Costs, their compilation and use in management

Front matter

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Foreword

This volume is dedicated to just two purposes.

First, to promote the most extensive use and application of Costs in management and production.

Second, to serve as a reference to those already using costs, suggesting standards by which they can test and measure their present methods and applications and determine whether or not their methods follow modern principles and philosophy, whether or not they are collecting usable data and, most important of all, whether or not they are using that which they do collect to the fullest extent possible.

It is not intended to be a "complete cost keeper." It does not offer a cut-and-dried, ready-made cost system. It is not a guide or reference to any one particular system of costing.

Much of the material included was written a number of years back in the form of separate articles published monthly in the pages of 100% Magazine. During this period the writer secured much valuable aid and inspiration from the interesting discussions at the editorial board meetings viii FOREWORD

of 100%, The Efficiency Magazine as arranged by- Harold P. Gould, its Editor-in-chief, and wishes to acknowledge his indebtedness for this contact and influence. When it was assembled and edited the writer found very little necessity to change his opinions or conclusions and since it has had this test of time, feels justified in offering it in this form as a permanent reference.

The writer wishes to acknowledge his appreciation and indebtedness to Edward L. Ryerson, Jr., with whom he was associated during the periods when much of the original material was written, inasmuch as a great many of the opinions, conclusions and arguments were developed during the many interesting discussions of the subject with him.

Sincere acknowledgment is also recorded here to his present associates, Mr. C. E. Knoeppel and Mr. J. P. Jordan, for their constructively critical review of all the material contained herein in its present form.

Irving A. Berndt

Introduction

The consequences of the World War have been felt in all phases of commercial life and the slogan of "production at any price" will continue to influence our ideas of relative values through a long period of reconstruction. With speed the predominating factor, extravagance has resulted to such a wholesale extent that a reaction must follow. Results will again more than ever before be determined by accurate cost comparisons.

Mr. Irving Berndt's treatment of this subject, with its clear analysis of the relationships between costs and successful scientific management, is a valuable contribution to the study of a problem so vitally important in this period of readjustments. The philosophy of cost accounting and its effectiveness in Executive Control, described by specific evidences, not by any particular system of cost keeping, should give the general executive or the cost accountant a new inspiration.

The trend of modern business toward the highest degree of efficiency requires exhaustive scientific analysis of causes and results which can only be obtained by a progressive and aggressive scheme of education of both employer and employee. The valuable use of cost keeping as described by Mr. Berndt has this idea as one of its principal motives and is the result of his successful application of this theory over a period of years when we were jointly interested in the development of this

INTRODUCTION work. His carefully worked out deductions have justified themselves in actual practice; they have grown more important and more clearly defined with use. With this background of successful application the author now presents them in this compact and illuminating treatise as a valuable aid in modern business methods.

Rather than a detailed description of cost finding we have here an interpretation of cost as related to the science of management and as a controlling influence upon both Capital and Labor. To emphasize the great importance of the relationship between analytical cost and management as affecting the employer and employee I can do no better than to quote Mr. Berndt as follows :

"Just so long as managers know little about true costs and fail to tell labor the little they do know, just so long will there be difficulty in securing the co-operative spirit. There must be established a more satisfactory common ground between Capital and Labor. They must learn to speak a common language of values, interpreted in terms of cost of productive effort and relation between performance and reward."

This presentation of the subject of cost accounting gives the reader an understanding frequently lost sight of when illustrated only by a tabulation of figures and a collection of forms. Here is a scheme with a practical application and a significant message of real value.

,, • Edward L. Ryerson, Jr.

Contents

Chapter Pago

I. The Cost Factor in Management . 17 Six Aids 18

II. Costs During Prosperous Periods 22

Chapter I The Cost Factor In Management

ALL industrial and commercial activities are based in the final analysis, on that one allimportant act of man-decision. The manufacturer decides to produce a certain article and then at what price it shall be sold. He decides to use in its production certain commodities and, further, to manufacture it on certain machines. The dealer decides to sell a certain article at a certain price; the purchaser decides to buy it at that price. The employer decides to hire an individual and pay him a certain wage; the worker decides to work for him at that rate of wages. The storekeeper decides the amount of material to purchase and the proper time to buy it. Under scientific management we find the specialist who decides the exact methods to be followed in each operation in the production and distribution of the product.

