Chapter XXVI of this book, where a full presentation of the case for

and against the inclusion of interest is made. The Distribution of Costs Over Stock-in-Trade It should be said that, due to the particular method of handling purchasing, delivery, and storage, it frequently is not practicable to take cognizance of all items which theoretically are constituents of cost. Each concern must establish a policy relative thereto and hold to it. Having done this, it is faced at inventory time with the problem of determining the cost figure applicable to each unit of the stock remaining unsold. Certain of the costs, such as freight and cartage, have probably been incurred by different lots of miscellaneous merchandise, and to distribute the proper charges to each unit comprising the lot is difficult. Usually a certain percentage sufficient to cover that particular item of cost is spread evenly over all units remaining on hand. Occasionally, especially where the stock is homogeneous and only a few varieties are dealt in, an effort is made to prorate these costs on a more accurate basis. In loading on the freight cost, for example, a combined weight and value record might bemused or, where possible, the official freight tariff might govern. Such minute accuracy is not often needed or desirable, the flat percentage rate on value giving in most cases sufficiently correct results. The Pricing of the Inventory A rule-of-thumb method of valuation requires that the purchase price as carried on the last invoice of the article shall be used for pricing the inventory. This usually proves a good working rule, but often raises perplexing problems and is subject to abuse and misuse. If several purchases have been made during the period at different prices, should the last price paid govern the valuation of the portion unsold? The argument for so doing is that the portions unsold probably belong to the last lot purchased, good merchandising requiring that the old stock be sold out before the new is brought forward. That, of course, is not always the case. If it is made an inflexible rule that the price of the last lot bought shall be the price of the inventory, a dangerous tool is placed in the hands of the unscrupulous. A manager needing or desiring to make a better showing of profits might in this way make an insignificant purchase at a high price near the end of the fiscal period and so secure a much higher valuation than the cost for the whole inventory. Where the inventory is likely to contain remnants of the various lots purchased during the period, or where the condition as to an insignificant final purchase may exist, the policy of using an average price for the inventory will be more accurate in its results. The weighted average, whereby each purchase price is weighted with the volume or quantities purchased, is fairer, though more complicated than the straight average. Thus 10 units bought at $100 per unit, 15 at $90, and 3 at $110, would give a straight average of $100 but a weighted average of $95.71, (1,000 + 1,350 + 330) ÷ (10 + 15 + 3). In manufacturing establishments where the fiscal period is short, say one month, and it is desirable to keep the raw material cost as nearly uniform as possible, the method of the weighted average is to be recommended. As mentioned above, each concern must fix its own policy as to what items shall be included in the cost of goods purchased. Whatever that policy may be, care must be exercised to make sure that the same items and no others form part of the value of the inventory. In the case of any doubtful items, instead of trusting to memory, a house classification of accounts or an accounting guide book should be drawn up so as to secure from period to period a similar handling of all items. Valuation of Manufacturing Inventory The whole of the foregoing discussion concerns the valuation of goods bought for resale, i.e., the inventory of a trading business. Some points in the application of the same principles to a manufacturing concern will now be considered. _Finished Goods._ So far as finished goods are concerned, the principle of valuation at cost applies. What constitutes the cost of manufacture was discussed in Chapter III, from which it is evident that many other elements in addition to those which must be considered in a trading concern must be taken into account. The manufacturing cost formula comprises the three items of: (1) raw material consumed, (2) direct labor applied, and (3) factory expenses incurred, this latter item sometimes called overhead expenses. When a concern operates a detailed cost system, the valuation of the finished product is not difficult, being the goal towards which the system works. Where no cost system is used, great care must be exercised to make sure that every item of cost is calculated as accurately as possible and that a proportionate share of such costs is applied to the finished product still on hand unsold. It is sometimes urged that instead of this cost-to-manufacture price, the price at which the article could be bought on the open market should govern; or, alternatively, that the article should be valued at least sufficiently above cost to give a theoretical profit to the factory. Just as in the case of the discussion of “cost or market price” for the trading concern, the same conclusion is reached here, viz., that cost should govern, because while good manufacturing is an element in profit-making, yet no profit is made until the sale is effected. It is true that if cost to manufacture is lower than cost to buy in the open market, a real _saving_ has been made by the policy of manufacturing rather than of buying, but a saving is quite another thing from a profit. This differentiation between a saving and a profit will be fully discussed presently. Correct accounting, therefore, requires a valuation of finished goods at cost to manufacture. _Raw Material._ The valuation of the inventory or raw material is on the same basis as that of a stock of goods bought for resale, i.e., raw material is to be valued at full cost up to the point of its consumption. _Goods in Process._ The valuation of