CHAPTER III

FACTORY COSTS Difference between Factory and Financial Accounting As was stated in Chapter II, the accounting records of a concern making its own product are much more complex than those of a concern which limits its activities to the buying and selling of stock-in-trade. A much larger mass of detailed information is needed for the proper conduct of the business. In this chapter it is purposed to study in a broad way the fundamental principles involved in factory accounting and to examine some of its distinctive problems. Factory accounting does not differ in the real fundamentals of account-keeping from any other kind of accounting. Its principles of debit and credit are the same; it employs the same or similar kinds of accounting records; and the same general use is made of the records, viz., to serve as a guide in the proper management and control of the business. Its distinctive features are seen in the application of certain principles to secure special information. To understand the problems peculiar to factory accounting, it will be necessary to consider the nature of this information. Definitions of Terms Three elements enter into the manufacture of a product. These are material, labor, and expense. The problems of factory accounting are therefore those connected with the accounting for the costs of material, labor, and expense. Some terms used in this connection will need explanation. A standard terminology for cost-keeping is becoming fairly well established. Direct and indirect costs, prime cost, factory burden, or overhead expenses, factory cost, full cost or cost to make and sell—these are some of the terms needing definition. Direct costs are those which can be allocated directly to a specific product. They are items which can be separated from all other cost items and applied solely to a particular product. Indirect costs are those which are shared in common by the various products and so must be distributed over them on some equitable basis. Direct costs are sometimes called prime costs. The cost elements which can almost invariably be applied directly to the product are material and labor. The sum of these two items constitute, therefore, the prime or first cost of the product. The other items of cost which are incurred _in the factory_ or with which the factory is chargeable are variously called factory expense, overhead, or burden. These indirect costs cannot be charged directly to any specific product, and so they are shared by the entire factory output. The sum of prime cost plus factory expense constitutes factory cost, i.e., the entire cost of manufacture up to the point at which the product is turned over to the selling department for sale. This is sometimes called total manufacturing cost. Full cost is the price at which the manufactured article can be made and sold. In other words, to the factory cost of the article must be added its equitable share of all the other costs of conducting the business and also a margin of profit in order to arrive at a selling price. These definitions indicate some of the purposes of cost-keeping. Other purposes are given below. Special Purposes of Cost Records To maintain adequate control over production, careful records as to consumption of material and labor must be kept, so that the cause of any marked fluctuations of the costs of the current period from those of former periods can be investigated. The determination of factory cost makes possible a comparison of the policy of manufacturing with that of buying the manufactured article on the open market. This sometimes shows that manufacture is being carried at a loss. Again, the fixing of a sale price on the article, which while covering all expenses, shall at the same time leave a margin of profit, is a prime essential in every business. To be of the greatest advantage and usefulness, cost records should not only determine factory cost but they should accumulate the data needed to _predetermine_ the selling price with accuracy. Nature of Raw Materials and Supplies Materials or raw materials constitute the crude commodities or semi-manufactured articles which are to be worked upon and fashioned into a new product. It is seldom that any factory takes its material in the raw form in which it comes from nature. The product of the mines goes through many degrees and stages of refinement and at each stage of the process some of it becomes the “raw material” for another class of industry. The term is therefore relative; that which is the finished output of one factory becomes the raw material of another factory, to be worked upon and given new forms. Auxiliary material and supplies are also made use of. Thus, certain parts such as screws, bolts, hinges, casters, fastenings, trimmings, and the like, are incorporated into the finished product without change of form or the application of any labor thereto. These also constitute a part of the raw material of the factory, their value as finished product being due to place utility rather than form utility. Supplies are to be distinguished from raw materials. This also is a relative term. In general, material which does not directly form a part of the finished product is carried under the head of supplies. Materials used in getting ready or seasoning the raw material, i.e., auxiliary material, such as paint, putty, etc., the quantity of which used on each piece of product cannot be measured with exactitude and must therefore be spread over the entire product—these and similar items constitute manufacturing supplies. They are usually treated as a part of factory expense rather than as belonging to prime cost. There are also factory operating supplies. These comprise the materials used in the operation of the factory. Repairs material, brooms, oil, waste, packing, nails, fuel, etc., are examples of this kind of supplies. These, of course, are classed with factory expense, also. The raw material which enters into _prime_ cost is thus seen to be only that which can be charged directly to the particular product. All other material is overhead or expense. Accounting for Material Cost The problem of applying the cost of the material directly to the job is largely a problem of systematizing which requires the careful oversight and accounting for all materials bought and used in manufacture. Two general methods are employed. Under the one, the old method of keeping record of all purchases and taking the inventory periodically to determine how much material must have been used in the processes of manufacture, is deemed sufficient. In a small factory making just one product—or a few simple products—where the conditions are such that the manager has an intimate knowledge of all processes and can exercise personal control over them, fairly