes
Of'Lidle capacity. Most of those who considered the problems
(of idle capacity measurement did so in broad general terms
Wit}! the expressed or implied hOpe that subsequent analysis
wouldyield the causes and therefore result in the elimination
Of tTLis form of waste.

In 1921 Dinlocker and Wainright classified the causes

Ofid1e facilities as follows:

~__‘~N‘_______

161
Ibid.

III p.

lOO
Normal or controllable

Excess facilities
Unequalized facilities
Obsolete facilities
Shortage of raw materials
Absence or lateness of men
Men waiting for

a) work or material

b) for instructions

c) for set—up

d) for helper

e) for power

f) for crane

g) for repair

h) for tools

i) for miscellaneous
7. Men absent for welfare activities

ONU‘IbUJNH

Abnormal or uncontrollable
8. Business depression
9. Strikes

10. Labor shortage
11. Material shortage

162

A cursory glance at this list is enough to make one
realize that the causes of idle facilities were known and
aPpreciated. Interestingly enough, Dinlocker and Wainright
wanted to exclude the abnormal or uncontrollable forms of
idle: capacity from product costs, but wanted to include nor-

mal 0r controllable items in product costs. Their reasoning

was that the abnormal items could not be considered a part

\—

162
Fa . T. W. Dinlocker and A. W. Wainright, "Idle Plant
czcllJlties: Separating Expense of Idleness from Manufacturing
OSt"' Automotive Industries, XXXXIV (May 12, 1921), 1012.

- 101

of managerial efficiency measures, while the normal or
controllable items could be. By this they meant that the
unit cost figure of one period could be compared with a

unit cost figure of another period to yield a measure of
managerial efficiency. One extra step taken by these men
‘was that the normal or controllable costs could be identified
loetter for purposes of elimination by first accumulating
them in a separate account. This account would later be

.apportioned to production on the basis of a supplementary

rate.163

Ten years after the Dinlocker and Wainright article,
Fimake also considered the causes of idle capacity in detail.

At ‘that time Fiske said:

Idle time represents a group of expenses rather
than a single expense and probably the greatest
error which has been made in treating it has been to
lump all types of idle time costs together thereby
including both controllable production idle time with
noncontrollable economic idle time in the same

account.
Fiske then agreed with Dinlocker and Wainright in
tanns of a broad breakdown between controllable and non—

contrcfllable items, though Fiske considered noncontrollable

_____“_______

163
Ibid., 1016.

IJA 164Wyman P. Fiske, "Accounting for Unused Facilities."
%. Bulletin, XIII, Sec. 1. (November 15, 1931), 361.

102

only cyclical and seasonal factors and broad changes in de—
mand, while Dinlocker and Wainright added to these factors
strikes and shortages of material and labor.165 The fore~
most difference between the ideas of these men was that
Dinlocker and Wainright did not want to consider the economic
factors as production costs while Fiske did. The basis

for the different points of View were Dinlocker's and
Ivainright's adherence to an efficiency concept and the
ealimination of noncontrollable items from product costs,
Mfliile Fiske adhered to the "normal overhead concept" which
Xmas based on the determination of a long-range basic selling

I

Price.

§£mms Special Problems: Influence of Standard Costing on
Epacity Measures

1 With the rise of standard costing a very interesting
PrCflalem arises concerning capacity measures. Under standard
COStLing it is not the difference between practical capacity
and <:apacity utilized that measures waste of facilities. It
is tile difference between practical capacity and capacity
thatd Should have been used to produce the actual output. In
otherwords, under standard costing waste of faCili’CieS is

a . . . . . . . . . .
combination of fac111ties not utilized and fac111ties ~

\—

165
Ibid.

 

103
wastefully utilized. Facilities not utilized are related to
output volume, and facilities wastefully utilized are
related to productive efficiency. The volume and efficiency
factors could be positive or negative.

Imposing this standard cost idea on the normal or
cycle overhead concept would also yield a volume and a
efficiency factor, when breaking down the difference between
normal or cycle capacity and capacity that should have been
utilized. When normal capacity is used both the volume and
efficiency factors would be considered income or expense
items dependent on whether they were positive or negative.
When cycle capacity is used the efficiency factor would
necessarily be considered income or expense depending on
whether it was positive or negative: the volume factor, on
the other hand, would be given the usual deferred charge
or deferred credit treatment in the balance sheet.

One point that must be noted is that under the
Practical capacity concept it would be almost impossible to
have other than a negative efficiency factor in the utili-
2ation of facilities: since practical capacity is equivalent
to maximum attainable capacity in the physical sense. With
the normal or cycle concept either type of efficiency variance

is Possible, since the capacity figure utilized is much less

104
than practical capacity. It is, in effect, an average of
expected volume over a period of years which yields a
built-in plus or minus variation on the basis of either

volume or efficiency.

Summary

The practical capacity concept is actually the
logical outgrowth of the supplementary rate. Its objective
is to measure the waste incident to idle facilities.

Problems concerning the costs of using different
categories of equipment were considered by the early ad—
vocates of the practical capacity concept. Their conclusions,
especially those of Church and Murdoch, present an interesting
conflict concerning two apparently mutually exclusive
categories of cost: idle facility costs and costs to manu—
facture (product costs). The conflict arises when a machine
is purchased and utilized only for a special purpose. In
such a case, all the costs incident to this machine should
be allocated to the special purpose, for this is the
reason Why it was purchased even though it would not be
used all the time. On the other hand, there are idle
faCilities in that the machine is not being utilized in
terms of its full practical capacity. The use of a special-

PUrpose machine at less than its practical capacity is

 

105
perfectly normal and does not technically represent waste.

Most of the early pioneers did not consider a
breakdown of idle facility costs between controllable and
noncontrollable items. In this sense they missed a very
important consideration applicable to measuring efficiency
by comparing unit costs for different periods. Dinlocker
and Wainright recognized the distinction between controllable
and uncontrollable idle facility costs and advocated that
the controllable idle facility costs be considered part of
product costs in order that efficiency might be measured
better.

On the other hand, Fiske, one of the normal capacity
adherents, advocated the recognition of a difference between
controllable and noncontrollable idle facility costs for the
sole purpose of eliminating the controllable items from
Product costs, for these items were waste and wens not to be
included in product costs for pricing purposes, as were the
unavoidable economic causes of idle facilities.

In addition to all these factors it is interesting to
note the influence of standard costing on capacity measure—
ment in terms of a volume and efficiency breakdown of idle
facility costs. The volume and efficiency factors can be

ascertained for practical capacity as well as cycle or normal

106
capacity.

Summary: The Sequel To The Supplementary Rate

The supplementary rate of Alexander Hamilton Church,
even though it was intended to measure inefficiency and
build up to a cost for sales price determination, developed
further in a number of different directions. Church's idea
of a measure of efficiency was refined (in effect) by con-
sidering only the unutilized portion of fixed costs as
waste incident to idle facilities. Furthermore, the use of
the supplementary rate to build up to a sales price based on
cost was dropped in favor of a more equitable and commercially
feasible cost-price concept which excluded the costs of idle
facilities.

With the advent of depression conditions the normal
and cycle overhead concepts were developed. Both of these
concepts turned their backs on measures of idle facilities,
but they did hang on to a selling-price foundation. This is
eSpecially true of the normal overhead concept which was
-based solely on the concept of a long—run average basic
Price. The cycle concept was primarily based on a cyclical
income concept Which absorbed in product costs the fixed
costs of manufacturing on the basis of expected activity

averaged over the cycle. Even though born under depression

lO7
conditions, the normal overhead concept is at the present
time the predominant method for measuring capacity. On
occasion the practical capacity concept is heard of as the
only capacity measure which still measures unutilized
facilities in a strict physical sense. It is truly the only
present counterpart to the refined ideas of Church, and it
is not at all tied to selling price ideology or the cyclical
income concept.

In order to illustrate more clearly, in this summary,’
the differences between the three concepts of capacity
utilized to absorb fixed manufacturing overhead costs, the
following diagrams are used. Illustration I shows the split
between fixed and variable overhead costs. Variable over—
head costs are all considered costs of production, while the
portion of fixed overhead costs to be considered costs of
production is identified as the "problem area" of accounting
fer fixed overhead costs.

Solutions offered for determining the amount of fixed
costs to include as costs of production are the practical
caPaCity concept, the cycle capacity concept, and the normal
capacity concept. In Illustration II, the solutions offered

by each of these concepts are quantified. As shown in the

(hegram (Data for Illustration) the annual physical output

 

ILLUSTRATION I

108

THE PROBLEM POSED

BY FIXED MANUFACTURING OVERHEAD COSTS

 

How Much

Are
Costs of ~9-
Production?

 

Fixed
Costs

 

 

The Problem

How Much of the Fixed

Costs are Costs of
Production or How are

Utilized and-Unutilized '6‘

Fixed Costs Segrated?

NOTE

 

 

variable -—a» All
Costs Costs of
Production

 

 

 

 

Fixed
Costs

 

 

/

Manufacturing
Overhead Costs

Possible Solutions
Practical Capacity
Cycle Capacity

Normal Capacity

In this and the following illustration there are assumed
to be no inefficiencies in the use of cost inputs.

llO

ILLUSTRATION II (CONTINUED)

‘QUANTIFIED ILLUSTRATION OF CAPACITY

 

CONCEPTS

DATA FOR THE ILLUSTRATION

Ph sical
qu uE

Fixed Ex ected p
235251 ___COS ’58 SaIes Po en a1 Average Cyclical

 

 

1 $ 6000 1800 Units 3000 units Sales Expectations 2000 Units
2 6000 2100 Units 3000 Units
3 6000 2200 Units 3000 Units Fixed Costs Per Unit
4 6000 2100 Units 3000 Units Average Sales $ 3.00
5 6000 1800 Units 3000 Units Physical Output
"“" » ~ ... -'-» ,, Potential $ 2.00

T°ta1 $;0000 10000 Units £2000 Units

111

potential is 3000 units, the average cyclical sales ex—

pectations par annum is 2000 units, and annual fixed

manufacturing overhead is $6000. Fixed costs per unit

considering physical output potential are $2 and fixed costs
per unit considering average sales expectations are $3.
In year one 1800 units are produced, while in year

two 2100 units are produced. Under practical capacity,

utilized fixed costs are $3600 in year one and $4200 in

year two. The utilized fixed costs or costs of production

are determined by multiplying actual output by fixed costs

per unit (1800 x 2 3 $3600, and 2100 x 2 3 $4200). ~The

unutilized fixed costs or costs of non—production (idle

capuacity) are determined by multiplying the unutilized

Phyriical output potential by the fixed costs per unit. In

Year- one the figures are 1200 units multiplied by $2 per

unit, or $2400. In year two the figures are 900 units

mUIt:igalied by $2 per unit, or $1800.

Under cycle capacity there is no such thing as costs
of ixilJe capacity. Fixed costs are averaged over cyclical
SalES expectations. Thus the fixed cost per unit becomes
$3 Inatiier than $2 as under the practical capacity concept.

’I'h '
slur'lutilized fixed costs of year one (200 units x $3) are

not;
Considered a loss but a deferred cost of production to

 

112

be utilized in the future when output will be above the

average. In year two output is above the average by 100

I

units and $300 (100 units x $3) of the previously deferred
fixed costs will be applied to production. To the fixed
costs of period two ($6000) is added the $300 in order to
yield the period two fixed costs of production, $6300

(2100 units x $3). Thus to period two, where production is
above average, will be added part of the fixed costs of
period one where production is below average. The cycle
capacity concept retains the cycle as the period for income
measurement by means of the averaging of fixed costs over
(sales expectations. In accomplishing cyclical income measure—
ment, the possibility of idle capacity costs is completely
obliterated.

Under the normal capacity concept the mathematical
Calculations are exactly the same as under the cycle concept.
‘Fhe only difference is the treatment given to unutilized or
oVerutilized fixed costs. Unutilized fixed costs are
1:I'eated as a loss due to less than average use of fixed
(“DSt inputs, While overutilized fixed costs are treated as
5* gain due to greater than average use of fixed cost inputs.
3319 nOrmal capacity concept represents a kind of halfway

PC)
irm:between practical and cycle capacity. Unutilized

 

5.9%

113
fixed costs are treated as a loss or a waste, but average
sales expectations rather than physical output potential
are used as the basis for fixed cost absorption. The reason
for the crossbreeding is an attempt to express the sales
price concept of recovering all costs over the cycle, mhile
attempting (perhaps inadvertently) to retain some semblance
of idle capacity costs. The cycle capacity concept actually
takes the sales price foundation of the normal capacity
concept and includes it in a more palatable income measure—
ment scheme, which does not allow for the possibility of
idle capacity costs.

In the next section the development of those factors
concerning efficiency and waste elimination, which originated
to a large extent in the supplementary rate, will be con—
Sidered. In the final section the development of cost
accounting for purposes of income measurement will be covered.

Cost Control and The Development of Overhead

Costing
General
The efficiency factor or waste elimination factor
haS always been very important in cost accounting. After a
SLLrveY 0f cost accounting in the medieval era, S. Paul

<3
aI‘ner concluded that most of the systems then in use were

114
designed for the purpose of accounting control over the steps
Of production and for the elimination of spoilage and waste
in material usage.166 Overhead might have been included
in the statement if it were important at the time. As it
was; overhead costs generally did not achieve fundamental
importance until late in the nineteenth century, so that it
was around the turn of the nineteenth century that a com-
bination of increasing competition and increasing overhead
costs began to focus attention on possible inefficiencies
in the overhead element of cost.

This attention was related in the beginning to some-
what vague measures of efficiency related to the use of
aggregate facilities. Close on the heels of these efficiency
measures and perhaps, in some respects, as an integral part
Of the idle facility problem, came the development of stan—
dard costing. Finally the standard cost idea developed into
a system where costs were accumulated by areas of functional

responsibility.

Idle Capacity Costs and Efficiency Measures

 

167
Church and Whitmore, as discussed previously, were
\
166
Garner, QB. cit., 25.
167
A, See the section "The Rising Influence of Cost Control:

IHamilton Church-and His Supplementary Rate", pp.48—55.

115

chth interested in the detection and elimination of waste,
arnd both placed great emphasis on the costs of idle
fEicilities as part of the measure of waste or efficiency.
It: should be remembered that Church considered his ”supple—
Inerrtary rate" to be a "barometer of efficiency", and the
cflrief elements making up the supplementary rate were idle
facxility costs as well as costs of inefficient operation
1J1 the techniCal sense.

Since Church's supplementary rate would fluctuate
direnctly with changes in commercial efficiency (volume) and/or
techuaical efficiency, a measure of efficiency or waste was
datermined. As for the procedure for eliminating this waste
or iruefficiency, Church was vague at best. Whitmore, by
elimiJiating idle facility costs from other costs (actual
prOdtKZtion costs), also came forth with a measure of efficiency
Or‘WaEYte which was well described by Gantt (1917), who said
that Stroduction costs should be separated from capital
CharQEHS, special repairs, and costs of idle plant and

Under such conditions, with a definite method
eand known wage rates and_cost of raw materials,

‘the cost of the manufactured article is an in-

Ciication of the efficiency with which the methods
CDf manufacture were operated.

\——_

1158
H. L. Gantt, "The Bases of Manufacturing Costs,"

Indu . .
1&1 Management, LIII (June,1917), 369.

 

116

The same idea was expressed by Dinlocker and Wainright
(1921) , who wrote that the inclusion of the expense of
idleness in costs would prevent the use of cost records for
comparing present performance with performance in those
periods in which more or less idleness existed.169

In the above cases efficiency was measured in a very
general sense, i. e., production costs per unit (exclusive
of idle facility costs) in one period were compared with
Similar figures in another to indicate the overall direction
and extent of efficiency, and in the income statement the

170 In both

Costs; of idle capacity were set out prominently.
inStEunces management was to be activated into remedial
meastures in order to eliminate idle capacity and inefficient

Operatzions; studies would be made as to the causes and

nEltur’e of the waste.

Standard Costing Ideology

'The exact timing of the evolution of standard costing

________~‘_______
1169
T. W. Dinlocker and A. W. Wainright, op. cit., 1015.
170 '

1“»that_ .Church's early ideas differed slightly from this

facilit; 111s "supplementary rate" included costs of idle

head 143s as well as costs of technical inefficiency (over—

rate ifirtion 011137): and it was Changes in the supplementary
a4; were to yield a "barometer of efficiency".

 

 

117

is quite difficult to ascertain. Lang feels that it is
the direct outgrowth of the supplementary rate in the sense
that the seed was planted which focused attention on
inefficiencies or wastes.l71 Urwick concurs in this point
of View.]’72 One of the best early statements on standard
costing is that by Harrington Emerson, who wrote in December
1908 that there were two very different methods of cost
finding. In the first or old method, costs were ascertained
after the work was completed. In the second or new method
they were ascertained before the work was started. He
believed the old method delayed information until it had
1ittle value remaining, and furthermore he believed the old
mEthod tobe wholly and absolutely incorrect.173
The "incorrectness" is that costs of waste and costs
0f aCtual production are all mixed together, and the analysis
Of Statements "does not lead to elimination of waste." A5

for the new or standard cost method, it divided costs

1) into standard expense and 2) into avoidable loss," and

-\\—
171 ‘
Lang, pp. cit., 388—9.

1
Newm 7213- Ul‘WiCk. The Golden Book gt: Management (London:
an Nearne, Limited, 1956), 112.
173 '
OPErat' Harrington Emerson, "Efficiency As a Basis for
1011 and Wages--Part VI. The Modern Theory of Cost

ACCQ .
336 untlng," The Engineering Magazine, XXXVI (December, 1908),

 

¥

118

gzrve rise to analysis of waste, constant revision of
. . . . 174

stuandards and the elimination of wastes that were isolated.
A ssimilar statement had been made six months earlier by

. 175 . '
Jcflin Whitmore. This is the same Whitmore who had
wrtitten so clearly about idle facility costs two years be—
fkyre, but even in his earlier series of articles Whitmore
was; very close to developing the standard cost idea when he
empfliasized waste in overhead as compared to wastes in
matexrials and labor. He then spoke of standards of economy

for (overhead being "less simple, less generally appreciated,

and.lless strictly enforced. . .” than those for materials

176
and l abor .

Church, a few months before his famous series of
articles on overhead were published, also spoke in a very
generetl sense about standards and comparison of actual re-

SUItS \vith intended results in order to make control a

177

liVing reality. These comments about Church and Whitmore
~~_ .
£174
Ibid.
175 . H II
Whitmore, Shoe Factory Cost Accounts, The Journal

 

O \
~ LCC‘Ountanc , VI (May. 1908). 14.

1.7
6Whitmore, "Factory Accounting As Applied to Machine

539. gig., 430.
177
Organiz A. Hamilton Church, "The Meaning of Commercial
atlion," The Engineering Magazine, XX (December, 1900),

397. ___ _____.__

ShOps , n

 

IIII-._.

119
could easily lead one to agree with Lang and Urwick, especially
when it is noted that Whitmore's clear statement on standard
costs came just two years after his very clear statement on
<:osts of idle capacity.178

Much of the early literature was not sufficiently
(descriptive of the types of variations of actual from stan-
ciard costs, especially in the case of overhead. McHenry in
1£916 clearly illustrated a volume and a price variance for
cnlerhead,l79 but it really was not until G. Charter Harrison
cmune upon the scene (1918) that overhead variations were
sepnarated into a number of different categories. At first
Haimrison worked with variations for fixed overhead charges
anti fluctuating overhead charges. In the case of fixed
Chainges, he considered variations due to a difference between
acttual and estimated fixed costs and variations due to volume
flUCtniations. In the case of fluctuating charges he con—

sidereui only comparisons between actual and standard

_____~__~___‘___
178

. People other than those named have also discussed
Ideas Vfliich could easily be considered early standard cost
aCCOUDiELng thought. Among these are: Garcke and Fells.

99' £15.. 74. Lane, 99. _c_:_i_t_., 894 and H. s. Garry, "Factory
COStSo" Elle Accountant, XXIX (July 25, 1903), 959.

79 .
McHenry, op. cit., 682.

120
fluctuating charges.180 Later, when Harrison worked up his
cost variation formulae, he used a large number of other
variations for overhead, including variations in working
(iays per month, in cost of idle time, actual output compared
tc>standard, in prices of services (power, light, etc.), in
c;uantity of services consumed and variations in overhead
(Expenses other than services. Furthermore, he considered
algl of these costs as they were divisible into variable costs,
fitxed monthly charges (salaries), fixed charges per working
(hay'(timekeeper paid on hourly basis) and fixed charges for
dajf‘worked (men paid hourly who worked only when their
depnartment worked).181 All of these variations were utilized
in <3rder that Mr. Harrison could answer in detail the inevi—
tabfile "why" concerning the difference between actual and
Standard costs .

Apparently Mr. Harrison's ideas on showing these

variertions fell on deaf ears, for no one else seemed to

 

182 ‘
adOpt liis variations. Through the twenties, overhead
\
180

P G. Charter Harrison, "Cost Accounting To Aid
roductxion," Industrial Management, LVI (November, 1918), 397.

181
G. Charter Harrison, "Scientific Basis for Cost

'ACCOunthIglu Industrial Management, LIX (March, 1920). 239-41-
I182

Mr. Harrison included these same ideas in his 1930

teXt. s .
Ybrk.‘“£££§9§£§.§2§£§ Fabllshed by Ronald Press Company of New

 

 

121

variances (other than over—or underabsorbed) were largely

. , 183
ignored by textbook writers and the literature. The
standard cost idea for overhead accounting made little head-
way. Lawrence (1925), Schlatter (1927), Amidon and Lang
(1928), Sanders (1929) did not consider Harrison's idea at
all, and did nothing concerning overhead variances except

perhaps to compare total overhead costs with standard over-

head costs and produce the already familiar over-and under—

absorbed overhead . 184

At the 1931 National Association of Cost Accountants
meeting Charles Reitell advocated two overhead variance
Classifications. These were a volume and a controllable
Variance. ‘ The volume variance was computed by deducting
bUdgeted costs for actual volume from budgeted costs for

Standard volume (expected long—range average). This variance,

“x
‘

 

183
An exception to this would be the excellent dis—
CuSalon on standard costs at the 1926 National Association of
Cost Accountants Meeting. See National Association 9_f_ Cost

WE'Yearbook 1926, 97-194.

184
W. B. Lawrence, Cost Accounting (New York: Prentice-

Halll Inc., 1925).
( Charles E‘. Schlatter, Elementag Cost Accounting,
Siew YOI‘k: John Wiley and Sons, Inc., 1927) (no mention of
andards at all).
of Cost L. Cleveland Amidon and Theodore Lang, Essentials
-.- ~-~ Accounting (New York: The Ronald Press Co., 1928), 273.
MCGraw_H. Thomas Henry Sanders, Industrial Accounting (New York:
111 Book Co., Inc., 1929), 277.

 

 

122
then, was nothing more than unutilized fixed costs or over-
Litilized fixed costs (in the case where actual volume exceeded
sytandard volume). The controllable variance was determined
byr deducting actual cost from budgeted costs for actual
vrilume. The controllable variance, although it was intended
tc> indicate efficiency of controlling variable costs by pro-
ducfl:ion men, did not do so, since it included with costs of
tecflinical inefficiency, variations in the prices of variable
as vvell as fixed overhead costs. 85

In 1932 Eric Camman published his ideas in book form
and aseparated overhead variations into variations related
to Guantrollable expense and fixed charges.186 Camman's two
variiinces, in effect, yielded a fixed charge variation which
was 'tlie same as idle capacity costs and the controllable
EXPenisse variation which was intended to measure the effective-
neSS c>f using variable overhead costs. The major problem

with (Zamman's ideas was that they were based on basic or

"bogexz" standards which were to be retained as yardstiCks

\

 

 

185
Reitell, gp. cit., 24—30.

E 186Camman had used this same breakdown in 1926. See
Ogic A“ Camman,"Uses 9f Standard Costs,"National Association
- 9% Agcountants'Yearbook 1926, 125 and 131.

123

as long as techniques were stable, and WhiCh were not to
be: Changed to reflect changes in price levels. Price—level
cflianges were to be worked into the analysis via index number
achustments, and both actual and standard costs were to be
caixried in the accounts. Camman's analysis, then, of
necxassity had to be considered in terms of overall percentage
cheuiges for the many elements making up overhead costs. This
in eaffect produced a highly complex mathematical analysis
whicfli did yield the above variances, but in such a way as to
make; cone wonder as to the efficacy of the results.187

Soon after this the now familiar three—variance
technique (volume, efficiency and price) appeared, even
thoufgflinany of the writers then, as today, disagreed on the
exact: Iiature of the three variances.188 All in all, when it
came ‘tt: standard overhead costing, the idea was primarily a

matteI? of segregating the differences between actual and

Standatrd.costs- In some instances, that is, in the case of

(

 

187
Eric A. Camman, Basic Standard Costs (New York: The
Amarican institute Publishing Co., Inc., 1932), 69-81.
188
Acco . Compare: Charles F. Schlatter, Advanced Cost
--Efl$fiL g (New York: John Wiley and Sons., Inc., 1939), 122-4.
YbrkyM_ John G. Blocker, Essentials 9f Cost Accounting (New
° C3Graw—Hill Book Co., 1942), 323. '
Adolf Matz, Othel J. Curry and George W. Frank,
SSBDunting (Cincinatti, Ohio: Southwestern Publishing
' 1957), 576-582.

 

 

 

SOSt A.
Co. "

124

fixed overhead costs, the variances were primarily a matter
of differences between standard and actual volume (volume
variance). This holds whether one summarizes all fixed

costs in one category or follows Harrison's ideas on different
categories of fixed costs, variations in working days per
month, and pure and simple idle capacity.

With variable overhead costs the differences between
actual and standard costs represented the costs of technical
inefficiency as well as price differences which could or
Could not be considered justified and therefore efficient or
ine£ficient. In some instances, although not all, the price
and physical usage (efficiency) variances were separated.189

The improvement of standard costing over actual costing
actually involved nothing more than the ability to identify
wastes more precisely. In actual costing there was no real
Standard of comparison, and therefore the measure of waste
was Simply a matter of comparing figures for different periods
to cIheck the direction of efficiency. In standard costing
there was an attempt to segregate and show explicitly the
Costs Of inefficiency.

The greatest problem with standard costing, as

 

189
Schlatter, Advanced _C_ost Accounting, op. cit.,

 

 

125

presented, was that even though waste was identified, it was

only in a broad or overall sense. Before remedial measures

could be taken, intensive analysis was necessary in order

to determine the more exact nature or causes of inefficiency,
as well as efficiency which could have been averaged out of

sight. This type of analysis was also necessary with actual

costs, so that the real difference between the two systems
was in introducing a yardstick. One could easily say, then,
that the standard cost system identified categories of wastes,

but after the identification a great deal still had to be

done in order to prevent continuation of the wastes.

The ResponsibilitygIdea

At practically the same time that standard costing

was developing in the above sense, it was also developing

in the sense of tying cost incurrence to the responsibility

for COst incurrence. This is the idea B. A. Franklin ex—

preSSed when he wrote in 1912

The expense of the department is totaled first
to a "controllable expense", this being the amount
Occurrable in the department, and so under the con—

trol and supervision of the foreman.

Franklin's analysis was excellent up to the point

\\
190

 

Franklin, pp. 233., 428.

126
where he spoke of relating labor dollars or hours to pppal
departmental expense rather than to controllable expense, in

order to see that "the executive has an Opportunity to study

"191

expense, to experiment with it, and to control it. He

lost sight of the effects of volume and of uncontrollable
expenses in the resulting ratios.
The same importance of cost responsibility also was
expressed by Harrison a few years later, but only in a gen—
. . . . 92
eral sense Without explanatory or descriptive material.
Jordon and Harris utilized the same concept in illustrative

departmental burden statements, but when they calculated

Comparative percentages they did so on the basis of total

193
cost, as did Franklin.

These men had the right idea, but it was not
effectively carried out or fulfilled until it was attached
to the idea of budgetary control, especially through use
Of the flexible budget. Reitell stated this very nicely in

1931 \Vhen he wrote,

\
191
Ibid., 429.
192
G. Charter Harrison, "Cost Accounting in the New

Industrial Day," pp. cit., 443.

3
Jordon and Harris, pp. cit., 295.

 

127

Our expense classification or Operating
code, as we call it, must be changed so that it
will fit exactly into the definite organization
set-up. It will then be possible to charge each
and every supervisor from foreman to president
with items of expense that are wholly, completely
and entirely under his or her control. Each in
turn will be held strictly responsible for these
expenses which are his. And each will be placed
under-budgetarygpontrol to see that responsibility
is maintained.

In addition, Reitell did not consider the controllable
ovexrhead variance as only a lump—sum figure, for he worked
Witfli individual items of overhead, the person responsible,
thE! causes of difference, the remedy and a report of progress
in 195 . . .

ea follow—up sheet. Finally Reitell described how
imFHDrtant his plan was for overhead costs:
The importance of this plan of determining
controllable variance must be driven home hard.

The identification of controllable variances in

the plant with supervisory responsibility con-

stitutes a tremendous stride forward in redeeming

overhead expenses from the class of illusive un—
certainties to placing them under a rigid and

definite control.

Budgeting was absolutely necessary in order to help

pinpoint responsibility, while flexible budgeting was ab-

solLrtialy necessary in order to allow for the difference

1r‘p§~*~_____—
194 , .
Reitell, pp. p;p., 17.
195_Ibid., 29-32.
196

128

between planned and actual volume.
glassy

The rise of increased accumulations of capital and
ccxnpetitive conditions around the turn of the nineteenth
cenitury brought forth the increasing importance of over—
head costs and the necessity for waste elimination. Out of
ttuase conditions came the recognition of idle facilities,
the: cost of which had to be removed from other production
COStns in order to yield cost figures that could be compared
t0 Cietermine the comparative extent and direction of efficiency.

Attempts to measure idle facilities gave rise to a
formn of standardization for overhead costs which blossomed
intxa standardization for all costs of production so that
'Wastaes or inefficiencies could be isolated. In the case of
OVeIfliead costs this meant ultimately a breakdown of the
diffFearence between standard and actual overhead costs into
the Inany categories demanded by G. Charter Harrison or into
the licwvnmme usual volume, price, and efficiency categories.
IntE31531ve analysis of these variances with action based
thereupon was usually considered the means of eliminating
the <2Ontinuance of the wastes identified.

Paralleling the rise of standard costs and the analysis

129
of variances, the ideas of accumulating costs by respon—
sibilities developed into its completed state in the form of
flexible budgeting. Overhead costing today still emphasizes
variance analysis and the responsibility accumulations of

flexible budgets as the basis of overhead cost control.197

Income Measurement and the Development of Overhead Costing

series;

Thus far in this functional approach to the history
0f overhead costing, sales price determination and efficiency
measures have been discussed as the primary motives, his-
torically speaking, behind cost accounting in general and
Overhead costing in particular. With this in mind, it is
not difficult to believe that cost accounting for income
measurement accepted with little, if any, qualification the

figure calculated for other cost finding purposes.

Early Wriplggs

 

Garcke and Fells (1887) certainly recognized in a

v , - . . . .
ery luCid manner the relationship between inventory valuation

\‘

197
RObert N. Anthony, Management Accounting (Homewood,

IlllrlOis: Richard D. Irwin, Inc., 1956), 268-324.

StUGi R. L. Brummet, Overhead Costing, Michigan Business

Michies’ Vol. XIII, No. 2 (Ann Arbor, Michigan: UniverSity of
(Jan, 1957), 139-51.

130

198
and income measurement, but the nature of the cost com-
ponents they used for inventory purposes make one wonder
xvhat the true rationale behind their cost calculations was.
For example they wrote:
When the indirect charges and depreciation

are of a more or less fixed character, it is

probably sufficient to know the cost of 189

article in wages and materials only. .

This comment was clarified a little later when they
unare speaking of establishment charges (selling costs):

The principals of a business can always judge
what percentage of gross profit upon cost is
neceSsary to cover fixed establishment charges

and interest on capital.

A few years later Garcke and Fells further clarified
thstir comment when in the 7th edition (1922) of their text
theyr admitted that their primary interest was a cost for
PriCKa determination. At this time Garcke and Fells were
defETHSing their exclusion of fixed establishment charges
and iJiterest on capital from costs of production. Their

reaSOHing was that these costs were costs of production in

a ’ . .
wldEfi sense, but were not costs of production insofar as

\———
198
Garcke and Fells, pp. cit., 122-3.
199
Ibid., 6.
.200

Ibid., 73.

131

cost of production regulates price. Garcke and Fells were

essentially interested in a variable cost or out-of—pocket
cost concept for pricing purposes. When allocating manu-
facturing overhead to products produced they were assuming
tfliat such costs were variable in nature.

Similar comments are applicable in the case of G. P.
Kharton who wrote an entire book, Textile Manufacturers'

Enookkeeping (1889), and then, when speaking of inventory

 

\naluation, advocated using net selling price. 02 What then
“mas his intention in accumulating cost figures? Could it
be: anything other than the then usual sales price and
efficiency measures?

The same is true of J. S. Lewis, who said in the case
Of eastablishment charges (selling expenses) that it mattered
littile if all were charged to profit and loss or allocated
to PIRDduct, "for the mere purposes of commercial book—
keepiaig."203 He then emphasized allocating establishing
chargens to products for purposes of estimating, and a
Separfrtion between factory and selling expenses for purposes

‘-~——1__~__________
201
Ibid., (Seventh edition, 1922). Footnote on page 119.

.202
Norton, pp. cit., 259-60. See also Footnotes 32, 33,

supra.

1203
Lewis, pp. cit., 174.

and 34’

 

132

of measuring manufacturing and commercial efficiency

better.204

Later writers were much clearer as to the basic
.foundations of their cost figures, for they readily admitted
‘that the major or only purposes of costing were to help set
asedling prices, to measure efficiency and to control costs.
Punong these writers were Church, Hatfield, Franklin, Jordon

auid Harris, Hattersley, and Paton and Stevenson.205

Breakdown of Commercial and Manufacturipg Overhead

As pOinted out preViously, most of the early writers
anti practitioners of costing did not separate selling and
marnifacturing overhead. As time progressed the separation
diti take place, but the basis for separation was not income
measnlrement. Objectives of the separation were the more
aCCLurate cost buildup to selling prices and the separation

0f Ccnnmercial and manufacturing efficiency. A more

204
Ibid., 174—9.

2oschurch, The Proper Distribution Q§_E§E§£§§.BH£Q§34

Hatfield, pp. p;£., 293-5.
Franklin, pp. plp., 421.
Jordan and Harris, pp. pip., 428.
LXIV G. Stanley Hattersley, "Costing", The Accountant,
(May 28, 1921), 681.
0f.Ac William A. Paton and Russell A. Stevenson, Principles
‘T'tegsflggpipg (New York: The MacMillan Co., 1922), 614.

.20
6See the Section "Influence of Price Determination on

133

sophisticated approach to this separation which seemed

related to income measurement was present in comments such

as those made by the editor of The Accountant, who advocated

'that inventoriable costs should stop at the point where the

207

:responsibility of the works manager ceased. The same

cnamment was also made by Frederick A. Halsey, who in so

cicung exhibited a very impressive knowledge of the relation—

208
sllip between inventory valuation and income measurement. '

The said concerning the procedure of including selling expenses

irl inventory,

. . .it inventories the expenses and makes them
show as an asset, a condition of things that

cannot be deferred.209

This all sounds very well until one considers that

eveni though selling costs are not production costs in the

sensua of being incurred by and for the factory, they can be

COnSidered inventoriable as assets. The idea that such costs

are rust subject to the control of the factory superintendent

 

 

_1_______7 .
the Content of Overhead" pp. 18-43.
207
Editorial, "Cost Accounts," The Accountant, XXXII
(June 17, 1905), 728.
208 . , ,
Norris, pp. c1t., 397—400.
209

Ibid., 398.

 

134

sounds more like J. S. Lewis' idea of separating manufacturing
and commercial efficiency210 than income measurement.

If elimination of selling costs from inventories is
to be considered as an income measurement concept, it must
be considered crude at best, for there is good reason under
many conditions to inventory selling costs if one follows
the usual matching concept of accounting. Under this con-
cept costs are associated with the income they produce, so
that if at the end of the year there are some costs, selling
or otherwise, applicable to future sales, they must be
treated as deferred charges, which is in effect the same
thing as an inventory item or an asset in the year-end
balance sheet.

Inclusion of selling costs in inventory is a point
Vi‘EJOrously stressed by William B. Castenholz at the 1922
National Association of Cost Accountants annual meeting,211

212
and by J. S. Seidman in 1946. Both of these men were

fimly and justifiably convinced that attitudes like those

\‘7

210
Lewis, pp. cit., 179.

and A. 711William B. Castenholz, "The Application of Selling
of Co Ihinistrative Expenses to Product," National Association
‘~-~§J; Accountants'Yearbook,l922, 127-154.

212
in Inxr J. S. Seidman, "Do We Mistreat Administrative Expenses
286~8 ‘entory," The Journal pf Accountancy, LXXXI (April, 1946),

 

‘
I—E—

 

 

135

213
of Halsey and the editor of The Accountant were quite

shallow for income measurement purposes.

Exclusion of Imputed Interest from Manufacturing Overhead

In the early history of cost accounting imputed

interest was considered to be an element of manufacturing

<:ost. Most of the arguments for its inclusion have been very

riicely summarized by Clinton H. Scovell, probably the most

aactive of those advocating the inclusion of interest as a

cxast. In one of his early works Scovell listed among the

ibenuefits of including interest in costs such things as more
acncurate price determination, determining efficiency of

vadiious items of equipment and determination of the cost of

, . . 214
ca rrying inventory .

A few years later Scovell stated that unless interest

is iJicluded as a cost it would be impossible to

1. compare efficiency of alternative methods.

2. allow for the time element in costs.

3. distinguish profit on two or more kinds of
business by the same management.

 

4. measure cost of carrying inventory.

5. compare costs and profits of companies which
differ as to the number of component parts they
make or buy.

“K‘—

213

Footnotes 207 and 209 Supra.

214
Appl' Clinton H- SCOVEll, Cost Accounting and Burden
“‘~<£SEEE$gg_(New York: D. Appleton and Co., 1916), 97—104.

 

136

6. compare costs in owned or rented plants.

7. compare costs of purchased or privately generated
current.

8. eliminate the effect of varieties of financing on
costs. 215

9. make uniform cost plans for associations.

For the most part Scovell concentrated on price
determination, comparison of alternatives, and equalization
of such things as methods of financing and differences in
cxast of facilities. Inventory valuation and income measure—

Hmndt as such did not seem to be very important in his

del iberations .

The ultimate exclusion of imputed interest from
marnafacturing costs seems primarily related to income
measurement. For example, Jordon and Harris, in their
Sununary of arguments against the inclusion of interest in
C0512, included the following six items among twelve arguments,

[1] Interest does not represent values received or

parted with.
[23 Inclusion of interest in cost leads to inflation

of inventories.
[3] Inclusion of interest leads to anticipation of

profits.
[EEIInterest inclusion might result in showing a
profit on the books even though no goods have

been sold.
[53.8ankers shave down inventories by the amount of

interest included.