partially completed goods, i.e., “goods in process,” is a much more difficult problem. To simplify the discussion these will be divided into two groups, first, goods manufactured for stock, and secondly, those made on a specific contract or for special order. To the first group the principle of cost applies without any qualification. The problem involved is that of determining what has constituted cost up to that particular stage of completion. Where a detailed cost system is in use and a production schedule forms part of the system, it is possible at almost any moment to ascertain exactly the values accumulated on any article at each stage or process of manufacture. Where definite costs are not possible, a careful estimate based on full knowledge of conditions is the best that can be done. Where parts are first manufactured for assembly into a completed whole, they should be treated as finished goods and valued at full cost up to that point. _Contracts._ The second group of goods in process, viz., those manufactured to fill specific orders, or, in large construction work, contracts taken but not completed, may be valued on a somewhat different basis from that applicable to the first group. Here a sale has actually taken place and only the intervention of the closing of the books raises the question of valuation. In a case of this sort it is customary to make a careful estimate of the costs of the work or contract, up to its present state, due weight being given to remaining costs necessary to complete it and to any provision for possible contingencies. When handled in this way, the estimated profit on the work already done is said to be applicable to the current period and is therefore taken into account. In other words, the portion completed is treated as sold, after making the provisions indicated above, and is charged off the books against a corresponding part of the sale price. Hence, the valuation involved here does not concern the inventory, but the cost of goods sold. It may be objected that, in the case of large contracts, perhaps running over a period of years, many unforeseen things may happen to wipe out any seeming profits on the completed portion, and that conservatism would demand that no profits be taken until the contract is completed or in a sufficiently advanced stage as to be reasonably sure of results. In such a case it frequently happens, however, that not only are stockholders impatient of delay, but very serious injustice may result to any who might be forced to give up their holdings before the completion of the contract. Moreover, a fair method of making payment on the contract is usually in force, the sale price often being on the basis of units of work accomplished, so that the contingencies giving rise to the objection mentioned are greatly minimized. Thus, some contracts may be on a fixed price per cubic yard of earth removed, per unit of goods manufactured, or other similar basis for periodic payment, a certain per cent being retained as a guarantee for the satisfactory completion of the whole. Again, where the price is for a lump sum, engineers representing the contracting parties may agree on the amount completed and periodical payment may be made on that basis. This topic of uncompleted contracts will come up again for treatment when considering the profit and loss summary for the year. It is sufficient to note here that some share of the profit on the completed portion of a contract may be taken as indicated above, in which case the inventory problem may be disposed of either by adding the amount of estimated profit to the cost value of the uncompleted contract, or by treating the payments made as sales. Contracts and Length of Cost Period In some lines of business, orders are booked several months ahead of delivery date, the factory operations depending somewhat closely on the contracts entered into. During the period of manufacture there may be few deliveries of the product, and therefore no actual profit. Obviously, the easiest method of handling such a situation is to make the fiscal period long enough to include the greater part of the deliveries, and so leave the inventory comparatively free of goods in process. Where this method is adopted, there is no serious objection to valuing the goods still in process at the close of the period so as to take a fair portion of the profit, although conservative practice usually values them at cost. The difference in the amount of profit under the two methods is insignificant under the condition named. Under other conditions valuation at cost is the rule. Valuation of Scrap Raw materials are never completely used up in manufacture; portions too small for the main product, corners, odd-shaped pieces, defective pieces, etc., are usually thrown into scrap. This scrap is frequently utilized in the manufacture of side lines if a market can be developed; otherwise it may be valueless. The problem of the valuation not only of the scrap but of any product that may be made from it presents some interesting features. If the entire cost of the raw material is charged to the main product, the scrap material used in the side line costs nothing, and to charge anything for it, either on the basis of cost or some arbitrary estimate, would result in inflation. Furthermore, the cost figures of a side line which is not charged for material might at some time be made the basis for a bid on a contract too large to be filled entirely out of scrap material, and so result in a loss. On the other hand, if the main product is charged only for the material actually consumed, and the side line is compelled to bear the cost value of the material it consumes, the cost of the side line may so increase that it cannot be marketed at a profit. The lowered cost of the main product might lead, in the face of keen competition, to the cutting of its price below real cost, unless, of course, all the scrap is being utilized in the side line which is also being sold at a profit. If such is the case, the valuation of the main product, the side line, and the scrap should be on a cost basis. This is not usually the case, however. No