ACCOUNTING METHODS FOR DETERMINING COSTS

AND PRICES

WILLIAM MORSE COLE

Those who are trying to develop the comparatively new science of accounting are placed in a position unlike that of almost any pioneers who have preceded them-if not in kind, at least in degree. They are facing in extreme form the sort of thing that economists in general have long suffered. For many years economists were rather laughed at by business men because they were giving strange uses to old words or seeking peculiar visual angles for the observation of common transactions. With this you are all familiar. Only those who are specially engaged in the consideration of accounting, however, realize in what a high degree this is true of the accounting branch of economics. In this branch the professional man (and by this term I mean both the practitioner and the teacher) is using not only the common terms of business but also the detailed paraphernalia of forms of record, and yet he is forced commonly to recommend that they be put to uses that violate the traditions of generations and generations of competent or quasi-competent and altogether respectable bookkeepers. The business man does not object to economic theories as such, nor always to the application of those economic theories in public affairs, but when these theories knock at the door of his own counting room, and bring with them a reputation that leads the bookkeeper to say, "If you let them in, you and I will have to go to school again and learn a new language", he is inclined to shrug his shoulders and say, "Go away, little boy, go away!" His attitude toward the little boy is natural enough-and the epithet "little boy" is not altogether bad. Accounting is a little boyhe is far from maturity; but he is a stalwart youngster, and he has already done a great deal for those who have trusted him with a job. Undoubtedly for many years the so-called practical business man will laugh good-naturedly at much that the professional accountants advocate, and the more conservative accountants will laugh at much of what the more venturesome will practice. The test will lie always in the results-where men can be found bold enough to forget tradition and try results-but it takes a long time to get the community into a frame of mind receptive enough

to test the results fairly. One thing is obvious: for an accountant to install for his client a system of accounting that the client does not trust is practically to foredoom the experiment to failure. The client must see the value of what is recommended; and he must see the economic principle underlying the accounting system, or he will not see the value of the system as a whole. To get the accounts of the business of this country put upon a sound basis means the education of the public to something of an appreciation of fundamental economic principles.

We who are here are supposed to be without the prejudice of tradition—we are supposed to be open-minded enough to welcome any new thing that can justify itself both rationally and practically-whether it violates tradition or not. I am going to ask you therefore to forget what has customarily been done with regard to the determination of costs, and to consider the subject independently of tradition. Then when we have considered what is desired, we may see how far the traditional methods may be used to produce the thing desired. If we can get the thing we want without much disturbance of tradition, so much the better.

In the first place, I wish to premise that business is not always profit-making or even intended to be profit-making. Many large and valuable enterprises are concerned solely with product; they not only seek no profit, but they distinctly wish to avoid profit. They are concerned only to get the maximum product at the minimum cost. The number of such enterprises is continually increasing. It is futile to deny that these are business enterprises, for they seek to produce definite results through the employment of paid human agencies; and I conceive that element, bargain and sale relations between human elements, to make the distinction between business and other things, mere handicraft on one hand, and mere physical and mental activity on the other. No accounting is adequate unless it is based on the fundamental fact that costs have in them no element of profit for the enterprise concerned. If profit is in the enterprise, the profit is an amount over and above the cost, and the cost must as clearly exclude any element of profit for the enterprise as if the enterprise were concerned solely with product and sought to avoid profit. We may say, indeed, that accounting is concerned with the economics of consumption quite as much as with those of producton; and no accounting is adequate which tries, figuratively speaking, to treat them both as if they were opposite sides of the same account-and

therefore presents what looks like a balance between them as if that were the final figure desired.

My second premise is this: With the determination of how much absolutely is a fair profit, accounting has nothing to do; but the facts upon which the fairness of profit hinges must be shown by the accounts just as far as those facts are capable of expression in figures. Let me illustrate: Whether interest shall be 6 per cent or 4 per cent, whether wages shall be $5 a day or $2, whether rent shall be $5 an acre or $1 a foot, is not a question for accounting to settle; but to discover all the figures that can be known as material for determining the fair rate of interest, of wages, and of rent, is the accountant's particular task. The final decision may involve important considerations of risk, of social desirability, of spiritual progress, that cannot be recorded in accounts. This is so obvious that you may wonder at my mention of it. I do it only because I find often that it is neglected in practice. In other words, the temptation is strong to try to strike a balance between the economics of consumption and those of production, and show a result which is neither-and therefore worthless for the purposes of either. For illustration, if in some municipal activity allowance for social value has been allowed to creep into a figure of cost (let me say a disregard of some fact in distribution of costs because the social value of the service is deemed to offset an

actual outgo), the result may be satisfactory for the purposes of that particular calculation, and yet be seriously misleading when the figure is used for purposes of comparison in another connection or as the basis for a new figure where the social value of the service is not a factor of the same weight.