No matter what is manufactured or sold, nor how, some one must make a decision at some time affecting each act performed. The success of the business or industry depends upon how shrewdly, intelligently and carefully these decisions are made. Their effect is far-reaching. They make or break an organization or an individual.

Decisions are usually made with one of the six following aids:

1. Intuition 4. Snap Judgment

2. Experience 5. Habit

3. Impulse 6. Analysis

Intuition is defined as ' 'complete and direct apprehension without reasoning." The fact that reasoning is not included in this action should alone point out its instability and unreliability as an aid in making decisions. It is certainly not dependable in these days of intensive business building when there is no time to wait for that psychic moment of intuitional inspiration.

Experience as an aid in making decisions would be satisfactory if the experience were always complete, detailed and accurate as to the point to be decided and all matters pertaining to it. It is valuable, therefore, only in the proportion that it completely meets these requirements. Experience is depended upon more than is necessary or wise in making decisions.

Impulsive decisions would be successful if the impulses were all in the right direction. It seems hardly necessary to point out that this is not true in the majority of cases. The very nature of this method of deciding points makes it unreliable and therefore unsatisfactory.

Snap judgment is usually resorted to for want of time to consider carefully everything having a bearing on the point to be decided. Like many other things done in haste, it is often repented at leisure.

Making a decision in a certain way from habit may be wise, if the habitual method has proved to be the best in all circumstances. Here the danger lies in the fact that the best possible action may not have been discovered before the development of the habit. It is well at least to check up such habitual decisions from time to time to see whether or not there is room for improvement.

We now come to the sixth and last aid in making decisions — analysis. This is the most consistently effective and successful basis of them all. It includes the complete investigation of all information pertaining to the point in question, and all related points, and the thorough analysis of all data at hand. This data should be complete, detailed, accessible, accurate and up-to-date enough to be of assistance in making prompt decisions based upon a knowledge of previous conditions and possible future effects.

If the money losses in business caused by the employment of unintelligent and unreliable aids in making decisions were totaled in a lump sum, their amount would be staggering. There can be little doubt that a great majority of the business failures reported by Bradstreet are traceable to this lack of investigation and analysis in deciding vital points.

Cost data, and particularly operating cost data, are a valuable aid in making decisions. There is hardly a decision made which is not directly or indirectly affected by costs and does not directly or indirectly affect costs in turn. A careful analysis of present and past cost conditions of any operation, item or factor in production should certainly assist by pointing out accurately, as nothing else can do, the effect of the continuation of present practices and policies, of a change in them or of the development of entirely new practices or policies.

Operating cost data are available for this purpose if they have been correctly collected and recorded.

We do not wish to be understood as advocating a new and complete investigation each time a decision, no matter how trivial, is made. We do insist, however, that all important decisions can best be made only after a careful analysis of all the information available.

Minor decisions, arising frequently, should be based upon general policies which have been determined periodically after the same careful and thorough investigation and analysis of available information. This determination of policies for guidance in making decisions is the real work of standardization which makes for efficiency.

We wish also to emphasize that no cost accounting plan is complete unless all information is collected and arranged so that it may be put to immediate use in making these decisions and determining these policies. The data collected must be complete and sufficient as to present and past practices, so that possible future results can be quickly and accurately estimated. This information need not all be tabulated currently in statement form, but it should always be available for easy tabulation when it is needed.

Chapter II Costs During Prosperous Periods

WHEN the production of your plant under prosperous conditions seems to have reached its limit and you are asked what additional demand you can take care of during the next one, two or six months, are you in position to give an intelligent reply, based on facts and records of past performance which you know you can live up to?

When the acceptance of a large order involving a considerable margin of profit depends entirely on your statement as to whether or not you can make the necessary delivery, can you conscientiously and quickly make the decision, without feeling in the future, if you decide in the negative, that you may have unwisely turned away some very good business, or without feeling a gnawing worry, if you decide in the affirmative, as to how you are going to make good on a very hasty, although wellintentioned, promise?