basis for valuation can be found which will prove entirely satisfactory under all circumstances. In the light of the conditions involved, particularly as to whether there is a constant market for the utilization of all the scrap material in the manufacture of the side line, each concern must adopt whatever policy best suits its peculiar needs. At all times the application of materials costs to the product should provide an intelligent basis for entering into future contracts. A _blind_ use of cost figures frequently invites disaster. In cases where scrap is not utilized in a side line, it has only scrap value. The thing to guard against is the double charge for the same material, i.e., a charge to the main product and also to the side line, resulting in an inflation of values. Inventory-Taking There remains, as a corollary to the problem of valuation, a consideration of the method of taking the inventory, for if the count is wrong the most careful valuation per unit will not give true total value. In connection with the count of the inventory, two fundamental rules must be observed. These are: (1) make sure that everything, i.e., all stock-in-trade, belonging to the business is included; and (2) be careful that there is no duplication of count nor inclusion of any stock belonging to others. In accordance with the first fundamental rule, care should be exercised to include all goods out for sale in other markets—these to be valued at full cost in those markets—and all goods not yet received into stock but belonging to the business. These latter include goods invoiced but not received, and goods received but not unloaded prior to the close of the period. In accordance with the second fundamental rule, any goods of others held for sale on a commission basis must be carefully excluded from the count, as should also goods received before the close of the period but with invoices dated some time in the future. Furthermore, all goods inventoried from their invoices, i.e., all goods not taken into stock, must be earmarked so as not to be charged into the next period’s purchases. This is best accomplished by stamping the invoices as “Included in the 19.... Inventory.” _Inventory Methods._ The careful organization of the physical stock to be inventoried, sorting any misplaced items, and separating them into classes, and an equally careful organization of the clerical force, acting under explicit directions based on a well-thought-out plan, are fundamentally essential to accuracy and to the prevention of any duplication of count. In some cases the use of duplicate or coupon tags proves very valuable. On these tags provision is made for recording in duplicate the number of units and condition as to salability, and they are ruled with two money columns. The tags are numbered on both parts consecutively and are charged out to the various departments, as many being issued as there are classes or compartments of goods. As the count is made of a certain class of goods, a tag is attached to the compartment or other storage place as evidence that the count has been made, after which the lower portion is torn off and sent to the office. Any missing numbers indicate omissions in the count. If the card has been lost, the duplicate still attached to its compartment will indicate the count. After all cards are accounted for, the duplicates are detached and the goods covered by them are then released for sale or other use. In taking the inventory it is especially important that where goods are below normal as to salability, their estimated per cent of normal condition be noted on the tag. This gives a basis for valuing and should show the amount of deterioration and its cause. Perpetual Inventory The use of a perpetual inventory system is quite general in some lines. Its operation requires almost as careful a record of stock as is made of cash, i.e., not only must all receipts be recorded but all disbursements as well. In a trading concern this record usually takes the form of a stock book of some sort, to which entry is made, as to quantities only, from the purchase and sales invoices, the balance shown at any time being the stock remaining on hand. The application of the unit value gives the value of the entire stock and so makes possible monthly statements of approximate condition. In a factory, a separate stores ledger may be operated, carrying an account with every kind of material used. This ledger is controlled by the Raw Material or Stores account on the general ledger. Entry to the stores ledger accounts is made from the purchase invoices for receipts, and from formal requisitions drawn on the stores-keeper for disbursements, i.e., for the issuance of material. The stores ledger may record not only quantities but also values, so that its balance should be the value of the stores on hand. This is possible because the material is drawn out at cost price. Oftentimes, for retail concerns, instead of the stock book method, the percentage method of book inventories described in Volume I, page 506, gives more satisfactory results when sufficient past experience can be drawn from. _Necessity of Physical Count._ It must not be assumed that a perpetual inventory system obviates the necessity of taking a physical inventory, for it does not. All that it accomplishes is to secure a closer supervision over stock between inventory times and to make possible the showing of approximate results at interim periods. Where operated, it is possible to take the physical inventory piecemeal, although there is a marked advantage in taking a complete inventory periodically. The piecemeal method means that any department can do its stock-taking during a slack time without regard to the time when other departments take theirs. Thus there is less interference with the regular conduct of business. It must be borne in mind, however, that the physical inventory is just as essential as ever because of the many inaccuracies that tend to creep into the perpetual inventory system, and furthermore because of loss, theft, over-measure, and so on, which throw the book record out of agreement with the actual count.