From these two premises that I have made-first, that accounting is concerned with all business, in the largest sense of the word, and, second, that accounting is not concerned with questions of policy but only with questions of fact (facts which justify policy or are the results of policy)-comes my fundamental thesis, that the proper function of accounting is nothing more or less than telling the truth, telling the economic truth, and telling it in such fashion that the known facts shall not be held in solution, so to speak, in a lot of supposed facts, estimated facts, and quasi facts. It is obvious that many figures in accounting are bound to be estimates as allowances for depreciation, debts that will prove uncollectible, valuations of property owned, demands on contingent liability, etc.; but it is equally obvious that these estimated

figures may be shown in their true character-as the results of estimates, with the bases on which they were deduced-and that they need not be combined with known items so as to hide the identity of the known items and put the combination into the category of estimated items. In other words, the method of accounting should be the general method of science-expressed in the precept "So far as possible, isolate your causes, and distinguish your results." Α physicist who should conduct all his experiments regardless of atmosphere and temperature would learn nothing of natural law. An accountant who constantly and unnecessarily combines known and unknown quantities gets results that tell little about business operations; he certainly is contributing nothing to the advance of economic knowledge.

Let us now examine the application of some fundamental economic principles to accounting, and see what they suggest in the way of accounting facts and methods. It is clear that here, at least, abstruse and somewhat disputed refinements of economic theory can have no place; for, however advantageous it might be to put certain of such theories to the practical test of operations and accounting record, such experiments are available only where a business enterprise is offered as a voluntary laboratory; we could hardly recommend that sort of thing as general accounting policy.

The subject of our discussion this evening, as indicated by the program, is a method of determining costs and of using those costs as criteria for fixing prices. Whether the prices are to yield a profit or not does not concern us here; for even if they are to do so, the amount is to be determined by the application of some ratio or formula to the cost already found. Let us begin our application of these principles with interest on capital invested.

On this matter of what is a fair return for capital invested, all communities are much divided; but if my fundamental thesis is accepted, this does not much concern the accountant. He is not— that is, as an accountant-concerned with policies, but with facts. It is his business to record what has happened, and to do it in such fashion that every one may for himself determine what he thinks ought to happen. If the accountant bases his figures on his own theory of what ought to happen-for example, in the matter of payment of dividends-his figures are of practically no use to anyone who has a different theory; indeed, the accountant's figures are of little use even to the people whose theory is identical

with his own, for unless he has informed them as to the theory that underlay his figures, they know nothing as to what those figures really mean. Let us take a concrete case. A company has inaugurated a new business which is slow in development. For the first year it does not pay, for it has not yet developed its following or created a sufficiently large demand for its product. The books show a deficit. At the end of the second year, the condition is improved, but though there is every prospect of success not only ultimately but even in the coming year sufficient to wipe out the deficit, the net result of the two years is still a deficit. The accountant decides that this deficit is really an organization expense; indeed, that the full first year's deficit is an organization expense; and that the real result of the two years' operations is a profit, for the amount sunk in the first year is permanent investment, akin to payment for good will. He even goes so far as to say that interest on that first year's deficit should be met out of the product and should be charged as a cost-exactly like interest on funds locked up in machinery. He will say in future years that no profit is shown until enough has been deducted from product to pay interest on this year's deficit. In other words, he will have capitalized this deficit. There are logical grounds for such a view. When, however, we in later years make a study of dividends of this company, and find that none were paid in this first year, we naturally think that a fair return on the investment has not been made unless the later years have paid enough to offset the loss in that first year. Unless we learn that this deficit was capitalized, and that in later years interest has been paid on this capitalized deficit before net profits were deduced, we never appreciate what has happened. The accounts are figures plus a point of view; and the reader of the figures does not know which is which. The accountant, as an accountant, should have no visual angle. He should always face front. Our real problem is to learn what are the focal points on which the face-front accountant should fix his attention and to which he should relate all the facts.

With regard to interest on capital, which we have just been considering, we are forced to observe, as a practical application of our principle of isolating causes, that ordinary interest is made up largely of return for risk assumed. That, of course, is the really variable element in most interest rates. Accounting that disregards it is by so much failing to tell what it might of business