When the question of more machinery, more equipment, more space or more buildings arises, are you able to correctly and definitely decide how much and what kind of equipment you need and can work to the best advantage, or how much additional space can be advantageously used and what size and design of building will fill the new requirements? Can you do this with a certainty that these investments can be afforded; that you will be able to utilize them to such an extent that the depreciation and interest on the investments will be paid for in additional business, and that these items will not become an unearned burden in the future when business conditions are not so good? Do you know just how far you can go?

When your foreman wants more men, how do you know that he needs the number and kind he asks for? Are you sure just which sections need additional help? Do you know how many burden men can be added without making the burden topheavy? Do you know whether or not it will pay to add to your organization?

If the source of supply of certain materials used in your production is temporarily or permanently stopped, and the use of substitute material will make necessary changes in processing which will affect your costs, can you readily tell just to what extent they will be affected?

It is, of course, understood that in order to make all these decisions wisely and intelligently, it is necessary to provide a correct organization, standardization of operations, methods, materials and equipment, and suitable and sufficient equipment

9A COSTS and facilities, but we wish to suggest that all these are not enough without adequate and complete operating cost statements.

We would suggest that this prosperous condition of a business offers many temptations to the executive in charge, not only to disregard the assistance offered him by cost statements, but to believe them a hindrance.

He is being pressed for more production. The sales department cries: "Get out more work. We can sell it." Profits are large, at least larger than they were, and the policy very easily resolves itself into one of "production at any price." The executive may be so busy following the many other important details of his plant necessary for this increased business, that he may soon believe that the cost statements which are laid on his desk are a nuisance, and barely looks at them. His more important work is to get men and buildings, buy more machinery and increase the capacity of his plant generally. In other words he is extremely busy spending money.

Several striking lessons which can be learned from such conditions will prove that the use of operating cost data is more necessary and valuable than ever before, and that it is good business.

In the first place, why should any good business organization be willing to let any portion of these extra profits during profitable times be wasted? Such money should be conserved in a fund to carry the business over periods when business is poor and profits small or not there at all. Not to do so is to class oneself with the man who, when money is plentiful, when he is "flush" in other words, extravagantly throws his money away for unnecessary things which probably do him more harm than good. Yet there is a striking resemblance to this case when, under prosperous conditions, a business dissipates its extra profits in wastes which would be unnecessary if someone in the organization took the interest and the time to watch each expenditure as carefully as it would be watched were conditions not so good and were economy the order of the day.

This extravagance in expenditure becomes a habit with a business organization and tends to demoralize it just as readily as it does an individual. Its ill effects will be felt long after the prosperous periods have come to an end, and especially when depressions come.

Another point to be remembered is that as the operating expenses for labor, burden and supplies legitimately increase there is opportunity for greater total amounts — as well as a tendency for a larger percentage of waste to expense — to be wasted, or saved by careful use of costs.

When such conditions occur and a great deal of energy is exerted in spending money, there should be a strong element in the organization at work studying all factors, with the idea of saving a part of it and eliminating inefficiencies. This influence should be stronger, if anything, than ever before, and might be brought to bear through additional executive control or through a betterment or efficiency manager or staff.

Cost statements should, if anything, be more promptly available for study and analysis. They should be studied with more interest, since they represent larger expenditures made under more difficult conditions.

The application of the principle of standard normal burden rates offers particular advantages during prosperous periods. If burden rates have been established and charged as they should be on a basis of normal operation, and the burden is properly watched and kept down with the aid of detailed cost statements, the results should of course be, with an increase in the number of units produced, a larger total of burden accounted for than is actually spent. This surplus, actually a profit, should be kept as a reserve to make up for deficits under less prosperous conditions.

In this way a more stable basis of operation is established and a record is provided which will serve to indicate how successfully the management is watching the rise and fall of burden expenses in proportion to production and earnings.

Chapter III Costs During Depressions

WHEN the demand for production decreases, direct production costs can be decreased, to a certain extent at least, in proportion to production requirement. Materials need not be purchased unless the product for which they are intended can be sold. Workmen need not be employed unless there is reasonable assurance that their production will be disposed of. But what of the majority of items of burden expenses? Can they be decreased? How shall we take care of idle machinery?