1r_p“~‘___-_~_
215 ’
Clinton H. Scovell, December 27, 1918 address to

the
(takgmfiuarican Association of University Instructors in Accounting
‘arl from Jordon and Harris, pp. cit., 431.

137

Kg Interest in sion produces misleading financial

clu
statements.216
In addition, Jordon and Harris mention that interest
can be shown in statistical statements and kept out of the
217 , . . .
books. This in effect yielded practically all the
benefits mentioned by Scovell, but left for emphasis the
income measurement approach.' These comments by Jordon and
Harris are in perfect agreement with those of a special
I
commuttee of the American Institute of Accountants (1918).
This committee also mentioned the possibility of side
calxculations to yield the benefits desired by Scovell, but
tduay'emphasized with regard to income measurement:
Interest on investment is not an expenditure,
but is at best only an anticipation of profits and,

as such, has no logical standing in the compu—
tation of production costs.

J. M. Clark, the eminent economist, made some
interesting comments on the inclusion of imputed interest

in nuanufacturing costs. He said that books which included

 

\
216
Jordon and Harris, pp. cit., 443.
217
Ibid.

Rel . 218"Report of the Special Committee on Interest in
atllln to Cost," The American Institute pf Cost Accountants'

1
__9_1§ Xearbook, 110 .

13E

interest as a cost were not prepared for the purposes of
financial accounting (construction of a balance sheet and

income account). Such books were prepared primarily for

such books interest
219

various types of cost analysis, and on
must be deducted before making up the income account.

Clark clarified his comments when he spoke of in—
ventory valuation and suggested that inventory valuation
Should result in showing income available for dividends and
interest to just the extent that goods have been sold for
rmare than they cost. 'Inventory valuations should be based

CH1 the actual value of manufactured goods, not the value

220
that they "ought to have."

Perhaps more than anything else, the controversy over
"intnarest as a cost" shows the rising influence of income
detEBrmination on cost accounting. The reduction of this
Comtxroversy to the ideas eXpressed by Jordon and Harris, the
Amexrican Institute of Accountants committee, and Clark, is
is irrterestingly paralleled in time with the emergence of.
Such IDrilliant financial accounting theorists as Hatfield

and FNaton. The rise of financial accounting theorists might

~1.“__~_______

219
Clark, 92. cit., 255-6.

229Ibid., 239—40.

139

explain the more definite consideration of income measure-

ment as an aspect of cost accounting in the period surrounding

World War I.

The SupplementaryiRate and Its Sequel

The supplementary rate of Church‘wasan outgrowth of
attempts to measure efficiency, detect waste, and determine
price. Its subsequent develOpment by Whitmore, Gantt, et. al.,
Changed the quantitative aspects but still retained the basic
yfioundations of Church. Nevertheless, there were those who

dixi an impressive job of adapting the idle capacity concept

tC> the twin problems of inventory valuation and income

21
measurement .

Further development of the basic concept into the
nornual overhead idea was based solely on the depression
pSYCfliology of a long—range average basic selling price. A
trarHaition to the cycle overhead idea is apparently based
on El cyclical income concept, but in conjunction with the
Cyclfi concept there is too much implied unvdllingness to
face 1ihe facts of poor years and willingness to hide the
facts <concerning good years, so that the real motives of

__-p~‘~_______*-

Nati 221William H' Alden, "Handling The Expense of Idle Time,"
‘E5~42253l ASSOCiatiOn pg Cost Accountants'Yearbook,1924, 118 and

O

140

many advocates are probably not income measurement, but
a leveling out or averaging of reported incomes.

The minority who favor or utilize the practical capa-
city concept are the only ones Who really retain the waste

detection ideas inherent in the Whitmore—Gantt approach to

capacity measurement. However, as will be pointed out in

(fliapter Five, there are definite limitations to the use of

gxractical capacity for purposes of income measurement.

A. Hamilton Church and Income Measurement

To illustrate how far A. H. Church's mind was from
incname measurement when he worked out his method for
diStributing overhead and the supplementary rate, it is only
neCfessary to review Church's 1910 work, Production Factors?22
h“ El chapter on "Costs in Relation To The Financial Books,"
Mr, (:hurch follows a prime cost method for valuing inventory.

His approach to income measurement is a matter of
Subtracting from gross sales the total prime costs (direct
matearfiials and direct labor) to determine gross profit. From
the gross profit is deducted manufacturing overhead incurred
duriJiSJ the period to determine net manufacturing profit. From
manUfacturing profit is deducted general and administrative

\——————

222Church, Production Factors, 2p. cit., 163-187-

141

. . . 223
expense incurred in the period to determine net profit.

With this information in hand it should be clearer

than ever that Mr. Church was interested in efficiency

measures, waste detection and elimination, and sales price

determination when he developed his thoughts on expense

thirden. Income measurement had no relationship at all to

.Mr; Church's thoughts concerning overhead; income reporting

lNaS incidental. Even though this is true of early methods

<1f allocating overhead to product, a brief analysis of over—
heaud allocation and its development does yield an insight

intKD the development of income measurement and accounting

f0r'manufacturing overhead.

Develppment of Overhead Allocation

Before the advent of competitive conditions, manu—
factnaring overhead was included in a percentage added to prime

COStHS, which was anticipated to cover all cost plus a profit,

h“ a. "hoped-for" selling price. Among the first to realize

thatl a.nmme scientific allocation was necessary were Garcke
and Fells. They mentioned that such charges could be
alloGated to jobs on the basis of wages expended or upon the

c
ost. CNE wages and materials. They then added that if raw

\
223

 

Ibid., 175.

142

materials were included in the base figure, cost results in

different periods would be non-comparable, since raw material

costs fluctuate considerably. Therefore the sounder over-

head allocation method to use would be a percentage based

on direct wages only. Then Garcke and Fells considered

that wage rates differ according to whether a man is skilled

or unskilled, and since many elements of factory overhead

snare more related to time, perhaps the best allocation

rmethod would be labor hours. Solomons felt that the

Prcflalem of differing wage rates was offset by the intro—

ducrtion of overhead departmentalization (assuming homogeneity

0f Ilabor rates in each department). The lack of depart-

menizal homogeneity of wage rates led to the labor hour

metllcd.of allocating overhead, according to Solomons.225

The next step in the development of allocation schemes
grey, out of a recognition that the labor hour method made

no allowance for the difference in the costliness of equip—

ment; lised. Thus the machine rate was born. The leading

experlent of the machine rate was Alexander Hamilton Church

Who kirltroduced his "scientific machine rate" in 1901. At

\

 

\
224
Garcke and Fells, pp. cit., 70-72.
225 u . . .
Solomons, The Historical DevelOpment of Costing,"

O .
‘9‘ Q” 23.

143

this time Church discussed and criticized the other methods
of allocating factory overhead in much the same manner as
did Garcke and Fells. The logical answer to Church's
criticism was his scientific machine rate, which not only
departmentalized overhead but related or converted practically
all elements of factory overhead into machine hours.

The next step was the recognition of different classes

(bf overhead. Kent in 1916 divided factory overhead into

fkaur broad categories. These were arranged according to

tlieir relationship to material, man—hours, number of jobs,

audd costs of keeping machines in operation. Kent even

adhnitted the possibility of using classes of machines or
Hmrterials. In other words, Kent brought out the point that
facrtory overhead included a great variety of items which
ShCNJld be subclassified into related groups in addition to
being departmentalized before they were allocated.227
The next and final step in the development of over—
heaci allocation is the direct outgrowth of accounting for
idle! time and standard costs. This is the stage in which

\

226
0 Church, The Proper Distribution of Expense Burden,
~E° Clt Chapter II.

‘\.l

 

227 -
COSt - William Kent, ”New Method of Determining Factory
8' " The Iron Age, XCVIII (August 24, 1916), 392-4.

 

144

fixed and variable overhead rates were established. Variations

from the fixed overhead were considered idle capacity items,

while variations from the variable items indicated a measure

228
of operating efficiency.

The income measurement approach contained in the
fixed-variable breakdown is a matter of recognizing that
fixed costs are costs of getting ready to serve while
‘Variable costs are costs of actual service. In this sense
iiixed costs should be allocated on the basis of readiness
tr) serve and variable costs of the basis of actual service.
Ifiiis line of thinking, although not new, was given much
purestige in recent years when it was recommended for income
nmaasurement purposes by Professors Schlatter and Vatter.229

The basic element in the development of allocation

SCfllennes is the recognition of the limitations or special

 

 

228 ' -
C. Howard Knapp, "Variations From Predetermined

Starudards of Burden in Manufacturing Costs," National Associ—

.231923 pf Cost Accountants'Yearbook,1924, 218.
J. L. Palmer, "Production Budgeting," N.A.C.A.

VII, Sec. 1.(October 15, 1925), 103.

 

gEiifiiglflf
229 ‘ ' ll ' H -
R . William Schlatter, Fixed Expense, The Accounting
“1997. XX (April, 1945), 158.
William J. Vatter, "Accounting Measurements of

iggremental Costs," The Journal p_f_ W: XVIII- (Jul-Y,

1945),

145

circumstances surrounding the use of certain procedures. For

example, the direct labor cost method is not truly represen—

tative of overhead incurred unless there is equality of

wage rates. Far more important, though, was the recognition

of departmental overhead rates——different categories of
overhead, each subject to different bases of allocation——
and the fixed-variable breakdown. Departmental overhead
rates are necessary since the various departments have many
unique elements, and not all products travel through all
departments. Categories of overhead are necessary since
overhead consists of such a wide variety of items, and non-

recognition of categories of overhead would lead to averaging

out of existence essential differences. Each of these

classes of overhead could be allocated to product on more

Precise bases. For example, those elements of overhead

Jrelated to materials (expense of storekeeping, inspection,
etC-) could be allocated on the basis of material costs or
Weight; while items related to man-hours could be allocated
on the basis of man—hours or labor costs if rates of pay were
equal . Finally, the distinction between fixed and variable
elements has much to commend it for purposes of allocation,

si . . . . . . '
Roe it involves a very baSic distinction as to the nature

Of COsts.

 

 

146

Although overhead allocation started out in a rough

and ready manner for purposes of estimating, it was refined

around the turn of the century to recognize efficiency
measures and more scientific price determination. This is
'best exemplified in the works of Alexander Hamilton Church,

‘NhO was concerned with waste elimination and sales price

(determination, and who discussed in such a succinct manner

riot only the need for separately allocating manufacturing
and commercial overhead to product and the need for
(departmentalizing overhead allocation, but also the limitations
(3f the then—prevalent methods of allocating manufacturing
(averhead which led, of course to his scientific machine
rtate.

As time wore on and competition grew keener, a more
Scnahisticated approach to efficiency measures and sales price
dsttermination brought to the fore the fact that all costs

neENS not be allocated in order to check efficiency, waste,

or ‘to provide aid in setting sales prices. In the case of

effj.Qiency and waste detection the responsibility idea

c . . . .
au“a into prominence, and was utilized to show how, for pur-

pos‘asa of efficiency measures and waste detection, costs need
not, kae allocated to products, but only to responsibility

c
endlears or to those people who had control over costs. For

 

147

those closest to actual production this meant that most

fixed costs need not be allocated, for those on the lower

levels do not have control over most fixed costs. For

sales price determination the incremental approach to

pricing was considered more and more useful, and thus fixed

costs were not allocated to products for short—run pricing

decisions. For long-run pricing decisions all costs are

still allocated, but the results of such allocation are

considered to be only one element in the process of price

determination.
In effect, then, the full allocation of manufacturing

caverhead to products came to be primarily related to income
uneasurement via the now familiar process of matching costs

vwith revenues. This purpose is still not fully understood,

fCrr there are some who oppose full allocation of overhead

CCHSts in very eloquent terms. The only considerations of

thxDse who oppose full allocation of overhead costs are cost
Corrtrol and the problems of pricing and decision-making where
emFflIasis is necessarily directed toward controllable and
inckrtEmental costs. These same people implicitly or explicitly

lgn’Ore the necessity for full allocation of overhead for
purEDOses of income measurement.23o
\

230 -
For some perfect examples of literature advocating

148

W

Income measurement has actually been the least

important factor in the development of cost accounting. In

'the early stages sales price determination was the sole

objective of cost finding. When competitive conditions be-

<:ame more difficult an interest in efficiency and waste

(elimination arose. The efficiency factor and sales price

(determination together became the basic underlying ideas

ibehind cost accumulation.
Today this is still true, and those interested in

income measurement have in effect adopted for their purposes

(data which is rationally intended for other purposes. This

143 especially true in the case of the normal overhead con-

Cxapt, which is tied to the apron strings of sales price

dertermination ideology. On the other hand, there are those

whO‘vigorously criticize overhead allocations because they

fadil to recognize the major purpose for which such allocations

partial overhead allocation see the following
artelcdes included in David Solomons,(edJ Studies pp Costing,

2%. Cit.
'174‘182.

Edmund Whittaker, "Realism and Cost Accounting,"

David Solomons, "Cost Accounting and The Use of Space

and Equipment," 277-291.
W. T Baxter, "A Note on the Allocation of Oncosts

BetWeen De artments," 267—276.
S. Edwards, "The Rationale of Cost Accounting,”

87~l 0
C03, 94‘ David Solomons, "The Historical Development of
ting, " 31-38.

149

intended, i. e., income measurement.

Both of these problems are responsible for one of
the greatest challenges to the integrity of financial state-
ments as they are often prepared today or as some writers
‘would have them prepared. This challenge is the subject of
Chapter Five. Chapters Three and Four will consider indus-
trial operations and overhead costs from the viewpoints of
economics and management in order that a more informative
and more well-rounded discussion of overhead costing may be

presented in Chapters Five and Six.

CHAPTER III

INDUSTRIAL OPERATIONS AND OVERHEAD COSTS:

THE VIEWPOINT OF ECONOMICS
Introduction
922§£§l

When industrial Operations are considered by

economists the discussion is naturally in the area of micro—

economics or the economics of the firm. Within this area

special emphasis is placed on marginalism in diagramatic,

coral or written exposition. The reason for this emphasis

is that the economist has sought a short-cut for the

Cietermination of price and output decisions of the firm, and

1"has found that the marginal or incremental approach emphasizes

tile strategic factors, that is, added revenue and added

COSt .

Of course, all of the above revolves around the usual

profits maximization assumption and generally the short—run

<1r short-period. "When economists talk about 'the' short

rmlrl they usually mean a period of time too short to make

Cheinges in the quantity of plant and equipment—~i.e., in the

151

'capacity' of an industry——but long enough to make changes

in the degree of utilization of that capacity." This

short—run, as long or short as it may actually turn out to
be, is the period which will be considered throughout this

dissertation.
Furthermore it must be remembered that the economist's

major interest lies in the economy as a whole. The econ—

omist is interested in the firm primarily as the vehicle
through which theories related to the aggregate economy are
formulated and tested on the basis of assumed and/or actual

firm behavior. The attachment of firm behavior to the total

economy leads to a concept of cost necessarily related to
ssupply price which must include certain futuristic expectations
éand certain imputations concerning normal profit and interest.

While generally the economist is interested in the

fiarm only as an integral part of an economy, there is
arHDther economic point of view, that of the "managerial

ec=Onomist." Here the economist devotes his attention to the

filnn as such rather than to the economy. It is in this

ar‘aéi that the distinctions between the industrial engineer,

thee accountant, and the economist become less distinct and

\_ -

l
( Kenneth E. Boulding, Eppppmgp Apalysisl Third edition ,
New York: Harper and Brothers, 1955), 570.

 

152

at times quite obscure. This is not difficult to understand

if it is realized that each of these practitioners must and

will deal with historical, current and/or future costs in

addition to certain cost imputations depending on the cir—

cumstances of each individual case.
Income Measurement and Cost Control

For the purposes at hand, income measurement and cost

(control are of paramount importance. A proper question at

tfliis point would be, "How does the literature of economics

:Eit;into these problems and into their relationship to

crverhead costs?" At this time it is quite difficult to give

arl appropriate answer, for much of the preliminary data

Hencessary for the understanding of this question and the
iJnE>lications it has for overhead costing are contained in
later sections of this chapter and in Chapter Five. We must

thfan be content for the moment with the assertion (to be

juStified later) that the literature of economics has an

X
2

 

s For an excellent discussion of these points of view

Ge :

of Lawrence R. Chenault, ”Business Behavior and the Theory
tile Firm," The Accounting Review, XXIX (October 1954L

Ac James S. Barley, "Recent Developments in Cost

PO:§“lnting and the Marginal Analysis,” Tpp Journpl pf

editicgi Economy, LXIII (June, 1955), 227—42.

\

153
important bearing on the accounting problems of income
measurement and overhead costing.

Cost control poses no apparent problem to orthodox
economic theory. The many real problems inherent in cost
control or making costs conform to standards of efficiency
are for the most part assumed out of existence by the con—
dept of the economic man. This economic man, being thoroughly
rational, tends automatically toward profits maximization,
therefore, there is no necessity to consider cost control,
for the economic man will determine the least—cost method of
manufacture and will automatically make sure that actual
results conform to the minimum expenditure of inputs. The
View that cost control is not part of traditional economic
theory was in effect supported by Joel Dean when he said that
the least—cost combination of inputs "is not always known,
not always politic, and sometimes not even sought,” as is
traditionally assumed.3 Dean added that the maximization of
EProfits in the short—run "is seldom the dominant objective,
aUdthe pressure for efficiency is not, as assumed in the
theory, constant and always sufficient."

3
Joel Dean, Managerial Economics (New York: Prentice

Hall Inc., 1951) 252-3.

4
Ibid., 257.

 

154

For purposes of cost control and waste elimination
Dean relies on the traditional variance analysis of cost
accounting which he complements with the use of correlation
analysis techniques. In either case the approach is still
the same, that is, one accumulates the variances and then
analyzes them to find root causes which are to be eliminated?

Since this dissertation relates to problems of cost
accounting, it is the matter of cost and volume variations
within the confines of the economist's short period that is
of major significance. For all practical purposes the
matter of revenue will be ignored or, when it is necessary
to discuss revenue, it will be assumed to conform to the
usual presentation in non—perfect competition. Cost from

the viewpoint of economics will be conSidered in terms of

the usual dichotomy, that is, variable and fixed costs.
Variable Costs and Volume Variation

general
From the viewpoint of economic marginalism the only

COSts which are of significance are the costs which vary

5

Ibid. Footnote on page 253 and Joel Dean, "Correlation
Analysis of Cost Variation," The Accounting Review, XII
(March,l937): 55—60.

 

155

with volume. These are the variable costs which are usually
assumed to vary with output in the form approximated by a
U—shaped curve.6 The U-shaped unit cost curve is accepted
because the variable inputs are considered to be combined
with a fixed amount of fixed inputs. If there is an Optimum
manner of utilizing a fixed input with variable inputs, as
there should be, utilization above and below optimum will
result in diminishing returns, which is the same as in~
creasing costs. An optimum with increaSing costs above and
below optimum yields the familiar U—shaped unit cost curves
,
for variable and marginal costs.

Not too many years ago economists began to have some
success in quantifying some of their analytical framework,7
and also began to question the assumption of fixed inputs.8
Such work brought forth a number of statistical cost studies

as well as a great deal of controversy concerning the utility

of marginalism. These studies and their related controversies

In the above comments a U-shaped curve is spoken of
Only with reference to variable and marginal costs per unit.
Total costs per unit will also vary with output in the form
approximated by a U—shaped curve.

_ One of the first cost studies was Joel Dean's,
§fiatistical Determination of Costs With §pegi§l Reference to
Marginal Costs, Studies in Business Administration, Vol. VII.
NO. 1 (Chicago: University of Chicago Press, 1936L l45pp,

 

 

8George Stigler, "Production and Distribution in the

Short Run," The Journal of Political Economy, XLVII (June,l939h
305-27. _—

 

156

have led to a reconsideration of the usually assumed

relationships of marginal and variable costs to output.

Statistical Cost Studies

 

Most of those actually making statistical cost
studies have come to the conclusion that the marginal cost
curve, and therefore the related variable cost curve, were

. . . , 9 .
both flat Within the confines of actual Operations. This
conclusion did not invalidate the assumption of U-shaped
curves as such, but it did extend the center portion of the
U to such a degree as to relegate the increasing and de—

creasing portions of the curves to the oblivion of insignifi-

cance. Of course, not all agreed with the conclusions of
these studies. One appraiser expressed his concluSions as
follows:

The literature on statistical cost functions
so far produced has certainly, as all measurements
are bound to do, enhanced understanding and aware—
ness of the complexity of the subject, but I cannot
help thinking that it also represents a case which

9

Theodore Yntema (chairman), "Round Table on Cost
FUnctions and Their Relation to Imperfect Competition," Papers
and Proceedings of the Fifty—second Annual Meeting of the
American Economic Association, Philadelphia, Pennsylvania,
December 1929, The American Economic Review, XXX, part 2
(March, 1940). 400-402.

 

 

157

bears out just that and not much else.lo

Most of the objectors point to what they call built~in linear
biases and the fact that slight deviations in linearity could
yield the usual cost curvature or approximations to it.ll
When one considers variability in the fixed factors
of production which coincides withthe insiStent demands for
flexibility in industrial capacity, there seems to be little
alternative to accepting the conclusions of most of these
cost studies. The connection between the statistical cost
studies, variability of fixed factors, and flexibility is
inherent in Mr. Dean's studies. He purposely sought out
plants Which had experienced wide fluctuations in output;
that is, whether he realized it or not he sought out plants
which would of necessity be built with maximum flexibility.
Flexibility would be a matter of utilizing as little fixed
Plant as possible and/or using many small machines rather
than larger machines. Flexibility either reduces the
Significance of fixed factors or increases their variability,

lO
Hans Staehle, "The Measurement of Statistical Cost

FUnctions: An Appraisal of Recent Contributions," The
flflggican Economic Review, XXXII (June,l942),333.

 

llggig. and Caleb Smith, "The Cost-Output Relation

fOr the U. 8. Steel Corporation,” The Review gf Economic
Statistics, XXIV (November,l942),166—76.

M

 

158

which gives us fewer than the usual reasons for accepting a

U-shaped cost curve, especially within the normal Operating

limits.

Controversy over Marginalism

The controversy over marginalism involves essentially
the applicability of marginalism for short-period price and
output determination. At times the argument has raged about
the calculability Of revenue curves and at other times about
the calculability of cost curves Of their applicability,
even if they could be calculated.

One Of the most persistent critics Of marginalism,
Professor Eiteman, has shaped his attack from both the
revenue and cost sides. When revenue curves are the focal
point Of his attack, the matter Of calculability is para—
mount. In fact, in one Of his most extensive works he basés
his whole argument against marginalism on the inability to
<3etermine revenue curves having any real significance. In

13
Other works the focal point is cost. His arguments run

Wilford J. Eiteman, Price Determination—Business
Eggctice Versus Economic Theory, Bureau of Business Research,
Report NO. 16 (Ann Arbor, Michigan: University of Michigan,
1949),39 pp

13Wilford J. Eiteman, "Factors Determining the Location

Of'the Least Cost Point," The American Economic Review, XXXVIII
(Decemben i947),910-918.

 

159

from calculable cost curves that reach the least—cost point

at capacity to calculable cost curves that are constant in

the normal Operating range. In both Of these cases the

marginal cost curve never rises to meet the marginal revenue

curve within the realm of reality, that is, normal Operating

range. The idea Of a least~cost point at capacity and the
constant marginal cost curves (within normal Operating range)
stems from the previously mentioned statistical cost curves
or at least from their implications.
As a substitute for marginalism Professor Eiteman
larings forth a theory Of inventory flows wherein changes
Lin the movement Of inventories are used as the thermometer
:fcu'price and output changes. Still the problem remains:
irl a given case, is the businessman to choose a price change
<31“ an output change? The choice here seems to necessitate
‘=C>st and revenue analysis in some form. The necessary
afhalysis need not lead back to Strict marginalism and smOOth
c3<1>St curves, but it dOes lead back to a fOrm Of incremental
analysis which is not mentioned 'by Professor Eiteman.
AIn addition to the calculability and applicability Of
Cosyt curves there are two other issues involved in the con—
troversy over marginalism. These issues are related to

a . . - .
Ct'-\-1al.buSiness behaVior and the problems concerning common

160

and joint costs. Studies Of actual business situations have
indicated that price and output decisions are not made on
the basis of an equality of marginal cost and revenue. A
"full cost" concept is used, which starts from direct or
prime costs and adds a percentage for factory overhead plus
another percentage for profits which supposedly takes care
of selling costs and interest on capital. There is no
doubt that these percentages would fluctuate with demand
conditions, so that the "full cost" concept has to be taken
xmith a grain Of salt in terms Of its exact meaning.

The "full cost" concept does in a sense bring out the
ciifficulties of cost computation, especially in multiproduct
industries where common and joint costs are encountered.
1Y3 inpute costs to individual products under such conditions
brings on problems which challenge even the most vivid
inmaginations. A l946 OPA report on cost accounting in
industry which revealed that of 187,370 companies covered,
Eipproximately 15 percent had total product costs on a unit

baSis, illustrates at least to a certain extent the

 

14TR. L. Hall amd C. J. Hitch, "Price Theory and Business

gehavior," Oxford Economic Papers, Number _2_ (May. 1939)
x50rd At The Clarendon Press, Great Britain, 12—45.

161

difficulties Of cost computations.15 The total cost figures
utilized most frequently spread selling and administrative
costs to products on the basis Of relative sales, and mpread
manufacturing overhead most frequently on the (many times
questionable) direct labor cost basis. Such methods may have
.given the CPA a cost figure for price control purposes, and
also may have presented the companies with a usable figure
for income tax return preparation and perhaps even for
annual reports, but beyond these uses the utility Of such
figures is very questionable.

The matter of common and joint costs is rarely dis—
crussed by economists,17 except to point out the difficulties
CDf allocating these costs. As for accountants, the above
(DEUX study clearly attests to their inability tO find a

EDIYactical solution to such problems.

 

 

15
Martin Ii Black and Harold B. Eversole, A Report 92
S¥2§i§.Accounting in Industry, Accounting Department, Office Of
iPlilce Administration (Washington: Government Printing Office,

June, 1946), 68 pp. (mimeo) .

 

16A point to remember is that the CPA study is based
°n~ian exceptional period--involving price controls when
prticdng'(not efficiency) was the prime purpose Of costing.
E3imilar study made in 1953 or 1958 might show different
reshdlts.

7
Th R. A. Gordon, "Short-Period Price Determination in
eOry and Practice, " The American Economic ReviewL XXXVIII

(June,1948),273.

 

162

Fixed Costs and Volume Variation
General

Af first glance a discussion of fixed costs and

volume variation would seem nonsensical. Fixed costs are

costs that do not vary with volume, at least within broad

ranges Of time and output. A lack Of functional relation—

ship would seem tO indicate that there is no problem here.

A closer look at fixed costs, however, indicates

at least two fairly sizeable problems. One problem is a

matter of terminology that has given rise to much confusion
in the literature Of accounting and economics and tO a

ssizeable controversy in academic and professional accounting

(Zircles within recent years. The second problem is the very

Scignificant role Of fixed costs in price discrimination as a
Hueans of destructive competition.

The terminology problem is related to a lack Of
identifying marginalism as a matter of recognizing only
StJfategic factors. When profit maximization is the goal, the
Stlfiategic factors utilized in its implementation are the
incremental items of cost and revenue. These are the only
factOrs that count under such circumstances, but they are

ruyt ‘therefore the only elements of cost and revenue. Failure

163

to label the strategic factors for what they are has resulted

in the problems discussed below under fixed costs and

economic waste.
The possibility Of price discrimination brings forth
problems concerning differential pricing in public utilities

and private enterprise. In both public utilities and pri-

vate enterprise the main issue concerning costs is the very

difficult problem Of apportioning fixed costs to different

classes Of customers. To prevent abuses and to provide

liniformity Of treatment, government regulation is necessary

.in public utility rate—making and in private enterprise. In

tflie field of private enterprise, the government responds to

Fuassible price discrimination via the Robinson—Patman Act
alld.its cost justification requirement for price differentials.
Tflie role of fixed costs in public utility rate—making and the
inbinson—Patman Act will be used to buttress the comments

which will follow concerning fixed costs and economic waste.

Fixed Costs and Economic Wastel8

In many instances those who deal with marginalism

Seen“ to ignorefixed costs and their real meaning. For

 

\

18
There are many forms of economic waste related to

t . , .
WSEE Unisallocation of resources, but as used here economic
Ste includes only the non—use Of the capacity to produce

prov:Lded by fixed costs.

164

example, throughout one very significant study is found the
idea that with established plant and equipment, unit costs
ordinarily depend on, among other things, the rate Of
output.19 The same idea is also expressed frequently in a
great deal Of literature as the spreading of fixed costs
over more or less output, thereby either increasing or
decreasing the fixed cost per unit. Although these ex-
pressions seem to have some validity in their usual context,
a more appropriate description would be "the utilization Of
‘vhat might otherwise be economic waste."

The above comments might sound like rather superfiCial
(Zriticisms if one did not encounter statements such as the

following:

It will be Observed that if marginal cost
(added variable cost) is the whole cost Of each
increment of output, then fixed C0858 could never
become part Of the cost of product.

The businessman, if not the economist, has
accepted the accountant's miracle of converting

X—

 

19
Cost Behavior and Price Policy, A Study

Prepared by The Committee on Price Determination for the
COWIference on Price Research (New York: National Bureau Of

ECOnomic Research, 1943), 353 pp.

20Alfred Bornemann, "Empirical Cost Study and

Egéiruomic Theory," The_AccountinggReview, XX (July,l945),

165

fixed cost into variable cost.21

Both of the above comments show some misunderstanding

of economic events. Mr. Bornemann (if his statement is

sincere) appears to have forgotten some Of the fundamental
facts Of economic causation in that if economic factors are

used, they cannot be treated as if they were unused-—as if

they resulted in no product; in other words, their classi~

fication as fixed costs does not automatically relegate them

to Oblivion. Comments like that Of Mr. Bornemann have in

recent years led to a great output Of literature and con-

'troversy in accounting which will be discussed in Chapter

Five.
As for Professor Gordon's statement, it is only

ruecessary to add the comment that no costs, however defined,

Cuan be allocated or become costs Of product unless there is

a. product to which to allocate them. Costs which do not

liaad to product must be charged Off as losses, that is, they

aJTe in.the category Of economic waste. Further, those costs

W1‘1.1'.c:h_dl_glead to product are not waste, but have contributed

\

 

lGordon, O . cit., 276.

22 '
St. C. Reinold Noyes, "Certain Problems in the Empirical
N udy of Costs," The American Economic Review, Volume XXXI
0- 3 (September,l94l),482-86. "

166

economic value to the product. Utilized and unutilized
fixed costs boldly outline the contrast between facilities

made available and those utilized. These comments should

illustrate that the accountant is not "converting" fixed

costs into variable costs; he is merely calling a spade a

spade when he recognizes unutilized capacity as a loss and

utilized capacity as a cost Of product. The accountant's

treatment Of fixed costs can be said, in effect, to make
Iitilized capacity cost a product cost——and it is not
EDarticularly important that this product cost be labeled

"variable” or something else. It is still, in a very real

Esense, a necessary cost Of production.

What, to the writer, is unsound thinking, is also

Cxontained at some points in the monumental work on Overhead

Cszts by John Maurice Clark. He stated, in effect, that the

-nEitural conclusion tO the statement that business is worth
taking at anything more than its differential costs is that
nothing but differential costs should be charged to pro—
all 23 . .

(rt. He added that if an accountant could isolate constant
CcDSS‘ts from all others, he would have neither cost Of

prC>duction nor idleness but Of readiness to produce,

\

23
John Maurice Clark, The Economics of Overhead

S:~C->~§lE~-§_(Chicagoz The University Of Chicago Press, 1923), 25l.

167

regardless of whether there is any production or not.24

In other parts Of his work Mr. Clark seemed to change
his mind and considered utilized fixed costs as costs Of
production. When discussing inventory valuation he said,

Making goods to stock increases the showing Of
net income available for dividends by just the
amount by which the book cost Of the goods exceeds
the differential cost. However, this is not an
evil, and since the books cannot charge total cost
and differential cost goth, it seems more reasonable

2
to charge total cost.

In a discussion Of public utility rate discrimination
Iflr. Clark again revealed a tendency to consider utilized
fixed costs as costs of product. He stated,

The chief purposes of a rate system should be
to earn a reasonable total return, tO develop the
utmost use of facilities so long as every service
pays at least its differential cost and tg gi§~
tribute residual costs fairly according :9 the
responsibility 9; different E§§£§ :9; the amount 9f
these costs.26 (italics mine)

 

 

 

The assignment Of these residual or capacity costs to
uSers is a problem that Mr. Clark spoke of over and over in
hiES work, and most other authors do the same when speaking
of Irate discrimination. Of primary importance for purposes
\

24

Ibid.

25ibid., 241.

261bid., 322.

168

of this discussion is the tacit admission in such cases

that fixed costs are product costs if they grg ”tj]jzgd

 

It may seem strange to belabor this point Of fixed

costs and economic waste. TO appreciate fully the reasoning

behind such stress it is necessary to bear in mind the
problems Of accounting income measurement as well as
identifying very specifically such items as economic waste
for purposes Of full disclosure in financial statements.

The loose language that has been used by both economists and

accountants, especially with regard to "different costs for

(iifferent purposes" (of which marginalism is an example),

lias added confusion to already loose thinking in accounting

circles .

Economists might be wise to insert into their

Ciiagramatic representations, especially in the realm of

'Tnanagerial economics,” the features of utilized capacity

aruj economic waste. This same idea could also be reflected

if! the usually over—simplified break—even chart. The

problem is usually avoided by an implicit assumption that

Satlfiis and production are equal. Introducing an inventory

pro1=>lem by assuming an inequality in either direction Of

27See Chapter Five, pp. 238—9.

169

sales and production would force the economist and the break—
even enthusiast into the position of considering fixed costs
as either the costs Of a period or the costs of product. As
shown above, they are costs Of product when utilized, and
when unutilized they become period costs in the form Of
economic waste. The whole key to this very real diagrammatic
problem is to recognize the usual unrealistic implicit
assumption of sales and production equality, and to change
to an analysis that assumes inequalities. This was done,
. . 28
at least in a hypothetical way, by Professor Brummet.
TO close the preliminary discussion, it would perhaps
IDe worthwhile to remember the words of C. Reinhold Noyes in
YLis commentary on the phrase, "different costs for different
FHeroses."
It is chiefly loose language or loose,
thinking; for what is meant is that, under
various contingencies which may arise in
connection with the processes Of production
decisions by those responSible may be made
without taking account of.all costs or even
with reference to one or two categories only.
That does not alter the fact Of costs. It does
not make the items ignored or forgotten any the

less costs. It is merely a way Of concentrating
attention on the strategic factor in the case.2

28
R. Lee Brummet, derhead Costing, Op. cit., 83~lOO.

 

29Noyes, o . cit., 485.

170

Fixed Costs and Competition

General

Considering the fact that fixed costs do not vary

with output, and that fixed costs are generally a measure of

capacity to produce, the ordinary ups and downs Of business

enterprise readily bring forth unutilized or excess capacity.

This excess capacity is the source of discriminatory pricing
policies and in some instances Of ruinous competition. The

attitude Of our government towards price discrimination, as

expressed in public utility regulations and the Robinson-

.Patman Act, seems to be that fixed costs are a part Of the

<:ost Of all production. In fact, the only reason for con-I

ESidering fixed costs and competition With reference to public

Lrtility and non-public utility industries is to show how

'tlie government has recognized the economics of fixed costs,

1 -e., fixed costs as truly part of production costs. The

f'Ollowing paragraphs are intended to support the previous

C3C>nc1usion30 that fixed costs must be considered costs Of

EDIKDduction, at least to the extent that they are utilized.

As for the discriminatory aspects of fixed costs,

JXDTLn M” Clark recognized the situation long ago when he said:

 

\

30See page 168.

171

Existing business may or may not cover
all overhead costs, but in either case, if there
is spare capacity, added business will cause no
added overhead and will be a gain at anything
above differential cost, s9.lggg_§§ 33.232 §§.E§EE
separate from existing business, so that existing
earnings are not impaired. This leads to a system
of making each separate section of the business
pay the largest possible yield above differential
cost. A 'section Of the business' may mean a
single customer or a single sale, but in general,
classification is limited by the extent to which
business convenience makes it pracgicable or
public sentiment makes it prudent.

Such discriminatory pricing practices can result in
ruinous competition if capacity Of fixed capital is wedded
to a specific industry (special purpose equipment), if

<:ompetitors are few, and if there is excess capacity in an

Lindustry where fixed costs constitute a large portion Of

txotal costs. In féct, the argument used to show how com—

Fuatition will bring prices down to cost can also be used tO

£3110w how competition will bring prices down further to

(icifferential cost if excess capacity exists.

Public Utility Industries

 

The natural result Of fixed costs, or overhead costs
( tile economist ordinarily works with a concept Of overhead
C‘?E§ts equivalent to fixed costs), has been numerous

Lr1sytances Of cutthroat competition in all forms Of business.

\

 

31Clark, op. cit., 416.

172
Very early examples were the railroad rate wars. As a
result Of such competition, state and federal governments
began to institute various forms of regulation.

Implied in these regulations is the idea that there
is some way to allocate equitably the fixed costs to users.
The regulatory laws did not say that discrimination per se
was evil, but that there must be some just basis for
discrimination.

In the public utility industries there is a perfect
example Of proportionately large fixed expenses and therefore
the problems Of excess capacity and discriminatory pricing.
.Again Mr. Clark clearly recognized the situation when he
said,

The problem of policy involved is twofold--

to stimulate Off—peak business in various ways and

so improve the utilization Of the plant, and to

apportiga justly the burdens that do not vary with
output.

There is (presumably) a just way to apportion the fixed

CNSsts to output, and one Of the major problems Of our
regulatory agencies is to work out a just apportionment,

reicognizing-—at least in public utilities——that different

EJIYDups Of users many times have more or less responsibility

\

32Clark, Op. cit., 15.

173

for different layers of capacity. The quantitative aspects

are the real problem here, for very few will doubt the

validity Of the concept of the just apportionment Of fixed

or capacity costs.

In the electric power industry an attempt is made to

classify costs for rate making purposes as follows:

Capacity costs--demand or readiness to serve costs
ordinarily dependent on maximum

daily demand.

1.

2. Output costs —-fuel, labor, and other costs
necessary to generate power.

Customer costs—~costs Of reading and maintaining
meters as well as costs Of billing,

collecting and maintaining
customer accounts.

3.

The classification is an attempt to categorize costs

Enzcording to causal responsibility by customers or groups of

Cnastomers. The above is just an example Of the problem of

iafillocating costs in one industry. The problem is difficult

and is sometimes complicated considerably as a result Of

t1"1e fact that regulatory agencies overlook the basis of

EECHDnomic causation Of costs. For example, in the telephone

ilidiustry, the Bell system argues for company—wide rate-making,

heiglecting cost differentials. Rates are desired on a

principle wherein rate—making promotes maximum development of

\

 

33 .
C: . . Martin G. Glaeser, Public Utilities in American
5* ltallSm (New York: The Macmillan Co., 1957), 421—22.