satisfactory results may accrue under this method, though the amount and therefore the cost of the material consumed in the product can never be known accurately until the inventory has been taken. The other method requires almost as accurate accounting for material as for cash. A stores room or department must be established and a stores ledger installed. As materials are purchased and come into stores, they are classified in whatever detail is desirable and charged to their respective class accounts kept in the stores ledger. As material is needed for manufacture it is drawn by properly authorized order on the stores-keeper. These orders are called “requisitions” and indicate the material needed and the job or product to which it is to be charged. The requisitions constitute the source of the credit entries to the various stores ledger accounts as well as the charges to the job or product. The balances on the stores ledger accounts thus show the amount of each class of material which should be on hand in the stores room. This method of keeping track of materials is known as the perpetual inventory system. By its use, it is possible to know without the taking of a physical inventory how much material is being used in manufacture and the cost of it. In this way much better control is secured over materials than under the physical inventory method. In keeping track of material values, of course, inward freight, cartage, handling and stores room cost must be loaded onto the invoice cost of the materials to arrive at the full cost at which they are issued for manufacture. Direct and Indirect Labor The second element of prime cost is labor. In factory accounting, labor is divided into two classes, direct and indirect. These are sometimes called productive and non-productive, terms doubtless carried over from the old economics which looked upon some labor as productive and some non-productive—necessary, it is true, but rather of the nature of a necessary evil. Direct labor is a direct cost as explained above. That is, it is the labor of the workmen who apply themselves directly to the manufactured product as distinguished from the labor of those employees who plan, lay out, and supervise the work of others. Direct labor can be definitely allocated to specific product or jobs, because it is applied directly to them. Indirect labor cannot usually be allocated to a definite product because it is applied to all the product, not being employed long enough or definitely enough on any specific product to justify keeping track of the time and charging it to specific product. Direct labor is a prime cost; indirect a factory expense. It is with direct labor that our present discussion is concerned. The problem to be solved in accounting for labor is not the determination of the total cost of labor used, as is part of the problem of accounting for materials, but the distribution of that cost over the product. Determination of labor cost, except that accrued at any time, is a comparatively simple matter because the workmen have to be paid at regular intervals. Distribution of the labor cost over the product is more difficult. This necessitates keeping a record of the amount of time spent by each workman on specific product. In that way the labor costs can be figured quickly and distributed to the various products worked upon. Time-Keeping Records To keep track of the workman’s time spent on each unit of product, record must be kept by means of time cards, timekeepers, time clocks, or other similar device which will show the time at which work was commenced and the time at which it was finished or when the working force is transferred to other work. The time card is arranged with space for number or name of the jobs or products worked on and the time spent on each. Use of the hour or day rate of wages paid the workman gives the labor charge to each particular product worked upon. This time card, or its equivalent, may be kept by department foreman, a special timekeeper, or by the workman himself. At the end of the week or other period, these time cards are turned into the office and they serve as the basis for making up the past week’s pay-roll or as a check against the pay-roll where some other source for the make-up of the pay-roll is used. Pay-Roll The pay-roll is merely a list of the names or numbers, or both, of the workmen, showing the time employed during the past period, and the rate of wages. A column to carry total amount due each workman is provided, as well as in some cases a place for the signature of the workman’s name to acknowledge receipt of payment. Provision may be made for other information, also, such as distribution of the labor cost to the specific product, but this is not usual. When the time cards of the workmen are turned in, they are checked against foremen’s reports or sick notices. The total time spent by each workman multiplied by the rate of wages gives the amount earned by each man. From this may be deducted any claims, such as insurance, rent, store charges, hospital and sick benefit, giving the net amount due the workman. Safeguarding the Pay-Roll Since the pay-roll is such a frequent source of error and fraud, all possible safeguards, chiefly of an internal sort, should be made use of. Where possible, workmen should be employed through an employment department to which requests for men needed should be sent. Some form of card record should be kept for office files of all men taken on—and perhaps of all men interviewed. Additions of names to the pay-roll should not be allowed without authorization, and the payment of the men should not be made by the same clerks who make up the pay-roll. The pay-roll should be checked as to mathematical correctness and, where possible, as to the content of the roster, both before and after making payment. Too often has the total of the pay-roll been changed after its correctness has been proven but before it has been presented to the treasurer to provide the funds needed, the thief pocketing the difference between the amount needed for payment of labor and the raised amount of the pay-roll. Checking before and after payment will prevent this. If payment is by check, the total amount of the pay-roll should be transferred by check to a special bank account on which the individual checks are drawn. If payment is in currency, this will be secured by check on the bank and the pay envelopes made up from it. Before drawing the currency, the individual amounts should be analyzed to determine the denominations of the coins and currency needed for filling each envelope. _Methods of Pay-Roll Payment._ On each pay envelope should be marked the name and the amount. One pay-roll clerk should count out the amounts, the other clerk verifying them and filling the