Should Interest be Included in Cost?
As there is a difference of opinion among accountants as to treating interest as a cost of production, the views of two writers of prominence are quoted at length in the present chapter, and reference is made to a number of articles on this subject. The question is of great importance, and therefore the views set forth in this chapter should be considered carefully, and the articles referred to should also be consulted before a final decision is made.
The author’s own position is that whatever expense is necessary to operate a plant must be charged against the cost of the product, if true costs are to be obtained; and as it is just as necessary to have buildings, grounds and machinery as it is to have workmen for manufacturing a product, these factors should be considered in ascertaining costs, especially where the values of these elements vary in relation to different articles manufactured.
To make this clear, suppose that a factory is producing several articles of different kinds, some of which necessitate the use of expensive machinery or equipment, while others are largely the product of hand labor, or cheap machinery. If the different values invested are not taken into consideration, the indirect expenses as distributed will not show the true variation that exists in the costs. The unequal burden, resulting from the differ ences in investment, is clearly an essential factor; and since this burden is a direct result of using the producing equipment, it seems that it should be considered as one of the elements of cost.
Of course, if the equipment is uniform, or if all the output passes alike through all the processes, there is no essential difference between including the interest as a cost and leaving it for a later supplementary calculation. Since, however, in either case, the amount invested must be considered in determining the selling price, the question still remains as to what method or base of calculation should be used. It may be interest on values, or some arbitrary charge based on time or other conditions of manufacturing.
The difference of opinion then centers on what is the best method of applying this charge to the cost; that is, whether it should be included among the regular cost items and become a part of the accounting system, or only be added to the cost in a statistical report.
From another standpoint the objection is raised against including interest cost as a part of the accounting system, that banks in many cases will not accept the valuation of an inventory which includes interest as part of the cost of the product.
Interest as a Charge against Costs
The following article on “Interest on Investment in Equipment,”* by William Morse Cole, Assistant Professor of Accounting in Harvard University, presents the view that interest is properly a cost item, and should be so treated:
Though it is common to speak of cost accounting as if it were different in nature from other kinds of ac
•”Journal of Accountancy,” April, 1913.
counting, virtually all accounting worthy of the name has for a prime purpose the determination of cost. Accounting should serve as a guide in three ways: In fixing prices so that they shall be adjusted properly to costs; in eliminating waste of material, of labor, and of burden charges; and in determining what had best be undertaken in the establishment itself and what had best be purchased or ordered outside. Since these three purposes are the recognized fundamental purposes of cost accounting, it is necessarily true that whether an enterprise is concerned with manufacturing, distribution, or service, its accounting should be, in a sense, cost accounting.
Let us examine these three aims in turn.
Prices must be fixed at such a point that they shall at least cover (1) materials, or goods; (2) labor, or service, and (3) expense burden, or what are commonly called “Overhead Charges.” Obviously, if the last of these is not quite fully covered, the continuance of production or service is not economically advisable (unless, of course, the work serves other purposes than those which are immediately connected with the initial enterprise). If, again, the income provided by the price gives less than a proper amount as interest on the investment—investment in the form of capital locked up in machinery, facilities, material, or waiting product—the return is not economically sufficient to make the enterprise selfsupporting. If this interest is not included in the expense burden, therefore, it must be added later, somewhere, before one can know whether the return is adequate to make the enterprise self-supporting. Since one of the purposes of accounting is to show whether the return is adequate, the interest would seem necessarily to be involved somewhere in the accounting.
Efficient management always attempts to eliminate as much as possible of excess consumption of material, excess expenditure of labor—both mental and muscular—and excess investment in machinery, in other facilities, and in supplies. The best guide for such elimination is an analysis of these various elements, so that comparison may be made between different methods and between different managements. To use a simple illustration, there may be a choice between two methods as follows: Machinery at a cost of $35,000, materials at a cost of $5, and labor at a cost of $20; or machinery at a cost of $5,000, material at $5, and labor at $30. We may know, perhaps, that the maintenance, insurance, and taxes on the machinery while the article is in machine process (that is, the share of maintenance, insurance, and taxes chargeable on this particular production) will be $10 in the first case, and $1.50 in the second case. These figures give us with the expensive machinery a production-cost of $35.00 (that is, $5 for material, $20 for labor, and $10 for maintenance, etc.), and of $36.50 ($5 for material, $30 for labor, and $1.50 for maintenance, etc.) with the less expensive machinery. Taking no account of the interest, therefore, the investment in the expensive machinery appears worth while—if, at least, our production is so large that a margin of $1.50 reduction in cost on each article of product is worth while when set against the possibly greater error in our estimate of depreciation, etc. Yet we have clearly left out of account one element of the problem, for until we know the length of time for which these different equipments are involved in production, we do not know whether interest on the greater capital in the first case will more than eat up the margin of saving over the second. If, for example, the machinery is employed a day in producing this article, even though we use as low a rate of interest as 3 per cent, there is in the expensive machinery an additional element of $3.50 in interest for the one day involved (on a 300-day basis), but there is an additional charge of only 50 cents in interest, on the same ground, for the inexpensive machinery. This difference in favor of the less expensive machinery turns the scale of advantage; for the costs are now $38.50 compared with $37. If, on the other hand, the machines were employed in this production only one hour, on the basis of a 9-hour day, the more expensive machinery with the lower labor cost would be a more economical means of production; for since the interest element is now only 39 cents, its total is $35.39, but the total for the other machine, with interest of 6 cents, is $36.56. It is absolutely essential, therefore, that interest be taken into consideration in determining which of two methods of production is more economical.