174

service by permitting the larger communities, in effect, to
. . 34 . .
subSidize the smaller. This concept of rate—making
emphasizes certain social aspects of allocating costs which
magnify immeasurably the complexities Of quantitative

determination.

Non-Public Utility Industries

Industries without the confines of public utilities
also must deal with fixed costs, excess capacity and dis-
criminatory pricing. They are not plagued by ruinous or
cutthroat competition to the extent that public utilities
Inay be, due primarily to a difference in the ratio of fixed
1:0 variable costs. Here again, though, the federal govern—
Dnent has stepped in to attempt a more just or equitable
Eipportionment Of costs which at least implies that fixed
(rests are part of the cost Of production.

The Robinson—Patman Act Of 1936 is the vehicle Of
‘gtJvernment intervention. The section involved is Section 2(a),
VVTIich gives rise to a cost proviso in cases where illegal
EDITice discrimination is charged. This proviso gives the
(ieifendant an Opportunity to defend a difference in price on
.t}1e basis that his price differentials "make only due
all-1C>wance for differences in the cost Of manufacture, sale

(Dr- delivery resulting from the differing methods or quantities

E:Ibidu 435—6.

175

in which such commodities aneto such purchasers sold or

delivered”.

From the inception Of the Act the intentions Of the
Acts' proponents were quite Obvious with regard to the
allocation of general overhead Of a fixed nature.

The committees both Of the House and Of the
.Senate discussed in their reports, in a general
way, the concept Of cost which they had in mind in
considering this act. The point Of most sig—
nificance is that they seemed determined that
general overhead should be allocated on a per-
unit basis, and that pricing in terms Of the
additional cost or increment involved in a
particular order should not be permitted as
justification for price discrimination.

The above view of the rationale Of the Robinson—
]?atman Act is supported vigorously by Professor Taggart,

(Ihairman Of an Advisary Committee on Cost Justification '

tn: the Federal Trade Commission.36 In a review of his

Chommittee's report he said:

35

Willard J. Thorp, "Price Discrimination and Cost.'
@e Journal _og Accountancy, LXIII (March,l937), 184.

36The Advisory Committee on Cost Justification was
appointed by Federal Trade Commission Chairman Howrey in
1953 in order to help the commission develop guides for
aclininistering the cost proviso Of the Robinson-Patman Act.
£3 committee's report was rendered in February, 1956.

176
If anyone has hoped that this committee

would give any aid or comfort to the marginal

approach to cost justification, he will be

disappointed. . . . The legislative history Of

the Act and its Obvious intent are completely

Opposed to the proposition that 'due allowance'

has been made if only added costs are taken

into account. '

The Act recognizes that all sales are responsible

for the effect Of volume on costs, and therefore the first
and the last customer should not be treated differently On
the basis Of the fixed costs of production. If any customer
is to be exempted from certain cost allocations it must be

on the basis of some singular difference from other customers,
such as a lack of benefit from the facilities or services
thich are the key to the price differential. Furthermore, it
:is incumbent on the seller to relieve all customers in a
J.ike position from allocations Of the costs involved.

The true position of the Robinscn-Patman Act is to
Errotect small buyers from those large buyers who might try
'tID extort large discounts from those sellers who could be
EDIJagued by a significantly high portion Of fixed costs. In
effect, the law is an anti—price discrimination measure, in
tliei sense that a system of price differentials must be

\

7
11' Herbert F. Taggart, "Cost Justification Under the
rcfl31nson-Patman Act," The Journal of Accountancy, C l
‘JUne,1956), 54.

 

 

177

based on cost differentials. In this way the law has
recognized an economic problem concerning the allocation Of
costs, specifically overhead costs of a fixed nature. It is
the law's intent to enforce a just means of apportioning
overhead costs. The marginal or incremental approach is
outlawed specifically. Both the laws regulating public
utilities and the Robinson-Patman Act conclude, at least
implicitly, that fixed costs are part Of the cost of all
production.

In addition to being described as an act proscribing
unjustified price discrimination, the Robinson—Patman Act
has been described by some as an unjustifiable outgrowth
of the unjustifiable anti—chain store campaign of the

38
.1930's, and by others as an act which enforces price
discrimination.39 Those who speak of the Robinson-Patman

Zxct as an anti—chain store measure back up their arguments
VVith.many statements made in Congressional hearings and

40
‘tlie speech—making surrounding the Act. In addition there

 

 

8

Frederick M. Rowe, "Price Differentials and Product
I)J.fferentiation: The Issues Under the Robinson-Patman Act,"
% Yale Law Journal,LXVI (November, 1956), 2-3.

39 -
M. A. Adelman, "The Consistency of the Robinson-

Pat”-rnan Act," The Stanford Law Review, VI (December,l953),3-22-

0
Frederick M. Rowe, loc. cit.

178

is Mr. Patman's admission that a Mr. Teegarden, counsel for
the United States Wholesale Grocer's Association, actually
wrote the bill.41 The only trouble with the anti—chain
store approach to the Robinson—Patman Act is that the
campaign is not recognized in its proper perspective. The
anti—chain store campaign should be viewed as the radical
answer to the discriminatory tactics of large buyers,
while the Robinson—Patman Act should be viewed as the
reasoned approach to prohibiting unjustified price dis—
crimination.

Professor Adelman champions the view that the
Robinson—Patman Act enforces price discrimination. He
points to inept administration of the act, and a few in—
tsonsistent provisions of the act.42 However, Professor
deelman would probably be quick to agree that the true
irationale Of the act is to eliminate unjustifiable price
Ciiscrimination. Inept administration is the key to Adelman’s

Ciriticisms Of the Robinson—Patman Act. There is no doubt

$131 the author's mind that Professor Adelman joins with many

41
Hearings Before the House Judiciary Committee on
533—118 to Amend the Clayton Act, 74th Congress, lst S ssion
(1935), 9. ‘

2
M. A. Adeleman, loc. cit.

179

others in hoping that the ultimate effect Of the reports

rendered by the Committee on Cost Justification43 and the

Committee to Revise the Anti-Trust Laws44 will be to pre-

vent unjustified discriminatory pricing practices.
Summary

In economks all costs are usually categorized as to

whether they are fixed or variable. Usually economists speak

of overhead and fixed costs as synonyms, but the accountant

includes in his overhead category both fixed and variable

costs. The accountant recognizes that a large and increasing

part Of his overhead is fixed, and that as production becomes

Inore complex the variable element is of decreasing signifi—

cance .

The concept of a constant variable cost within the

CDperating range would have to be interpreted with extreme

(rantion (and perhaps even abandoned) in the case Of over—

1mead. This is true, since the idea involves all variable

43
Advisory Committee on Cost Justification, gpppgp pp

.SEEEE Federal Trade Commission (Washington: Government Printing
office, February, 1956) , 26 pp, (mimeo) .

44
Report pf the Attorney General's National Committee

EL52§tudy the Antitrust Laws, (Washington: Government Printing
Office, March,l955), 393 pp.

180

costs and the variable costs included in overhead are only

a portion of the variable costs. Also, the variable costs
other than in overhead usually include both of the other

cost elements (direct labor and direct materials) which are
more than likely of a constant unit cost nature. It is
probably, under these circumstances, that the reason for
constancy of total variable unit costs is the preponderance
of direct labor and direct materials which would Offset to

a large extent any lack of constancy in variable overhead
costs. In other words, the constancy of variable unit costs
may well be an averaged constancy. There is nothing inherent
in the-statistical cost studies or the idea of variable fixed
inputs that would vitiate such a conclusion.

Overhead, by definition, would include all fixed
czosts which, due to their increasing significance, must be
(zonsidered an important phase of any study of overhead., This
1.8 especially true when a fluctuating production volume
<3)<ists and apportionment of fixed costs is necessitated
‘Jéirious forms of legislation, espeCially the Robinson—Patman

33C2t in the case of non—public utility industries, have
<=<Jncluded that fixed cost allocations to customers or groups
Cfo customers or to products or services must be just or

EECIUJtable. The strict logic of economic causation demands

181

such allocation and a recognition of the fact that at least
the utilized fixed costs are true costs of products and
services, even though in certain cases they may not be

significant for decision—making purposes.

CHAPTER IV

INDUSTRIAL OPERATIONS AND OVERHEAD COSTS:

THE VIEWPOINT OF MANAGEMENT
General

The task of management is inextricably related to
the problems of profit making and the rendering of services.
Profit-making concepts vary from that Of the total economic
man interested in profit maximization to the various shades
of the less-than—total economic man interested in satis—
factory profits. In order to achieve whatever profit goals
are decided upon, much work must be done and accounting
(accumulations should aid in the attainment of these managerial
<goals. This is the essentially pragmatic view that should be

as part of every functional division of an organization.

The goals that are established involve the overall
EDEarformance of the firm as well as breakdowns of overall
E>€3rformance in terms of functional divisions and subdivisions.
tr'he determination of the firm goals in an overall sense as

“”6111 as in the many unavoidably delicate and intricate details

1‘3 usually considered the planning function of management.

183

Closely related to planning is the control function, or that
function which is intended to make actual results conform

to plans. In accounting the actual cost and revenue
accumulations must be related to the benchmarks, anticipations,
or goals which have been set up, in order to perform the
function of comparison which is designed to ferret out and
eliminate waste. The comparison and correction function,

of which accounting is a part, is essentially the control
function.

In addition to the planning and control functions
there is still one major task in which accounting accumu—
lations should be of aid. This is the decision—making
function. In the broadest sense this is the function that
selects the path to follow or the goals to be achieved from
iamong the many alternatives available. Planning is in
Gassence both preliminary to and the result of the decision—
nnaking process. Planning involves such tasks as determining
tflue means and methods necessary to achieve goals, the necessary

IEEacilities, manpower and other factors of production. De-
<2isions to act must be made before the plan for acting is
c3C>mplete, and at the same time a plan is being carried out it
nnuStbe constantly and continuously challenged in order to

reCheck the original choice among alternatives as well as to,

184

allow for the introduction of new alternatives which may
or may not be introduced into a new and revised plan.

If accounting data is to be of any value in the
performance of the above functions, those who accumulate
the data must be familiar with the functions they intend to
serve.1 This is the only approach that will maintain for
accounting data any semblance of utility. It is the only
approach that will aid the responsible executive in achieving
his goals.

In accordance with the goals of this dissertation,
control of overhead costs will receive special emphasis in
the general discussions that will follow in this chapter.
.First, financial and cost accounting will be considered in
Llight of how they can aid in the achievement of managerial
ggoals. Then management views on fixed overhead costs will

kDe considered in order to illustrate certain aspects of

fiixed overhead costs which will be worked into the concepts

1 .
For excellent statements on this point of view see,

R. H. Coase, ”Business Organization and the Accountant,

:Lr1C1uded in David Solomons (ed. ) Studies in Costing (London:
SWeet and Maxwell Ltd. 1952), 105— 6.

Verne Breitenbucher, "Putting Cost Accounting to Work —
FVDIT Cost Control," National Association of Cost Accountants'

)(e\arbook 1946,112.

185

of income measurement in Chapter Five.
Financial Accounting As A Management Tool

Financial accounting is that area of accounting which
revolves around the measurement of income. The income is
determined periodically, at least annually, and is portrayed
in an income statement which is usually accompanied by a
balance sheet. In the income statement the information
presented consists of gross income, the various deductions
therefrom and the net income figure. In the balance sheet
are listed various categories of assets and equities.

Granting the existence of changing price levels and
the necessary corrections therefore,of what values are the
statements of financial accounting? Can the individual items
EDresented in the statements or any combination of them be
liseful in the various phases of the internal management of
Ein industrial enterprise?

To answer these questions three important features

C>ffinancial accounting must be recognized. These are as

ffOllows:

l) the statements prepared are very summarized
presentations.

2) the statements are prepared from a long-run point
of view

186

3) the statements are "outsider oriented".

Summarized Data

The summarization of accounting data in the financial
reports yields only very general data concerning Operations;

‘this is especially true of published financial reports.

VVithin the confines of a particular organization, the fin—

eancial reports are in effect unsummarized to yield more

:Lnformative data. The summarized versions are very general

iJIdeed, and can only yield information of an overall nature

'Mfliile at the same time they can hide or average out Of sight
aniny significant items. Information concerning the con—
tributive effect of individual divisions, plants, or

CHepartments as well as product lines or products is completely
1“iciclen in the summary presentations of financial accounting.
Wi thout the more detailed data and other information which

there

1‘3 <3rdinarily considered the realm of cost accounting,
15‘ ‘very limited managerial utility in the reports of

f in ancial accounting .

Long-Run Assumption

In addition to the summary aspects Of financial

a _ _ ‘ . .
(:Ciounting, the long-run pOint of View is ever—present and

187

is in reality a vital feature of financial accounting. The

foremost example of this is the accounting for fixed
assets. Accrual accounting is, by its very nature, ijlong-

run significance. This long—run idea is perfectly illustrated

lay the going-concern concept inherent in financial accounting.
'The going-concern concept assumes that the enterprise is not
in danger of voluntary or involuntary cessation of activities.

'Iherefore under some circumstances incurred costs are

Eiccumulated as investments in the future (assets) until such
tzime as the investments bear fruit in the form of revenue.

ZXt.that time the investments become expenses, and are

Eisssociated or matched with the revenue they gave rise to in

CDrder to yield a net income figure. Such is the nature of

aC=<:'rua1 accounting, which is inextricably associated with
‘tflea going-concern or long—run outlook of financinal accounting.
The fact that reports of financial accounting can be
prEspared for periods much shorter than a year should not
‘leééid.anyone to believe that such statements are prepared from

' a. Sshort—run point Of View. It takes more than working wifli

S‘tICDrtuperiods to reflect a short—run point of view. The
$11(Drt—run as such demands an incremental point of View and

recognition of the relationships between costs and output.

lq<3vfhere in financial accounting are these short—run

188

characteristics found,2 and since the various internal
management functions necessitate both a short and a long—run
point of view the presentations of financial accounting

are not at all adequate for management use. This is es-
pecially true in the case of manufacturing firms where the

Inyriad activities of the factory are summarized into a cost

(of goOds sold figure.

Outsider Orientation

Foremost of all the criticisms of financial accounting,

\

111 terms of its utility for internal management, is the fact
‘tliat financial accounting is “outsider oriented”. The

EDITesentations are intended primarily for the use of outsiders

2See the section on cost accounting (pp.214-23).for
a. Ciiscussion of recent proposals concerning the introduction
CNE' short—run characteristics into the financial accounting

f ramework .

_ 3Outsider orientation is considered by A. C. Littleton
lr‘ his Structure pf Accounting Theory, American Accounting
ASssiociation Monograph No. 5., 1953, on pages 79—81, in terms
‘31? the stockholders and financial statements as reports of
Inaflagerial stewardship. The cornerstone of the public
ac:Clounting profession, that is, independence and the
heCzessity of financial statement certification to third
parties, also indicates without doubt the outsider
Or'ientation of financial statements.

 

189
such as tax collector, the banker, the security analyst,
as well as current and prospective investors. This external
orientation is actually what leads to the two previously-
considered features of financial accounting. Details
concerning individual parts of the enterprise or its products,
as well as the short—run or incremental features of certain
aspects of business, are considered confidential information.
As such they are not to be considered as part of the end
products of financial accounting, which are intended for the
use of outside parties in order that they may judge the
overall effectiveness or profitability or progress of a
business enterprise during a particular period of time.
Peter F. Drucker recognized the limitations of
ftnancial accounting as an aid to internal management when
he stated
. . .we have to focus accounting data on
management's needs in running a business rather
than on the requirements of a tax collector and
banker, or on the old wives' tale so many
investors imbibe at their security analyst's

knee and forever after mistake for financial
wisdom.4

 

4
Peter F. Drucker, Tpp Practipp 9: Management

(New York: Harper and Brothers Publishers, 1954), 72.

 

190

Measure of Economic Progress

Financial accounting as described thus far has very
serious limitations in terms of internal managerial utility.
There is, though, one way in which it can yield some
internally useful data, that is, by providing an overall
or summarized measure of econqmic progress. The measure is
the income figure, or, as Littleton said, "the center of
gravity“ around which all of financial accountinglrevolves.5
Management, in addition to desiring details as to the in-
dividual elements of an enterprise, also is in need of a
consolidated point of View which shows the overall results
of the firm's efforts during a particular period of time.
Effie results or progress in one period could easily be used
for comparative purposes. Comparisons of relative economic
prOgress could be made between periods, similar firms,
industry averages and perhaps even economy averages. These
comparisons could be made in terms of the net operating
income figure or of the summarized presentations of revenue
or expenses. In the following pages, the idea of financial

accounting data as a measure of economic progress will be

integrated into that overall framework designed to provide

5Littleton, o . cit., 18-35.

191

managers with useful accounting accumulations.

As for the breakdowns Of overall progress, this is
usually the province of cost accounting. The need for
details concerning the progress or contributive effect of
enterprise subdivisions must be recognized, as well as
details suited to the short—run point of view with its
related categories and classifications Of cost. With these
changes the external orientation of financial accounting is
replaced by, or at least supplemented with, an internal
orientation. The next section on cost accounting is intended
to show how more useful data can be prepared. 'Financial
accounting has been found wanting except for the presentation

of an overall report of economic progress.
Cost Accounting As a Management Tool

The field of factory cost accounting can be sub-
divided into two broad categories. In the first category
c0st accounting can be considered as simply an extension of
financial accounting, while in the second category cost
accounting can take on a more intensive and searching review
of the individual elements of the factory in a manner that
is not at all apparently related to financial accounting.

In this section primary emphasis will be on the factory costs,

192

for it is factory overhead that is the main concern of this

dissertation.
Extension of Financial Accounting

Perusal of many cost accounting texts6 could easily
lead one to believe that the major or sole purpose of cost
accounting is the determination of a unit cost figure to be
utilized in inventory valuation for balance sheet purposes,
and for measuring the cost of goods sold for income statement
purposes. In effect, such works are interested primarily
in cost accounting only for the purpose of filling the gaps
in financial accounting which result from the fact that an
enterprise manufactures all or some of the products it sells
“Hither than purchasing all of its products complete and ready
to sell. Cost accounting in such instances is only a means
Of providing the equivalent of a purchase price figure.

This approach has the same inherent limitations as
financial accounting for internal management purposes, except
that it does show or bring out some of the details. The

6An outstanding example of a text which does not

follow this pattern is:

Carl T. Devine, Cost Accounting and Analysis (New York:
The Macmillan Co., 1950), 752 pp.

193

long-run approach and the outsider orientation are still
predominant. As for the idea of utilizing the income
statement as a measure of economic progress, certain very
useful accumulations are possible, dependent on whether

historical or predetermined costs are used.
Historical Costs Versus Predetermined Costs

By historical costs is meant the accumulation of cost
data on the basis Of what actually happened in the factory.
There is no comparison between what did happen and what should
have happened. The only comparison possible is between what
happened at this time or period and what happened in the
past. Such a comparison brings out only the overall extent
of progression or regression between actual occurrences.

The yardstick used to measure progress is not based on what
should have occurred; it is based on what did occur at one
time.

Obviously then, there are inherent limitations to
historical costs. This is what was on the mind of Harrington
Emerson many years ago when he wrote that there were two

". . . radically different methods of ascertaining costs..."7

7
Harrington Emerson, "Efficiency as A Basis for

Operations and Wages, Part IV, The Modern Theory of Cost
Accounting,"The Engineering Magazine, XXXVI (D cember,l908), 336.

 

194

The first method determined what costs were after completion
of the work, while the second method determined what costs
should be before actual work was undertaken. The first
method erred, since it delayed valuable information and,
even more important, it combined the costs of inefficiency
with costs as they should have been. The second method
divided costs into "standard expense" and "avoidable loss",
and thus facilitated the elimination of readily identified
waste.8

With the introduction of standard costing as pre-
sented by Emerson, financial statements could be prepared,
at least for internal purposes,9 in such a way that deviations
from expected results were highlighted.) Thus the results of
operations for period were, in effect, compared with results
as they should have occurred, and, furthermore, comparison
of periodic reports could yield a more accurate determination
of the direction and extent of progress. Standard costing

then added to the concept of financial accounting as an

8
Ibid., 336—9.

9Standard cost variations are never a part of exter-
nal financial reporting, due to the confidential nature of
such information.

195

overall measure Of economic progress the idea that manage—
ment would be shown not only the profits i: dig gpkp, but
also what happened to the pgofits that i: should have made.10
The standard cost variations are generally broken
down into price and quantity variances for direct material
and direct labor, and budget, efficiency and capacity
variances for overhead. Price variances measure the
difference between prices actually paid for the elements
of production and standard or expected prices. Quantity
variances measure the difference cost—wise between quan-
tities actually used and quantities that should have been
used in producing certain volumes of output. The overhead
laudget variance is essentially a price variance, while the
CTverhead efficiency variance is essentially a quantity
VEiriance. The overhead capacity variance is actually a
Itleasure of idle facilities, or that portion of fixed
manufacturing overhead which has not been productively

utliclized when practical capacity is used as the measure of

Capacity. When normal or cycle capacity is utilized the

\

10
This is the view of G. Charter Harrison, often

COnSidered the father of standard costing.
Iéae5= G. Charter Harrison, "Working Plans for Standard Costs—
:[33 Obtaining Real Value from the Cost System," Management

Eafliiineering'lll (August,l922), 98.

196

meaning Of the capacity variance changes.

Under normal capacity, the overhead capacity variance
represents fixed overhead costs recovered in selling prices
of this period which will not have to be recovered in the
:future (overabsorbed), or fixed overhead costs not re-
czovered in selling prices of this period but which will have
‘to be recovered in the future (underabsorbed). Under cycle
<:apacity, the overhead capacity variance represents fixed
(overhead costs applicable to current revenue which will be
anid for in the future (overabsorbed), or fixed overhead
(costs applicable to future revenue (underabsorbed).

In addition to the use of these variances for
illustrating in a very dramatic fashion what happened to
EDrOfitS that should have been made, there are many who
recommend the use of such variances for cost control, that

is the elimination of waste or deviations from plans or

I

EStandards. Waste elimination is of course the idea behind

Ehuerson's statements,12 and waste elimination is still

11
For a complete discussion of these concepts see

tile section in Chapter Two on ”The Sequel To The Supplementary

12Emerson, o . cit., 336.

197
emphasized in cost accounting texts and actual accounting
practice as the major goal of standard costing.l3
The use of such variances for cost control is pre-
dicated on analyses which determine the causes of the
\rariances as well as responsibility for the variances.
VVithout these analyses cost control through variances would
k>e ineffectual. In the case Of direct materials and direct
ILabor, the causes and responsibilities for variances can be
aassessed with relative ease and procedures can be instituted
1:0 correct variations not caused by changing conditions.
As for overhead, the variances accumulated leave much
‘to be desired for internal management purposes. Overhead
(or indirect manufacturing expenses represent a considerable
‘variety of items which cannot be or are not worthwhile
‘tracing to a particular product or batch of products. The
fsetting of standards related to unit overhead costs is an
éiveraging process in which so many individually different
Zitems are averaged that the efficacy of the standards
tlihemselves is questionable, let along the variances from
sStandards. Such standards might be the most reasonable way

13 . '
How Standard Costs Are Being Used Currently

(New York: National AssociatiOh of Cost Accountants, 1950),
26-50.

 

 

 

 

198

‘to approximate a unit overhead cost to fulfill the require—
Inents of financial accounting, but that is all.14 Accounting
for overhead costs is the area wherein one is forced to
:recognize the inadequacies of cost accounting when it is
(iirected towards fulfilling the requirements of financial
accounting.

Professor R. S. Edwards recognized this point very
eaxplicitly when he stated that the purpose of costing is
t:o shed light on constantly recurring management problems.
fie added in a very cynical fashion that to too many accountants
tihe inclusion of all costing procedures within the confines

"16

(Df double—entry is "the hallmark of respectability. They

(30 not realize that the enormous drawback to a double-entry

czosting system is that some arbitrary assumptions have to be
. 17

Set up to make it workable. These assumptions relate

EDrimarily to overhead allocations, wherein managerial utility

14
Ibid., 49. This study concludes that those who do

(accumulate overhead budgets and variances use them primarily
for costing production, that is, accumulating inventory
figures rather than for cost control.
15
R. S. Edwards, "The Rationale of Cost Accounting,"
included in David Solomons (Ed.),Studies in Costing (London:
Sweet and Maxwell, Ltd., 1952), 88. —_ _—

16 ,
Ibid., 100.

17 _
Ibid., 91.

199

iS sacrificed for the double-entry framework of financial
accounting .

With this limitation in mind, it is no wonder that
(zost accumulations in terms of responsibility have been
aadvocated for so long. These accumulations are outside of
'the double-entry framework and many times include all the
ealements of factory costs in addition to overhead costs.
'rhe next section is reserved for a discussion of respon-

ssibility accounting.

Responsibilipy Accounting

 

Facilitation of factory operations should be the
nnajor goal of industrial accounting. To operate the factory
{plans are needed, which must be put into effect, and finally
‘the operations must be controlled in accordance with the
Enlans. The essence of the problem of industrial accounting
is then the determination of what information is necessary

. . 18
for the planning and control of factory operations.

18 .
Planning and control are the two categories

Suggested for cost analyses in the "Tentative Statement of
Cost Concepts Underlying Reports for Management Purposes"
jby’the Committee on Cost Concepts and Standards of the
z\merican Accounting Association. See The Accounting Review,
XXXI, (April, 1956), 184.

 

200

Since plans are based primarily on forecasts of
future conditions, it is necessary to consider costs as
'they will most likely be at such future times. Also, since
‘there is the problem of assuring that the elements of pro—
ciuction will be present when needed, the relationships between
czost and volume must be brought into perspective. In the
first place, certain future commitments are made on the
loasis of forecasts which result in a relatively inflexible
relationship between cost and volume. .This inflexibility
recognizes the fact that commitments made for the future
\vill lead to the incurring of some unavoidable costs within
‘the confines of the present planning period. An inflexible
relation between costs and volume brings out the short—run
<:Onsiderations of fixed and variable costs and the related
flexible budget for planning purposes. In other words, in
addition to standards and plans based on sound forecasting,
it is absolutely necessary to recognize the relationship of
costs, to output in order to be prepared to manage the fixed
and variable factors of production more accurately. There—
fore, for planning purposes, costs must be considered in
terms of volume (fixed and variable) as well as in terms of
future expectations concerning prices, efficiencies, and

even management attitudes.

201

In addition to future expectations and volume con—
ssiderations, if the planning and control phases of management
aare to operate effectively the plan must recognize cost
(zontrollability. This means that planning must recognize
‘the organization structure (the real structure, not
riecessarily the formal paper structure), for if control is
t:o be effective it must pinpoint responsibility.

The concept of expense controllability was recognized
aas long ago as 1919 by G. Charter Harrison, a contemporary
(of many early management pioneers as well as one of the most
ealoquent and persistent advocates of standard costing. His
relevant comments were so lucid that they must be quoted.

"It is quite Obvious that for a cost system 'to
enable the superintendent to know whether or not he is doing
the work he is responsible for as economically as possible'
it is necessary for us to distinguish between expenses for
‘which the superintendent is directly responsible and those
over which he has no control...”19

Controllability OWfl'CostS is a matter of level in the
organizational hierarchy. All costs are controllable at
Some level; thus even the summarized statements of financial

19
G. Charter Harrison, "Cost Accounting in the New

Industrial Day," Industrial Management,LVIII (December,l919),443.

202
aaccounting can be considered as fairly adequate overall
Ineasures of managerial ability or stewardship. At lower
Inanagement levels some costs begin to assume uncontrollable
garoportions. A perfect illustration is when high level
eexecutives commit the company and its subdivisions to
eaxpenditures on the basis of decisions affecting the future;
for example, depreciation, taxes, and insurance on real
EDrOperty which are the result of high—level expenditure
(decisions. The high—level executives are responsible for
'these costs even though for purposes of computing a total unit
<:ost they are chargeable to an operating subdivision.

The concept of cost controllability is nothing more
than fitting the system of internal accounting to the
organization structure. Planning for future periods involves
a build—up of estimated future costs by areas of respon-
sibility. These areas of responsibility should extend as
far down in the organization structure as responsibility
extends, at least to the foreman level. Only in this way
can cost control be effective.

Under such a system plans must, in effect, relate
the incurring of costs to personal responsibility. In the
Case of a foreman, he should be charged with all those

<205ts in his activity center over which he has control.

203

These costs would include direct labor, direct materials,

supplies and some forms of indirect labor. He would not be

held responsible for such items as depreciation on equipment,
taxes, and utilities such as heat, which are controlled by

managerial policy and other external conditions. Someone

above the foreman is responsible for the depreciation,
PrOperty taxes and other costs not controllable at the

foreman level. Costs such as depreciation and property

taXes are controllable by those who make long—run commit—
ments and purchase the depreciable property.
Service department costs such as maintenance present

a problem in assessment of responsibility. The service

department manager is responsible for all costs over which
he has control, but at the same time, since operating fore—

men can request maintenance work, they also are responsible

fOr maintenance costs. This common situation where at
leaSt two persons are responsible for costs must be faced
ScJuarely. If both the Operating foreman and the service
de[Dartment manager are able to influence the cost through
their own actions, they should both be held responsible.
In this way the operating foreman would be forced into that

heCessary position of balance between requests for main-

teriance and continuity of efficient production. The rule

204
here is to. charge a man with cost responsibility if he is
able to exert a significant influence on the cost.20

Of course, in the case of a factory, cost plans must
be based on a forecast of sales and on inventory policy in
order tobuilde estimates of production. In order to
allow for the possibility of variations in expected sales
and the effect of such variations on production, the plan
adopted takes the form of aflexible budget, which is a
Plan that recognizes that certain costs change with volume

Va r iat ions .

The control that comes with cost planning related

'10 responsibility is a matter of communicating information
to responsible people about the desires of management, and
at the same time motivating responsible peOple by giving

t”—l'lem goals. There is also the desireability of comparing

actual and expected performance in order to determine out-of-

line performance which can be eliminated in the future. These
thI‘ee aspects of control, that is, communication, motivation,
‘ and checking—up are those considered important by the

American Accounting Association's Committee on Cost Concepts

and Standards .

\

Committee on Cost Concepts and Standards Of the
American Accounting Association, _qp. cit., 189.

21
Ibid., 188-190 .

L;%_

205

It is unfortunate that the committee did not integrate
tliese ideas more closely and also that it did not drop the
zapnoroach of “checking up“ as simply a matter of improving
:ftrture performance. 'The desired integration in cost control
its a matter of informing those responsible for costs as to
What is expected of them, thus motivating them to attain
taa<p>ectations, since they should be aware of the fact that
't}1€3 attainment of expectations is their job. Then management
Cfiara compare actual and expected results not only in order
‘tCD find out what went wrong so that future problems may be

eliminated, but primarily in order to find out what went
“firwong and what has already been done to correct out-of-line
c(Draditions. A truly integrated cost control system is the
Slllsject of Chapter Six. Assumed throughout this discussion
C>f7 responsibility accounting is the cooperation and approval
(3f? those men who are to be held responsible in the setting
‘JF> of their segment of the total plan.

The above View of responsibility accounting is quite
Sehparate and distinct from the traditional accounting
EDITflolems of income measurement. This distinction does not
mean that profit goals have been relinquished; in fact, it
means quite the opposite, for emphasis is focused on profit

rmaximization. This seeming paradox is simply explained by

206
tflie fact that there is quite a difference between working
'tcxnard profit maximization and the periodic measurement Of
Earxofit. Every day-to—day effort of the enterprise should
fc>cus attention on profit maximization in the sense of
l<eaeping costs within predetermined limits, expending every
eafffort to find ways and means of reducing the predetermined
1.11nits and also increasing revenue. All of these things
Eirwe done by individuals, and these individuals should be
Cflaiarged with responsibility therefor and given every credit
:ECDI'the contributive effect Of their efforts. The contri-

I>L1t.ive effect is measured only in terms of costs and
IT€!Venues over which people have control. In the case of
‘tliee factory, which is of primary interest here, revenue is of
1'1C) significance since factory personnel rarely if ever have
arljyaffect on revenue as such. The factory personnel are
affected primarily by cost, in terms of making it conform to
EDIWsdetermined limits and expending efforts (research and

me‘thods development) to reduce the predetermined limits.

Other Aspects of Cost Accounting: Pricing

 

There is no doubt that costs do have a place in the
E3rocess of price determination. As pointed out in Chapter

'PwO

, the origin of cost accounting for overhead was related

 

207

aJJnost exclusively to price setting. In such cases direct
Inerterial and direct labor costs were accumulated and a
Eaexrcentage was added to cover manufacturing overhead,
<2cnnmercial and administrative costs, and the hoped—for profit.
TQlEE percentage used was actually a rule Of thumb percentage.

With the advent of competitive conditions there was a
IUCDITe searching and scientific analysis of costs utilized to
hndtild up to selling prices,22 and at the same time there were
'tT1case who were propounding a selling price ideology based on
a. czost existent under efficient conditions. In other words
wEisstes, whether related to unused or wasted facilities or to
<3t:}1er production waste (labor and materials), were to be
e>{c21uded in setting prices that would tend toward industrial
tranquility.23

At about the same time there were those who began to
as Sume an even more sophisticated approach to pricing.
Thease were the men who spoke in terms of a price being given
13}’ an autonomous market, cost being used merely as a

22See A. Hamilton church. The. Eraser Distrihution. of.

'figflpgnse Burden (New York: The Engineering Magazine Co., 1908),
1L6 pp.

 

23H. L. Gantt, "The Relation Between Production and

(30sts," Transactions pg the American Sociepy g; Mechaniggl
lingineers, XXXVII (June,1915 Meeting), 128.

 

 

 

208

determinant of whether or not production shOuld be under—
taken. This point of View took two lines of thought. One
was related to a long—run situation involving complete pro-
duct costs (including a share of fixed overhead)24 while
the other involved the short-run situation and partial pro-
duct costs of an incremental nature (excluding fixed
OVerhead) .

Today all of these ideas are still with us, and
together they form a rather complete picture concerning
'tllee way various individuals look upon price determination.

The Office of Price Administration of World War II
and the Office of Price Stabilization of the Korean War
illustrate the idea of utilizing all costs to build up to a
Selling price. There is some question as to how scientific

the build-up was, for the CPA did recommend the use of highly

 

 

24
B. A. Franklin, "Cost Methods that Give the

EXecutive Control of His Business — VI The Vexing Question

if Expense," The Engineering Magazine, XLIII (June,l912),
28. I

25 ,
Ibid.

George 0. May, "Cost Accounting, " Twenpy—five Years p_f_
qunting Responsibility 1911-1936 (New York: The American
Institute Publishing Co., Inc., 1936), 364.

 

209

questionable methods in apportioning manufacturing overhead
as well as commercial and administrative costs.26 Re—
negotiation of government contracts seems to insist on costs
under efficient conditions and a normal profit. These
ideas, taken in conjunction with labor's expressed views on
normal profits, management's expressed rationale for price
ir1<2reases and the emphasis on cost—price relationships in
recent years as a result of the inflationary spiral, indicate

a. Itather pronounced view among many people that cost and
E>Iiices are closely tied together.

An example of the connection between efficient costs
alici prices was provided by Howard Greer when he said:

"Much as we may desire to realize a price which will
CKDrnpensate us for our costs, justified or unjustified, we
Cfiirlnot expect our customers to pay us a premium to cover

ifleafficiency, wastefulness or disadvantageous position."27

26The recommended method for allocating selling and
'aéhninistrative costs to different products was relative
Salles volume. For manufacturing overhead, the (many times
qué'stionable) direct labor cost method was recommended.
See: Martin L. Black and Harold B. Eversole, A Report 92
S¥E§t Accounting in Industry, Accounting Department, Office of
PlZ‘ice Administration (Washington: Government Printing Office,
JWlne,1946) 68 pp. (Mimeographed).

27Howard Greer, "Cost Factors in Price-Making," The
kfiirvard Business Review, XXX (July-August.l952), 43.

 

210

The idea of an autonomous price which will govern
‘ufliether or not production is to be undertaken is still found
t:cxday. Under autonomous prices there can be no such thing
at; a cumulative cost computation to set a price. Pricing
sstuarts from the consumer's wants and purchasing power, and
earnfls with the task of finding a means of satisfying the
(:cxnsumer's wants within the limits of his purchasing power.
'IQIIJS, under autonomous pricing, society's "consuming
<3!3;oartment" places orders with its "producing department",
‘311Ci it is the task of the executive to keep the plants going
53C) that the orders may be filled.28

As for the incremental or marginal View of pricing,
tifiis has been pretty much the domain of the economist. In
r<3<3ent years, though, this concept has been under heavy
at‘tack from the point of view of inability to determine
InEirg’inal revenue as well as from the point of view of a
c:Ol'lstant marginal cost within the realm of normal output
expectations. Under either of these conditions marginal
re-‘Venue and marginal cost would never meet and establish a

p'i‘ice of output in the short—run.29.

8Jules Backman, Price Practices and Price Policies
(New York: The Ronald press Co., 1953), 145—46.

29See the "Marginalist Controversy" in Chapter Three,

pP~158-62.

 

211

A review of cost and pricing literature shows that
ixieas do not change too much over the years. In actual
EqITicing practice today there is involved some kind of a
czcnnbination of all of the above ideas. Hall and Hitch came
'tC) the conclusion, on the basis of their studies, that
13Llsinessmen based their prices on cost plus a percentage to
CZCTver manufacturing overhead and another percentage to cover
CYtlaer expenses and profit.30 Offhand it looks as if we are
lDéicmLWMere we started from in the beginning, except that
‘tlleere are two add—on percentages rather than one. A closer
EiE>§maisa1 would indicate that no percentages are quantified,
and that the total percentage added on is subject to change
<i€3§ending on the status of competition. Rigidity in the
E>rwofit percentage is undoubtedly present, to some degree
1Dth it is not absolute.

The above approach based on the Hall and Hitch studies
153 quite realistic when one considers the many common and
jCDint costs of a fixed and variable nature (most of these
are overhead items) that are ever—present in the usual
ITu-llti—product, multi—process business firm. To allocate such

3
0R. L. Hall and C. J. Hitch, "Price Theory and

BUsiness Behavior," Oxford Economic Papers, Number g,(Mayll939),
OXford At The Clarendon Press, Great Britain, 12-45.

212
cxosts requires a great deal of judgment, but at the same
‘thne it must be recognized that all allocation methods are
airfloitrary. Therefore every element in the cost—plus pricing
‘teachnique must be taken with at least one grain of salt.
IDj.fficulties in cost allocation, especially overhead, yield
TliJghly subjective cost figures, and difficulties in assessing
‘tluea status of the market lead to a highly subjective adding—
C>r1 of percentages of profit.

These conclusions related to the Hall and Hitch
SStIUdies, are consistent with other studies of cost—price
Ifealationships. A 1948 National Association of Cost Accountants'
S”tJde showed that most of the 72 companies surveyed used ‘
Sfitiandard manufacturing costs as a basis for prices. Such
Standards were based on, or converted to, expected input
F>ITices, and unavoidable variations from standards were also
tliea subject of special adjustments.31 Judgment enters into
‘t}1ius pricing scheme not only in setting standards, but also
1“ Inaking adjustments thereto for pricing purposes. In

.
acaddition it should not be forgotten that the largest area
rfiquiring judgment is the percentage to add to standard
miinufacturing costs in order to yield a selling price. This

31
How Standard Costs Are Being Used Currently (New

‘York: National Association of Cost Accountants,1952), 73.