If burden cannot be decreased, and relentlessly continues regardless of the amount of production, it becomes an ever-increasing proportion of the total cost and usually a higher unit cost is the result. The total burden must be charged to something, and if the number of units manufactured is smaller, each unit must carry a larger amount of the total burden. To increase the cost and necessarily the price is, of course, very undesirable, especially at a time such as we are considering, when it is difficult enough to secure business at the original prices. And so the problem becomes more and more complicated.

Complicated as this problem is to the company that knows exactly what effect decreased production and sales have on its costs, how much more complicated must it be to those companies which do not know accurately the amount of their burden, how it is classified, its proportion to direct costs and to units produced; those companies which, in short, have no dependable cost data. There remains nothing for them to do but to take chances in the dark.

Is it, then, surprising that so many disasters occur when such concerns attempt without chart or compass to sail the troubled sea of business upon which even the best equipped business bark finds it difficult to navigate?

The least an industrial organization should do under such business conditions is to positively ascertain whether or not its cost data are accurate, what total burden is carried, of what items it consists, how it is distributed, and whether or not its plan of burden distribution is the best available.

There is no doubt that a period of business depression puts a method of burden distribution to a most severe test. This is proper because, as we suggested before, it becomes an especially important factor. We regret, however, that the tendency of many executives is either to neglect to refer to a plan of distribution or to brand it as inaccurate merely because it tells facts which are unwelcome. Herein should lie its value — that it does tell the facts.

We believe there is a tendency among many managers and executives to fail to recognize sufficiently that there are at least two fundamental purposes in collecting cost data, and especially burden expenses. These fundamental purposes are:

1. The control and reduction of costs

2. The study of price.

First of all, cost data should tell true costs and should not be used for setting selling prices until they do so.

If these two purposes of making burden distributions are recognized, we should above all be honest with ourselves and should not attempt to disregard or change a method which tells the truth under prosperous conditions, just because we find under less prosperous conditions that that truth is unwelcome. If the method is right and serves these purposes under any condition, it should be right under all conditions; otherwise it is not standing the test.

Therefore, let us have truth first, and under all conditions let there be no variance from the method which tells the truth merely to make matters seem more agreeable on the surface. We should, if anything, study it all the harder because it gives us correct information, and should make every possible use of it in keeping costs down and prices right.

To set the selling price it is of course necessary to consider many other factors beside the cost. In setting this price under various conditions of the trade, study is needed and good judgment must be exercised. Having a true cost, which is unvaryingly accurate, we at least know in setting the selling price when we are taking chances of loss.

The correct method must, therefore, give true cost under all conditions so that it designates immediately and exactly the loss or profit at any price we set. It must never allow us to juggle the figures so that they seem to show anything we want them to show.

There is another lesson to be drawn from strained business and trade conditions. Too often do many companies increase prices to take care of increased unit burden costs when a study of this burden and the items that go to make it up would point out possible reductions in its total and make such increases in price unnecessary. In other words, they try to make up losses from the outside rather than from the inside. An internal study should be made first, and here again the burden classification and distribution, if they are properly made, become very important and valuable.

If an internal study were consistently made, losses during poor business seasons might be made up by extra profits during good seasons when operating under the decreased burden total brought about by the "house cleaning" such study developed.

In other words, if proper advantage were taken of the extensive study which should go hand in hand with periods of business depressions to decrease operating costs, such periods might become valuable rather than destructive, teaching a lesson which, if properly accepted, would permit the reaping of greater profits under normal business and trade conditions.

As indicated in the last chapter, the application of burden rates established on a basis of normal operation and applied under all conditions, serves to provide a reserve after a period of greater production, to make up for deficits in burden earned occurring during less prosperous conditions, and in this way provides a more stable basis for operation.

However, the existence of this reserve is no excuse for any less energetic study of burden reduction, since it really represents profit so long as it is not absorbed during dull periods. The period of depression should take care of itself as long as possible, with resort to a reserve established during prosperous times only as a final expediency in order to keep conditions stable.

Chapter IV Co-operation On Cost Methods

THERE is certainly great significance in the statements of Edward N. Hurley, formerly chairman of the Federal Trade Commission, when he addressed the Ohio Bankers' Association at Columbus, and, among other things, recommended that one of the most important means of strengthening American industry to meet European competition after the war was the establishment of cost systems.