The same sort of consideration of interest is essential in attempting to determine what we shall make in our own establishment and what we shall order outside; for if work at home involves investment in machinery, or other facilities, so that we must get a return of $38.50 from our ultimate product or service, but we can purchase the same product or service outside for $37, it is obviously foolish to do the work at home—unless, indeed, our freedom from outside dependence is worth to us more than the difference in cost, or unless we can find no employment for our capital elsewhere at a rate as high as that which we have used in our calculation.
No comparison is possible between different establishments, between different periods in the same establishment, or between different methods in the same establishment, if capital investment in labor-saving or material-saving machinery is neglected; for the very purpose of such investment is to save cost in other directions; and to neglect the capital sacrifice made in saving other costs, is to neglect in part the very aim of cost accounting.
Opponents of treating interest as a cost may admit the need of knowing the figure of interest, but may deny the desirability of showing it on the books. The function of an accountant is to analyze a situation and learn the facts; and the function of a bookkeeper is to record the facts, which, if not recorded, will be forgotten. It seems, therefore, as if it is the function of a cost accountant to learn regarding interest the facts which will serve as a guide in determining prices, in eliminating wastes, and in determining what may best be undertaken; for one cannot otherwise easily get a safe guidance in these particulars. It seems, too, as if it is the function of the bookkeeper to record the results of such study, for surely they will be forgotten if they are not recorded.
Possibly some persons admit that for such purposes as those just discussed, interest must be considered, but deny that it is a cost. Discussions of terminology are quite as likely to be fruitless as fruitful. Any practical value that they may have must lie in a possible better common understanding of one another’s meaning when men use the terms in question. To-day the word “profit,” which is the complement of “cost,” is used in many senses. Under many partnership agreements, salaries and interest on investment are charged as expenses, and net profit is the gain arising from proprietorship pure and simple— from the circumstance of responsible ownership, aside from the salary of the manager as manager (not financially responsible) and from the income of the capitalist as capitalist (not personally responsible). The happy conjunction of ownership and personal responsibility often results in a gain not otherwise realizable; and that gain is profit. When there is no provision for interest and salaries, on the other hand, the term “profit” is commonly applied to the difference between the gross income and the charges incurred for purchases and outsiders’ (non-partners’) services; so that the profit shown is a compound of return for proprietors’ services, for interest on partners’ investments, and for the circumstance of responsible ownership. In corporation accounting, again, salaries are always included in expenses, and the net in-, come is the return to the stockholders as owners of capital. In common parlance, therefore, the word “profits” means much or little. Knowing this, men always interpret it with a mental foot-note.
On the announcement of the figure of profits under an agreement which makes no provision for interest, the first mental act of anyone interested in the business is to see what relation those profits bear to the capital—so as to see what are the excess profits over a reasonable return on the investment. Instinctively, interest is a first deduction—partly because it has a definite basis that can be figured, and partly because it is the one thing that everyone counts on. One does not think of terminology; one thinks only of the fact. Virtually everyone admits that in partnership or other settlements the most satisfactory agreement is one that provides for a definite interest charge. This is mere practical convenience. Though the accountant is not much concerned W1th theoretical economic distinctions, he is at least interested when he sees that economists use a term in a sense that happens to be, for his own practical purpose, most convenient to him. Professor F. W. Taussig, in his “Principles of Economics,”* a recently published and standard authority used in many universities, says: “So much only of a business man’s income is to be regarded as profits
Vol. II, p. 179.
as is in excess of interest on the capital which he manages.”
We have seen that for analytical purposes, in studying operations, practical necessity requires us at least to consider interest in virtually all calculations when investment is involved; and we have seen that in financial statements practical convenience is served by the treatment of interest as a charge, or cost, rather than as a residue, or profit. It seems reasonable, therefore, for accountants to adopt a terminology that will serve their own ends, will agree with the terminology of economists, and will mislead no one. Business men are likely to be misled in the future, as they have been in the past, by statements of profit which assume that no cost is involved in the use of capital.
Interest a Profit—Not a Cost
The following article, entitled “The Fallacy of Including Interest and Rent as Part of Manufacturing Cost,”* by A. Lowes Dickinson, C.P.A., presents the other side of the question, viz: that all interest is fundamentally a profit and not a cost.