213

leeads us unavoidably back to the results of the Hall and
32
Iijgtch study.

A somewhat more pertinent study by the National
Ikensociation of Cost Accountants would certainly give some
ssenuse of relief to the marginalist. In this study the
CZCnnpanies involved separated costs into fixed and variable
Eilxements. However, the separation was not for the purpose
CDfE a marginal pricing scheme. The fixed and variable break—
Cicymms were utilized to recognize the relations between costs,
\7C>1ume, and profit in such a way that within the range of
E>C>ssible prices and the quantities of product that could be
E5C>1d at such prices, the most profitable combination of cost,
\7C31ume, and profit could be approximated.33 Fixed costs (a
1-arge element of overhead) are basic factors in the price
EsCheme uncovered by this study. These conclusions on the

utility and use of a fixed—variable cost breakdown are in

agreement with a recent survey of pricing practices by the

32
Hall and Hitch, loc. cit.

————.

33N.A.C.A. Research Series No. 23, "Direct Costing,"
WBulletin. XXIV, Sec, 3.(April,l953), 1108-1110.
SQe also: .
Alwyn M. Hartogensis, "The Art and Practice of
I-’ricing:" N.A.A. Bulletin, XXIX,Sec. 1.(March,1958),
63-74. ‘

214

IDaItnell Corporation.34

In summary it might be said in the first place that

'tliere is some relationship between costs and prices. The

rrelationship should and does concern expected costs, not past

()1? historical costs. Secondly, it is wise to segregate

ftixed and variable costs, but not for the purposes of a
nnairginal pricing scheme which might be relied upon under
cieepmessed conditions, in obtaining a one—time sale, or in
CDgiposition to the Robinson—Patman Act. The fixed—variable
sseagregation is exceedingly useful in judging cost—volume-

E>1rcfifit.relationships applicable to a range of prices

eaestablished by competitive conditions in order to consider

HICDIe adequately the effect of volume on costs and, of course,

(Dr! profits.

Other Aspects of Cost Accounting: Decision Making

In the broad category of decision—making, cost data

E‘ITE of great significance. Decisions in a business enterprise

51113 most apprOpriately influenced by incremental costs and

reP-‘venues. The word "incremental" does not necessarily

ixldicate a marginal approach, for in many decisions fixed

4"Pricing Techniques and Practices Today: A Surveyg'
:The Management Review'LXVI (MayIl957), 8—9.

215

cxosts do become incremental in nature.

Capital expenditure decisions must necessarily
rtecognize added fixed and variable costs as increments.
bdefl<e—or-buy decisions are also influenced by fixed and
XIEtriable costs, especially in the case of a new product where
‘tlie decision has yet to be made to manufacture or buy. When
63 company is already in the process of manufacture, a make—or-

IDLJy decision still involves fixed costs. A decision to buy

<2<>uld eliminate many costs fixed by policy as well as by
tLiJne, such as maintenance, insurance, and all the costs of
IDLJilding occupancy, just by disposing of the property that

Vveas.previously used to manufacture. A decision to make, on

1:}1e other hand, should recognize that manufacturing facilities

nFillst be replaced.

Pricing decisions also must recotnize fixed costs,
‘3><cept perhaps in the case of a one-time sale, or those
$53€£flal sets of circumstances involving by—products and
(ieflpressed conditions. Business continuity demands recog—
nition of fixed costs in pricing decisions.

,Too many people have made a very quick and very
3Eallible transition from the short—run marginal pricing

Schemes to the application of marginal costing to practically

 

216

envery form of business decision.35 Such peOple forget that
tliere are very few strictly short—run decisions to be made
iri a business. Most business decisions (including pricing
(fleecisions) have long—run implications, and therefore, fixed
(:casts must be considered. In reality many fixed costs do
\Jairy; they do change in accordance with time, management
E><>licy, and level of output.

The idea of basing management decisions on a simple
IDJTeakdown of costs into fixed and variable components is
EDCDpular with the advocates of "direct costing", which (as
tifiey say) is nothing more than recognizing that costs are
E23.ther fixed or variable.36 The direct costing approach to
c3ecision-making fails to recognize that fixed costs must be
c3C>nsidered in making decisions, that the costs of significance
3LT} decision—making are not yesterday's costs, but are the
‘3<>Sts being incurred or avoided today and costs to be in-

<2urred or avoided in the future, and, finally, that each

(3EH2ision must be based on an independent study of how the

For this View see:
Jonathan N. Harris, "Case Against Administrative

EIIXpenses,” The Journal of Accountangy, LXXXII (JulyIl946).
32—6. "-

 

Raymond P. Marple, "Direct Costing and the Uses
<3f Cost Data," The Accounting Review,XXX (July.1955), 432—3.

6
Marple, Ibid., 431-2.

 

217

CNDSt factors behave. There is no method that will fit all

cnases or even most cases. The incremental approach to

cienzision—making must be considered in its broadest sense,

tliat is, added costs no matter what their relation is to

\rcylume in the short-run.

Accounting for manufacturing overhead is, without

CJLzestion, of great significance in decision-making. In fact,
C>\7erhead is the category of costs usually emphasized in
"Ciirect costing”, since direct labor and materials are con—
Esj.dered variable. Overhead includes a great variety of costs
C>ff varying variability and varying fixity, as well as costs
VVTIich are extremely difficult, if not impossible, to trace
thD particular units of product or those categories applicable
t1C) decision-making. These considerations alone should make
cDrIe quite wary of any suggestion that a breakdown of over—

1dead costs into fixed and variable components is all that is

heieded for decisionwmaking. An attempted breakdown of

37
The usual techniques recommended for the breakdown

fo costs into fixed and variable components are:
1. Visual inspection of accounts
2. Statistical analyses
3. Engineering studies to determine how costs
should vary.
For a complete explanation see: N,A,c,A, Research Series,
No. 16 "The Variations of Costs With Volume," N.A.C.A. Bulletin,

XXX,,Section 3. (June 15, 1949), 1228-36.

218

caverhead costs into fixed and variable categories would
iiivolve a highly questionable averaging technique after a
cieacision was made as to the definition of fixed costs.
this is meant that a variable overhead rate would be an

I3)’

eaxlerage of a great many unrelated items of varying variability,

VVT1ich should makes its efficacy subject to great doubt, even

i.f? a fixed-variable breakdown is all that is needed for

Cieacision-making purposes. The next section will consider

titiis point further.

Other Aspects of Cost Accounting:
Beware of Oversimplification

In a number of instances, a breakdown of overhead

 

8
Some definitions recommended in the literature in—

crlJude:
l. Shut—down costs of ”every cost that could not

kDe? eliminated by boarding up the hose plant" (in Clem N. Kohl,
'What is Wrong With Most Profit and Loss Statements, " N.A.C.A.

EglretinlxvuLSec. 1, (July 1, 1937), 1211.

2. Costs of getting ready to produce a certain
‘VYDlume of business or costs that the management cannot or
will not vary on the basis of actual output, N.A.C.A. Research
Series No. 23, "Direct Costing," pp. g_i_t_., 1087.

definition of fixed
many arbitrary classi—
were found in

In practice the applied
C=<Dsts is very haphazard and involves

fications of cost. Examples of this
(iiscussions with industrial and public accountants and also

31h "A Group of Letters on Direct Costing," N.A.C.A. Bulletin
XXXV, Sec. 1.(March,1954) , 907-11.

 

219

cxosts into fixed and variable portions (direct labor and
Ciirect materials are considered variable) has been advocated
ftar certain uses in which it may be extremely dangerous if
Iacat properly handled. An instance of this is where a so—
(:51lled short—run point of view is advocated for the income

:st:atement. The income statement recommended usually takes

39
‘tlle following form:

Net Sales Income
Less Variable Cost of Goods Sold
Manufacturing Margin
Less Variable Selling Costs
Merchandising Margin (Marginal Income)
Less Fixed Costs
Fixed Factory Expense XX
Fixed Selling and Administrative ‘xx
Expense
Total Fixed Costs
Net Operating Income

iiifiiéiiiié

iii-ii

As can be seen, the statement is an adaptation of
‘tlle economists' marginal analysis or of that type of analysis
aEasociated with short—run decision—making based on a simple
breakdown of costs into fixed and variable components
(Ciirect costing). Claims for this form of income statement

Elire always associated with cost—volume—profit relationships,

39
N.A.C.A. Research Series No. 23 "Direct Costing,"

2p. cit., 1097.

220

or what amounts to the same thing, break—even analysis.4O

Pkor example, it is frequently noted that from the mer—
cflaandising margin (marginal income or contribution to fixed
cxosts) figure in conjunction with the fixed cost figure, a
IDIxeak—even point or an approximation to it can be computedfn'
I?Ixom this point on, then, the break—even idea is worked
irito its traditional forms concerning effects of various
SEDending decisions on income, profit forecasting in terms of
‘VEirious combinations of sales volume and costs, and such
‘tliings as the determination of “true profit contributions”

CDf? individual branches, products, classes of customers,

42
and even salesmen .

The contribution income statement seems reasonable

Ulitil one recognizes its inapplicability to all except one-

 

 

pflrocess, one-product firms. In the usual multi—product,
4O . . -
G. Charter Harrison, "The Practical Economists'
Profit and Loss statement." N.A.C.A. Bulletin,XXX,Sec. 1.

 

(IDec. 15, 1948), 443-56.

Waldo Neikirk, "How Direct Costing Can Work for

Mianagement," N.A.C.A. Bulletin XXXII,SeC. 1.(Jan.,l951),
523-35. '

41
Marple, pp. cit., 433.

42
G. Charter Harrison, "The Practical Economists'
Profit and Loss Statement," pp. cit., 447.

221

Inulti—purpose firm, broad break—even analysis for the firm
aas a whole involves assumptions concerning sales mix,
E>roduction mix, a gigantic practical problem of defining,
fiixed and variable cost components, and, finally, such an
cnyerall averaging process to yield an average variable cost
EDear unit that anyone should be extremely wary of the results.
Shame of the same wariness should be present when individual
EDxcoducts, classes of customers, branches, and even salesmen
éaxre analyzed as to their profit—contribution. This is
rueacessary in the case of the smaller segments of an enter-
EDITiSe, since joint costs are ever—present, and there is
‘aflLways present in joint cost allocations a great deal of

a rbitrariness .

Furthermore, the contributive effect of individual
Sfiagments of an enterprise cannot be measured in terms of a
Simple fixed—variable cost separation. What is necessary is
51 comparison of costs and/or revenues over which control
iJS exercised, or costs and/or revenues which are specifically
1Identifiable with an individual enterprise segment. Which-
<3ver way this is done, fixed costs become identifiable with
Segments of the enterprise.

Control and variability are not at all synonomous,

except perhaps at the lowest levels of the enterprise. At

222

‘higher levels, those in charge have a great deal to do with
Ebolicy decisions concerning commitments into the future out
CDf which fixed costs arise. Therefore, if the contributive
esffect of their work is to be analyzed, all costs (fixed
c>r variable) over which they have control must be included.
Ifiie same holds true in the case of a product line, for there
Etre fixed costs that would not have to be incurred without
‘tlle product line. Special-purpose equipment and certain
Stalaried personnel are outstanding examples of such costs.

Perhaps the best argument for the short-run income
Eitatement was that presented by Philip Kramer who said that
iqts chief advantage is "the segregation of the effect on
cxosts of management's long-range policy decisions from .
Charrent operation decisions."43 Kramer's idea, like all
1ihe other ideas concerning a short-run income statement,
Siounds reasonable until it is realized that a significant
EDOrtion of the fixed costs in a business enterprise could

<Eoncern future decisions involving a year or even less than

E1 year. Many salaried personnel are in the category of costs

 

fixed for a year or less. The same is true of some ad-
vertising and research programs. In other words, fixed costs,
43

Philip Kramer, "Selling Overhead to Inventory,"
N.A.C.A. Bulletin; XXVIII,Sec. 1.(January 15, 1947), 591-2.

 

 

223

other than those related to long—term asset aquisitions,
involve current operating decisions.

The objective of this section has been to place a
warning sign where one is needed. There are too many people
concerned with accounting who would have everyone believe
that practically all their managerial problems can be solved
by the process of segregating costs (especially overhead)
into fixed and variable components. They do not emphasize,
as is necessary, that variability and controllability are
not synonymous, that most business decisions have long-run
implications which demand consideration of fixed costs,
that there are real problems in deciding what really are
fixed costs, that fixed cost decisions can be part of
current operating decisions, and finally that variable
overhead costs (assuming agreement on content of these costs)
consist of many unrelated items of varying variability
which are averaged into one variable rate per factory or
per department. Without consideration of these warning
signs the presentation of short—run cost breakdowns for the
firm as a whole or for any of its subdivisions can be use—

less, or worse, misleading.

224

Fixed Overhead Costs and Management

Thexnums of H. L. Gantt and his contemporaries, as
presented in Chapter Two, yield a rather interesting
attitude concerning fixed overhead costs which is in accord
with the ideas of economics as presented in Chapter Three.
At issue is the relation of fixed overhead costs to costs
of production.

Mr. Gantt and many others believed that only that
portion of fixed overhead costs which was actually utilized
in production was to be considered as a cost of production.
In other words, fixed overhead costs were to be considered
utilized in the ratio of actual usage to usage provided
for. The unutilized portion of such costs was considered
as a loss of the period in which it was unutilized.

As stated before (Chapter Two), behind the ideas of
these men were the determination of selling prices, measure-
ment of operating efficiency, and only in the case of Gantt,
the social problem concerning labor and capital. To them, a
realistically competitive and fair selling price could not
include the costs of unutilized capacity. Furthermore, with
idle capacity costs not considered part of product costs,

unit cost figures could be utilized as an indication of

225

manufacturing efficiency where a definite method of
manufacture existed and labor and material costs were known.
Gantt felt that neither management nor labor should be
remunerated for wasted efforts, and he believed idle
capacity was a form of waste to be borne out of the profits
of businesses and not foisted upon the laboring classes in
the form of selling prices.44

This whole View was rather nicely summarized by

A. Hamilton Church in 1931. At that time he stated that

overhead costs are the costs of production preparedness,

not of production. Overhead can be used or wasted. If
used, it is part of true product cost. If unutilized, it
is a loss chargeable to income. Overhead, that is, the

fixed-cost element, is a function of time, and therefore if
facilities are idle the unutilized overhead costs accumulate
‘ II II 4 5 ' H H '

in a pool of waste. This pool of waste concept is

identical to the "economic waste" concept developed in

Chapter Two and it is carried forth to the present day in at

 

44
For a complete statement on these views see

Chapter Two, PP-59-6l.
45
A. Hamilton Church, "Overhead - The Cost of
Production Preparedness," Factory and Industrial Management,
LXXXI (January’l931), 40.

 

 

 

226

least one part of the literature of production management.46
IIf we were to have again the depressed economic conditions
:remembered so vividly by Gantt, Church, and their contem-
[poraries, these ideas might again creep into management

literature on a more extensive scale.
Summary

Financial accounting has been found to have very
limited managerial utility due to the fact that it involves
summarized data, which is outsider oriented as well as long-
run in nature. One saving feature of financial accounting
is that it provides a measure of an individual firm‘s
economic progress. The measure of economic progress (net
income) when combined with standard costing, yields the

interesting comparison of what earnings were made and what

 

happened to those earnings that should have been made.

 

Standard costing does yield some control features,
which in the case of overhead are quite restricted due to
the double-entry framework. Out of the limitations of
standard costing came responsibility accounting. In both

46
B. Gordon Carson (Ed.),Production Handbook (New

York: The Ronald Press Co., 1958), 52-3.

 

227
cases the type of control involved was primarily a matter
of improving future performance rather than correcting
out-of-line current performance. An improved approach to
control, to be discussed in Chapter Six, was suggested in
general terms.

Other aspects of cost accounting related to mana—
gerial utility were considered in a broad sense, and warning
signs were posted against an overenthusiastic reliance on
a breakdown of costs, especially overhead costs, into fixed
and variable components. Finally, fixed overhead costs were
considered as to their proper treatment, in order to identify
idle or wasted capacity. As in the case of economics,
utilized fixed costs are considered product costs while the
unutilized fixed costs partake of the nature of"economic
wastenor a "pool of waste". This concept is admittedly a
long-run concept, and for this reason has specific utility
in the accounting concepts concerned with income measurement

which is the subject of the next chapter.

CHAPTER V

THE MODERN APPROACH TO OVERHEAD COSTING AND INCOME
MEASUREMENT AND THE NEED FOR RECONSIDERATION OF

BASIC IDEOLOGICAL FOUNDATIONS
General

During the last twenty years the accounting pro—
fession has been engaged in a sometimes furious debate about
overhead costs and income measurement under conditions of
changing production volume.1 At the present time the heat
of the debate has subsided, but not because of an agreement
on basic issues. The opposing groups seem to feel that they
have aired their opinions in such a way that there can be
no alternative to their views, and each is waiting for proof

of the pudding in actual practice.2

 

1
In order to verify this comment it is only necessary

to check the leading accounting publications for literature
concerning "direct costing" since about 1951.

2This is an impression gathered at a special session
on "direct costing" at the 1958 Annual Meeting of the
American Accounting Association held in August 1958 at
Syracuse University, Syracuse, New York.

229

Essentially the controversy (direct costing con-

. 3. .
t:r<)versy) involves the fixed element of overhead costs and

tIIEE question of whether they are costs of particular periods

c>f’ time, unrelated to production as such and therefore not

a. Ebart of inventoriable costs. In other words, fixed costs

ante: costs of getting ready to produce as opposed to variable

CHDSSts which are costs of actually producing. Such a

<izisstinction between cost elements leads to an incremental

cxr' variable cost approach to inventory pricing.

Analysis of the direct costing controversy will show
‘feaxfiy clearly the two general schools of thought current in
aCczounting literature. This analysis, in conjunction with
1:}IEE previous discussions of the economic and managerial

‘VTLGEqunJms, as well as of the development of cost accounting,
“71-1-1 provide the framework for what I consider a unique

solution to the controversy.

Direct Costing: Origins

The more current origin of direct costing is to be
4

f l .
‘3’L1nd in a 1936 article written by Jonathan N. Harris.

-\\p\\‘

 

3
The other aspects of "direct costing" related to short—

:;}1r1 deCiSion-making and other aSpects of break-even analysis
ai‘fe been considered in the preceeding chapter, pp.214-23.

"What Did We Earn Last bbnth?"

4Jonathan N. Harris,
1936), 501-26-

Eig§£§58ulletin, XVII,Sec. 1.(January 15,

230

Mr. Harris was worried about the inability to forecast
production in a way which would eliminate under- and over-
absorbed overhead. These under- and overabsorbtions, which
were inseparably tied to forecastproduction and the fixed
element of overhead costs, led to such violent fluctuations
Of income unrelated to sales volume that Mr. Harris was
forced (as he states it) to develop a new approach.5 An
.example of the problem confronting Mr. Harris is contained

in the following data for three months.

June July Augusp

Sales -- 20,000 units 20,000 units 20,000 units
Production 20,000 units 30,000 units 15,000 units
Direct Material

Costs $100,000 $150,000 75,000
Direct Labor

Costs 100,000 150,000 75,000
Variable Overhead ,

Costs 50, 000 75, 000 37, 500
Fl>{ed Overhead

Costs 150,000 150,000 150,000

dm inistrative
and Selling
F‘ Costs 50,000 50,000 50,000
cDr‘ecasted
Production
For Year 240,000 units
Rate for Absorbing
EPixed Overhead
Costs 12 months X $150,000 . $1,800,000 : $7.50

240.000 units 240,000 per unit

 

Ibid. , 504.

231

From these data the following income statements are

developed. Note that sales, the rate of variability for

variable expenses, fixed costs and efficiency are all held

constant in order to emphasize the effects of fixed over-

head absorption. The fixed overhead absorbed changes solely

because production differs in each of the three months.

(all figures in thousands)

 

 

 

 

June gply August
Sales $480 $480 $480
COSt of
Sales $400 $400 $400

Add Under- -0- 400 (75) 325 37.5 437.5

absorbed

Overhead
GJi‘Cbss Profit on

Sales $ 80 155 42.5
Adm inistrative

and Selling

Expenses 50 50 50 -
Net Income 51.2.1. SEE-5: 3701—5)

(Loss)
Strange as it may seem, each of the three months

pr‘Qduces a different income figure and in one month there

i .
S a net loss. How can all of this make sense when sales

a
rQ equal in all three months? (Mr. Harris' question).

Mr - Harris and his followers believe that the statements

d . .
Oh 't make sense and are 1ncomprehens1ble to management.

1‘at is required is a complete overhaul of accounting theory

232

for the determination of income which recognizes fixed
costs for what they are, that is, the costs of a period

not allocable to product and therefore not allocable to

inventories (their argument).

The new treatment of the fixed element of overhead
costs would then produce the following income statements

for the same three months.

(all figures in thousands)

 

 

June July August

Sales $480 $480 $480
Cost of Sales* _gg _2_5_0_ 250

Gross Margin $230 $230 $230
other Costs

Administrative

and Selling :30 50 50

EPigxed Overhead 150 __;§g 150
bleat: Income § 30 § 30 § 30

 

 

 

I

\’°\7ariable costs of merchandise only)

With this innovation Mr. Harris was quite satisfied.
Iii-ES income statements were understandable in terms of having
Sales and Net Income vary sympathetically. The erratic
r6253ults produced by under—and overabsorbed burden were
EEJLJiJninated and replaced by what Mr. Harris believed was a
mQre sensible measure of operating results.
Actually the ideas expressed by Mr. Harris were not

rleiVV; Garcke and Fells said practically the same thing in

233

1E387fl6 Their comments, as quoted below, consider only
sealling and administrative costs (establishment expenses)
latrt they apparently would have treated factory overhead
sstnilarly if it were fixed in nature. Garcke and Fells in

‘triis comment and most other parts of their book assumed

'tliat.factory overhead was variable in nature.

The course adopted by most of the best
manufacturing firms is to value . . . manufactured
articles on hand at their cost of production,
without any addition for profit, or for standing
charges as distinguished from factory charges.
The practice of including in the valuation of
stock a percentage for establishment expenses
or standing charges is one which cannot be too
strongly condemned, if on no other ground than
that a business really the reverse of profitable
might, by the simple device of manufacturing and
accumulating a large stock, be made to appear for
a time as at any rate self-supporting.

6Even though Garcke and Fells made comments similar to

L43: - Harris', their objective was much different. Mr. Harris
“75153; interested in income measurement while Garcke and Fells
wGal-‘e interested in price determination via marginal costs.
Gris~31.‘cke and Fells merely accepted for income measurement pur-

C)Ses a figure that they intended to use as a price
:iea'tLermining cost. For a complete explanation of Garcke and
I35331.l's view, see Chapter Two on the “Influence of Price
Eatlermination on the Content of Overhead", pp. 22-6.

7 .
I) See Chapter Two on the “Influence of Price
eat:ermination on the Content of Overhead", pp.24-6.

8Emile Garcke and J. M. Fells, Factory Accounts,

IREJurth edition (London: Crosby Lockwood and Son, 1887),
l2l-2.

234

At first glance this may not seem to be the same
idea as that held by Mr. Harris. The identity is recognized
when one realizes that when fixed costs are allocated to
inventory and when inventories are increased, the propor-
tion of a particular period's fixed costs included in
inventory rather than cost of goods sold increases as the
inventoriable stock increases. This is the same point
Mr. Harris made when he wrote:

. .desire for an understandable profit and loss
statement was not unreasonable if one is willing

to grant that a manufacturing company cannot

realize a profit until its products have been

sold. It cannot make money merely by producing

goods for inventory.

John Maurice Clark recognized the same principle in
the early 1920's when he wrote,

Making goods to stock increases the showing

of net income available for dividends by just the

amount by which the book cost of the goods ex-

ceeds the differential cost.

Professor Clark stated the same ideas in terms closer
to Mr. Harris's when he said that the natural conclusion to
the statement that "business is worth taking at anything
more than its differential costs“ is that nothing but

9
Harris, pp. cit., 510.

10John Maurice Clark, The Economics 9; Overhead Costs

(Chicago: The University of Chicago Press, 1923), 241.

 

 

235

differential costs should be charged to product.11 He also
said if an accountant would isolate constant costs from
all others, he would have neither cost of production nor of
idleness, but of readiness to produce, regardless of whether
there is any production or not.12

As will be seen later these same ideas-concerning
direct costing were at least implied in break-even analysis
and the economist's graphic analysis of total costs and

revenues which are products of the late nineteenth and

early twentieth centuries.

Direct Costing: The Period of Refinement

Early Emphasis: Eliminate the Normal Overhead Concepp

The early years of direct costing, that is, the period
from the time of Mr. Harris's article (1936) through the
early 1950's, saw the proponents utilizing some variation
of Harris's illustration. A statement of their case (as it
looked to opponents) was very well summarized as follows:

A favorite illustration of theirs was to

present two income statements, each with the same
volume of sales but with final profit figures

 

11. ,
ibig., 251.

12
Ibid.

236’

quite different, or two income statements in

which the one with the larger sales volume

yields the lower profit figure. In both

cases, management, usually the president,

is represented as asking how such results

are possible. The accountant . . . blames the

results all on unabsorbed burden. Management

is then assumed to become naively confused by

this explanation being pictured as knowing

little about the effects of low volume and

high unit costs.

The sequel to this state of affairs is that the
accountant redesigns his records so as to do away with the
' baffling results of such statements. The new system, which
inevitably must be direct costing, eliminates the apparently
contradictory profit reporting by treating fixed costs (the
villain) as period costs. The possibilities of over or
under absorbed burden are avoided by the new concept of
. l4
income measurement.

The attack on the conventional system of reporting
income seems to have been something of an evasive tactic,
in that the new concept of income measurement was developed

primarily to avoid estimating a normal or expected volume

of production which could be used as the basis for overhead

 

13 ‘
George W. Frank, "Will Direct Costing Theory Stand

Inspection?" N.A.C.A. Bulletin, XXIV, Sec. 1. (December, 1952),
492.

 

l4Ibid.

237

absorption. Over and over again in the literature a major
point of the proponents of direct costing was that there
would be no necessity to estimate normal or expected volume
since all fixed costs would be excluded from inventory.
Eliminating the necessity to estimate normal or expected
volume was one of Mr. Harris's major points which he
15
followers eagerly adopted.
The rather awkward emphasis on eliminating over—and
underabsorbed overhead by means of eliminating the
necessity to allocate fixed costs to inventory led Professor
Doyle to make the following humorous, but quite appropriate,
parody on Antony's speech to the mob (cost accountants
everywhere) at the funeral of conventional cost accounting.
Romans, country men, and lovers! hear me for my
cause. If there be in this assembly, any dead friend
of overhead costs, to him I say that direct costing's
love of overhead was no less than his. If, then,
that friend demand why direct costing rose against
overhead allocation, this is my answer-—Not that we
loved overhead allocation less, but that we loved
our sanity more. Had you rather that overhead
allocation were living and go nuts explaining it,

than that overhead allocation were dead and ye can
keep your marbles and sleep at night?

 

15Harris, pp. cit., 508-9.

Leonard A. Doyle, "Overhead Accounting Comes Full
Circle." N.A.C.A. Bulletin, xxv, (August, 1954), 1584.

238

Switch in Emphasis: Approach of the Economic Marginalist

From a stress on avoiding calculation of normal out-
putg there was a discernible change to a breakdown of costs
into fixed and variable elements, as before, but with the
(anphasis now on the view that fixed costs are costs of a
period, costs of getting ready to produce, costs which will
exiSt without actual production. The change in stress,
although one author emphasized the period approach as early
as 1937,17 was apparently the result of wide publicity
given to the controversy here and abroad, which attracted
the attention of many people familiar with economic
marginalism and break—even analysis.

Perhaps the most sophisticated publication emphasizing
the period cost approach was that of the Englishmen,

Lawrence and Humphreys, published in 1947 under the title
Marginal Costing.18 The reason for the title becomes clear
when it is realized that the authors' approach is an ex-
tension of the economic theory of the firm dealing with price

17
Clem N. Kohl, “What is Wrong with Most Profit and

LOSS Statements,"u.a.c.A. __B_ulletin, XVIII, Sec. 1. (July 1, 1937),
1217.
18
F C Lawrence and E. N. Humphreys, Marginal
Costing (London: MacDonald and Evans, 1947), 117 pp.

239

and output decisions. The arguments presented can be
summarized by saying that the income derived from a particu-
lar sale is the difference between the sale price and the
Inarginal cost of the item sold. To derive total income,

all that is necessary is to take the sum of the incomes from
all of the sales. To derive net income deduct the fixed
costs for the period from the previously calculated total
which is often called marginal income or the total contri-
bution to fixed costs.l.9 There is no doubt that this
argument has a telling effect on a great majority of those-
who are willing to listen, especially those who are schooled
in the rudiments of economic theory. In England the title

marginal costing still prevails for the practice known as

direct costing in the United States.

Switch in Emphasis: Approach of the Break-even Enthusiast

A variation of the marginal costing point of view is
break-even analysis. The argument runs as follows: Under
break-even analysis no profit is earned until fixed costs
are covered--how then can fixed expenses be allocated to
products? Fixed expenses are time expenses, not performance

19ibid.,

H
|

13.

240

expenses, and should therefore be charged to the period in
question, irrespective of production during that period.
"This is the reasoning which supports the break-even

formula."20

Switch in Emphasis: The Perfect Argument

 

The almost perfect extension of the break-even
argument took the form of a challenge to unbelievers.21
So refined was the approach, that it pinpoints the elements
of the controversy. Illustrative of this approach is the

following example of an assumed chemical fertilizer manu-

facturer.

1958
Sales 10,000 tons @$ 20.00 per ton
Production 15,000 tons
Variable Costs $ 8.00 per ton
Fixed Costs $150,000

According to the break-even formula the break-even

point would be derived as follows:

20Alexander Bac, "Advantages of 'Break-even' Income
Statement Compared With Conventional Statement," The
Journal pf Accountancy,XCI (January,l95l), 109.

21Raymond P. Marple, "Try This on Your Class
Professor," The Accounting Review,XXXI (July,1956), 492-295.

 

 

 

241

Break-even Point = Sales = Variable Costs As A + Fixed
Percentage of Sales Costs
S = V (S) +_F
S a 8/20 (S) + $150,000
S = .4 S '+ $150,000
.68 = $150,000.
S : $250,000 (12,500 Tons)

According to conventional accounting, unit costs
will be determined by dividing total costs by total pro—
duction as follows:

Total Cost + Total Production = Unit Cost

Variable Costs.+ Fixed Costs ; 15,000 : Unit Cost
8 x 15,000 _+ 150,000 ; 15,000 2 Unit Cost
120,000 4. 150,000 ; 15,000 : $18.00

With a unit cost of $18.00 per ton and sales of
10,000 tons at $20.00 per ton, there is a profit of $2.00
per ton or $20,000.00. How can this be if the break—even
point is 12,500 tons ($250,000)? Sales of less than the
break—even amount should produce a loss, not a profit.

The logical resolution of this dilemma, according
to those who propose it, is that the break-even calculations
are correct and accounting is all wrong. Accounting is
"wrong" since it spreads fixed costs over all production,

thereby including some fixed costs in inventory.

242

In the determination of periodic profit, the
only costs which should be deferred in inventory
for application against the future are those
costs which, because they have been incurred in
the past, will not have to be incurred in the
future.22 ‘

The costs which will not have to be incurred in the
future are the variable costs. The fixed costs are with
us, with or without production. Following this approach

to solving the dilemma, the results of operations for

the year 1958 in the previous illustration should be as

 

 

follows:
Sales (10,000 tons @ $20 per ton) $200,000
Less Costs
Variable $ 80,000
Fixed- 150,000 230,000
Net Loss _§(30L000)

This loss of $30,000 is quite consistent with a
break—even point of $250,000 for the added $50,000 of sales
would result in a contribution of $30,000 to cover fixed
costs, since $20,000 is necessary to cover the added variable
cost element of added sales.

The variable costs ($80,000) in the above very
summarized income statement are the variable costs applicable
to merchandise produced and sold (10,000 tons @ $8 per ton).

Variable costs applicable to merchandise produced and not

221bid. , 497.

243

sold (an increase in inventories) are considered to be the
total cost applicable to the inventory increase ($40,000 or
5,000 tons @ $8 per ton). Fixed costs ($150,000) are
considered to be the costs of the period in which they are
incurred and therefore they are not allocable to inventories.
Traditional break-even analysis assumes sales and
production equality. An inequality as presented here (sales
10,000 tons, production 15,000 tons) actually brings forth
the conflict between conventional income measurement and
break-even analysis. This conflict will be considered

further in the next section of this chapter.
The Case of the Defense

2911621531

One of the surprising features of practically all
the literature on direct costing is the lack of con-
sideration given to the recognition of loss from idle

capacity. Garcke and Fells23

can be excused in this regard
since these concepts were developed after their time.

Mr. Harris24 and most of his followers apparently have no

 

23See "Direct Costing--Originsr pp. 232-4.

4
Jonathan N. Harris, pp. cit.

244

excuse, since, as shown in Chapter Two, the problem of idle
capacity was given considerable attention by H. L. Gantt,
Alexander Hamilton Church, G. Charter Harrison and many
others. Furthermore, it is incredible to believe that

Mr. Harris and his followers could have had no knowledge

of these concepts because the National Association of Cost
Accountants, an organization in which Mr. Harris was active,
had considered these issues in its Bulletin25 and at its

annual meetings as late as 1931.26

 

25Illustrative examples of the then available litera-
ture are : A. F. Stock and J. M. Coffey, "Overhead During

Low Volume Production," N.A.C.A. Bulletin. VI. Sec. 1
February 16, 1925), 11 pp. and

Wyman P. Fiske, "Accounting for Unused Facilities,"
N.A.C.A. Bulletin, XIII, Sec. 1. (November 15, 1931), 355-69.

Illustrative presentations at annual meetings in—
clude the following:

William H. Alden, "Handling the Expense of Idle Time,"
National Association pf Cost Accountants'Yearbook, 1924 , 115-
20. '

Edward P. Rush, "In Establishing The Budget for
Burden, Shall Normal Capacity Be Set To Allow Only For
Operating Interruptions, Thus Giving A Normal Which Is The
Maximum Just Possible of Attainment; Or Shall It Allow
For Unused Capacity Due to Insufficient Sales Demand, Thus
Giving a Maximum Which May PrObably Be Obtained," National
Association p: Cost Accountants'Yearbook 1930, 167—71.

Charles Reitell, "The Standard Cost Plan for the Naca
Company," National Association pf Cost Accountants Yearbook,
1931, 14-15.

Discussion, "Some Debatable Points in Cost Accounting
Theory," National Association p; Cost Accountants' Yearbook,
1924 Egg 1925, 229-72 and 157-205.

 

 

245

(Mr. Harris published his article in 1936 in the gygppygp
‘Bpllppip). All of this material was available to Mr. Harris
as well as to all of his followers, since the concepts then
known have become a standard part of the literature on cost
accounting.

In addition to the lack of consideration given to
idle capacity, there was an equal lack of evaluation of
the nature, intent, and purposes of economic marginalism
and break-even analysis. Too many ideas concerning fixed
costs, income measurement, economic marginalism, and break—
even analysis were treated as if they were related and
consistent with each other. Actually, many of the ideas
adopted by direct costing advocates are not at all related
to income measurement. As shown in Chapter One (Part IV
"Income Measurement and the History of Overhead Costing")
even traditional accounting concepts of income measurement
include some ideas not at all related to income measurement.
Unfortunately those who defended traditional accounting
based their defense on the inadequacies of direct costing.
In this chapter (under "An Improved Approach”) both the
inadequacies of direct costing and traditional accounting
will be considered. The inadequacies of both sides must

be considered for (as will be shown) direct costing arose

246

out.of the inadequacies of traditional accounting.
Idle Capacity as a Defense

The idle capacity concept in accounting is an
adaptation of the concepts of “economic waste” or "pool of
‘waste" described in Chapters Three and Four. As stated in
'both chapters the problem is one of recognizing the
essential difference between utilized and unutilized capacity
or fixed costs. As one accountant said many years ago,

”the expense chargeable against the shop should be only that
portion of the constant expense which the current activity
is of the normal activity, plus the actual variable ex-
pense."

The ratio of actual to normal output then determines
the amount of fixed costs which can be included in inventory,
and the difference between this amount and the actual fixed
charges is designated as a loss, chargeable to management,28

because the facilities represented by these cOsts were

sterile or non-productive.

 

7

Nicholas Thiel Ficker, Industrial Cost-Finding,
Factory Management Course, Volume 5, (New York: Industrial
Extension Institute, Inc., 1917), 477.

281bid., 475-78.

247

One of the best analyses of this part of the direct
costing controversy was published in 1945 by Professor
Charles Schlatter.29 He said that the utilized portion of
fixed expenses or expenses of getting ready to produce are
costs of production because there could be no production
without such costs. To him, as to Mr. Noyes,3O it was
simply a matter of economic causation. The problem of sales
and income varying sympathetically is dismissed by means of
the idea of unutilized fixed costs being considered losses
which do not have an effect on Operating income. Operating
income in conjunction with a specially designated "Fixed
Manufacturing Expense Lost Through Non-Use” is used as a
true measure of the firms‘ total progress. The "loss through
non-use" suggests possible "greater earnings if the plant
were not overequipped or if the volume of sales could be
increased to require greater use of the facilities of pro-

duction with which it is equipped."31

 

29Charles F. Schlatter, "Fixed Expensefl' The

Accounting Review,XX (April,l945), 156-163.
30 .
C. Reinhold Noyes, "Certain Problems in the
Empirical Study of Costs,” The American Economic Review
XXXI (Sept.,l94l), 482-86.

 

1
Schlatter, pp. cit., 161.

Professor Schlatter's ideas can be illustrated by

the following hypothetical income statements comparing his

method and the direct costing method of handling fixed

 

 

 

 

expenses.
Schlatter's Method
, 1957
Sales $175,000
Cost of Sales ' ' 125,000
Gross Profit on Sales $_50,000
Selling and AdministratiVe 25,000
Expenses
Net Operating Income $ 25,000
Fixed Manufacturing Expense Lost
Through Non—use 25,000
Net Income § 0

 

Direct Costing Method

 

Sales
Cost of Sales (Variable Costs
Only)

Gross Profit on Sales

Sales and Administrative Expenses
Net Operating Income

Fixed Factory Expenses
Net Income

In 1957 sales and production are equal.

1957

$175,000
100,000

 

$ 75,000
25,099
$ 50,000
50,000
.i======2

1958

$175,000
125,000
$ 50,000

25,000

 

 

$ 25,000.