envelopes. A very ingenious pay-roll machine can be used for filling envelopes with the proper amount. The total amount of the pay-roll is placed in a coin rack operated by a keyboard. As the amounts of the individual envelopes are set up on the keyboard, the coin rack delivers the correct amount into a chute which carries it to the envelope. At the same time the amount delivered is listed, making it easy, in case of error, to locate the envelope containing the wrong amount. When the envelopes are delivered to the workmen, each man should identify himself in the presence of his foreman and give receipt for his pay. This is usually done by signing the pay-roll. The clerks making payment and the witnessing foremen should sign the pay-roll. Any unclaimed envelopes are returned to the treasurer to be held a certain length of time for claiming, after which time they may be diverted to other uses, though the liability for them must still be shown. Distribution of Labor Charges Distribution of the labor charges may be made in several ways. The precise method must depend largely on local conditions. In a small factory making only a few products, or where cost by departments is the desideratum, the voucher register may be provided with sufficient distributive columns to meet the requirements. At the time the pay-roll check is entered, it is distributed according to the labor cost in the various departments or on the various batches of product. This dispenses with a general pay-roll or labor account on the ledger. In a larger concern or one in which a more detailed distribution is desirable in order to secure definite and accurate costs on a diversified product, distribution on the face of the voucher register might not be feasible. Here, the pay-roll check will be run through the register as a charge to pay-roll. When the desired analysis is made in accordance with workmen’s time cards or other sources of information, a general or cost journal entry is made, charging the proper accounts and crediting Pay-Roll. Or, and usually better, a “Pay-Roll Distribution Book” may be used. This book is a recapitulation of the time cards distribution sheets. Each time card must be analyzed according to jobs, product, or departments, and these distributions as summarized should as a matter of permanent record be entered in a recapitulation book. This, by being made a posting medium, becomes the pay-roll distribution book. Charges to the proper accounts are made from this book, offset by a credit of the total of the book to Pay-Roll account. Sometimes the pay-roll book itself carries distributive columns and can therefore be made to serve as a pay-roll distribution record. _Accrued Wages._ Distribution of wages accrued at the end of the fiscal period is perhaps best made through the general journal, although it can without much difficulty be run through the distribution book by making two recapitulations of the last week or pay-roll period at the end of the fiscal period, the portion of the week belonging to the last fiscal period being summarized separately from the portion belonging to the next period. Both summaries, however, should be run through on the regular pay-roll voucher for that week’s wages. Expense The third item or element which goes into the cost of manufacture is factory expense. Under this head are included all the costs of manufacture excepting the prime cost elements of materials and direct labor. Indirect labor, factory supplies, light, heat, power, repairs and maintenance to factory buildings and equipment, depreciation on factory buildings and equipment, rent, insurance, etc., constitute the main items under this category. These are the indirect costs of manufacture because, while just as necessary as the prime cost elements, it is impossible to allocate them directly to the product. How much of the cost of light, how much of repairs cost, how much of the cost of factory supplies, etc., shall be charged to each unit of several different kinds of product constitute a problem on the solution of which depends the whole structure of accurate costing. Accurate distribution of materials and labor costs may be complex, but presents no real difficulties. It requires little more than careful and painstaking work. On the other hand, to secure an equitable basis for the distribution of factory expenses, and one which is at the same time a workable basis, is in some cases well nigh impossible. One common basis of distribution for all the factory expenses will not usually give satisfactory results. Each item of overhead must be considered separately and will often require a distinct basis of distribution. Thus, indirect labor is sometimes distributed over product on the basis of the cost of the direct labor item in the product, on the theory that the cost of supervision is a cost of supervising the direct labor and so closely related and dependent on that cost. Under some conditions, the number of direct labor hours is used instead of the _cost_ of direct labor. Again, the time the product is worked on in a given _department_ is taken as the most equitable basis for distributing indirect labor costs. Power, where metered to a machine, may be charged to the product on the meter basis. Where not metered, it may be charged on the basis of the time the machine is operated. So, every item of expense must be analyzed and effort made to secure an equitable basis of distribution. Summary of Manufacturing Cost Each unit of product, therefore, as it comes from the factory must carry its burden of cost composed of materials, labor, and factory expense costs. The sum total of all of these costs for all products—the entire output of the factory—will be the record of manufacture on the general books, the detailed record being carried in subsidiary books. At the close of the fiscal period when the temporary proprietorship activities of the business must be summarized, an entirely distinct group or section will be devoted to the activities of the factory because these costs must be shown separately from the others. For this purpose, the first section of the profit and loss statement and account is treated as the “Manufacturing” section, and under it are summarized in two groups the prime cost elements of materials and direct labor and the factory expenses. The total of this manufacturing section gives the cost at which the manufactured product is charged to the sales department of the business, and there this item takes the place of the cost of purchases in a business which buys its stock-in-trade. A detailed explanation of the manufacturing section as a part of the profit and loss summary is given in Chapter XXVII. The principles of cost accounting cannot here be developed further than this mere statement of the ends sought.