The -fundamental objection to treating interest and rent (which, except in so far as it includes compensation for services rendered, is only a form of interest) as an integral part of the cost of manufacture is that all interest is in fact profit. The practical effects of this objection are as follows:
First, that from an accounting standpoint costs are used mainly to determine the valuation of inventories of stocks on hand and that to include interest (that is, profit) in such costs leads to inflation of these values and consequent anticipation of profits not yet earned by the sale of products.
•”Journal of Accountancy,” August, 1913.
Secondly, that it is impracticable to determine a rate of interest on any but an arbitrary basis and that consequently costs arrived at on such a basis have no real meaning and may easily be misleading. For example—owners of a business are earning profits equivalent to 12% on the capital employed and decide to make certain extensions and improvements which will result in savings equivalent to 10% on their cost; they are in a position to raise the money by an issue of bonds on a ^fo basis or of preferred stock on a 7% basis. What rate of interest should be added as a charge to cost accounts if such a principle is adopted?
Thirdly, that the common methods of including interest in costs calculate such interest only on buildings, plant and machinery and ignore the investment of working capital, and frequently also the element of time during which the capital facilities are required for each manufacturing operation.
Fourthly, that to include interest in costs of every operation results in concealing from those in charge of the business the exact effect of two of the important factors involved in profits—namely, the amount of capital employed and the time for which it is employed—and consequently the actual return on the investment necessary to produce it which is yielded by any particular article.
Whilst perhaps the point is not material in a discussion of the theory involved, it may be pointed out that there is a strong objection on the ground of policy to the inclusion of interest as a part of the cost, particularly in the case of public service corporations. In fact, this objection is so pronounced that some banks stipulate in agreements with borrowers that inventories must be taken upon a basis that excludes interest on capital invested.
If any interest rate is to be assumed it can only be a rate which represents a fair compensation for the use of the capital. If the selling price or rate yields a profit over and above the cost of material and labor, a fair return on the capital employed and fair compensation for management, it would seem that to the extent of this profit the price charged is excessive, at least where the manufacture is not conducted under some patent or other special process for which a further compensation may fairly be exacted. This is not a conclusion that a manufacturing or public service corporation whose prices or rates are attacked can afford to admit, more especially as those attacking the rates are not bound by the interest rate adopted, as the corporation might be.
While, however, so far as the general accounts of a business are concerned, it must be held that interest is not a proper element in the cost of product, there is an undoubted demand, and even necessity, for some supplementary statistical accounting which will give effect to the principal elements involved in the earning of profits. The factors involved in profits are the following:
(1) The labor, material and expense cost of a unit of each class of article.
(2) Facilities used in manufacture, such as land, buildings, machinery, tools, stocks on hand, and other working capital, all segregated between the different classes of articles.
(3) The time during which such facilities are in use for a unit of each class.
(4) The selling price of each unit of each class.
If these elements be known, comparisons can be made between different articles produced in the same factory or between the same articles produced in different factories, as to the amount of fixed capital employed in different processes and the time for which it is employed; as to the amount of working capital constantly maintained and used; and as to the effect of further expenditures on additions and improvements with a view to cheapening cost of production. Only the first of the above four factors should enter into the general accounting books and form the basis of inventory valuations and so of the actual profits earned; the remaining factors should be dealt with only in subsidiary statistical records. The difference between the sum of all selling prices (4) and of all costs (1) will agree with the gross profit in the accounting books; and a comparison of this figure with the total capital employed, including not only fixed but circulating capital necessary for manufacturing purposes, will give the rate of return yielded by all classes of articles. The cause of any variation in this rate* of return, as compared with a previous period, or of the • varying rates of return on different articles in the same factory, or of the same articles in different factories, will be obtained from the detail figures. Such variations may be due either to (1) higher or lower cost of labor, material and expense; (2) greater or smaller amount of facilities used; (3) longer or shorter time during which these facilities are used; and (4) lower or higher selling price. If interest at an arbitrary rate is included throughout in labor, material and expense costs it means that the fluctuations in profit due to the first three of these variations are merged into one and cannot without considerable labor again be segregated. The best measure of factors (2) and (3) would seem to be the value of the facilities used, multiplied by the fraction of the year during which they were used and divided by 100, which product would be equivalent to interest at 1 % per annum; the actual margin between selling price and cost of labor, material and expense divided by this product would thus be the actual rate of return yielded by any particular class of articles, the average of such yields corresponding to the yield shown by the principal accounting records.
Unused facilities would under this system appear as a factor in reducing profits either by lack of sufficient business to employ them or by excess facilities in one portion of the plant as compared with another. The product factor corresponding to these unused facilities would form part of the divisor in obtaining the average yield.
Comparative costs of separate operations will be reached by a consideration not only of the actual labor, material and expense cost in different periods or in separate factories, but also by a comparison of these costs with the facilities employed. Thus the estimated savings to be effected in any operation by additional expenditures on construction account should be found reflected in the reduced cost of these operations.
Such a plan as that here suggested gives proper weight to all the factors entering into profits, without introducing any arbitrary rate of interest; it will be no more complicated in its working than are cost systems which are in constant use; and its complications will vary with the number of different articles produced for which separate costs are required.
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