__2—.<1..9.9.Q
§ 5,000

1958

 

$175,000
_l00,000

$ 75,000

25,000
$ 50,000
_m50,000

.§._.___Q

Under the

direct costing method the fixed expenses for the period

(1957) are treated as one category, viz.;

EXpense".

expenses are divided into two categories,

"Fixed Factory

Under Schlatter's method fixed manufacturing

"Cost of

249

Goods Sold" ($25,000) and ”Fixed Manufacturing Expenses
Lost Through Non—Use" ($25,000). Under Schlatter's method
actual output (sales and production equal) is one-half of
practical capacity; this is the reason for considering one—
half of the fixed costs as lost through non—use and the
other half as part of the cost of producing the merchandise
sold.

In 1958 production is more than sales, which thereby
increaSes inventory. The inequality of sales and production
does not affect the direct costing statement, since cost
of sales includes only the variable costs of goods sold and
all fixed costs are considered costs of a period and not
allocable to production. Thus, under direct costing, the
costs allocable to the inventory accretion are the variable
costs of production. Fixed costs are not considered costs of
production under direct costing and therefore they are not
considered part of inventories valued at cost; Under
Schlatter's method the income statement is affected by the
inequality of sales and production. Schlatter considers
utilized fixed costs as costs of production and allocates
utilized fixed costs to inventory. Thus,in 1958 when
production is greater than sales, not as many fixed costs

are considered lost through non-use as in 1957 when sales

250

and production were equal. The decrease in lost fixed
costs ($5,000) is considered part of inventory costs, since
these fixed costs were utilized in obtaining the inventory
accretion.

In the direct costing statement, there is sympathy
between sales and net income, the goal of Jonathan N.

32
Harris, but in obtaining this sympathy Mr. Schlatter
would have said that he (Harris) lost much more than he
(gained, if he gained anything at all. Harris lost sight of
the simple commen-gaug fact that all sacrifices incurred
in connection with the manufacturing processes (including
only the utilized element of fixed costs) should be
associated with the results of such processes. The results
are products and the sacrifices are the cost elements; thus
the utilized fixed manufacturing expenses should be con-
sidered costs of production. Goods manufactured and sold
should be included in cost of goods sold at a cost price,
including the proper portion of utilized fixed overhead
costs. Goods manufactured and not sold should be included
in inventory at a cost price, including the proper portion
of utilized fixed overhead costs. Unutilized fixed over-

head costs should be treated as a "loss through non-use".

 

32Supra, Footnote 5.

1 (I! III..||’|‘ (.1),

1.1‘ A J/ ‘1‘. l

251

Professor Schlatter showed clearly how Mr. Harris's
problem concerning fixed manufacturing expenses could be
handled. He (Schlatter) believed that the place where
sympathy between sales and income could exist, assuming all
other factors are held constant, would be at the "Net
Operating Income" level of the income statement. Below the
"Net Operating Income” level, there could be an unsympathetic
relationship between sales and income due to the factor of
unutilized fixed overhead costs. In addition, Professor
Schlatter believed that he showed clearly the effect of
wasted or unutilized capacity. Finally, the gravity of
the contention that profits could be influenced by inventory
manipulations33 is considerably reduced, since "Net Operating
Income" is used as the measure of operating performance.
Inventory changes would affect only the fixed costs lost
through non-use which are shown below "Net Operating Income".
An inventory increase would involve only a transfer from
unutilized fixed costs to inventory.

Schlatter believed that the transfer from unutilized

fixed costs to inventory was an appropriate transfer because

 

33This is the problem considered by Garcke and Fells

(Supra-Footnote 7), Jonathan N. Harris (gupra-Footnote 8).
and John Maurice Clark (Supra-Footnote 9).

252
the previously unutilized fixed costs had been utilized in
the processes of production due to the inventory increase.
In the previous illustration of Schlatter's method, un-
utilized fixed manufacturing overhead costs were $25,000 in
1957 and $20,000 in 1958. The difference is accounted for
solely by the fact that production for 1958 was greater than
sales to such an extent that $5000 of fixed manufacturing
expenses were considered to be utilized and thus inventoried.

The problem that remains with regard to utilized and
unutilized capacity is the measure of total, or full, or

34 Ficker referred

normal capacity. In the previous citation
to normal capacity while Professor Schlatter refers to full
practical capacity.35 The measure of capacity which is
utilized can easily affect the dollar segregation between
utilized and unutilized capacity costs.

Through the years accountants, in attempting to
quantify the capacity problem, have come up with a number
of capacity definitions, most of which have been considered

in Chapter Two. To a large extent the usual definitions

can be regarded as platitudes, because some vague conception

 

4
Supra. Footnote 29.

35Schlatter, pp. cit., 160.

253
, _ , , 3
of normal capac1ty is ordinarily used.

There is no quarrel here with the concepts of
utilized and unutilized capacity. The solution put forth
by Schlatter and most others is defective in terms of how
to quantify the waste incident to capacity costs for income

measurement purposes. These issues will be discussed further

in succeeding pages.
Recognizing Limitations of Marginalism

Dealing with the marginal and break-even approach to
direct costing is a problem that must be faced squarely.
The refined direct costing approach which deals with break—
even analysis presents more of a problem than the earlier
burden absorption problems. Usually the defenders of con-
ventional cost accounting bring forth such ideas as, the
equality of production and sales assumed by marginalism and
break-even analysis, and the aforementioned distinction

37
between utilized and unutilized capacity costs.

 

36599; chapter Two on normal capacity. PP- 71-4.

37See: R. Lee Brummet, "Try this On Your Class
Professor--A Rejoinderfl The Accounting Review,XXXII
(July,l957), 480-4.

254

If sales and production are equal there is no change
in inventory, and if the fixed cost element assigned to
product is the same in the equal physical inventories at
both ends of the year, there is no_problem concerning income
measurement. If, as is usually the case, there is a
difference between production and sales, there will be a
difference between the ordinary break-even measures and
the accounting measures of income.

At least two attempts have been made to overcome the
failure of marginalism and break—even analysis to treat
possible idle capacity and to overcome the assumption of
production and sales equality. One attempt was inadequate
in that the only solution offered was a calculation designed
to determine the difference between the total fixed cost
element in the beginning and ending inventory which was
utilized to adjust the income figure determined by break-
even analysis.38 Assuming the income per break-even
calculations is $130,000, which assumes that all fixed costs

are period costs, the income from the usual accounting

point of View would be $130,000 plus or minus the difference

 

38
Wyman P. Fiske, and John A. Beckett, Industrial
Accountant's Handbook (Englewood Cliffs: Prentice-Hall,
Inc., 1954), 63-64.

 

255

between the total fixed cost element in the beginning and
ending inventories. For example, if the total fixed costs
in beginning inventory were $4000 and in the ending inven-
tory $10,000, the $6000 increase would be added to $130,000,
since the conventional break-even analysis charges all
fixed costs to the period, while accounting income measure—
ment demands in this instance that $6000 of fixed costs
belong in inventory which should thereby reduce expenses
and increase income by $6000. The reverse would hold true
if the total fixed cost element in inventories decreased.
The other attempt involved the capacity concept and
sales and production inequality in diagramatic exposition.
In this case Professor Brummet completely discarded the old
break-even diagram and replaced it with a diagram that
would include the effects of wasted or unutilized capacity.39
The diagram is the logical diagrammatic exposition of the
concept of wasted capacity. It uses what are known as 150-
profit lines, that is, lines of~constant profit or loss or
lines connecting all combinations of sales and production,

that would produce the same income or loss. Sales and

 

39
R. Lee Brummet, Overhead Costing, Michigan

Business Studies, XIII, No. 2 (Ann Arbor, Michigan:
University of Michigan, 1957), 83-100.

 

256
production are utilized as the determinants of income rather
than sales being the sole determinant, as is assumed in
marginalism and break—even analysis.

Sales has its effect on income by providing the
revenues to absorb cost. Production has its effect on
income in terms of whether or not all fixed production costs
have been utilized. In this way sales provide revenues and
production can provide a special form of waste, that is, un-
utilized capacity. Income becomes bifunctional, that is, a
function of sales and production (idle capacity), rather
than monofunctional, that is, a function of sales.

Under these circumstances a break—even point can be
obtained by a number of different combinations of sales and
production (idle capacity). Income produced by high sales
could be offset by the idle capacity of lower production. A
lower income produced by less sales could be offset by less
idle capacity of a slightly higher production. On the other
hand, a higher income produced by greater sales could be
offset by the greater idle capacity of lower production. What
holds true for a break-even position would also hold true
for various levels of profit and loss. That is, each level
of profit or loss could be attained by various combinations of

sales and production (idle capacity) The diagramtredioilhBUEHa

257

this bifunctional or three dimensional approach is shown

below:
Illustration 3
Three Dimensional Break—Even Chart
1
Units
of
Sales ‘

$20,000 profit
$10,000 Profit

Break-Even

 

$10,000 Loss

 

 

9
r

0

Units of Production

As in traditional break—even analysis, constancy is
assumed for prices of inputs and outputs. Efficiency is
also assumed to be constant. The $10,000 loss line

represents all those combinations of sales and production

258
(idle capacity) which result in a $10,000 loss. Large
sales (more revenue) are combined with low production (more
idle capacity) at one extreme while low sales (less revenue)
are combined with high production (less idle capacity) at the
other extreme. The same is true of a break-even position or
any profit position. As it should be, the break-even
position is above and to the right of the $10,000 loss
position, that is, at higher sales (more revenues) and
higher production (less idle capacity). The same is true
of the successive levels of profit above the break—even
position.

Both of the above changes in traditional break-even
analysis are attempts to support traditional accounting
theory in the face of the proponents of direct costing.

They represent adaptations of break—even analysis which are
necessary to overcome limitations in a method which assumes
sales and production equality and ignores unutilized
capacity. Brummet's ideas, especially, present a rather

40
Brummet presents these same ideas in a two-chart

,system: one for recognition of the sales function and
another for the recognition of the production function
(wasted capacity). In addition he ties this two chart
system into one chart which is slightly different from the
one above. See Brummet, pp. pip., pp. 91-95.

259
formidable defense against the direct costing ideology
which assumes that income is monofunctional, that is, a
function of sales. In order to improve the defense and
perhaps make it impregnable, it is necessary to introduce
a few new ideas in addition to a recognition of old ideas
for what they are. In this and in this way only is it
possible to obtain agreement among accountants, and perhaps
even between marginalists, break-even enthusiasts, and

accountants.
An Improved Approach
General

At the present time there are three basic assumptions
involved in the accounting for overhead costs. These

assumptions are:

1) a fixed-variable cost segregation is best for
income measurement.

2) all fixed costs are related to long-lived
asset acquisitions (fixed assets).

3) unit costs should not be allowed to vary
with volume.

The fixed-variable cost separation is admitted to be
a difficult process, but as usual, all that is asked of

practitioners is to do the best that can be done in a

260

difficult situation. Once the cost elements are separated
into fixed and variable components, each group (fixed and
variable) can be allocated to production on appropriate
bases, e. g., variable costs on the basis of actual service
and fixed costs on the basis of readiness to serve. The
readiness to serve allocation method for fixed costs is
used in all three capacity measures (practica1,norma1 and
cycle capacity).

Under each capacity measure variable overhead costs
would be allocated to products on the basis of actual
output. Presumably each unit of output is charged with
those elements of variable overhead which it (the unit of
output) gave rise to. A11 variable overhead would thus be
allocated to output, for without output there would be no
variable overhead costs. Under each capacity measure fixed
overhead allocated to production is represented by the
portion of capacity utilized multiplied by the fixed costs.
The method of capacity measurement affects the measure of
utilized capacity costs.

Fixed cost allocation under the three—capacity

measures can be illustrated by the following diagram:

Capa ity
Utilized

261

 

 

Fixed Measure of
Overhead capacity
Costs

 

 

The meaning of "measure of capacity" for each of the

three-capacity concepts would be as follows:

CAPACITY CONCEPT

 

Practical

Normal

Cycle

MEASURE OF CAPACITY

 

Physical output potential

Average cyclical sales
expectations

Average cyclical sales
expectations

Capacity utilized would be actual output under all

capacity concepts, and unutilized capacity under each of the

three capacity concepts would represent the following:

CAPACITY CONCEPT

 

Practical

Normal

MEANING OF UNUTILIZED CAPACITY

 

Idle capacity in a strict
physical sense

Idle capacity due to less
than average use of fixed
costs.

262

(cont'd)

Cycle Deferred fixed costs to be
utilized in the future when
greater than average use of
fixed costs occurs.

Under normal and cycle capacity actual output can be
greater than average cyclical sales expectations. Thus the

41
previous illustration would have to be changed as follows:

i ' ’l'

 

 

 

 

 

 

Overutilized
CapaCity
Actual Output
Fixed
Average
Overhead Cyclical
Sales
Costs EXPGCt tlohs

 

 

 

 

 

v

Overutilized capacity would represent a special gain
due to greater—than-average use of fixed costs under normal
capacity, and a deferred credit due to greater-than-average
use of fixed costs under cycle capacity. The deferred

charges and deferred credits associated with the cycle

 

41In Chapter Two under "Summary: The Sequel to the

Supplementary Rate" (pp.108-110) more detailed illustrations
of the three capacity concepts are shown.

263

capacity concept are treated as offsetting items. Over-
utilized capacity cannot exist under the practical capacity
concept, since practical capacity is defined as physical
output potential which cannot be exceeded.

The above illustrations of capacity concepts and the
treatment of overhead costs show how overhead costs are
divided and allocated for income measurement purposes.

Fixed overhead costs are assumed to be one lump sum which is
cut into slices of equal cost for allocation to individual
units. Each unit of actual output under all the capacity
concepts has an equal fixed cost allocation.42 Thus, unit
costs are not allowed to fluctuate with volume, that is, the
fixed costs of a period are not allowed to be allocated to
the actual output of the same period, and thus yield a
varying fixed cost per unit based solely on changes in
production volume. The possibility of unit costs fluctuating
with volume is eliminated by means of the special treatment
'of unutilized and overutilized fixed overhead costs.

Thus far, the assumptions concerning the fixed—variable
cost breakdown and constancy of fixed overhead cost per unit
have been illustrated. Both assumptions are inherent in all

42

Each unit of output also has an equal variable
cost allocation.

264

three capacity concepts. The third assumption, which is
also inherent in all three capacity concepts, is much more
subtle and implicit. In fact it would probably be almost
impossible to find an explicit statement that would admit
that fixed overhead costs as used for income measurement

are assumed to relate solely to long-lived asset acquisitions
or fixed assets. The average cyclical sales expectations

of normal and cycle capacity implicitly recognize the
assumption of fixed costs applicable to long-lived assets,
for the objective of normal and cycle capacity is presumably
to average the fixed costs over the period to which they are
applicable—~a cycle of years. Practical capacity also
_implicitly assumes that fixed costs are all applicable to
long-lived assets, since it measures capacity and allocates
all fixed overhead costs on the basis of the physical
attainable capacity of equipment.

Objection is necessary to all three of the above
expressed assumptions involved in the accounting for
manufacturing overhead costs. A fixed-variable cost
breakdown is not best for income measurement. All fixed
costs are not and should not be related to long—lived asset

acquisitions. Unit costs should be allowed to vary with

volume under the conditions to be spelled out in succeeding

265

pages.

Overhead Cost Segregation for Income Measurement

 

For income measurement purposes overhead costs
should not be segregated into the familiar fixed-variable
dichotomy. A threefold categorization of manufacturing
overhead would be best to illustrate the recommended approach
to income measurement. The segregation is as follows:

1) Acquisition costs of long—lived assets (fixed
assets).

2) Indivisible cost inputs related to supervisory
personnel, practically all of the costs of
service departments, and practically all of the
expenses flunrred.by the plant superintendent's
office and the manufacturing vice—president's
office.

3) All other overhead costs; these are primarily the
the costs of operating equipment and facilities

At first there may not seem to be too great a dis—

tinction between the twofold and the threefold categorizations
of overhead costs. Categories (1) and (2) of the new three-
fold grouping can almost be described as a breakdown of the
old fixed cost category, while category (3) can almost be
described as the old variable cost category. However,

category (2)--indivisible cost inputs-—consists of cost

elements (usually called semi-fixed or semi—variable)

266
which are segregated into fixed and variable components for
purposes of refining the usual fixed—variable cost break-
down.

In addition to the threefold cost categorization
recommended, there is another very important difference
(perhaps the most important) in the approach to income
measurement to be recommended. Each of the three cost
groups is to be allocated to production in a different
manner. The acquisition costs of long-lived assets are to
be allocated to production on a unit of production basis.
In other words, depreciation pp ppp to be calculated on a
straight-line basis; depreciation lg to be calculated on a
unit of production basis. Under straight—line depreciation
the useful life of fixed assets is calculated in terms of
years. Under the unit of production method the useful life
of fixed assets is calculated on the basis of expected
output during the time the fixed asset is expected to be
used.

Indivisible cost inputs are to be allocated to actual
output produced. Indivisible cost inputs are costs that
come in chunks (semi-variable). It is absolutely necessary
to incur these "chunks” in order to obtain any output within

the range of output serviced by the indivisible cost inputs.

267

These “chunks“ are added when production reaches a certain
level, and such "chunks" are absolutely necessary to all
output possibilities starting from the point where the
”chunk" is first added and ending at the point where it is
necessary to add another ”chunk". All classes of super-
visory personnel are perfect examples of ”chunk costs”
which are absolutely necessary for all output possibilities
within a certain range. Since these indivisible cost
inputs are absolutely necessary for production, they must
all be considered costs or production no matter what output
is within the range for which the "chunk costs" are
absolutely necessary.

On the basis of these indivisible cost inputs, unit
costs can and must vary with volume. If costs are ab-
solutely necessary for production, they cannot be considered
other than true costs of production and thus allocable to
units produced. A system of accounting which will not
allow unit cost figures to fluctuate on the basis of pro-
duction volume and indivisible cost inputs is inaccurate.
Such an accounting system takes the indefensible position
of describing an absolutely necessary cost element as waste.

Describing an absolutely necessary cost element as

waste is a natural concomitant of those cost systems which

268

will not allow unit costs to fluctuate with production
volume. If the unit cost is stabilized at the top of the
"chunk cost" output range (practical capacity), the cost
per unit would be stabilized at its lowest possible level.
If production is at any point in the output range below
the top point, the justifiable increase in costs per unit
would not be allowed. The justifiable unit cost increase
would be removed from production costs and classified as
waste due to unutilized facilities in a strict physical
sense (practical capacity).

If the unit cost is stabilized at an average of
expected output within the "chunk cost" output range
(normal and cycle capacity), the cost per unit would be
stabilized at the average unit cost level. If production
is at any point above the average, the justifiable decrease
in unit costs would not be allowed. The justifiable cost
decrease would be removed from production costs and con-
sidered as a special gain under normal capacity and a
deferred credit under cycle capacity. If production is at
any point below the average, a justifiable unit cost increase
would not be allowed. The justifiable cost increase would
be removed from production costs and considered as a loss

due to less than average use of "chunk costs" under normal

 

 

269

capacity and a deferred cost due to less than average use of
”chunk costs" under cycle capacity.

Thus, under any of the three capacity concepts an
absolutely necessary cost of production could be considered
as a loss due to unutilized capacity or as a deferred
charge. Under normal and cycle capacity, when output is
above average unit costs would be stabilized at an inflated
level. The inflated unit costs would be offset by the
bookkeeping manipulations of a special gain or a deferred
credit due to greater than average use of "chunk costs". It
seems hardly necessary to restate that unit costs should be
allowed to fluctuate on the basis of whatever output is
achieved within the range for Which ”chunk costs“ are
absolutely necessary. None of the capacity concepts con-
siders this possibility, and therefore all three concepts
are in error. What are absolutely necessary costs of
production cannot sensibly be considered otherwise.

The third category of overhead costs is essentially
variable in nature. These costs are incurred only if there
is production, and thus they should be allocated to units
produced.

In the case of all three cost categories, costs are

allocated to actual production, for it is actual production

270

which gives rise to these costs. Note that the actual
production basis is usable for depreciation because
depreciation is recognized on a unit of production basis.
Actual production is usable for indivisible cost inputs
because the indivisible cost inputs are absolutely necessary
to produce actual output. Actual production is usable for
the third cost category because of the variable nature of
these costs.

A possible objection to the use of actual production
as the basis of allocating indivisible cost inputs is the
case of retaining on the payroll supervisory employees even
when they are not absolutely necessary for production. Such
a case arises in times of recession where the salaries paid
to excess supervisory personnel would be less than the costs
of acquiring and training new supervisors when business
conditions improved. Under these conditions there is no
need to object; there is only a need to introduce a refine—
ment into the treatment of indivisible cost inputs. If
supervisory personnel are retained, not for present use but
for expected future use, the costs of present retention
should be allocated against the expected future use. Thus
the costs of retention are not costs of production in the

period in which they are paid; they are costs of production

271

of those periods in which we expect to gain benefit out of
the present retention of supervisory personnel. Some might
say that the problem of retaining supervisory personnel
under depressed conditions is only an academic problem and
really need not be considered. However, the academic nature
of the problem is present only when business conditions are
other than depressed.

A graphic illustration of the traditional allocation
of overhead costs and the method recommended here is pre-

sented on the following page.

lily I]: .Illll! I. 1'1!!!

 

272
Illustration 4

The Traditional and the Recommended Methods
of Allocating Overhead Costs

TRADITIONAL METHOD

 
 
  
  

Allocate to
Production on
variable the basis of
Overhead actual

“COSt usage

Allocate to

production on the

basis of the proportion
of capacity utilized
multiplied by fixed
overhead costs

 
   

 

RECOMMENDED METHOD

   
  
 

Costs of Qperating
Equipment and

Depreciation Facilities

 

 

Allocate on

the basis of

actual usage
(output)

Allocate on a unit of
production basis
(actual output)

 

 

Indivisible Cost Inputs

 

Allocate on the basis of actual
output; the output for which in-
divisible cost inputs are absolutely
necessary.

273

In accordance with the ideas summarized in the pre—
ceeding illustration, the old fixed—variable cost breakdown
should be discarded for income measurement purposes. Fixed
costs associated with straight-line depreciation should also
be discarded in favor of depreciation on a unit of production
or usage basis.43 ‘The fixed cost portion of indivisible cost
inputs should be reassociated with their variable counter-
parts, and then allocated to the output for which they were
absolutely necessary elements of production. Finally, unit
costs of production should be allowed to fluctuate with
volume within the range for which indivisible cost inputs

are absolutely necessary.
Idle Capacity Costs and Income Measurement

In general there should be no idle capacity costs for
income measurement purposes due to a varying production
volume brought on by changes in sales volume. The truth of
this statement will be clear after a consideration of each
of the cost categories recommended for purposes of income

measurement.

Depreciation of fixed assets should be on the basis

 

43
The practicality of a unit of production basis for

depreciation will be considered in succeeding pages under
”Some Objections Considered".

274

of a useful life, for fixed assets are acquired to be used
over a useful life. If the useful life expectancy turns out
to be correct, all of the fixed asset costs will be allocated
to the units produced.44 If the useful life expectancy is
incorrect, all that is usually necessary is a change in
depreciation rates as is ordinarily recommended in financial
accounting.

In the extreme case where a useful life is changed
on account of unexpected technological change or market
deterioration, an argument can be made for treating some of
the fixed asset costs as a loss. Such a loss would be
recognized at the time the change in expected life occurred.
Useful life can be unexpectedly increased due to material
increases in the market potential of present products, or
development of new products which can be produced with
present equipment. An unexpected increase in useful life is
a kind of windfall which could possibly be treated as a gain
in the accounting measurement of income.

Between the extreme cases of change in useful life

where an argument can be made for recognizing a gain or a

 

A unit of output depreciation method is assumed
to be utilized in this section unless otherwise stated.

 

1'11 I‘ll. I I'll I
all. ll]! 1

275

loss, and the normal cases of change in useful life where
depreciation rates are revised, there is a grey area where
judgment must be exercised. Judgment comes into play when
it is necessary to determine whether a particular case is

an extreme wherein gain or loss could be recognized, or the
more usual case involving a revision in depreciation rates.
Thus, for fixed asset costs the only case that can be made
for recognition of gain or loss due to volume considerations
relates to the extreme cases of change in the useful life of
a fixed asset.

Since indivisible cost inputs are absolutely necessary
for all output ranges which they service, none of the
indivisible cost inputs can lead to a loss due strictly to
a fluctuation in volume. Indivisible cost inputs are
absolutely necessary for production within their relevant
range, and therefore none of the indivisible cost inputs
could be considered as a loss or waste.

On occasion a case may arise in which indivisible
cost inputs are retained when output dips below the point
where such costs are necessary. This is the extreme case
‘where an employee may be kept on the payroll for one of two
reasons. One reason is that costs of retaining an employee

Inight be less than the costs of hiring and training a new

276

employee when business revived. The other reason is a
matter of sentiment, where trusted and faithful employees
are being rewarded for their prior services by being retained
on the payroll when their services are not really necessary.
In either of these two cases there is still no loss due to
wasted capacity. The costs of retaining an employee for
the future are costs applicable to the future; they are not
losses of the period in which they are paid. The costs of
retaining employees on the payroll for sentimental reasons
can be considered as costs applicable to prior periods of
service or as a distribution of psychic income to the
owners of an enterprise. Thus in no case can indivisible
’cost inputs be considered losses due to fluctuations in the
volume of production.

The last category of overhead costs is the cost of
operating equipment and facilities. There can be no 1055
here due to changes in production volume, for such costs are
variable in nature. Decreases in production volume would
decrease these variable costs, and increases in production
costs would increase the variable costs. The increases or
decreases are simply expressions of costs necessary for
production.

Overhead costs cannot be considered as elements of

277

waste due to changes in marketability of product which

bring on changes in production volume. The only exception

to this general statement would be an extreme case of change
in product marketability or equipment obsolescence that
would change the useful life of a fixed asset. Other

changes in the useful life of fixed assets are handled not

as losses or gains but as revisions in depreciation rates.
Indivisible cost inputs are absolutely necessary production
costs within their relevant ranges. Indivisible cost inputs
retained when not needed for present output are not wastes;
they are costs applicable to the future or to the past, or

an expression of psychic income. Since variable inputs

(the only other category of overhead) vary with volume, there
is no waste in such costs due solely to changes in commercial
conditions.

A logical question at this point would be: If the
above statements on the general inapplicability of idle
capacity costs are correct, why have accountants accepted
for so many years the possibility of idle capacity costs?

An answer to this question is possible only if the rational
foundations of each capacity concept (practical, normal,
and cycle) are considered.

Practical capacity is the outgrowth of the comparison

278

of actual output with physical output potential of facilities.
The comparison is logical in its own right. It is primarily
related to engineering comparisons that are and should
always be made in industrial plants. The comparison stated
in the form of a question would be: How much more output
can be produced with existing facilities?

A knowledge of the physical output potential of a
plant as a whole as well as the physical output potential
of individual departments or items of equipment is useful
for scheduling activities and possible capital expenditure
decisions. However, for purposes of income measurement it
is the "useful life" of equipment, not the "physical output
potential" (comparable to physical life), that is appropriate.

The measurement of additional output possible with
existing equipment is perhaps made best in terms of physical
units of output. However, the measurement of "lost" or
"unused" output potential in dollars could be useful for
certain purposes. Management might be interested in a
figure which tells how much total and unit cost could be
removed from present output if expected output (useful life)
could be increased to physical output potential (physical
life).

Economists might also be interested in a dollar figure

279

that would represent a measure of unutilized physical out-
put potential. This dollar amount is the measure of economic
waste (unutilized fixed costs from an economists' View) as
developed in Chapter Three. Within the field of economics
the concept of economic waste is part of the losses due to
misallocation of resources. Losses due to resource mis—
allocation are not related to income measurement; they are
.only useful as evidence of the fact that economic activity,
from the viewpoint of an aggregate economy, could have been
directed more efficiently.

The practical capacity concept can be said to produce
a "loss", but the "loss” is not at all related to income
measurement. The "loss“ is simply an expression of the
total cost that could be removed from expected output
(useful life) if expected output could be increased to
physical output potential (physical life), or an expression
of economic inefficiences that could be decreased or removed
by a better allocation of resources (direction of economic
activity). The grafting of the practical capacity concept
onto accounting measurements of income is probably nothing
more than the outgrowth of the influence of engineers on
early industrial accounting.

The normal capacity concept is the outgrowth of the

280

practical capacity concept and the search for a cost

45 A

determining price and a measurement of efficiency.
unit cost useful for long-range price determination should
be based on an average expected use of facilities, and should
not be allowed to fluctuate with fixed cost absorption.
Fixed cost absorption has no effect on the value of mer-
chandise, and thus it should not be allowed to affect unit
costs. A unit cost figure which varied only with shop
efficiency (not fixed cost absorption) would produce a
fairly good overall measure of the extent and direction of
efficiency.

With an unvarying fixed cost per unit, the normal
capacity concept produces over-and underabsorbed fixed
costs. The under- and overabsorbed fixed costs are related
to the difference between actual output and average expected
output. The under- and overabsorbed fixed costs are con-
sidered as losses and gains solely because those who
advocated normal overhead were unable to divest themselves
completely of an attachment to the practical capacity concept.

Another possible reason why under- and overabsorbed fixed

costs are considered as losses and gains is the refusal of

 

45
See Chapter Two especially ”The Ideas of H. L. Gantt"

and "The Normal Overhead Concept", pp. 56-65 and pp. 66-76.

 

281

the accounting profession to recognize that the averaging
of fixed costs over expected output should be followed
through with a deferred charge and deferred credit treatment
of under— and overabsorbed fixed overhead.46

As it is generally promulgated today, the normal
overhead concept is related to a combination of a long—run
price determining cost and the practical capacity concept'
which demanded that underabsorbed fixed costs be treated
as a loss. Since the practical capacity concept has
already been shown to be inapplicable to income measurement,
it is only necessary to state that what is good as a price
indicator (and even an efficiency indicator) is not
necessarily good for income measurement purposes. The
advocates of the normal capacity concept have failed to
recognize the inapplicability of their approach to income
measurement, and out of the inapplicability of normal
capacity arose the direct costing controversy.47 Fortunately,

the early direct costers recognized the inapplicability

of the normal overhead concept and its concomitant gains or

 

46
Brummet, pp. cit., 82.

47See the preceeding section of this chapter on
"Direct Costing: The Period Of Refinement", pp. 235-37.

282

/
losses due to over- and underabsorbed fixed overhead. Un-
fortunately, however, the direct costers did not remove the
inadequacies of normal overhead from accounting for income
measurement. The direct costers only avoided the inadequacies
of normal overhead by eliminating fixed overhead costs from

. 48 . . .
production costs. The defenders of traditional accounting
for income measurement didn't even recognize the inadequacies
of the normal overhead concept; all they did was to argue
that fixed costs are costs of production via a practical

. 49 . . . .
capac1ty concept (this eliminated the embarraSSing over—
50 51

absorbed overhead) or a cycle concept. The cycle
concept eliminated the gain and loss treatment of over- and
underabsorbed fixed overhead and thus eliminated an un-

sympathetic relation between sales and income. An

unsympathetic relationship between sales and net income was

 

48Ibid.

4
9See Schlatter, lpp. cit.

 

0
Overabsorbed overhead is embarrassing because it is
treated as a gain which is offset by an inflated unit cost

figure.

1

Joseph Mauriello, "Convertibility of Direct and
Conventional Costing," N.A.C.A. Bulletin, XXXV,Sec. l.
(March/1954), 893.

 

283

the keystone of the early direct costing argument.52

The cycle capacity concept is primarily the outgrowth
of using a business cycle rather than a year as the basis
for measuring periodic income.53 Fixed overhead is averaged
over the years of the cycle and thus the cycle concept does
not yield a gain or loss due to under-or overutilized

54 The lack of gains or losses due to volume

facilities.
changes is quite consistent with the approach an overhead
accounting recommended in this dissertation, but the cycle
capacity concept gains the favorable feature of no gains or
losses due to volume changes at too great a cost. The error
in the cycle concept is that it aims at leveling out the
results of a year or series of years, so as to make the
results of individual years uniform. The advocates of the
cycle concept forget that the results of each year should be
made to stand out prominently.

The cycle concept evades the fact that indivisible

cost inputs ("chunk costs") are entirely applicable to

 

52
See the preceeding section of this chapter on

"Direct Costing ; Origins" pp.229—235

53
See Chapter Two on "The Cycle Overhead Concept", ppJ6-90.

54

Brummet (pp. cit., 71-2) recognizes the possibility
of gains or losses on the basis of changes in average sales
expected over the cycle. This is the same as a change in the

useful life of a fixed asset.

284
whatever output they are used to produce. Thus considering
the "chunk costs” of production, the economic fact of
varying unit costs would be averaged into oblivion by the
normal overhead concept. If one is interested in a cycle
type of concept, let him add together the short period
Velements of the cycle in order to obscure the ripples in
economic activity for Whatever purpose he has in mind. For
accounting\purposes of income measurement the economic facts
of life cannot be ignored. The task is simply one of
determining a unit cost figure on the basis of estimated
output for a peridd and the costs necessary to produce such
an output (including all of the "chunk costs"). These are
the data concerning a particular operating period which do
not obscure or normalize out of existence the economic
individuality of different operating periods.55

The calculations of practical capacity are not
appropriate for income measurement because they are based
on "physical life" not "useful life". The calculations

of normal capacity are not appropriate for income measure—

ment because they are based primarily on a price determining

 

55
The normalization of net income under the cycle

concept comes from the adoption of an unvarying fixed cost
per unit which would average "chunk costs" over output expected
in a cycle of years.

285

cost which is not necessarily appropriate for income
measurement purposes. The calculations of cycle capacity
arenot appropriate for income measurement because they
average the economic individuality of different operating
periods.

Add to the above stated inadequacies of the various
capacity concepts the erroneous assumptions implicit56 in E
all capacity concepts, and we have the arguments necessary to
discard all of the traditional concepts of allocating fixed
overhead costs. In place of the traditional concepts the
approach to income measurement recommended in this disser-
tation would be substituted. Overhead costs would be

classified as

1) acquisition costs of long—lived assets (fixed
assetsL

2) indivisible cost inputs or "chunk costs".

3) all other overhead costs; these are primarily
the costs to operate equipment and facilities.

Depreciation would be allocated to production on a unit of

production basis. Chunk costs would be allocated to actual

 

56 .
1) A fixed-variable cost segregation is best for

income measurement.

2) All fixed costs are related to long-lived asset
acquisitions (fixed assets).

3) Unit costs should not be allowed to vary with
volume.

286
output, and all other overhead costs would also be allocated
to actual output. Finally, there would be no recognition of
loss or gain due merely to the fluctuations in production

volume based on commercial conditions.

Some Objections Considered

 

It would seem that there are two possible objections
to the method of accounting for overhead recommended in
the preceeding pages. Objection one relates to the
practicality of calculating depreciation on a unit of output
basis. Objection two relates to the possibility of subjecting
supervisory salaries to a unit of production cost amorti-
zation plan.

For those who claim that they utilize a normal

d,57 there

capacity concept for allocating fixed overhea
should be no problem in calculating unit of production
depreciation. The normal capacity concept yields a perfect
approximation to unit of production depreciation if under—
and overabsorbed straight-line depreciation is treated as

an adjustment of the allowance for depreciation.

There is no suggestion here that one should revert

 

57
The normal capacity concept is most often used in

overhead accounting. See Chapter Two on "The Normal Overhead
Concept". pp. 71-74.

287

to a normal or cycle overhead concept- All that is suggested
is that the average cyclical sales expectation of normal

and cycle capacity can yield an approximation to unit of
output depreciation. The only costs that would be subject

to the normal or cycle concept would be depreciation costs
and possibly the taxes and insurance on depreciable property.
The taxes and insurance on depreciable property are a part
of the costs of utilizing equipment and thus they could
justifiably be allocated to production on the same unit of
output basis as depreciation costs.

The dollar equivalence of the unit of production
depreciation method and the normal or cycle approach to
capacity accounting (as applied to depreciation and perhaps
insurance and taxes on depreciable property) can be illustrated
by the following examples concerning an item of equipment.

Illustration 5

UNIT OF PRODUCTION DEPRECIATION

 

Cost (less salvage) $ 3,000.
Expected output 150,000.
Depreciation per unit $02
:Xears Output" Depreciation Charged To Product
1 20,000 $ $400
2 25,000 500
3 30,000 600
4 35,000 700
5 40,000 800

 

 

150,000 5 3,000

 

 

 

 

288

Illustration 6

Depreciation Costs Under
Normal or Cycle Capacity

 

 

Cost (less salvage) $3000

Useful life 5 years
Depreciation per year $ 600
Expected output during useful life 150,000 units
Average expected output per year 30,000 units

(150,000 ; 5 )

 

 

 

 

 

 

 

 

 

 

 

Ratio of Actual §traighp- Depreciatiqg Depreciation
Actual Output to Averagp X Line Charged to (under) or
thput Outogp pepreciation Egpduct Overabsorbed
20,000 20/30 , s 600 $ 400 $ (200)
25,000 25/30 600 500 (100)
30,000 30/30 600 600 -0—
35,000 35/30 600 700 100
40,000 40/30 600 800 200
150,000 3000 $3000 -0-

 

 

—

 

 

As shown in the above illustrations, the amount of
depreciation charged to production is the same in each year
under the unit of production method and the normal or cycle
capacity method. The equivalence between the two methods
could be made complete if under- and overabsorbed depreciation
were regarded as deferred credits or deferred charges, or
perhaps as adjustments to the allowance for depreciation.

In any case the equivalence of unit of production depreciation

and the cycle or normal capacity concept used for depreciation

289

would be present in the income statement as long as under-
and overabsorbed straight-line depreciation is kept in the
balance sheet.

There can really be no complaint such as "It is too
difficult to apply in practice the unit of production
depreciation method,” for the most often used capacity
concept would yield a perfect approximation to unit of
production depreciation. Practitioners could retain straight-
line depreciation and at the same time apply the already—
used normal overhead concept to yield an approximation to
unit of production depreciation.

Today in many business enterprises manufacturing
facilities are leased rather than purchased. Thus the
question cones up concerning the allocation of lease rentals
to output. Since the lease is only another way of acquiring
the service utility of property, there should be no new
problem here. A lease involves the acquisition of property
with someone else's money, rather than with the purchaser's
money as in the case of an outright purchase. The periodic
payments on a lease can be regarded as regular installments
paid for the total useful service potential of the property
during the life of the lease. Thus the total lease payments

can be added up, and divided by useful life in terms of

290'
units of output in order to yield a unit of production
method of cost allocation for the lease costs. The unit of
production method is defensible in the case of a lease,
since a lease still represents the acquisition of the
expected output use of an asset during the life of the
lease.

An extension of the unit of output amortization plan
for lease rentals, can possibly be made to supervisory
salaries. Under an argument which states that supervisory
salaries should be made subject to a unit of output
amortization plan there is one implicit assumption, viz.,
salary payments are not given for services in the year or
month paid, they are only periodic payments given as an
installment on the total useful service potential of the
supervisor.58 Such an assumption was accepted above for
leasehold rentals, but there seems to be quite a bit of
stretching necessary to use the same assumption for super-

visory salaries. Supervisors are paid for whatever use-

fulness they can render within the volume range they are

 

58
This is also an implicit assumption in the cycle

overhead concept. The unreasonableness of the assumption is
recognized when clerical and service department costs incurred
by or for the factory are considered. Clerical and service
department costs are "chunk costs" necessary for all volumes
within the range of volumes they are capable of servicing.

291
necessary for. When the upper limit of a supervisor's
volume range is reached another supervisor is added. When
the lower limit of a supervisor's volume range is reached
the supervisor may be dropped from the payroll, or kept on
the payroll for future service, as recognition of reliable
past service, or as a form of psychic income for management.
When an unnecessary supervisor is retained, his wages
should be charged to future (past) periods benefited or as
a current consumption of income (psychic income for manage-
ment).

It is the opinion of the author that a unit of

59 is unacceptable for super-

production amortization plan
visory salaries for two reasons:

1) Supervisors are paid for whatever usefulness
they can render within the volume range they
are necessary for.

2) A unit of production amortizatiai plan would
yield the undesirable effect of normalizing
supervisory costs per unit of output, which
would have a tendency to normalize income.

The two possible objections (perhaps modifications)

of the accounting for overhead costs recommended in this
dissertation are not valid in the eyes of the author. A

unit of production method of depreciation is not easy to

quantify. All that is recommended is that practitioners

 

59The same would hold for the "cycle overhead plan"
which could yield an approximation to the "unit of production
plan".

292
either make the attempt to quantify the unit of production
method or use an approximation thereto. The approximation
would be the normal or cycle overhead concept applied to
depreciation (insurance and taxes on depreciable property
also). The normal overhead concept is the most extensively
utilized overhead concept, and thus the approximation to
the unit of production method for depreciation is calculable
on a practical basis. Supervisory costs could not logically
be considered as a form of lease rental, so supervisory costs
must be considered with other "chunk costs" as the cost of
producing whatever output is produced within the relevant

volume range.
The Misguided Marginalist and Break-Even Enthusiast

In the preceeding pages (The Case of the Defense)
idle capacity costs are used as a defense against the direct
cost approach to income measurement. Idle capacity is now
lost as a defense against the direct costing ideology, be-
cause under the improved approach to overhead costing

recommended here there can be no idle capacity costs.6O

 

60
The only exceptional case where idle capacity costs

can exist relates to extreme changes in the useful life of
fixed assets.

293

Thus the direct costing approach to income measurement
must be discredited on other grounds. The most appropriate
grounds on which to discredit direct costing are on the
basis of the exact nature and intent of economic marginalism
and break-even analysis.

Economic marginalism is not related to the measurement
of income; economic marginalism is only a method of illustrating
income maximization via the determination of the most pro-
fitable price and output combinatiai in the short—run. The
only cost factors to consider in the short—run are variable
costs, for they are the only cost elements of significance
in short-run price and output determination. As stated by
Noyes, marginalism is a means of concentrating attention on
strategic factors, that is, the incremental factors in-
cluding variable costs.61

The lack of consideration given to fixed costs by
economic marginalism does not mean that fixed cost elements
are not costs, it simply means that fixed costs have no
relevance to short-run price and output decisions. The
fact that fixed costs are costs of production and allocable

to production is a point made by economists and others

when they consider the problems of public utility rate-making

 

61Noyes, pp. cit., 485.

“_—

294

and the rational foundations of the Robinson-Patman Act.
In both of these cases the problem is one of allocating
fixed charges to products or services. In the case of
public utilities, equity demands a just apportionment of
fixed expenses to the beneficiaries of the services. In
the case of the Robinson-Patman Act the problem of the big
buyer wielding the club of the large order is the issue.
Incremental or marginal pricing is considered unjust since
all buyers contribute to the effects of volume and therefore
all should be subject to a just apportionment of fixed
costs. Price differentials are considered a luxury which
must be cost justified. In other words, fixed costs are
costs of producing products or services.

Anyone who considers economic marginalism an
argument for direct costing completely misunderstands
marginalism. Short-run price and output determination
which concentrates on incremental costs and revenues is the
object of marginalism; the measurement of income has nothing
to do with marginalism.

Break—even analysis is also unrelated to income
measurement. The intent of break-even analysis is to focus
attention on the strategic factors (incremental costs)

involved in short-run decision-making. Short-run

295

decision-making related to income maximization is a far
cry from income measurement which is a long-run concept.
If break-even or marginal analysis is to be used as
a means of measuring income, two very basic assumptions
must be spelled out, viz.:
1) there is an equality of sales and production

2) production inefficiency is assumed to be
constant or nonexistent

Consideration of an inventory problem, that is, an
inequality of sales and production, is almost impossible to
find in the literature of marginal and break—even analysis.
If (as is usual) there is an inequality in sales and pro-
duction, modifications must be made in the break-even or
marginal approach to income measurement. Only the fixed
and variable costs applicable to sales must be shown in
the break—even chart used to measure income. The fixed and
variable costs applicable to inventory must be removed from
the break-even calculations. Another possible modification
producing the same effect, would be a calculation concerning

62A somewhat crude attempt is made to recognize this

problem in C. E. Knoeppel and Edgar E. Seybold, Managing
For Proflp (New York: McGraw Hill Book Co., Inc., 1937),
178.

296

the difference between fixed costs included in the beginning
and ending inventories, which would be used to adjust the
traditional break-even income calculation. If there are
$6000 more of fixed costs in the ending inventory, $6000
would be added to the break—even income calculation, since
the break-even income calculation included $6000 of fixed
costs which were allocable to the ending inventory. If
there are $6000 less of fixed costs in the ending inventory,
$6000 would have to be deducted from the break-even income
calculation, since the break-even calculation did not
include $6000 of fixed costs applicable to the inventory
reduction.

Break-even and marginal analysis assume implicitly
that income is monofunctional, that is, a function of sales.
A monofunctional relationship was actually the goal of
direct costing advocates, since they always sought a direct
sympathy between sales and income. Professor Brummet's
ideas on idle capacity as a form of waste yield a bi—
functional income determination.63 Income is considered to
be a function of sales and idle capacity by Brummet. Of
course Brummet, like break-even analysis, assumes that

63
See "The Case of the Defense" in this chapter, pp.254-59,

297

Eiroduction inefficiency is constant or nonexistent. A
realistic approach to income measurement is that it is
(metermined by a multitude of functions including sales,
syales mix, and the innumerable forms of waste and inefficiency
vfliich are always present when human beings are present.

Among the wastes which are an ever—present part of
the production process are price and usage variances
traditionally segregated from efficient costs under standard
costing. In the case of overhead there would be waste due
to improper use of fixed assets, indivisible cost inputs and
the costs of operating equipment and facilities. Idle
capacity costs are not considered as waste for income
measurement for they relate to the "physical life" and
not the "useful life" of assets and also the inappropriate
practical and normal capacity concepts.

The original goal of direct costing, that is, the
elimination of the normal overhead concept, was admirable.
The normal overhead concept was and still is entirely
inappropriate for income measurement. Under- and overabsorbed
overheads produced by the normal overhead concept were the
combined results of a cost determining price and a throwback
to the practical capacity concept (recognition of loss due

to idle capacity). Neither the cost determining price nor

298

'the "physical lifeH feature of practical capacity have
any necessary relation to the measurement of income. The
cycle capacity concept did not save traditional accounting
concepts from error by treating under— and overabsorbed
overhead as deferred charges and deferred credits. The
cycle concept merely concentrated the error of traditional
accounting in the normalization of unit costs and income.

Direct costing focused attention on an error in
traditional accounting, but devices used to correct the
error were entirely inappropriate, that is, elimination of
normal overhead via a marginal or break—even approach to
income measurement. The opponents of direct costing failed
to recognize the error in traditional accounting and tried
to defend the traditional accounting for overhead on the
basis of the inappropriate practical and cycle capacity
concepts. The proponents of direct costing failed to
recognize that neither marginalism nor break-even analysis
were methods of measuring income.

Both proponents and opponents of direct costing
failed to recognize the real inadequacies in the traditional
accounting for overhead costs which were embodied in the
assumptions underlying each of the three capacity concepts;

viz.:

299

l) A fixed-variable cost segregation is best for
income measurement.

29 All fixed costs are related to long—lived asset
acquisitions (fixed assets).

3) Unit costs should not be allowed to vary with
volume.

Overhead costs should be classified for income
measurement into three categories, viz.:
1) Costs related to fixed asset acquisitions
including depreciation, and insurance and
taxes on depreciable property.

2) Indivisible cost inputs ("chunk costs")

3) All other overhead costs which are essentially
the costs to Operate equipment and facilities-

Group (1) costs should be allocated on a unit of
production basis, and groups (2) and (3) should be allocated
to the actual output produced. The indivisible cost inputs
(many times called semi-variable costs) can yield a varying
cost per unit dependent on production volume within the
range serviced by the indivisible cost inputs. A varying
unit cost on the basis of indivisible cost inputs is quite
sensible, for indivisible cost inputs are absolutely
necessary costs of production for every volume possibility
' within the range they service.

Income measurement in accounting is a process of

matching sacrifices (costs) and the results of the sacrifices

300

(revenues). Costs would include all of the overhead costs
necessary for production (the traditional fixed and variable
costs are both included here). If goods remain on hand at
the end of a period they should be valued at their cost of
production (all overhead costs included) in order that the
costs of items sold may be properly matched with the.
revenues they create. Inventories are costs held in
abeyance so that they may be properly matched or associated
with the revenues created by the sale of the inventory in
succeeding periods. A proper association of costs and
revenues yields the measure of income which is sought after
in accounting.

If wastes or inefficiencies64 occur in the process of
manufacture and they can be identified,65 they should be
removed from inventoriable costs. Waste and inefficiencies
represent losses or drains on the income generated in the

period in which the wastes occur. Wastes and inefficiencies

are consumers of income, not producers of income, and

 

64 . .
Since idle capac1ty costs are generally non—existent

for income measurement purposes, they would not be included
in the wastes and inefficiencies used in income measurement.
A cost due to misused capacity (technical rather than
commercial efficiency) would logically be a part of income
measurement.
65
The goal of standard costing is to identify waste.

301

therefore they cannot be accumulated in inventories.
Inventories are the resting ground of all effective efforts
to produce income. Wastes should be deducted from income
in the period in which they occur, for they represent the
difference between income as it should have been and income

as it actually was.
Summary

Income measurement is a process of matching effort
expended with benefits received. Effort expended must of
necessity include fixed and variable costs of overhead,
for neither of these efforts would have been expended unless
there was some goal or benefit to be obtained. Any wastes
or inefficiencies in the efforts expended should be identified
at least in internally-used financial statements. The
focusing of attention on such wasted effort in terms of
presenting income as it should have been compared to what it
actually was is no doubt the best means of indicating the
total impact of waste to the dollar-minded executive.

Such wastes consume income in the period in which they
occur. They cannot in any sense be considered generators of
income, and therefore should not be held in abeyance in the

form of inventory, which is the resting place of all effective

302

efforts expended to produce income. When the income is
realized, then the inventoried efforts associated therewith
are removed from inventory and considered as costs of
revenue production in order to set forth clearly the
results of operations. Wastes include the misuse of all
cost inputs, whether they be associated with materials,
labor, or overhead. Idle capacity costs are not considered
with these wastes, because for income measurement purposes
there are no such things as idle capacity costs.

The dilemna created by break—even and marginal analysis
is not really a dilemma at all, for such analyses are not
intended to measure income. They are intended to maximize
income by means of pointing out the incremental aspects of
cost and revenue necessary for decision—making. Any use of
marginal or break—even analysis to measure income is a clear
violation of intended purpose as well as a misrepresentation
of fact. This point should be well recognized by those who
have considered the problems of public utility rate—making
as well as the rational foundations of the Robinson-Patman
Act.

To many the challenge to the accountant's method of
determining income, presented by direct costing, has brought

forth a more refined and defensible method of measuring

income. This would be
it:s preoccupation with
aJuci the fixed-variable
Accounting measures of

" physical life" factor

303

true only if accounting disposed of
the inapplicable capacity concepts
segregation of overhead costs.
income should not be subject to the

in practical capacity, the sales price

ixiexology of normal capacity, and the normalizing or averaging

txaruflency of cycle capacity. Income can only be measured

Mflieuu every attempt is made to segregate and allocate over—

}Meaci costs properly to units of output so that costs of

PIVDéhJcts may be matched or associated with the revenues

<3elfiwxed from the sale of merchandise.

CHAPTER VI

THE MODERN APPROACH TO OVERHEAD COSTING AND COST CONTROL AND

THE NEED FOR AN INTEGRATED AND CONTINUOUS APPROACH
Traditional Cost Control

There has truly been very little change in the
approach to cost control since the time of John Whitmore.
Whitmore wanted the costs of idle capacity to be shown as
a dollar figure which was to be an income statement deduction.
By highlighting the idle capacity loss as an income deduction,
rather than allocating it to product on the basis of a
supplementary rate, Whitmore believed management would be
made to realize the true impact of the loss. Then manage-
ment would institute the procedures necessary to analyze
idle capacity costs by cause and responsibility in order
that the waste might be eliminated.1

G. Charter Harrison and others took the same atti—

tude towards cost control when standard costs came upon the

 

1See Chapter Two on "The Rising Influence of Cost
Control: A. Hamilton Church and His Supplementary Rate,"
especially the section entitled "The Prime Critic: John
Whitmore." pp. 48-51.

305

2 With standard costing, though, dollar

industrial scene.
variances were accumulated for wastes of materials and
labor as well as overhead, but the approach was still the
same, that is, to accumulate variations (wastes), then
analyze them by cause and responsibility in order that
effective procedures might be instituted to eliminate the
detected wastes.

In the case of overhead, recognition of the fact
that the variance accumulations were summarizations of a
multitude of unrelated items of varying variability and
fixity led to the cOncepts of responsibility accounting and

the related flexible or variable budgets.3

 

2For example see:

G. Charter Harrison, "Cost Accounting to Aid Pro—
duction," Industrial Management,LVI-LVII (October,l918—
June.l9l9), 273—82, 39l-8,456-63,131—9,218—24, 314—18, 400-4,
483-7.

G. Charter Harrison, "Scientific Basis for Cost
Accounting," Industrial Management,LIX (March, 1920), 237—42.

George A. Prochazka, "Controlling Costs by Their
Variations, ” Industrial Management LXXIII (January—March,
1927), lO— 15, 117—22, 147- 50.

 

 

3See Chapter Two on "Cost Control and the Development
of Overhead Costing" and Chapter Four on ”Responsibility
Accounting." pp.125-28 and 199-205.

See also:

Clarence B. Nickerson, "Cost Control——A Review of
Techniques, " .AQA3Bulletin XXIX Sec. 1.(July 15, 1948),
1399- 1408.

 

306

Vfiith flexible budgets, costs are accumulated by responsibility
centers, and individual cost elements are classified by
Object of expenditure within each responsibility center.
'Variances are then accumulated for individual items of
expense in each responsibility center by comparing budgeted
and actual amounts. Still, the approach to cost control
is the same, that is, to eliminate the waste after the
variances are accumulated, which effectively means that the
only cost control feature inherent in the accumulations is
the elimination or reduction of similar wastes in the
future.

The approach to cost control thus far considered
is the approach still accepted in most quarters. It is the
approach discussed in most texts on industrial management

4

and :1st accounting. It is the approach that is inherent

 

4
For examples see:

Richard N. Owens, Management 9; Industrial Enterprises
(Homewood, Illinois: Richard D. Irwin, Inc., l955),d638-8 and
643. ‘

 

 

Franklin G. Moore, Manufacturing Management (Homewood,
Illinois: Richard D. Irwin, Inc., 1953), 738 and 742.

Ralph C. Davis, Industrial Organization and Management
(New York: Harper and Brothers Publishers, 1940), 598—622.

L. P. Alford and Russel H. Beatty, Principles 9;
Industrial Management, Rev. Ed. (New York: The Ronald Press
Company, 1951), 591.

Cecil Gillespie, Cost Accounting and Control (New
York: Prentice Hall, Inc., 1957), 824. —r

Stanley B. Henrici, Standard Costs for Manufacturing

 

 

 

307

in the National Association of Cost Accountants'studies on

standard costing5 and analysis of variances.6 It is the

approach inherent in the uniform cost accounting system

I

proposed by the National Electrical Manufacturers
Association.7 It is the approach of a number of "how to do
it" presentations at annual meetings of the National
Association of Cost Accountants.8 It is the approach of
some Certified Public Accountants and industrial accountants

who were interviewed in conjunction with this study. It is

 

(New York: McGraw—Hill Book Co., Inc., 1953), 336.
William B. Lawrence, Cost Accountingy Fourth edition,

revised by John W. Ruswinckel (New York: Prentice—Hall, Inc.,
1954), 659 pp.

5
How Standard Costs are Being Used Currently (New

 

 

York: National Association of Cost Accountants, 1950), 26—50.
6N.A.C.A. Research Series No. 22. "The Analysis of Cost
Variances," N.A.C.A. Bulletin, XXXIII, Sec. 2. (August, 1952),

1547-82.

7
Uniform Accounting Manual for the Electrical

.Manufacturing Industry, (7th ed.) (New York: National

;Electric Manufacturers Association, 1949 , 501-29.

8A good example would be:
vern Breitenbucher, "Putting Cost Accounting to

Work--For Cost Control," National Association _g_f_ Cost
flgccountants'Yearbook, 1946, 96—113.

308

. 9
the approach of a recent study on overhead costing and a
. 10 . .
recent textbook on management accounting. Finally, it
is the approach adopted by the committee on cost accounting
of the American Accounting Association in a statement con-

. . ll
cerning cost accounting for management purposes.

OPERATING CONTROL IN THE FACTORY: PHYSICAL STANDARDS
General

Physical standards are actually the foundation of
the dollar standards used in standard costing. This is
especially true of direct labor and direct materials. In
the case of direct labor, personnel activities take care of
such matters as a complete description of various jobs (job
description) and a complete description of the type of
person best able to meet the requirements of the job (job

specification). Methods personnel analyze each job and

9
R. Lee Brummet, Overhead Costing, 9p. git., 139-151.

 

1
0Robert N. Anthony, Management Accounting (Homewood,

Ileinois: Richard D. Irwin, Inc., 1956), 268-324.

 

1Committee on Cost Accounting Concepts and Standards
C>f the American Accounting Association, "Tentative Statement
<>f Cost Concepts Underlying Reports for Management Purposes,"
2312 Accounting Review, XXXI (April, 1956), 188-190.

 

309

determine the best way to perform assigned tasks. Time—study
personnel then time each task. After a time study the
physical standards should be just about complete, for the
requirements of the job and man are known, the most appro-
priate methods are known, and the times to be taken are
known.

'In the case of direct materials, engineering per-
sonnel determine the most appropriate materials to use and
the physical quantities of each type of material to produce
each completed unit. Engineering personnel also handle
such technical tasks as determining the output yield of
various inputs, the specifications for purchased materials,
and certain aspects of processing direct materials.

For overhead, physical standards do present some
difficulties, but they are not inSurmountable. Of special
significance are methods and procedures determined by
engineering personnel, setting forth the proper ways to

Operate the various items of equipment.

Direct Materials

 

In the case of direct materials, the physical stan-
d.ards most often heard of for purposes of cost control relate

tCD excess material requisitions, yield reports, and scrap

310
reports. The value of excess material requisitions was
recognized as long ago as 1887 by Garcke and Fells when they
said:

Before any order to manufacture is given
it is advisable, as tending to produce greater
economy in the cost of production, that the
person best acquainted with its processes and
details should estimate the probable cost to
be incurred in wages and materials, in the
production of the articles in question. This
estimate should be a minimum rather than a
maximum one, and the storekeeper, having been
furnished with the particulars of it should
not, without special authority, issue more
material for the order than is estimated.12
Use of excess materials requisitions is considered
by Gillespiel3 as a means of controlling material usage
at the source. Henrici also considers these requisitions,
but seems to discount them on the basis that no excess
requisitions will be issued if it is permissible to complete
and order with less production that was originally stipu—
l4 . . .
lated. Even though Gillespie and HenriCi conSider these

requisitions, they do so in an incidental or fleeting

manner, in the form of a digression from the usual type of

 

12
Emile Garcke and J. M. Fells, Factory Accounts,

Fourth edition (London: CroQDy Lockwood and Son, 1893), Sl-
52.

 

3
Gillespie, op. cit., 420—1.

4
Henrici, pp. cit., 234.

311

variance analysis.

Excess material requisitions are ordinarily of a
color different from that used for ordinary requisitions,
and they can be issued only on the basis of a foreman's
signature. In this way, out-of-line performance is de—
tected much earlier than it would be by the analysis of
dollar variances.

Yield reports are an excellent complement to excess
material requisitions. Analyses can be made on the basis
of inputs of materials, product that should have resulted,
and product that did result. Depending on circumstances,
such reports can be rendered daily, weekly or even monthly.
Of course, the more frequently reports are turned out the
earlier will notice be given of out—of—line performance.
Exemplary applications of yield reports would be in bottling
plants, chemical processing plants and garment manufacturing
plants.

Scrap and spoilage reports are also useful aids in
pointing up out—of—line performance. Depending on circum*
stances the reports can be issued more or less frequently.
Each of these reports has been considered at one time or
another in the literature on cost control, but the approach

to cost control is still very much the same as for dollar

312

variance analyses. Controls related to the reports in terms
of physical units are more precise and more proximate
(closer to occurrence of out-of-line performance) than
monthly dollar variance analyses, but all that can be
corrected is the continuation of out—of—line performance
which has already occurred, just as in the case of dollar

variance analyses.

Direct Labor

 

Reports in physical terms for purposes of direct
labor cost control relate most often to performance and
idle time. G. Charter Harrison considered performance
reports as early as 1920 when he said it was unnecessary to
record for each employee the time taken on each Operation
in order to compare it with a standard time and thus
compute a measure of efficiency. He stated that all that
would be necessary was a comparison of actual output per
day in terms of standard time and actual time, in order to
determine the efficiency of a worker during a particular

15

day Even though he did consider this physical measure of

 

l

5G. Charter Harrison, "Cost Accounting in the New
Industrial Day," Industrial Management,LIX (January, 1920),
13.

 

3l3
efficiency, Harrison treated it lightly and immediately
returned to dollar variance analyses.

Performance reports comparing actual output in terms
of standard hours and actual hours used to produce the
actual output yield a measure of operating performance in
strict physical terms. Such reports can be issued daily,
weekly, or even monthly, dependent on circumstances. To
the foreman is given a report of physical performance by
individual workers, and to the foreman's superior is given
a summary report for the department and perhaps detailed
data on exceptionally good or bad workers. To a plant
superintendent could be given summary data for all depart-
ments, as well as a plant summary. To each successive step
in the organizational ladder is given a summary of the
detailed data which was given to lower levels.

Idle time reports can summarize all direct labor
hours into that which was used on actual production, and
that which.w§§ not utilized on actual production. The
unutilized or idle direct labor hours can then be summarized
bu cause, such as maintenance delay, lack of material, and
power failure. These reports can be prepared for any time
period or any division or subdivision of the firm. Their

purpose is to show in physical terms how much of the direct

314

labor time has not been productive and the reasons therefor.
Performance reports, idle time reports, and other
reports of direct labor utilization in physical terms have
been considered many times in the literature on cost control,
but the general approach was rather well stated by Henrici,
who said they "are prepared to illuminate the variances that
accounting methods reveal.”16 Even though these reports
might be issued earlier than dollar variance analyses, their
point of View is the same, that is, to eliminate the con-

tinuation of detected variances (wastes).
gysrhssé

Physical standards are very difficult to set for
overhead costs. The reason for this is the heterogeneous
nature of overhead costs and the practical impossibility of
identifying individual elements of overhead with output in
a specific manner. Without the possibility of physical
standards such as exist for direct labor and materials, there
is still a possibility of a form of physical standard for
elements of overhead.

Maintenance costs and delays can be effectively

 

l6
Henrici, QR. cit., 215.

 

315

controlled by means of a preventive maintenance program
which calls for periodic examination of all equipment items.
As to when or how often equipment is to be checked or
tested, this is an engineering problem related to machine
capability and expected and actual use. Utilities can also
be controlled by physical standards in much the same way.
Information on how to use lighting fixtures can be dis-
seminated to appropriate personnel, and from then on test
checks on how such fixtures are utilized can be made. The
same ideas are applicable to the use of power facilities,
heating, air conditioning and even water usage.

Various elements of indirect labor can also be
subject to some form of physical control. For example,
with expected output and facilities it should be known how
many material handlers, inspectors, stockroom employees,
helpers and even janitors are needed. These physical quotas
establish the need for such men. As to their performance,
it can be tested by volume of activity measured in any
number of ways. The janitors' performance could easily be
checked by visual observation, for example.

Indirect materials can also be checked in terms of
physical standards. The length of time such things as

gloves, safety goggles, and foundry sand should last can be

316

established and used as a measure of control. The same

ideas are applicable to cutting oils, small tools and many
other elements of indirect materials. The only real limit
to the use of physical standards or measures for overhead

items is the usual balancing of benefit and cost.
THE INTEGRATED AND CONTINUOUS APPROACH

Limitations of Traditional Cost Control

 

Cost control in the traditional sense has limited
effectiveness for two reasons. In the first place, the
data are stated in dollars which must be analyzed in
order to determine causes and pinpoint responsibility
for out—of-line performance. The analysis of productive
efficiency variances must actually be broken down into
physical terms in order to yield real causes and to state
properly remedial measures. Secondly, the data as accumulated
is past history, and becomes ancient history by the time it
is analyzed to determine cause and responsibility. All that
can be done is to eliminate future recurrence.

These comments are relevant to all the variance.
accumulations of standard costing and variable budgeting.

A very good summary of cost reports that indicates their

317

limitations as expressed here was given by Professor
Anthony, a member of the Committee on Cost Concepts and
Standards of the American Accounting Association which
prepared a statement on cost concepts for management pur-

l7 .
poses. Professor Anthony's comments which were an
explanation and a defense of the committees' work are as
follows:

In this area, we first must face a familiar
paradox, which can be stated as follows:

Cost reports describe what has already
happened; therefore they cannot be used to

control events, since no one can alter or undo

what has already been done; therefore, a control

report cannot really control anything.

He (Anthony) attempted to explain away the paradox
by saying that the reports really provide the basis for
actions such as "praise, criticism, or suggestions for
change, all designed to improve future performance."19 He

added what he called a subtle way in which cost reports can

influence performance, that is, they have the effect of a

 

l7
Supra footnote ll.

18
Robert N. Anthony, "Cost Concepts for Control,"
The Accounting Review, XXXII (April, 1957), 233.

19Ibid.

318

report card,20 since advance knowledge that cost control
reports will be issued tends to provide a stimulus to better
performance on the part of the persons to be judged.

The attempt to salvage traditional cost control on
the basis of a "report card effect" is admirable, but it
still leaves us with an incomplete or partial concept of
cost control. As will be explained later, cost control
reports are part of a much broader concept of cost control,
and they can be the least important part of an effective

cost control scheme.
Limitations of Physical Standards

The physical standards which are the foundation of
the pecuniary standards of accounting can be much more
timely in reporting out—of—line conditions than pecuniary
data, and therefore they are a much more effective control

device. For this reason Billy E. Goetz has long advocated

 

20
The term "report card" was used by the head of the

management services division of a national public accounting
firm in an interview conducted in conjunction with this
study. He Was referring to flexible budget reports by
responsibility centers, which he considered the keystone of
cost control.

21
Anthony, pp. 933., 233.

3L9

the control of direct labor and direct materials by means of
physical standards and the complete abandonment of pecuniary
data for control purposes.22 A typical Goetz conclusion is,
"No job order cost accounting system, no process cost
accounting system, and no standard cost accounting system
gives as prompt and as precise control reports."23

In the case of overhead Mr. Goetz makes one con-
cession; that is, he uses a combination of physical standards
and flexible budgeting for control purposes. He, like Fred

24
Gardner, believes that the use of flexible budget data
places him miles ahead of accounting people who, as he states
it, divide, allocate, reallocate and merge costs until the
components "are no longer accessible for management planning

"25

and control. Neither Goetz nor Gardner seem ready to

 

Billy E. Goetz, “Tomorrow's Cost System" included
in William E. Thomas, Readings in Cost Accounting Budgeting
and Control (Cincinnati, Ohio: South-Western Publishing
Co., 1955), 67—80.

Billy E. Goetz, Management Planning and Control
(New York: McGraw-Hill Book Co., Inc., 1949), 294 pp.

23 .
Billy E. Goetz, "Tomorrow's Cost System," op. cit.,

 

 

75.

Fred V. Gardner, Profit Management and Control
(New York: McGraw—Hill Book Co., Inc., 1955), 17—18.

25
Billy E. Goetz, "Tomorrow's Cost System," 92. cit.,

 

67.

320

admit that flexible budgeting and responsibility cost
accumulations have long been a part of accounting practice
and literature.

Physical standards are certainly useful for cost
control purposes, but they have two limitations which are
also inherent in cost accumulations. In the first place,
reports in physical terms are still past history. They are
not as ancient as cost accumulations, but their limits are
the same, that is, they can only lead to improved future
performance and the same "report card effect" of cost
accumulations. The other limitation of physical standards
is that the data relate to only part of a truly effective
cost control system.

A limitation of physical standards that is not in—
herent in cost accumulations is that physical standards
cannot aid in the process of making sure that input prices
are controlled. Physical standards aid only in the control
of physical usage. Furthermore, control of usage with
physical standards can be complemented effectively with
gmxzuniary data to illustrate the impact of waste to
operating men. A knowledge of input prices can also help
operating men in directing their effort towards the greatest

cost savings.

321

Neither dollar nor physical standards provides all
of the necessary ingredients for truly effective cost con—
trol. Cost accountants make their mistake when they rely
primarily on dollar accumulations. Goetz and those who are
impressed by his arguments make their mistake when they
rely primarily on physical accumulations. Both of these
groups make their greatest error, though, when they approach
cost control with the question what must we g9 ngw, after
we take the precious time to find out what went wrong in
the first place. The appropriate question which defines the

correct approach is, what has gone wrong and what has

 

already been done to eliminate those factors giving rise to

 

out-of-line performance.

This more effective approach can only be appreciated
in the light of the organization structure and its various
levels which will bring into focus an integration of cost
and physical standards and an appreciation of the true
position of cost accumulations in the overall cost control
framework.

The next section will consider in a general way the
general principles applicable to a truly integrated and

continuous system of cost control.

322

Hierarchial Ranking_and the Integration of Cost and Physical
Standards

 

 

At best the ideas to be expressed here are nothing
more than a statement pulling together the contributions of
every facet of the business organization as they relate to
cost control. There is really nothing new, except perhaps
a definite statement that brings many of the activities re-
lated to cost control into proper focus. The approach of
traditional cost control as stated by the Committee on Cost
Concepts and Standards, as well as the approach of Mr. Goetz,
most likely imply many of the ideas to be expressed below.
It is unfortunate, however, that the most important aspects
of cost control are left to implication, and are not brought
together in such a way that the proper position of cost
accumulations can be fully appreciated.

For purposes of illustration, it is to be assumed
that there are six levels in the organization structure.
Each of the levels is to be considered a line of defense
against out-of—line performance. The line closest to actual
production is considered first, and the line furthest away
from actual production is considered last. The function
of each line of defense is to detect out—of-line performance

and ask those in prior lines of defense what went wrong and

 

323

what has already been done to correct out of line performance.

 

 

The first line of defense cannot ask this question for its
function is to eliminate out-of—line performance before it
starts. The cost control function of subsequent lines is
to detect the out-of-line performance that may have occurred,
and to find out if the necessary correctives have been
applied, and if not to apply them immediately.

The lines of defense can be identified as follows:

Board of Directors Sixth

President Fifth

Manufacturing Vice—President Fourth

Plant Manager Third
Foreman Second
Worker First

For each line of defense the type of information
required is different. Knowledge of expected results in
physical and dollar terms, visual observation, accumulations
of out-of-line performance in physical and dollar terms,
and even the traditional income statement, all play a part
in cost control. At the worker's level visual observation
is paramount. A keen eye used by a worker who has a sense
of responsibility and a knowledge of his task can spot

impending trouble or those conditions that would inhibit

324

the attainment of expected performance. A machine that is
beginning to act up, preceding operations which are moving
too slowly to assure production continuity, and an impending
lack of materials are all factors that can be overcome be—
fore they result in out-of-line performance.

At the foreman level visual observation is also im-
portant, but it can be complemented by reports in physical
terms. The foreman oversees the work of many, so visual
observation must be on a sampling basis. With this in mind,
reports of physical progress such as yield reports or per—
formance reports play an important part. These physical
reports are utilized to make up for the necessarily limited
observation. A knowledge of pecuniary data related to the
physical reports can also be of importance at the foreman
level. A perfect application of a knowledge of pecuniary
'data would occur in those everpresent situations where the
foreman must allocate his time in such a way as to yield the
maximum benefit. In other words, a foreman must have a
knowledge of pecuniary data in order that he can direct his
efforts towards the greatest cost savings or the greatest
sources of waste.

The foreman's position is the second line of defense.

He must be in a position to identify visually any potential

325
sources of out-of—line performance that workers fail to
'recognize and also identify actual waste (visually and from
reports) in order to find out what has already been done to
eliminate such wastes. If nothing has been done, then the
foreman should take appropriate action. Thus it is seen

that the foreman's position is secondary if the worker has a

r—h

sense of responsibility and a wary eye. Without the aid 9_

(D

the worker, for one reason 9; another, the foreman would b

 

 

g second-best choice for the first line 9f defense.

The plant manager is ordinarily not in a position to
make very extensive visual observations, so he must rely
heavily on reports comparing expected and actual performance
in physical and dollar terms. These reports are usually sum—
maries of reports given to foremen and may also be prepared
less frequently than reports given to foremen. Physical
and dollar reports are both important to the plant manager;
physical reports, since they represent the language of the
shop, and dollar reports, since they facilitate choices in-
volving the most effective utilization of time and an under-
standing of the full impact of waste. Again, though, the
position of the lines of defense behind the first line is
the same, that is, to find out what has already been done to

eliminate detected waste, and, if nothing has been done, to

institute procedures necessary to eliminate the continuation

326

of the wastes that earlier lines of defense failed to
recognize and eliminate.

The manufacturing vice—president presumably has under
him a number of plants. Visual observation in his case is
of little consequence. Physical and dollar reports that
compare actual and expected results are the most effective
control media he has. These reports are summaries for each
plant as a whole, based on the more detailed and more
frequently-prepared reports that are given to plant managers.
At this level it is more than likely that dollar reports
are as important, if not more important, than physical re—
ports,_for the manufacturing vice-president is at that
level where profit—and—loss responsibility and the dollar
impact of waste is beginning to be emphasized. As in all
prior lines of defense, the point of view is to ask the
question what has already been done to eliminate the de-
tected wastes. An important factor that could have been
noted earlier is that analyses of physical or dollar variances
should not be necessary. Under the broad cost control
system recommended here, the analysis already exists in the
hands of prior lines of defense in the form of the data
summarized to provide the reports to higher levels.

The president's position is one of profit and loss

.4

responsibility in the fullest sense of the word. To him

327
very summarized physical data concerning plant operations
can be given, but more important than this is the dollar
data given in the form of standard cost and flexible budget
variances. Dollar data illustrate in the best possible way
the full impact of waste to the dollar-minded tOp executive,
1 and prepare him for the questions that are bound to be asked
by the board of directors when they receive the company's
income statement showing what income was earned and what
happened to the income that should have been earned
(variances). The income statement which includes the
variations from standard costs and the overall flexible
budget reports yields the sixth line of defense, which is the
point where dollar variations are of greatest significance.
As usual there is no need for detailed variance analysis at
this point because the variances as calculated are summaries
of already-existing physical and dollar reports prepared
for the more immediate lines of defense. Also, the controls
applicable to these variances relate to the usual question
of what has already been done, and if certain items are
found to have been overlooked they will then be considered.

Each level of defense becomes more and more remote
Ifrom the operating departments where real control actually

should take place. The only reason for the more remote

328

lines of defense is as a check on the effectiveness of the
more immediate lines of defense. The more effective the
immediate lines of defense are, the less important the more
remote lines of defense are. In some cases, then, the more
remote lines of defense can be and are taken more casually,
and may eVenbeignored. The more remote lines of defense
emphasize the cost accumulations related to standard cost
accounting and flexible budgeting. The general position of
these cost accumulations and their proper context in the
broad framework of cost control should now be better
appreciated. The traditional approach overemphasizes cost
accumulations, while the physical approach does not appreciate
their utility. Only the integrated approach presented here
places both cost and physical accumulations in their prOper
context.

The foregoing description of six lines of defense
could easily include a number of other factors. Some of
these are prior to the worker's position and some come after
the board of directors. In a sense the activities prior to
the worker are even more fundamental to cost control than
the above—mentioned lines of defense. Among these possibly
more fundamental activities are the three categories of

personnel administration, engineering, and production control.

329

In the case of personnel administration, there must
be effective hiring and placement policies at all organi—
Vzational levels. The right man for each job is the major
goal here. This of course necessitates a knowledge of job
characteristics (job description) and a knowledge of the
man characteristics (job specifications). Very closely
related to this is the engineering function of determining
expected performance. In other words, there must be a
knowledge of the physical relation between the various type
of inputs and outputs. This knowledge is preferably
determined on the basis of engineering studies. Past re-
sults could also form the basis of expected performance.
However expected performance is determined, it should be
common or available knowledge to all levels in the organi-
zation. Production control activities are also very
essential to cost control. Proper production planning and
control yields the appropriate quantities and qualities of
inputs at the apprOpriate time. There is really no end to
the relationships between the operating and facilitating
agencies of any industrial firm as they relate to cost con—
trol. It is believed, however, that the more important
aspects have already been noted.

Beyond the level of the board of directors, there

330

are the stockhOlders who can also be related to the overall
cost control process. The stockholders do not receive a
report of income that includes variances from standard
costs, but the income statement they do receive is a measure
of the firm's overall economic progress. This measure of
progress,.if understood properly, should be considered the
result of all the firm's activities and therefore a function
of sales and the innumerable forms of waste that can be
found in any business. If stockholders are not satisfied
with the firm's progress they can put pressure on the board
of directors to make more intensive efforts to increase
income by increasing sales and/or decreasing waste. The
stockholders could possibly force a change in the make-up
of the board of directors or perhaps, if nOthing else could
be done they could give up and dispose of their stock. Thus
the stockholders can also become, at least to a limited
extent, a line of defense against out—of-line performance.
In summary, the six lines of defense explained above
should illustrate that both dollar and physical accumulations
have a place in the broad framework of cost control. However,
more important that either is the visual observation of

workers and their foreman. With the first lines of defense

visual observation is most important. The sixth line of

331

defense, on the other hand, is aided by a report of income
that shows what income was earned and what happened to that
which should have been earned. In between the first and
the sixth lines of defense physical standards play a more
important part at the more immediate levels while dollar

standards play a more important role at the more remote

 

 

 

 

levels. This can be illustrated as follows:
Lines of Defense Basis of Control
VI Board of Directors An Income Statement Showing
‘ Variances
m 1
. m A "a ’
V PreSident E E fg E The area of
_ . ,g H g H Physical and
IV Manufacturing Vice- {(3 e 46)) 8 Dollar Stan-
Pre51dent p O O dards
U) E H E:
H m E 8 0‘:
III Plant Manager m E m .H E m
H o.u m o u
H O H a U H.
II Foreman o m o ,2 m 0V
Q on Q4 D4 m Clo
I Worker Primarily Visual Observation

Of primary importance in the integrated and continuous
approach to cost control is the basic change in attitude
wherein the question related to variances becomes what went
wrong and what has already been done to correct deviations
in expected performance. When physical and dollar standards
are taken in their proper context there is no need to relate

their significance solely to the improvement of future

 

 

 

 

332

performance and the "report card effect”. The most
appropriate position of dollar and physical standards can be
appreciately only in the light of the integrated approach

as presented here. The next section is designed to give
more specific data concerning control of costs as it relates
to direct labor and direct materials in order to lay the

groundwork for a discussion on control of overhead costs.
ILLUSTRATIONS OF THE INTEGRATED AND CONTINUOUS APPROACH
General

The development of the above general ideas and the
more specific ideas to be presented about cost control
are actually the result of a process of personal development
and growth on the part of the author. For a long time I had
been disturbed by the great reliance placed on cost accumu-
lations in the literature on cost control. The use of the
more immediate physical reports had great appeal, especially
with reference to direct labor and material usage. Price
variances were ordinarily dismissed as being essentially
caused by external forces over which operating men and
purchasing personnel had no control. These price

variations were considered the means necessary to make

333

double-entry bookkeeping work when standard costs were not
kept up to date.

In the case of overhead variances, as they are
usually prepared in standard costing, I believed them to
possess absolutely no utility for cost control purposes due
to the fact that they were broad historical averages of a
great mass of unrelated items of varying fixity and
variability. Without the flexible budget approaCh to over-
head cost control, the control of overhead costs was, I felt,
shrouded in the darkness of double-entry bookkeeping. At
this point I had read a great deal of the literature on
cost control. The next logical step was to conduct some
interviews with actual practitioners involved in the managerial

services activities of national public accounting firms.

 

These men were:
Paul Hamman, Partner and Head of Management Services
Touche, Niven, Bailey and Smart, CPA's
Detroit Michigan
Leonard Spacek, Managing Partner and
Basil Regione, Partner and Head of Administrative
Services
Arthur Anderson and Co., CPA's
Chicago, Illinois
Hugh Campbell, Partner and
Edward Weise, Head of Management Advisory Services
Price Waterhouse and Co., CPA's
Chicago, Illinois
Horace Barden, Partner
Ernst and Ernst, CPA's
,Chicago, Illinois

334

In the process of these interviews the full broad
implications of cost control were developed. In the first
interview the merits of physical standards and pecuniary
standards were brought to a head when the interviewee
stated that in a facetious way one could assert that costs
could be controlled without dollar accumulations. I
questioned the use of the word facetious and finally we
decided that reports of physical usage could be much more
important for purposes of controlling direct labor and
material usage. In the existing literature, the ideas of
Billy Goetz seem to be thoroughly in accordance with this
viewpoint.

In a succeeding interview, an exchange of ideas on
the need for control data at various leyglg in the organi—
zation led to an appreciation of the fact that physical
reports were in the language of the shop, and therefore
more appropriate at organization levels close to actual
performance of the work. Dollar reports were in language
more appropriate for higher level management, in that they
provided an excellent summary of waste in terms very
familiar to the dollar-minded executive, that is, dollars
and cents.

Other interviews confirmed these ideas as they

335

related to direct materials and direct labor. The inability
to set physical standards for overhead led to a unanimous
Vconclusion that flexible budget reports were probably the
most appropriate basis for accumulating data for overhead
cost control. Upon returning to the academic community,

I discussed these ideas with a number of people. Finally,
after considerable discussion and thought, the concept of
lines of defense was conceived in conjunction with the
strategic importance of visual observation on the part of
the worker and foreman.

The introduction of and the appreciation of the
strategic importance of visual observation is the most im—
portant aspect of the concept of lines of defense. It brings
into focus the tremendous role of worker and foremen in
effective cost control, which starts before conditions get
out—of-line. Furthermore, a full appreciation of the role

of visual observation yields a complete turnabout in the

approach to cost control. No longer is it necessary to rely
only on improving future performance. Cost control is seen

to be the role of operating men of whom we should ask what

went wrong and what have you already done to correct the

 

situation. Finally, the lines of defense approach presents

a very understandable explanation for the non-use of cost

336
accumulations for purposes of cost control. "Cost
accumulations don't even begin to motivate about ninety
percent of the people for whom they are prepared", was the
statement of one practitioner, and was generally agreed to
by the others. The reason is that cost accumulations relate
to the latter lines of defense against out—of—line perfor—
mancelwhich could make them relatively insignificant if the
more proximate lines of defense could be relied upon to con—
duct their affairs properly.

An opportunity was made available to test these
ideas in three industrial concerns.27 To a certain extent
they had been tested before in the interviews with public
accounting practitioners and in the author's memory, which
contained a number of personal experiences in the field of
public accounting. Now, though, the full or complete idea
was available for testing. In each case it was found that
the concept developed did fit actual circumstances, although
there were modifications in the approach. In one instance
direct labor was considered to be of prime importance and
all control efforts were directed toward it. Material and

overhead costs were slighted somewhat in this case. In

 

2 _ ,
7A. B. Dick Company, Chicago, Illinois

.Automatic Electric Company, Northlake, Illinois
Curtiss Candy Company, Chicago, Illinois

337

another instance direct materials and direct labor were both
carefully considered due to equal importance, and indirect
labor and materials were singled out as strategic elements
of overhead to be controlled. In the third instance the
same ideas were generally present, but a lack of familiarity
with the productive processes was found to be a stumbling
block for accounting personnel. Implied rather than
explicitly stated was the importance attached to supervisory
and operating personnel in terms of visual observation. One
shortcoming found in all the interviews was that the
attitude toward cost control seemed to emphasize too much
the factor of improving future performance and leave only

to implication the fact that a good many potential and
actual out—Of—line conditions had been eliminated by
operating and supervisory personnel long before cost control
reports could be prepared.

In succeeding pages the broad concept of cost control
thus far developed will be treated in more detail as it
relates to direct material, direct labor and overhead.
Direct materials and direct labor will not be treated in
too great detail since overhead cost control is of major
importance here. The treatment of direct materials and

direct labor provides an excellent framework around which to

338

build a more detailed approach to overhead cost control.

It is to be assumed in all of the succeeding dis—
cussions that two very fundamental aspects of cost control
exist. First, effective hiring, training and placement
policies are carried out in such a way as to get the right
man for each job at all organizational levels. Each job must
be analyzed in such a way as to yield a knowledge of the type
of person necessary to fill the job. ‘Second, any effective
system of cost control must incorporate worker and super-
visory knowledge of expected performance on each job. This
knowledge about the physical relations between several
inputs (material, labor, machine hours) and their output,
is determined preferably on the basis of engineering studies.
These two characteristics, selection of the best people and
a thorough knowledge of what performance is to be expected of
them, actually form the basic framework of manufacturing

cost control.

Direct Materials

 

Control of direct material costs will be built
primarily around usage variances. Price variations, though,
will also be considered. In the cases of usage variations

the reports of physical quantities to be considered are

339

excess material requisitions and yeild reports. Illustra-
tion 7 probably illustrates better than words the approach
to control of material usage which is recommended.

The major purpose of the illustration is to show
the proper position of cost accumulations in the cost
control process related to material usage. The lines of
defense range from the worker to the board of directors.
At the worker level visual observation is paramount, while
at the board of directors' level a summary usage variance
becomes the basis of control. In between the worker and
the board of directors the effectiveness of visual obser—
vation becomes more and more limited and it is replaced
primarily by physical reports concerning excess material
requisitions and yield. Dollar knowledge of relative
material_prices also becomes useful as a guide to allocating
effort towards the greatest cost savings. As the progression
is made toward the board of directors, physical reports
become more and more summarized and are complemented by a
very understandable measure of the true impact of waste,
that is, the dollar variance. Finally, as the shop area is
left behind, the language of the shop is for all practical
purposes disposed of, and is replaced by dollar variance

accumulations, a more appropriate form of language at higher

Illustration 7

340

Summary of Control Over Material Usage

 

Lines of Defense

 

II.

III.

IV.

VI.

 

Worker Visual Observation
Sample Visual
Observation
Foreman
Physical Reports
Dollar Knowledge
Sample Visual
Observation
Plant Physical Reports
Superintendent
Dollar Knowledge
Dollar Reports
Manufacturing

Vice—President

Physical Reports
Dollar Reports

President Physical Reports
Dollar Reports

Board of

Directors Dollar Reports

Bases of Control

 

quality of material
condition of equipment
physical surroundings or
condition of workplace

same as above
worker attitude or

condition

excess material requisitions
yield reports

relative material values
same as foreman

foreman attitude or
condition

summary of excess material
requisitions

summary yield reports

details on strategic
materials

relative material values

usage variance

summary yield report on
strategic materials

summary usage variance

summary yield report on
strategic materials

summary usage variance

summary usage variance

341

Illustration 7 (cont'd)

Comments on Summary of Control

over Material Usage

Reports rendered to superiors are made known to or

are given to those being supervised.

All reports are prepared in terms of personal responsibility.

At each successive level reports become more summarized

and they are issued less frequently.

There is no need to breakdown and analyze dollar variances
at higher organizational levels since the break—
downs and analyses already exist in the form of
physical and dollar reports rendered to the prior

lines of defense.

To

To

To

To

342

Illustration 7 (cont'd)

Objectives of the Summary of Control over Material
Usage

illustratethe proper position of cost accumulations in

the cost control process.

illustrate that potential and actual waste can be and

 

is eliminated by visual observation, that is, long

before physical and dollar reports are prepared.

illustrate that actual wastes that evade visual ob—
servation can be and are detected by physical

reports.

illustrate that cost accumulations occupy a residual

position and show the profit impact of waste.

 

343

management levels.

Visual observation is the most immediate form of
defense available and it is relied upon to eliminate
potential and actual waste even before such wastes are
brought out in physical and dollar reports. Actual wastes
that evade visual observation can be and are detected by
physical reports. Dollar reports occupy the position of
detecting the residuum, that is, the actual wastes that have
evaded visual observation and physical reports.

Physical and dollar reports detect practically all of
the actual wastes, but their use should be directed toward
eliminating continuing waste. In this way the receiver of
the report will be notified of wastes, will find out which
wastes have already been eliminated, as they should have
been, and then he will concentrate on the elimination of
the previously uncorrected waste.

Illustration 7 on material usage control summarizes
the position of each person in the control process. The
worker, on the'basis of visual observation, should be able
to detect potential and actual waste that might be caused
by inferior materials, improperly maintained equipment, and
even poor lighting. Foremen, too, can use visual obser-

vation to detect potential and actual waste in the same

344

manner as the workmen and also by visually inspecting the
attitude or condition of the workmen. Since the foreman

must supervise a number of people, his visual observation
must necessarily be on a sampling basis.

Physical reports on excess material requisitions and
yield provide a perfect complement to the necessarily limited
visual observation of the foreman. Excess material requisi-
tions are brought to the foreman's attention immediately,
since they can be issued only on his signature. Yield
reports for the foreman can be prepared on a daily basis,
and they will compare physical inputs of material and physical
output yield in actual and expected quantities. In cases
where the foreman is forced to make a choice as to
allocating his time to waste elimination, a knowledge of
relative material values will help him direct his effort
towards the greatest possibilities for cost saving.

The plant superintendent is in a position where he
must also aid in waste detection. He relies on those closer
to the actual work to bear the brunt of the cost control
burden, but, just in case, he checks on their work per—
formance by a necessarily very limited visual observation,
coupled with daily summaries of excess material requisitions,

and perhaps weekly summaries of yield reports by departments

345

or responsibility centers. Dollar knowledge of relative
material values is useful in order that effort can be con—
centrated where the greatest cost savings lie. A monthly
dollar usage variance report prepared by classes of
material and departments or responsibility centers serves
the purpose of summarizing the dollar impact of waste. It
is possible under some circumstances that only a dollar and
cents figure will awaken people to the true profit and.loss
potential of cost control. Summarized, the plant superin-
tendent's position is a matter of being informed about
wastes, finding out what has already been done, and then
taking action to eliminate previously undetected and
uncorrected wastes. If a plant superintendent desires more
information concerning the summary reports given to him, a
simple request for the more detailed and more frequently
prepared reports used by the foremen is all that is
necessary. These detailed reports and a conference with
foremen concerned should give the superintendent all the
information he needs in order to find out if there is any
basis for action on his part.

The manufacturing vice—president relies on even more
summarized reports, plus the details that can be provided

by various plant superintendents, in order to determine if

346

there is any reason to take action. He, too, should rely
on the more immediate lines of defense to take care of most
cost control activities. His responsibility is the
detection of undetected and uncorrected variances. Reports
rendered to the vice—president would be monthly summary
yield reports on strategic material, by plant, and dollar
usage variances, by plant. Strategic materials might be
certain kinds of shoe leather in the shoe industry, more
expensive materials and furs in the garment industries, and
precious metals and jewels in the jewelry industry.

The president's role would be essentially the same
as the vice-president's except that reports would be more
summarized. Finally, the board of directors' position
would also be very much the same, although monthly dollar
variances as contained in an income statement showing income
actually earned and income that Should have been earned
(usage variance) would be the basis of any cost control
activities that it might still be necessary to institute.

The above presentation is only a model that could
easily be modified. For example, other types of physical
reports could be prepared, and some reports could be pre-
pared less often or more often, or they could include more

or less detail. Also, continuous physical yield reports

347

could be abandoned in favor of occasional or sample yield
tests. Sample yield reports for materials involving large
dollar amounts could be made more often than sample reports
for small dollar items. Depending on the size of the firm
there could also be more or fewer lines of defense. How—
ever this may be, the general framework should be clear.
Visual observation is most important, while physical
reports are secondarily important, and dollar reports serve
a residual position and effectively put forth the dollar
impact of waste.

Thus far usage variances have been considered. Price
variations for materials have many dimensions different
from usage variances. Usage can be determined with a fair
degree of scientific precision, but prices used in setting
cost standards are the best estimates of prices that will
exist in the period for which the standards are being set.
Errors in the estimates or the inflationary process give
rise to variances over which no one in the firm has control.
Such variances are more closely related to external than to
internal conditions. Those price variances which are related
to internal conditions can serve to indicate various internal
efficiencies. In the case of the purchasing department,

control is exercised over economical buying quantities and

348

methods of transportation,28 if purchasing procedures are
not disturbed by internal conditions which would upset
normal buying quantities and transportation methods.
Internal conditions which could upset the price variance

as a measure of purchasing performance are the acceptance of
rush sales orders, failure of the factory to anticipate its
needs, and abnormal spoilage by the factory resulting in
rush purchase orders in non—standard quantities which are
delivered by more expensive methods.

The concept of lines of defense would fit the control
process surrounding price variances with minor modifications.
After the determination of economical buying quantities,
economical methods of transportation and the price standards,
the lines of defense would start with buyers, followed by a
purchasing agent, followed by a manufacturing vice— president
and then the president and board of directors. Physical
standards are impossible here, so dollar standards must be
relied on.

A control procedure would involve the necessity for

 

28
The determination of buying quantities and methods

of transport is a never-ending process due to changing
technologies, improved knowledge, possibilities of forward
buying, or a change in any one of the elements used to
determine buying quantities and methods of transportation.

349

buyers to prepare memos concerning off—standard purchase
prices. The memos would contain an explanation such as
price change, rush order, excessive Spoilage, or inability
to use preferred transportation. Such memos could be
periodically reviewed by the purchasing agent, who might
also receive a dollar variance report monthly. This dollar
variance report could show data by classes of materials and
causes of purchase price variances. The dollar variance
report would be nothing more than a summary of the memos
prepared by buyers. Sales personnel should be immediately
notified of purchase price variances caused by accepting
rush orders. Factory personnel also should be immediately
notified of purchase price variances caused by abnormal
spoilage or failure to anticipate needs. In this way
divisions of the business will be kept aware of the fact that
their activities have a direct and observable bearing on
material prices.

The manufacturing vice-president, the president and
the board of directors each in turn will receive summaries
of material price variances classified by responsibility
centers and perhaps by classes of materials. At each
successive line of defense the process will simply be a

matter of determining the excusability of variances and

350

what has already been done to eliminate the conditions
giving rise to internally controllable price variation.

Comparable to the importance of visual observation
in material usage variations would be, in the case of
material price variations, the determination of economical
quantities to buy, economical methods of transportation and
the dissemination of this information to all those who can
affect the attainment of economical buying methods. This
information, coupled with a need for explaining the cause of
all price variances, would force a consideration of possible
out—of—line conditions at the time an order is placed. The
functions of more remote lines of defense would be to ask
questions to find out if price variations were justifiable,
to determine if prior lines of defense appreciate the profit
impact of off-standard prices, and to make sure that those
who are able to affect price variations are well aware of
the wastes that they can control.

Cost control related to direct material usage and
.prices involves a number of factors. After the placing
of the best possible men in each occupation, the determination
of physical usage standards, the determination of economical
buying quantities, economical methods of transportation,

and standard prices, and the dissemination of this

351

information to all affected parties, the essence of cost
control lies in visual observation for material usage and
the requiring of explanations for all off—standard prices
at the time a purchase order is made. Physical reports of
material usage aid in the detection of waste not detected
by visual observation, and a review of memos relating the
cause of price variations establishes a basis for determining
whether or not price variations are excusable. Dollar
reports occupy a residual position and_provide a perfect
illustration of the profit impact of waste. The residual
position of dollar reports will assume more importance if
only strategic materials are reported on physically, if
physical reports are prepared on a sampling basis, or if
.on-the—spot memos on price variances are required only for
strategic materials or for those prices which are off—

standard by a stated percentage (e.g., 5 percent).

Direct Labor

 

Control of direct labor cost will be constructed
primarily around usage variances. Price variations will
also be given some consideration. Physical reports that
will be utilized to illustrate the lines of defense concept

are performance reports and idle time reports. Again an

352

illustration will prObably best illustrate the recommended
approach to control of labor usage.

The major purpose of Illustration 8 is to illustrate
the most appropriate role of cost accumulations in the
control of labor usage or efficiency. As in the case of
materials, the lines of defense range from the worker to the
board of directors. At the worker level visual Observation
is of prime importance, while at the board of directors
level a summary dollar usage variance is of prime importance.
In between the worker and the board of directors visual
observation is of decreasing importance due to the necessity
of more limited observations. Physical reports take up the
slack created by the necessarily limited observation.

These physical reports relate primarily to performance and
idle time, and they are in a language most appropriate for
use in the shop. Within the shop dollar knowledge of wage
rates is important since it can help direct effort towards
the greatest cost savings. At the higher levels of the
shop, dollar reports of usage variance yield a measure of
the profit impact of waste which is a perfect complement to
the summarized physical reports. As one leaves the shop
area, the physical reports become less important, and they

are replaced by reports conforming to the language of higher

Illustration 8

353

Summary of Control Over Labor Usage

 

Lines of Defense

 

I.

II.

III.

IV.

VI.

Worker

Sample Visual
Observation

Foreman

Physical Reports

Dollar Knowledge

Sample Visual

Observation

Physical Reports
Plant Super-

intendent

Dollar Knowledge

Dollar Reports
Manufacturing Physical Reports
Vice-President

Dollar Reports

Physical Reports
President

Dollar Reports
Board of Dollar Reports

Directors

Visual Observation

Bases of Control

 

quality of material
condition of equipment
physical surroundings or
condition of workplace
impending bottlenecks
impending lack of material

same as above

worker condition or attitude
performance report

idle time report

wage rates

same as foreman

'foreman attitude or

condition

summary performance report
summary idle time report

wage rates
usage variance

summary performance report
summary idle time report

summary usage variance
summary performance report
summary idle time report

summary usage variance

summary usage variance

354

Illustration 8 (cont'd)
Comments on Summary_of Control over Labor Usage

Reports rendered to superiors are made known to or

are given to those being supervised.

All reports are prepared in terms of personal

responsibility.

At each successive level reports become more summarized

and they are issued less frequently.

There is no need to breakdown and analyze dollar
variances at higher organizational levels
since the breakdowns and analyses already
exist in the form of physical and dollar
reports rendered to the prior lines of

defense.

355

Illustration 8 (cont'd)

Objectives of the Summary_of Control Labor Usage

 

To illustrate the proper position‘Qf cost accumulations in

the cost control process.

To illustrate that potential and actual waste can be

 

and is eliminated by visual observation, that
is, long before physical and dollar reports are

prepared.

To illustrate that actual wastes that evade visual
observation can be and are detected by

physical reports.

To illustrate that cost accumulations occupy a
residual position and show the profit

impact of waste.

356

organization levels, that is, dollar reports. These dollar
reports cannot be improved upon to illustrate the true
impact of waste on profits.

Visual observation is the most proximate form of
defense available and it is relied upon to eliminate
potential and actual waste even before such wastes are
brought out in physical and dollar reports. Actual wastes
that evade visual observation can be and are detected by
physical reports. Dollar reports occupy the position of
detecting the residuum, that is, the actual wastes that have
evaded Visual observation and physical reports.

Physical and dollar reports detect practically all of
the actual wastes, but their use should be directed toward
efliminating continuing waste. In this way the receiver of
the report will be notified of wastes, will find out which
wastes have already been eliminated, as they should have
been, and then he will concentrate on the elimination of
the previously undetected waste.

In the illustration on labor usage the position of
each person in the control process is clearly illustrated.
The worker, on the basis of visual observation, is able to
detect potential and actual labor waste related to quality

of materials, condition of equipment and workplace, impending

357

bottlenecks and impending lack of materials. The foreman as
the second line of defense relies on sample visual observa—
tion of the same things the worker should be watching for,
as well as of the condition and attitude of the worker.
Physical reports on daily worker performance and daily
departmental idle time by causes effectively complement
visual observation. The same is true of wage rate knowledge
which helps the foreman direct his effort.

The plant superintendent complements his necessarily
limited observations with weekly departmental summaries of
performance reports and weekly departmental summaries of
idle time reports. Dollar knowledge of wage rates and dollar
reports of monthly labor usage variances by departments or
responsibility centers are also useful at the plant super—
intendent level. The dollar reports present an excellent
technique directed toward making people realize the full
profit impact of wasted labor.

To the manufacturing vice-president are given monthly
physical reports summarizing labor performance by plant and
idle time reports by plant. These reports, plus a monthly
dollar variance report by plant, give the vice—president
ythe information necessary to find out what has already been

¢flone to eliminate wastes, and what wastes are still

 

 

 

 

Ill till, . I'd-II, 1‘11; I .

358

continuing. If the vice-president desires more detail
concerning either physical or dollar reports, all he needs
are copies of the information given to and consultation with
prior lines of defense.

The president and board of directors rely primarily
on dollar reports which are more summarized. Their roles
are similar to that of the vice—president, but they are
more remote; The key to the board of directors position is
an income statement which exhibits the waste or profit lost
through inefficient use of labor.

As in the case of material usage, the illustration on
labor usage is a model which can easily be modified. Physical
reports other than performance or idle time reports can be
prepared. Reports can be prepared more or less often.

More or fewer lines of defense can be used, depending on
the organization. Continuous physical reporting may be
abandoned in favor of sample tests. Even with such modifi-
cations the general framework, indicating the primary
importance of visual observation, the secondary importance
of physical reports, and the residual importance of dollar
reports, is left undisturbed.

Labor price variations have not yet been considered.

Relatively this variance is of little consequence, since

359

wage rate determination is largely an external problem of
collective bargaining and community wage levels. The
variance itself is primarily a means of making the double—
entry system work when standards are not kept up to date.
At least two aspects Of labor price variances might be
useful for control purposes. These are in the use of non--
_preferred men, and overtime. The use of a non—preferred man
is a case where a $3.00 an hour man is used for a $2.00 an
hour job. Control of these two causes of labor price
variances can be worked into the lines of defense framework
with minor modifications. Lines of defense might work from
the foremen through the board of directors. In such cases
it would be the foreman's job to keep production moving
smoothly in order to avoid those rushes or bottlenecks which
create a need for using non-preferred men or for overtime
work. In any case where non-preferred men are utilized,
the foreman should be required to prepare a job—change
notice which details the causes and the men involved. In
cases where overtime work becomes necessary the foreman
should be required to obtain approval for the overtime
from his superior.

Reasons for use of non—preferred men and overtime

work can be uneven production caused by unexpected bottlenecks,

 

' lit! 1!: I. Ifil .. 1.1%.? . . J 1i. .. .

360

poor production scheduling, or the acceptance of rush
orders. Unexpected bottlenecks can be caused by poor

worker performance, delay in making decisions by super-
visors, poor scheduling, machine breakdowns, and lack of
materials. With the foreman required to explain these
out—of—line conditions, notice will be given to higher

lines of defense, and all related parties will become aware
of their impact on wage rate variances. This awareness,
coupled with the necessity to explain the reasons for the
variances, should provide later lines of defense with the
information necessary to determine not only the excusability
of the variances controllable by the firm, but whether or
not the causes of unexcusable rate variances have been
eliminated. Dollar accumulations of the rate variations,
classified by cause and responsibility centers, show the
dollar impact of waste and yield a starting point from which
later lines of defense can begin to ask questions concerning
the excusability of internally controllable variances. In
many cases, use of non-preferred men and overtime work are
excusable as being the least expensive way out of a
bottleneck, but the cause of the bottleneck is the condition
that must still be rectified.

Control of labor costs in terms of usage or prices

361

relates to a number of factors. Of primary significance are
selection and placement policies, training, the development
of preferred methods of operation which can be given standard
times, and production scheduling activities. With these
points in mind, the essence of labor cost control relates

to visual observation and required explanations for the use
of overtime and non—preferred men. Physical reports of
labor usage aid in the detection of waste not detected by
visual Observation, and a review of explanations concerning
non-preferred men and overtime establishes a basis for
determining the excusability of wage rate variances. Dollar
reports, as stated before, occupy a residual position and
provide notice of waste in terms of profit and loss. The
cost accumulations of accounting are thus seen in their

true light as a residual for the more remote lines of

defense against out—of-line performance.

Overhead

 

Control of overhead costs presents many problems
which are not present in the case of direct materials or
direct labor. In the first place, overhead costs represent
a variety of unrelated items which vary in every conceivable

‘way with output. Secondly, overhead costs are not susceptible

362

to the type of physical measures applied to direct materials
and direct labor. Finally, controllability of overhead
costs varies in accordance with organization levels.

Depreciation and taxes on buildings and equipment
are controllable by the committee or persons who authorize
capital expenditures. Insurance costs are controllable by
an insurance committee or the person who authorizes
insurance expenditures. Salaries of supervisors and clerks
are controllable by those who establish rates of pay.
Workers and foremen can cOntrol the costs of operating
equipment and facilities and other operating costs. Fringe
benefits, payroll taxes, compensation insurance and personal
property taxes are hardly controllable by company personnel,
for they are usually determined by factors external to the
company.

In order to present a sound framework encompassing
the control of overhead costs, a summary has been prepared
to illustrate the factors involved and their relative
positions in Illustration 9. The same general framework
developed for direct material and direct labor has been
retained because of its general applicability. In fact, the
only reason for discussing direct materials and direct labor

was that they presented the easiest and perhaps most

Illustration 9 363

Summapy of Control Over Overhead Costs

Categories of Overhead Cost Bases of Control
Operatinggor Physical
Prior to Accounting Accumulations

Expenditures for Factory Pre—expenditure justification by the
Buildings and Equipment top-management committee which authorizes
capital expenditures.

Readiness to Serve Costs
The committee or person who approves
the number of personnel and minor
equipment expenditures. Visual ob—
servation (by supervisors) of the
personnel at work can establish the
continuing need for and efficiency of
personnel.

Costs of Operating Equipment and

Facilities
Engineers or the company from which
equipment is purchased should determine

 

 

 

Operating Department » proper methods of using equipment. A
Costs preventive maintenance program could

2 also be set-up. Visual test checks
on actual use can be made by engineers,
maintenance men, and departmental
supervisors in order to establish a
basis for cost control. Costs covered
here would be all those incurred to
operate the equipment and fixtures.
Other Operating Costs
The residual, primarily supplies con-
trollable on the basis of requisitions
signed by supervisors and visual Ob-
servation of actual use by the super-

visor.

 

Readiness to Serve Costs
Same as producing departments

 

 

Service Department Costs of Operating Equipment and Facilities
Costs Same as producing departments

Other Operating Costs
Same as producing departments

Office of Plant Superintendent

Other overhead COStS Same as service departments
foice of Manufacturing Vice-President

Same as service departments

Categories of
Overhead Cost

 

 

Expenditures for
Factory Buildings

 

364

Illustration 9 (cont'd)

Summary of Control Over Overhead Cost

 

 

and Equipment

 

Operating De—
partment Costs

Service Depart—
ment Costs

 

 

Other Overhead
Costs

Bases of Control
Accounting Accumulations of Cost

 

 

 

 

 

First Level Second Level Third Level
Post—expenditure {Wasted
justification on the Capacity
basis of revenues and (\Cost Variance
costs arising out of
previously approved
capital expenditures
Regular recurring
comparisons of im—
portant costs in Overhead
terms of the most Budget
appropriate output Monthly flex— (Price)
measure ible budget Variance
reports for
each responsi- Overhead
bility center Efficiency
ariance

Perhaps also a
rotating sample of
less important

items in terms of
the most appropriate
output measure

365

understandable way to develop the integrated and continuous
approach to cost control, The succeeding discussion will
utilize the concepts previously develOped as a point of
departure. Necessary modifications will be made to allow
for categories of overhead, lack of physical standards and
the matter of controllability.

The categories of overhead chosen (Illustration 9)
are 1) expenditures for factory buildings and equipment,

2) operating department costs, 3) service department costs,
and 4) other overhead cOsts. The bases of control are
divided into operating or physical, which are prior to
accounting accumulations, and the accounting accumulations
of cost. Accounting accumulations, Which still occupy a
residual position in cost control, are divided into three
levels. The three levels are successive refinements of the
residual position of accounting accumulations.

In the case of capital expenditures the Operating or
physical basis of control is the program of pre—expenditure
justification utilized by the company. The accounting bases
of control are after the fact and aid only as a guide to
future action, if they aid at all. First and foremost is
the process of post-expenditure justification. This is a

process of accumulating the revenues (cost savings) and

 

366

costs arising out of the previously approved capital
expenditures in order to use hindsight as a basis for

future expenditure decisions. The other level of accounting
control (there are only two for capital expenditures) is the
accumulation of a wasted capacity cost variance. This

wasted capacity cost variance should be based on an average
of sales expectations since it represents the overhead con-
cept most closely related to capital expenditures. Expected
utilizationcnmm five life of capital equipment is the capacity
figure utilized in making capital expenditure decisions,

and thus it should be used for determining the wasted
capacity cost variance related to capital expenditure
decisions. The ability of actual production to absorb all

of the costs of capital equipment will provide a sort of
overall measure of post—expenditure justification. In
addition to the costs of depreciation connected with capital
expenditures,there are other costs which should be considered.
These are the prOperty taxes and insurance costs which are
automatically incurred on the basis of factory building

and equipment expenditures. All three of these costs,
depreciation, property taxes, and insurance on capital
equipment, are controllable by the top management committee

which authorizes capital expenditures. Therefore such

367

committee should be charged with the responsibility for these
costs via post expenditure justification and the wasted
capacity cost variance.

The average expected sales concept used here is the
same as the cycle overhead concept, but in this case it
refers only to long—lived assets. Since long-lived assets
have varying lives, the average sales expectation concept
includes not only an average of expected sales, but also an
average of the lives of long—lived assets. Theoretically
each capital asset Or related groups of capital assets
could be worked into individual wasted capacity cost
variances. Such a theoretical refinement would not only be
unmanageable without great expenditure of effort, but it
would also be impractical due to the relation of cost to
benefit received. The wasted capacity cost variance has
utility only in terms of yielding an overall approach to
the dollar impact of waste in capital expenditure decisions.
For control as such it has little utility, except perhaps
as a means of illustrating the overall importance of capital
expenditure justification. Therefore, from the pragmatic
point of view, an average of the lives of long-lived assets

would be justifiable.

The accounting accumulations relevant to post-expenditure

'1‘—

'1.”_____..-..,
.

 

368

justification of individual capital expenditures are much
more important control—wise than the capacity cost variance.
Post—expenditure justification yields data related to
individual cases which can be utilized in terms of improving
future similar expenditure decisions. The real basis of
control for capital expenditures is not an accounting
accumulation, but an intensive study of all the factors
surrounding an expenditure decision before the actual
decision is made. Accounting can help here, but only in
terms of trying to quantify the quantifiable elements of
expected revenue, expected cost savings, and expeCted costs
involved in a capital expenditure decision.

The second category of overhead costs exhibited in
Illustration 9 is for operating departments. Within
operating departments, costs are divided into three
categories which are very appropriate for control purposes.
The categories are l) readiness to serve costs, 2) costs»
of Operating equipment and facilities, and 3) other
operating costs. Operating or physical bases of control
which are prior to accounting cost accumulations are
different for each of these three categories. Readiness
to serve costs are controllable by the committee or person

who approves the number of personnel and minor equipment

-.ws-$i

is IT‘" '

 

369

expenditures. Visual observation by supervisors can
establish the continuing need for and efficiency of such
personnel. Control of minor equipment expenditures can be
achieved on the basis of a very modified capital expenditure
justification program which would establish the need for such
minor equipment (replacement or expansion), and then visual
Observation by foremen and plant superintendents could be
used to check if the equipment was being used in accordance
with instructions. Visual observation could also be used

to establish whether the equipment was needed in the first
place by simply observing if the equipment is being used in
the manner and to the extent believed necessary to establish
the need for the equipment. If it is found that unnecessary
equipment was purchased, a correction can be made in the
process through which need is established.

Operating and physical bases of controlling the costs
of operating equipment and facilities are primarily related
to the instructions established for use of the equipment.
These instructions, Which could include a preventive
maintenance program, can be determined by engineers or the
seller of the equipment. Visual test checks on how
instructions are followed yield a fundamentally important

basis of control. These visual tests can be made by

370

engineers, maintenance men, and departmental supervisors.
The costs covered here would include all those costs
incurred in the Operation of equipment and fixtures.
Examples would be power for lighting fixtures, power or
fuel for air conditioning or heating fixtures, power for
all machinery and equipment used in the process of manu—
facture, and Operating supplies such as cutting oil.

The residual operating department overhead costs
are primarily supplies. They are controllable on the basis
of requisitions signed by supervisors and visual obser—
vation of actual use by the same supervisors. Control of
the three categories of operating department costs rests
primarily on the use of operating or physical bases of
control. This means essentially the determination and
dissemination of operating instructions and visual obser-
vation to test the ability of subordinates to carry out
instructions.

The accounting accumulations of costs are only useful
as test checks of how well prior lines of defense have
performed their duties. These accounting accumulations can
exist in three levels. First, there is a process of
concentrating attention on individually important elements.

Second, there is the monthly summary approach known as

371

flexible budgeting, and third, there is the very overall
approach of overhead variances which are intended to illustrate
the total dollar impact of waste.

Regular recurring comparisons of important or large
elements of overhead costs on the basis of the most
appropriate output measures can serve as an accounting check
of the efficacy of operating or physical controls. Indirect
labor is often subject to this form of comparison.29 Other
elements of overhead not as important individually as
indirect labor, and therefore not necessary to check as
often, can be checked on the basis of a rotating sample.

For example, if there are ten other items to check, two or
three items can be tested in one period, and dropped in a
successive period when two or three other items are tests
checked. In this way all items will be tested intensively

at one time or another, in order to determine if operating

or physical controls are functioning as intended.

 

29
Curtiss Candy Company of Chicago checks the re—

lationship of indirect labor to physical production on a
weekly basis. Catepillar Tractor Company checks the
relation of indirect labor to direct labor daily as reported
in C. A. Woodley, "Organizing for Efficient Production and
Effective Cost Control", New Controls For Fixed and variable
Costs, American Management Association Production Series

No. 178 (Papers presented at the March 1948 Production
Conference of the American Management Association), 1948, 10.

372

The flexible budget, which is the second level of
accounting control, cannot ordinarily be used to test—check
operating and physical controls in the same manner as
regular recurring or rotating sample comparisons. This is
true since flexible budgets covering the costs controllable
within a responsibility center are ordinarily related to
one overall output measure, such as direct labor dollars,
direct labor hours, or machine hours. Intensive study of
individual items may require analyses in output measures
differing from those used in the flexible budget. For
example, labor hours might be the basis of flexible
budget computations, but cutting oils might be better
tested in terms of machine-hours. Another reason why
flexible budgets cannot serve the function of regular
recurring or rotating sample comparisons is that flexible
budget reports are usually prepared on a monthly basis,
while the comparisons might be necessary on a daily or
weekly basis. However this may be, flexible budget
reports do provide an excellent approach to detecting
those out-of-line conditions not detected by operating
or physical controls, or the first level of accounting
controls.

Flexible budgets are prepared for each responsi-

373
bility center, and within each responsibility center costs

are classified by object of expenditures. Comparisons
are made between budgeted and actual amounts and the
variations are used as a starting point in those
discussions intended to find out what has already been
done to alleviate out—of-line conditions.

The third and last level of accounting control for
operating department overhead costs involves the ”overhead
budget variance” and the ”overhead efficiency variance."
The summary nature of these variances for all practical
purposes eliminates any control features, except perhaps
the possibility of illustrating the over—all profit impact
of waste in overhead costs which could bring forth a fuller
realization of waste and thus yield an important pressure
for cost control on the prior lines of defense.

Overhead costs applicable to operating departments
are thus primarily controlled by operating or physical
bases including modified expenditure justification programs,
determination and dissemination of operating instructions,
and visual observation. Accounting controls are designed
to detect all wastes, but their importance is related to

the residual out—of—line conditions not previously

 

corrected before or after they occurred. This same

approach can be applied to service department overhead

374

costs as well as costs within the offices of the plant
superintendent and the manufacturing vice—president. The
only real difference would be that readiness to serve costs
will be of much greater importance in non-operating departments
than costs of operating equipment and facilities are in
production departments.

The lines of defense concept thus far developed for
Overhead costs is somewhat different from that developed
for direct labor and direct materials. A summary of the
lines of defense approach in a form more comparable to that

used for direct labor and direct materials is as follows:

375

Lines of Defense Bases of Control

 

 

Primary Operating or Physical
a) committees or person who approves
capital-expenditures or readi-
ness to serve costs.
b) determination and dissemination
of_operating instructions.
c) visual observation
Secondary or Residual Accounting Accumulations of Cost

a) for capital expenditures

1) post—expenditure justification
2) wasted capacity cost variance

b) for all other expenditures
1) regular recurring or rotating
sample comparisons
2) flexible budget reports

3) overhead budget and efficiency
variance

A somewhat more detailed approach to the lines of
defense concept can be found in illustration 10 which is,
patterned after the illustrations presented earlier for
direct materials and direct labor. Illustration 10 covers
only one cost category in the operating departments, but
the extension to the other categories of overhead costs
would be essentially the same.

The process presented here is again a model which

can be changed to fit circumstances. Of major importance

376

Illustration 10

Summary of Control Over Operating Departmenp
Overhead Costs Related to the Operation of
Eguipment and Facilities

 

Lines of Defense

 

III.

IV.

VI.

VII.

Prior to Worker

Worker

Foreman

.r
3.

"’ ‘“\/”“ \r“

Plant Superintendent;
l

Manufacturing vice-
president

President

Board of Directors

/*—*‘”“—m r"‘\ r—”

Bases of Control

 

Preparation and dissemination of
instructions on the use of equip-
ment and facilities

Preventive maintenance program

Visual Observation of condition of
equipment and facilities

 

Visual observation of condition of

equipment and facilities, and
worker performance

 

Dollar Reports

 

Regular recurring reports on indivi—
dually important costs

Regular recurring reports on less
important costs on the bases of a
rotating sample

Flexible budget reports

Same as foreman except for more
limited visual observation and

summarized dollar reports

Summarized flexible budget reports

Summarized flexible budget reports

Monthly overhead budget variance
and overhead efficiency variance

377

is the residual position of accounting data. These data
aid only in detecting those wastes not previously detected
by the operating and physical bases of control and in
illustrating the dollar impact of waste.

Physical standards as used in overhead cost control
are quite different from those used in the case of direct
materials and direct labor. In all cases the preparation of
Operating instructions and making these instructions known
(essentially a training process) is of great importance.
After these instructions there is nothing in the case of
overhead costs to correspond to excess material requisitions,
yield reports, performance reports, or idle time reports,
except perhaps the regular recurring or rotating sample
cost comparisons. Reliance must be placed on the worker
performing his tasks properly, the ability of supervisory
personnel and the accumulations of cost accounting.

Price variances for overhead costs have not been
separately considered here. This is because the only items
subject to control are indirect labor and indirect materials,
and the control over their prices is essentially the same as
for direct labor and direct materials. The prices of
practically all other overhead inputs are of no consequence

for control purposes, for they are related to factors external

378

to the business (wage or salary changes), or are taken care

of in the process of expenditure justification.

SUMMARY

Control of factory costs does not proceed from an
analysis of standard cost variances or flexible budget
variances. This is especially true of overhead costs where
the standard cost variances are an average of many un-
related items of varying variability and varying fixity.
Flexible budget reports for overhead cost control are
somewhat useful in that they provide cost reports concerning
budgeted and actual costs by responsibility centers. These
reports are prepared on a monthly basis, which restricts
their utility to the possibility of improving future per«
formance since the usual presumption is that the cost
accumulations provide the basic means of detecting waste.
The "report card effect" attributable to flexible budget
reports seems to improve the position of flexible budget
reports as a cost control device.

However, standard cost variances and flexible budgets
represent only a part of a truly effective cost control
program. In fact, they usually represent the least important

aspects of cost control. Cost control includes these

379

accounting reports, but they are subordinate to other more
important factors such as preventive cost control, physical
reporting and visual observation. Preventive cost control
includes proper hiring and placement policies at all
organizational levels, employee training programs, capital
expenditure justification programs, the determination of
operating instructions covering the use of equipment and
facilities, and the dissemination of information on expected
performance (perhaps tied to a wage incentive) to employees.
For direct materials and direct labor physical usage
standards based on engineering studies are useful for pre—

ventive cost control.

After the preventive cost control program comes visual

observation of operations by workers and supervisors in
order to detect potential and actual waste. In the case of
direct labor and materials physical reports concerning
yield, excess material requisitions, performance and idle
time can be used to detect wastes that evade visual obser-
vation. These physical reports are not possible in the case
of overhead costs. The control process for direct costs
involves in succession preventive cost control, visual

observation, physical reports and then dollar reports

(standard cost variances). The overhead cost control process

 

dun—-J-MWJ'
|

 

380

skips physical reports and involves in succession preventive
cost control, visual observation and dollar reports. Over—
head dollar reports relate to post—expenditure justification,
intensive studies of individual costs, flexible budgets, and
standard cost variances. Intensive studies of individual
elements of overhead costs on a continuing or rotating sample
basis are the overhead counterpart to the physical reports
possible with direct labor and direct materials. The cost
control processes for each of these cost groupings can be
summarized as follows:

(’Preventive Cost Control

Visual Observation

Direct Costs { Physical Reports

 

Dollar Reports

(Standard Cost Variances)
Preventive Cost Control
Overhead Costs Visual Observation

Accounting Reports

The accounting reports for overhead cost control can

be summarized as follows:

381

Capital Expenditures

 

l) post—expenditure justification
2) wasted capacity cost variance

All Other Overhead Costs

/
Accounting Reports 1) regular recurring or rotating

sample comparisons

2) flexible budget reports

3) overhead budget and efficiency
variances

The lack of physical reports in the case of overhead
costs is offset somewhat by intensive study of individual,
costs on the basis of regular recurring or rotating sample
comparisons of budgeted and actual costs, but there is no
denying that there is a great need for more reliance on
preventive cost control, faith and confidence in supervisory
personnel, and perhaps the "report card effect” of flexible
budget responsibility accumulations.

As summarized here, cost control does not begin with
accounting accumulations of cost. Cost control in a sense
ends with accounting accumulations which are designed to
detect wastes which have evaded visual observation, physical
reports (direct costs), and recurring analyses of individual

overhead costs. The position of accounting accumulations is

residual with regard to the detection of waste, for the

382

question that must come from accounting reports is what has

already been done to eliminate these wastes and not what must

 

 

HE dB to eliminate these wastes. The only other function of
accounting accumulations in the process of cost control is

to illustrate the full profit impact of waste to the

 

dollar—minded executive. rm

@5973 “I “m"

 

CHAPTER VII
SUMMARY AND CONCLUSIONS

Throughout this dissertation the emphasis has been
on overhead costing for income measurement and cost control.
Chapter Two, on the development of overhead costing, illu-
strates how relatively unimportant income measurement was in
the early development of overhead costing. The origins of
overhead costing involve the determination of selling prices
and the need for cost control. To a large extent accountants
accepted for income measurement whatever figures were derived
for other cost finding purposes.

Price determination was the most important factor
in the early period of overhead costing. In the beginning
manufacturing overhead was combined with commercial overhead
and a desired profit in an.all-inclusive percentage. The
all-inclusive percentage was applied to prime costs (direct
materials and direct labor) in order to derive the "hoped
for" selling price. With the advent of competition, price
setting had to be more scientific; thus the progressive
accumulation of costs up to selling prices had to be sub—

stantially changed. First overhead cost as a whole had to

384
be considered in terms of its component parts, including
the separation of manufacturing and commercial overhead;
then wastes or costs of inefficiencies were eliminated from
selling price computations; and finally out—of-pocket cost
pricing came to be used under conditions where it was deemed
appropriate.

In conjunction with the rise of increasingly com-
petitive conditions around the turn of the nineteenth
century, there arose a need for and an interest in cost
control. Early evidence of cost control was the separation
of commercial'and manufacturing overhead in order to separate
manufacturing from commercial efficiency. Church's supplee
mentary rate was also intended as a cost control device or
"barometer of efficiency". The supplementary rate was
changed into a dollar measure of idle capacity costs, which
were removed from production costs in order to derive a unit
cost that varied with shop efficiency; thus the supplementary
rate was changed in order to yield two measures of efficiency;

1) a dollar amount of idle capacity which varied
with product marketability (commercial efficiency).

2) a unit cost which varied with shop efficiency
(technical efficiency).

The next steps in the development of overhead cost

control were standard costing and the accumulation of costs

 

 

 

385

by responsibility centers.

In the development of overhead costing Church's
supplementary rate led a double life. The supplementary
rate was an inextricable part of the evolution of the
capacity concepts used in income measurement, as well as a
very important element in the evolution of cost control. The
capacity concepts which grew out of the supplementary rate
are the practical capacity concept, the normal capacity
concept, and the cycle capacity concept. Practical capacity
emphasized the physical output potential of facilities,
while normal capacity and cycle capacity emphasized the
average cyclical sales expectations during the useful life
of facilities. The practical capacity concept is based on
the determination of those costs applicable to physically
unused facilities or fixed costs. The normal capacity con-
cept is based on the determination of a long—run basic
price, and the cycle capacity concept is based on an income
measurement theorywhich states that fixed manufacturing
costs should be averaged over a cycle of years.

The major conclusions of this study are to a large
extent derived from the historical develOpment of overhead
costing. In general terms the conclusions are as follows:

1) The income measurement aspects of overhead costing

386

are neither fully developed nor separated from
the problems of price determination.

2) The cost control aspects of overhead costing have
not yet been developed (at least in the literature)
to a point where the real significance of cost
accumulations is known and appreciated.

These general conclusions and the more specific con-
clusions which will follow are the natural outgrowth of the
two objectives of this dissertation:

l) to provide a more reasoned approach to overhead
costing and income measurement with special
emphasis on the fixed element of overhead cost,
and,

2) to provide a meaningful approach to the position of
overhead cost accumulations in a cost control
system.

Today the most prevalent capacity concept used in
measuring income is the normal capacity concept. As a re—
sult the accounting for income measurement is attached to
the determination of a long-run basic price rather than to
the measurement of income. The most objectionable feature
of the normal capacity concept is the treatment of over- and
underabsorbed fixed overhead costs. The advocates of normal
capacity say that over— and underabsorbed fixed overhead
costs are gains or losses due to greater or less than average

expected use of facilities. However, the true meaning of

overabsorbed fixed overhead costs would be costs recovered

387

in this period and not to be recovered in the future; and the
true meaning of underabsorbed fixed costs would be costs

not recovered in this period which are to be recovered in
future periods. The true meaning of over— and underabsorbed
fixed overhead, as stated above, is the only rational ex—
planation of over- and underabsorbed fixed overhead that
would fit the price determination foundations of normal
capacity. In addition, the only treatment of over- and
underabsorbed fixed overhead costs that is consistent with
the long-run selling price foundation of normal capacity is
the deferred charge and deferred credit treatment used under
the cycle capacity concept.

The treatment of over— and underabsorbed fixed over»
head as gains and losses brought on the "direct costing
controversy", one of the greatest controversies ever to
concern the measurement of income. The advocates of direct
costing were upset by the effect on income measurement of

over— and underabsorbed fixed overhead costs being treated

as gains and losses. The changes recommended by the advocates

of direct costing involved the complete abolition of over—
and underabsorbed fixed overhead costs on the basis of a
theory which considered fixed overhead costs as costs of a

period and not costs of production. To support their

til,
'.
I
I

may”. .- .' 21"‘1‘?

 

.1

 

388

ideas the advocates of direct costing used a break-even or
marginal approach to income measurement.

Unfortunately, those advocating direct costing did
not recognize that neither marginalism nor break—even
analysis is a form of income measurement. Marginalism is a
technique designed to concentrate on the strategic factors
involved in the short-run price and output decisions of a
firm. Break—even analysis is essentially a process which
focuses attention on the strategic factors involved in
short-run decision making. Both marginalism and break—even
analysis are short—run decision-making processes related to
income maximization, which is a far cry from income measure-
ment—-a long—run concept. The lack of consideration given
to fixed costs by marginalism and break—even analysis does

not mean that fixed costs are not costs of production, it

 

only means that fixed costs are not relevant to short-run

 

decision-making.
The fact that fixed costs are costs of production

and allocable to production is a point made by economists

 

1
As explained in Chapter Four even a fixed-variable

segregation of costs is not adequate for decision-making
purposes. Fixed costs do vary with time and executive
decisions and most decisions have long-run implications
which demand a consideration of fixed costs.

389

and others when they consider the problems of public utility
rate-making and the rational foundations of the Robinson—
Patman Act. In both of these cases the problem is one of
allocating fixed charges to products or services. As pointed
out in Chapter Four, some of the early pioneers in the

field of industrial management explicitly stated that fixed
manufacturing costs were costs of production and therefore
allocable to production.

The defenders of the traditional treatment of fixed
overhead costs for income measurement rested their case on
the logic involved in the economic facts of life, that is,
fixed costs are necessary for production and therefore they
cannot be considered as other than costs of production.

As to the determination of how much of the fixed costs were
costs of production, the defenders of traditional accounting
utilized the cycle and practical capacity concepts. Under
cycle capacity over— and underabsorbed fixed overhead costs
'are treated as deferred credits and deferred charges, thus
eliminating the irrational effect on income measurement of
over- and underabsorbed fixed overhead costs being treated
as gains and losses. Under practical capacity the portion
of fixed overhead costs which represent the unutilized

physical output potential is considered as a loss due to

390

idle capacity. The cycle capacity concept averaged fixed
overhead costs over production, while the practical capacity
concept removed from production costs those fixed costs
represented by unutilized physical output potential. The
defenders of traditional accounting thus rested their case
on sheer logic (fixed costs are incurred for production) and
the cycle or practical capacity concepts.

With the above brief summary of the direct costing
controversy, the following more specific conclusions on
overhead costing and income measurement can be made.

1) The advocates of direct costing were correct in

maintaining that the normal capacity concept pro-
duced irrational results for income measurement

purposes.

2) The defenders of traditional accounting were
correct in maintaining that fixed overhead costs
were costs of production, but incorrect when they
utilized the practical and cycle capacity concepts.

3) Both Opponents and proponents of direct costing were
incorrect when they implicitly or explicitly
assumed the following:

a) a fixed-variable cost segregation is best
for income measurement

b) all fixed costs are related to long-lived
asset acquisitions (fixed assets)

c) unit costs should not be allowed to vary
with volume.

The normal overhead concept is not appropriate for
income measurement because it is based on a long-run average

basic price which is not necessarily correct for income

391
measurement purposes. In addition, the average cyclical
sales expectations of normal capacity demand a deferred
charge and deferred credit treatment for under- and over—
absorbed fixed overhead, rather than a gain or loss treatment.
The cycle overhead concept is not appropriate for income
measurement because it averages out of existence the econ—
omic facts of life for individual Operating periods. Cost
applicable to the production of the current year could be
applied to the production of the future, and costs applicable
to the production of the future could be applied to the
production of the present by the cycle capacity concept.

The practical capacity concept is not appropriate for income
measurement purposes because physical output potential is
essentially the same as the "physical life" of assets. For
income measurement purposes "useful life” is appropriate for
amortizing the costs of long-lived assets—~not "physical life
or physical capacity".
For purposes of income measurement overhead costs
should be classified as
l) acquisition costs of long—lived assets (fixed
assets), including insurance and property taxes
on long—lived assets.

2) indivisible cost inputs or "chunk costs"

3) all other overhead costs; these are primarily the

392
costs of operating equipment and facilities.

Fixed asset acquisition costs should be allocated to
production on the basis of a unit of output depreciation
scheme or an approximation thereof, which would be the
cycle capacity concept. Indivisible cost inputs ("chunk
costs") should be allocated to the production they give rise
to. ”Chunk costs" are wholely applicable to any volume of
output within the volume range for which ”chunk costs" are
absolutely necessary productive inputs. On the basis of
indivisible cost inputs, unit costs should be allowed to
fluctuate with production volume. The remaining overhead
costs should be applied to actual output, for they give
rise to and are necessary costs of producing actual output.

The objective of accounting for income measurement is
to match the results (revenues) and the sacrifices (costs)
involved in the process of production. A prOper calculation
of costs must include the best possible means of allocating
factory overhead costs to production. The methods commonly
used for overhead cost allocation today have been shown to be
inappropriate for income measurement. The method prOposed
here is considered to be a fundamental improvement. The
change in method as recommended can hardly be considered an

immaterial refinement in the process of income measurement,

393

for the possibility of losses or gains due to fixed cost
absorption would be effectively eliminated.

In the preceding pages the first general conclusion
of this dissertation was considered in more detail. The
income measurement aspects of overhead costing were shown
to be neither fully developed nor separated from the problems
of price determination. In succeeding pages the second
general conclusion of this dissertation will be considered
in more detail.

The cost control aspects of overhead costing have not
yet been developed to a point where the real significance
of cost accumulations is known and appreciated. The control
of overhead costs is usually presented as starting from the
overhead variances of standard costing and the overhead
variances associated with the responsibility accumulations
of flexible budgeting. Actually the reverse is and should
be true——overhead cost control should end, not begin with,
the cost accumulations of accounting.

Prior to the secondary or residual position of cost
accumulations are the operating or physical bases of over-
head cost control. The operating or physical bases of
overhead cost control include preventive cost control and

visual observation. Preventive cost control includes proper

394

hiring and placement policies at all organization levels,
employee training programs, capital expenditure justification
programs, the determination of operating instructions covering
the use of equipment and facilities, and the dissemination
of information on expected performance to employees. Visual
observation by workers and supervisors is intended to detect
potential and actual waste. Together preventive cost
control and visual observation are intended to prohibit the
occurrence of out-of-line performance. Visual observation
is also used to detect out-of—line conditions as soon as they
do occur in order that corrective steps may be taken immediately.
The position of cost accumulations is residual or secondary
in that many potential and actual out—of—line conditions
are detected and eliminated long before cost reports can be
prepared. Cost reports are useful in detecting previously
undetected out—of-line performance.

The question that should be asked when cost reports

are received is what has been done to eliminate these wastes

 

which have been detected, and not what must pp g9 to elim—

 

inate the detected wastes. As indicated in Chapter Four,
the control of costs is perhaps the most important phase of
accounting for an industrial enterprise. Anything which

can be done academically and professionally in order to

395

present and illustrate an integrated system of cost control
must be done.

The control process for overhead costs as described
above would involve in order of importance and applicability

1) preventive cost control

2) visual observation

3) accounting reports

The accounting reports for overhead cost can be

summarized as follows:

Reports for Capital Expenditures

l) post-expenditure justification

2) wasted capacity cost variance

Reports for All Other Overhead Costs

1) regular recurring or rotating sample cost
comparisons

2) flexible budget reports

3) overhead budget and efficiency
variances

In each of the two categories of overhead costs the
reports listed first are of primary importance, for they are
prepared earlier and are more specific in pinpointing out—of—
line conditions. The latter reports are useful as broad

or summarized indications of waste which illustrate in the

best possible way the profit impact of waste.
The specific conclusions on control of overhead costs
which can be made as a result of this study are:

1) Overhead cost control does not proceed from
the cost accumulations of accounting.

2) Preventive cost control and visual observation
' are more important in the control of overhead

costs than are cost accumulations.

3) Cost accumulations are of residual importance in
the control of overhead costs.

4) Cost accumulations are extremely useful indicators
of the profit impact of waste.

In the preceeding pages general and specific con-
clusions were made concerning each of the two objectives of
this dissertation. These conclusions should be of signifi—
cance for academic, industrial and public accountants.
Academic accountants should be interested in the conclusions
on both income measurement and cost control in order that
students may be given a more complete understanding of two
very important aspects of accounting for overhead costs.
Industrial accountants should be especially interested in the
conclusions on cost control, for cost control is one of the
most important phases of internal management to which
industrial accountants can make a contribution. Public
accountants should be especially interested in the conclusions

on income measurement, for income measurement is the major

397

consideration of the public accountant who certifies financial
statements. All accountants should be interested in the con-
clusions on income measurement and cost control, since these
are among the most important functions for which costs are

accumulated.

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"A Group of Letters on Direct Costing," N.A.C.A. Bulletin,
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Anthony, Robert N. "Cost Concepts for Control," The
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Avery, Harold G. "Problem of Idle Equipment," The Accounting
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Bac, Alexander. "Advantages of 'Break—Even' Income Statement
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Bass, A. W. "Modern Trends in Cost Accounting," N.A.C.A.
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g. .1 2“ «F‘W—W
. .- ‘1
E i Z ‘. F
. "!

 

404

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Bornemann, Alfred. ”Empirical Cost Study and Economic
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Browne, Nelson J. and Burt B. Titus. "How Much Do Indirect
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Cassady, Ralph Jr. "Legal Aspects of Price Discrimination:

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405

Cassady, Ralph Jr. "Some Economic Aspects of Price
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Chambers, Charles R. "Conversion to Direct Costs," N.A.C.A.
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Chenault, Lawrence R. "Business Behavior and the Theory of
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Church, A. Hamilton. "Overhead-—The Cost of Production

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Church, A. Hamilton. "The Meaning of Commercial Organization,"
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Cooper, Howard E. "Some Controversial Phases of Standard
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Copeland, M. A. "A Social Appraisal of Differential Pricing,"
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Cowan, David. "With Special Reference to Oncost: What it
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406

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Dean, Joel. "Correlation Analysis of Cost Variation,"
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Dohr, James L. "What They (Economists) Say About Us
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Doyle, Leonard A. "Overhead Accounting Comes Full Circle,"
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Downie, L. W. "Normal Capacity and Its Uses," N.A,C.A.

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Drucker, Peter F. "Business Objectives and Survival Needs:
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Dugdale, Harry. "Management Accounting: Segregation of
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407

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Editorial. "Cost Accounts," The Accountant, XXXII (June 17,
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Edwards, James Don. "This New Costing Concept—-Direct
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Edwards, Ronald S. "Some Notes On the Early Literature and

Development of Cost Accounting in Great Britain,".Ihe
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Eiteman, Wilford J. "Factors Determining the Location of
the Least Cost Point," The American Economic Review,
XXXVIII (December, 1947), 910-18.

 

Eiteman, Wilford J. "The Equilibrium of the Firm in Multi-
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Eiteman, Wilford J. "The Least Cost Point, Capacity, and
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XXXVIII (December, 1948), 899—904.

Emerson, Harrington. "Efficiency As A Basis for Operation
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Fiske, Wyman P. "Accounting for Unused Facilities," N.A.C.A.
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Fitch, Stanley G. H. "Deflation in Relation to Cost
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Fitch, Stanley G. H. "Present Day Problems in Industrial
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Frank, George W. "Will Direct Costing Theory Stand Inspection,"
N.A.C.A. Bulletin, XXXIV, Sec. 1. (December, 1952), 490-9.

408

Franklin, B. A. "Cost Methods That Give the Executive
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XLII-XLIII (January-July, 1912), 577-85, 921-27,
48-56, 192-97, 421-33, 560-66.

 

 

 

 

Franklin, W. H. "Allocation of Overhead Costs--A Short Cut,"
N.A.C.A; Bulletin, XXXII, Sec. 1. (August, 1951),
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Freer, Robert E. "Accounting Problems Under the Robinson-
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480-7.

Gantt, H. L. "The Basis of Manufacturing Costs," Industrial

 

Management, LIII (June, 1917), 369-70.

 

Gardner, Fred V. "Variable Budget in Management by
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Garry, H. S. "Factory Costs," The Ageguntant, XXIX (July 25,
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George, Eéwin B. "The Robinson-Patman Act Begins to Acquire
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Goetz, Billy E. "Tomorrow's Cost System," included in
William E. Thomas. Readings pp Cost Accounting,
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Management, XII (December, 1947), 172-8.

 

 

 

 

 

 

Goliger, Josef. "Fixed Charges and Profit," The Accounting
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Gordon, R. A. "Short-Period Price Determination in Theory
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Green, E. A. "Practical Standards--Their Development and
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Greer, Howard C. "Alternatives to Direct Costing," N.A.C.A.
Bulletin! XXXV, Sec. 1. (March, 1954), 878-88.

409

Greer, Howard. "Cost Factors in Price—Making," The Harvard
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Greer, Howard. "Differences in Cost as a Basis for Price
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Grover, Albert E. "Some Important Points in Burden Dis-
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1930), 1653-68.

Haines, W. W. "Capacity Production and the Least Cost
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Hanson, O. E. "Depreciation Is A Period Cost—-Practica11y
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1182-5.

Harris, Jonathan N. "Case Against Administrative Expenses,"

Thngournap_pp Accountancy, LXXXII (July, 1916), 32-6.

 

Harris, Jonathan N. "The Author Replies," N.A.C.A. Bnlletin,
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Harris, Jonathan N. "What Did We Earn Last Month?," N.A.C.A.
Bulletin, XVII, Sec. 1. (January 15, 1936), 501-26.

Harrison, G Charter. "Bugbear of Burden Distribution, A
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Harrison, G. Charter. "Cost Accounting in the New Industrial
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Harrison, G. Charter. "Cost Accounting to Aid Production,"
Industrial Management, (October, 1918-June, 1919),
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Harrison, G. Charter. "Scientific Basis for Cost Accounting,"
Industrial Management, LIX (March, 1920), 237-42.

Harrison, G. Charter. "Standard Costs as an Element of
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XVII (April, 1932), 57-62.
Harrison, G. Charter. ”The Practical Economist's Profit

and Loss Statement,” N.A.C.A. Bulletin, XXX, Sec. 1.
(December 15, 1948), 443-56.
$

 

Harrison, G. Charter. "Working Plans for Standard Costs,"
Management Engineering, III (June—December, 1922), 331-6,
5-10, 97-101, 161-6, 227-31, 289—94, 353-7.

 

Harrison, W. E. "Marginal Costing; A New Tool for Management,"
The Accountant, CXXXII (June 25, 1955), 716-23.

 

 

Hartogensis, Alwyn M. "The Art and Practice of Pricing,"
N.A.C.A. Bulietin, XXXIX, Sec. 1. (March, 1958), 63-74.

 

Hattersley, G. Stanley. "Costing," The Accountant, LXIV
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Heckert, J. Brooks. "Coverage and Cost Provisions of the
Robinson-Patman Act," N.A.C.A. Bulletin, XXX, Sec. 1.
(March 1, 1949), 269-82.

Hepworth, Samuel R. "Direct Costing--The Case Against,"
The Accounting Review, XXIX (January, 1954), 94—9.

 

 

Hosick, Ted R. "Effect of Direct Costing on Asset Accounting,
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Hovey, Floyd F., and C. E. K. Mees. "Cost Control With
Fluctuating Production; A Description of a Definite
System for Making Up Cost Control Sheets Under Fluctuating
Production," Bulletin pp the Taylor Society, XIV
(August, 1929), 160-7.

 

 

 

Jackson, J. Hugh "Quarter-Century of Cost Accounting Pro-
gress," N.A.C.A. Bulletin, XXVIII, Sec. 1. (June 1, 1947),
1201-9.

Kemp, William S. "Budgets and Predetermination of Costs,"
N.A.C.A. Bulletin, VII, Sec. 1. (July 15, 1926),
817—827.

Kennedy, Donald D. "Variability of Overhead Costs," The
gpppnal pp Accountancy, XLIX (March, 1930), 202-12.

 

411

Kent, William. "New Method of Determining Factory Costs,"
The Iron Age, XCVIII (August 24, 1916), 392-4.

 

Klein, Frank. "Some Developments in Variable Budgeting,"
,N.A.C.A. Bulletin, XVII, Sec. 1. (June 1, 1936), 1155-71.

 

Knapp. C. Howard. "How to Determine Costs on Pre-determined
Sales Forecasts With Special Reference to Idle Capacity
Costs Applied To the Product," E.A.C.A Bulletin, XIV,
Sec. 1. (February 15, 1933), 901-30.

 

 

 

Knoeppel. F. J. "Fundamentals of Accounting for Industrial
Waste," The Journal pp Accountancy, XXV (May, 1918),
351-59.

Kohl, Clem N. "What is Wrong with Most Profit and Loss
Statements?,” N.A.C.A. Bulletin, XVIII, Sec. 1.
(July 1, 1937), 1207—19.

 

Kramer, Philip. "Selling Overhead to Inventory," N.A.C.A.
Bulletin, XXVIII, Sec. 1. (January 15, 1947), 587-603.

 

 

 

Lang, Theodore. "Concepts of Cost, Past and Present,"
N.ALC.A. Bulletin, XXVIII, Sec. 1. (July 15, 1947),
1377-90.

Lawrence, W. B. "Weaknesses in Standard Costs," N.A.C.A

Bulletin, XI, Sec. 1. (July 15, 1930), 1493-17305.

Lemke, B. C. "Is Manufacturing Cost an Objective Concept?,"
The Accounting Review, XXVI (January, 1951), 77-9.

 

Ludwig, John W. "Inaccuracies of Direct Costing," N.A.C.A.
Bulletin, XXXV, Sec. 1. (March, 1954), 895-906.

 

 

Luenstroth, H. W. "Case for Direct Costing," N.A.C.A.
Bulletin, XXXIII, Sec. 1. (August, 1952), 1479-95.

 

McAnly, H. T. "Should Unusual Costs Be Allocated to Period
Rather Than Product?," The Journal pp Accountancy,
LXXXIII (May, 1947), 426-35.

 

McEachren, John W. "Can Standard CosfisBe Standardized?,"
N.A.C.A. Bulletin, XXI, Sec. 1. (February 1, 1940),
681-92.

I

412

McHenry, William B. "Is Your Cost System Scientific,"
The Engineering Magazine, LI (August, 1916), 678-86.

 

 

Machlup, Fritz. "Marginal Analysis and Empirical Research,"
The American Economic Review, XXXVI (September, 1946),
519-54.

March, James H. "Applying Burden by Production Factors,"
N.A.C.A. Bulletin, XXXIII, Sec. 1. (April, 1952),
911-20.

Marple, Raymond P. "Direct Costing and the Uses of Cost
Data," The Accounting Review, XXX (July, 1955), 430-8.

Marple, Raymond P. "Try This on Your Class Professor,"
The Accounting Review, XXXI (July, 1956), 492-97.

Mauriello, Joseph A. "Convertibility of Direct and
Conventional Costing," N.A.C.A. Bulletin, XXXV, Sec. 1.
(March, 1954), 888-94.

 

Moss, Morton F. and Wilber C. Haseman. "Some Comments On
The Applicability of Direct Costing To Decision Making,"
TanAccounting Review, XXXII (April, 1957), 184-93.

Murdock, Andrew A. "The Proper Treatment of Machine Costs--
A Criticism and a Theory," The Journal pp Accountaney,
III (December, 1906), 123-30.

 

Myers, J. H. "Standards for Manufacturing Expense," N.A.C.A.
Bulletin, XIX, Sec. 1. (November 15, 1937), 318-29.

Neikirk, Waldo W. "How Direct Costing Can Work for Manage—
ment,",N.A.C.A. Belletin, XXXII, Sec. 1. (January,
1951), 523-35.

 

 

Nickerson, Clarence B. "Cost Control--A Review of Techniques,"
N.A.C.A. Bulletin, XXIX, Sec. 1. (July 15, 1948), 1399-
1408.

Nielsen, Oswald. "Direct Costing--The Case 'For'," The

Accounting Review, XXIX (January, 1954), 89—93.

Norris, Harry. "Overhead Costs," The Accountant, CXVI
(January 18, 1947), 35-7.

413

Noyes, C. Reinhold. "Certain Problems in the Empirical
Study of Costs," The American Economic Review, XXXI
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Oliver, H. M., Jr. "Marginal Theory and Business Behavior,"
The American Economic Review, XXXVII (June, 1947),
375-83. ,

Palmer, J. L. "Production Budgeting,” EAA.C.A. Bulletin, VII,
Sec. 1. (October 15, 1925), 98-103.

Patrick, A. W. "Some Observations on the Break-Even Chart,"
The Accounting Review, XXXIII (October, 1958), 573-80.

 

Pedder, 8. "Cost Accounts: their Advantages and their
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Pinkerton, Paul W. "Step—by-Step Approach to the Pre—
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Bulletin, XVI, Sec. 1. (March 1, 1935), 754-76.

 

"Pricing Techniques and Practices Today: A Survey," The
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Prochazka, George A. "Controlling Costs by Their Variations,"
Industrial Management, LXXIII (January-March, 1927),
10-15, 117-22, 147-50.

 

Raff, R. J. "Accounting for Profits—-Cost Control of Sales
Volume and Profit," The Accountant, CXXVIII (February 7,
1953), 146-8.

 

Rahl, James A. "Antitrust Policy in Distribution," The
University pp Pennsylvania Law Review, CIV (November,
1955), 185-221.

Raun, Donald L. “Problem of Fixed Charges," The Accounting
Review, XXVI (July, 1951), 338-46.

 

 

Rautenstrauch, Walter. ‘"Economic Characteristics of the
Manufacturing Industries," Mechanical Engineering, LIV
(November, 1932), 759-70.

Reder, M. W. "A Reconsideration of the Marginal Productivity
Theory,“ The Journal pp Political Economy, XL

 

 

414

(October, 1947), 450-58.

Rowe, Frederick M. "Price Differentials and Product
Differentiatiation: The Issues Under the Robinson-
Patman Act,“ The Yale Law Journal, LXVI (November, 1956),

1-49.
Sapega, Andrew S. "More Useful Accounting for Indirect
Costs," NpA.C.A. Bulletin, XXXIII, Sec. 1. (September,

 

1951), 13-25.

Schlatter, Charles F. "Fixed Expense," The Accounting Review,
XX (April, 1945), 156-63.

 

Scholefield. J. R. "RObinson-Patman Act and the Accountant,”
The Journal pp Apcountancy, LXIV (July, 1937), 16-73.

 

Scovell, Clinton Homer. "Cost Accounting Practice With
Special Reference to the Machine-Hour Rate," ppe
pournal pp Accountancy, XVII (January, 1914), 13-27.

 

Seidman, J. 3. "Do We Mistreat Administrative Expenses in
Inventory?," The Journal pp Accountancy, LXXXI (April,
1946), 286—8.

 

 

Seiler, Robert E. "Improvements in External Reporting by
Use of Direct Costing," The Accounting Review, XXXIV
(January, 1959), 59-66.

 

Smith, Caleb. ”The Cost—Output Relation for U. 8. Steel
Corporation," The Review pp Economic Statistics, XXIV
(November, 1942), 166-76.

 

Smith, Gershom. "Distribution of Indirect Costs By the
Machine-Hour Method," The Engineering Magazine, XXXVII
(June, 1909), 384-94.

 

Solomons, David. "Cost Accounting and the Use of Space and
Equipment,“ included in David Solomons (ed.). Studies
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277-91. Reprinted from The Accountant (March 27-
April 3, 1948), 240-1, 260-3.)

 

Staehle, Hans, "The Measurement of Statistical Cost
Functions: An Appraisal of Recent Contributions," The
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415

Steele, F. R. Carnegie. "Significant Developments in
American Industry and Accounting," The Journal pp
Accountancy, XLIII (January, 1927), 20-32.

 

 

Stigler, G. J. "Production and Distribution in the Short-
Run," The Journap pp Political Economy, XLVII (June,
1939), 305-27.

 

Stock, A. F. and J. M. Coffey. "Overhead During Low
Volume.Production," N.A.C.A. Bulletin, VI, Sec. 1.
(February 16, 1925), 11 pp.

Straus, Everet. "Cost Accounting and Statistical Cost
Functions," The American Economic Review, XXXV (June,
1945), 430-31.

 

 

Taggart, Herbert F. “Cost Justification Under the Robinson—
Patman Act," The Journal pp Accountancy, CI (June, 1956),
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Taggart, Herbert F. "The Standard Brands Case," N.A.C.A.
Bulletin, XXI, Sec. 1. (October 15, 1939), 195-262.

 

 

Thorp, Willard L. "Price Discrimination and Cost,” ppp
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Torian, Thomas R. "Measuring Activity and Capacity for the
Budget," N.A.C.A. Bulletin, XXXIII, Sec. 1. (October,
1951), 156—67.

Ullrich, William A. "Manufacturing Expense Analysis,
Classification, and Distribution," N.A.C.A. Bulletin,
XI, Sec. 1. (December 1, 1929), 397-418.

Uerk. L. "Cost Accounting and Management," The Cost
Accountant, XI (April, 1934), 327—35.

 

 

Vatter, William J. "Accounting Measurements of Incremental
Costs," The Journal pp Business, XVIII (July, 1945),
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Vatter, William J. "Cost Accounting and Statistical Cost
Functions," The American Economic Review, XXXV
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416

Vatter, William J. “Limitations of Overhead Allocation,"
The Accounting Review, XX (April, 1945), 163-76.

 

White, Ben C. "What is Overhead?," The Journal pp
Accountancy, LXXIX (June, 1945), 445-50.

 

 

Whitmore, John. "Factory Accounting As Applied to Machine
Shops," The Journal pp Accountancy, II-III (August, 1906—
January, 1907), 248—58, 345-57, 430-41, 20-31, 106-14,
211-18.

 

 

Whitmore, John. ”Shoe Factory Cost Accounts," The Journal
pp Accountanpy, VI (May, 1908), 12-25.

 

 

Whittaker, Edmund. "Realism and Cost Accounting," The
Accounting Review, XXI (January, 1946), 13—19.

 

Wilks, Paul A. "Flexible Budget System at Strathmore
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(June 1, 1936), 1143—55.

 

Williams, C. B. "Treatment of Costs During Periods of
Varying Volumes of Production," The Journal pp
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Williams, C. B. ”Treatment of Overhead When Production is
Below Normal," The Journal pp Accountancy, XXXI
(May, 1921), 336-42.

 

 

Wolfe, Frank B. "Providing a Check on Unused Productive
Capacity; Accounting for the Cost of Idle Plant,"
Industrial Management, LXXIV (November, 1927), 305-9.

Wyer, Rolfe. "Replacing the Myth of Fixed and Variable
Costs," N.A.C.A. Bulletin, XXXVIII, Sec. 1. (November,
1956), 353-61.

 

C. PROCEEDINGS, REPORTS AND MISCELLANEOUS PAPERS

Advisory Committee on Cost Justification. Report pp The
Federal Trade Commission. Washington; Government
Printing Office, February, 1956.

 

417

Alden, William H. "Handling the Expense of Idle Time,"
National Association pp Cost Accountants' Xearbook,

1924, 115-20.

Armstrong, W. C. "In Establishing The Budget For Burden,
Shall 'Normal' Capacity Be Set For Each Department by
(1) Giving Due Regard To The Capacities of Related
Departments; or (2) Without Regard to Other Depart—
ments; or (3) With All Departments Set At The Same
Arbitrary Level?," National Association pp Cost
Accountants' Yearbook, 1930, 172-4.

 

 

Aronson, A. S. "Defenses under the Robinson—Patman Act with
Special Reference to Cost Defenses," National Association
pp Cost Accountants' Yearbook, 1937, 27-46.

Black, Martin L., and Harold B. Eversole. A Report pp Cost
Accounting pp Industry, Accounting Department, Office
of Price Administration, Washington: Government
Printing Office, June, 1946.

 

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Camman, Eric A. "Uses of Standard Costs," flational Aesociation
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Castenholz, William B. "The Application of Selling and
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Committee on Cost Concepts and Standards of The American
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418

Cornell, C. H. ”How is Over-or-Under—Absorbed Burden To Be
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Discussion. "Some Debatable Points in Cost Accounting
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Discussion. "Some Debatable Points in Cost Accounting,"
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Duncan, W. L., Jr. "Modern Management Control of Factory
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Edwards, Corwin D. "Types of Differential Pricing,” ppp
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419

Gantt, H. L. "Influence of Executives,"Anpals pp ppp
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Harrison, G. Charter. "Some Fundamental Defects in Cost
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420

James, Charles C. "Capacity,Costs and Prices," National
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N.A.C.A. Research Series No. 7. "The Uses and Classifications
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N.A.C.A. Research Series No. 17. "Analysis of Cost--
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421

N.A.C.A. Research Series No. 18. "The VOlume Factor in
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N.A.C.A. Research Series No. 22. "The Analysis of Cost
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N.A.C.A. Research Study. "Practice in Applying Overhead and
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Thus Giving A Maximum Which May Probably Be Obtained,"
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400-02.

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