Mr. Hurley stated that nine-tenths of the concerns reporting to the Federal Trade Commission do not keep adequate cost systems and that fully one-half of the 60,000 corporations that report an annual income of $5,000 or over, do not charge off a single penny for depreciation.

He said also that the Trade Commission was prepared to send experts to assist trade associations in adopting sound systems.

These statements are important: first, because both certainly indicate the need of attention to this phase of executive control, and second, and

.32 more especially, because the last statement offers a definite solution.

It is a long step forward when the United States Government prepares itself to co-operate with industry in groups in such a matter as the standardization of cost methods. It will be a still greater step forward when industry prepares itself to accept this assistance from the Government.

The greatest good will result from the general consideration of this matter by groups in each industry. In that way one company will assist another, and, finally, allied groups will co-operate with onejinother.

The one thing which will retard the advance of this movement is, no doubt, a misunderstanding of the results to be obtained.

Many executives and companies may hesitate to join in this study of cost methods through a feeling that a study of costs must include a consideration of actual cost figures, which they would not be ready to divulge.

This is entirely unnecessary; first, because standard methods and systems cannot in any case be based upon figures, but must be the result of logical conclusions based upon experience and the development of principles; and second, because it will be noted that Mr. Hurley emphasizes systems and methods. It is, of course, obvious that a government, the legislation of which forbids it, could not encourage price fixing in any sense.

We are hoping that manufacturers will study this phase of cost accounting with an appreciation that cost finding and price determination are two separate, distinct functions, the first being merely a basis for the second. Further, that cost methods and actual cost figures are entirely separable, the latter being merely the result of the execution of the plan outlined in the former.

It is in the development of this basis for securing cost figures that the co-operation of industrial groups will be so valuable.

Take for instance depreciation, which as Mr. Hurley pointed out, is so much neglected: there can be no doubt as to the value of the discussion and consideration of this cost factor in a given industry.

The discussion of depreciation must be based upon certain experience; the greater the experience available, the more intelligent will be the decision.

The information to be desired will be not how much Wm. Brown & Co. charge per unit for depreciation, but first, whether or not it is correct to include depreciation as a portion of costs; second, on what kinds of equipment, building, etc., it should be figured; and lastly, from the combined experience of the members, what rates of depreciation are advisable under various conditions.

In addition to this, there are several different methods of charging depreciation, only one of which can be absolutely correct, and it is here that not only members of a group, but groups as well, can co-operate.

After all these points have been decided upon and each manufacturer has based his costs on correct methods, we venture to suggest that there will still be ample opportunity for competition, but it will be a fair competition, an intelligent competition, and, what we need above all in these United States, a co-operative competition.

We sincerely hope that manufacturers will accept this opportunity to help themselves and each other, and that the plans outlined by Mr. Hurley may meet with unqualified success.

Chapter V Elements Of Costs

EFFICIENCY in its broadest sense is denned as the ratio of results obtained to .effort expended. Efficiency in its relation to industrial enterprises may be denned, then, as the ratio of production to dollars expended — dollars representing wages for labor, cost of material and equipment and all other necessary expenditures.

Science represents knowledge duly arranged and systematized, and it follows that the science of management must include a complete, accurate and systematically arranged knowledge of the efficiency of each dollar spent.

Like all other sciences it is not complete without a record of analysis, and a complete and permanent record of results of experiments and the effects of all varying conditions and changes.

In the same manner that the science of chemistry analyzes chemicals and their uses, and then prescribes correct combinations for most efficient use, so must the science of management analyze the use of dollars and prescribe methods for their most efficient use.

To fill the need for such records, to give to the student of scientific management such methods of analysis, and to provide a permanent record of experiments and research for future guidance, we must have cost statements, records and data.

It was not so long ago that operating cost statements were considered a luxury. Hard work, long hours, shrewd bargaining and judgment spelled success. In these days of intensive competition, however, this definition has been changed; judgment has been largely replaced by scientific analysis and cost records.

Operating cost statements are receiving ever-increasing attention. They now have a recognized value, and will soon be considered indispensable.

To a failing business they represent a new lease on life, pointing out possible retrenchments which would never have appeared without them. To a prosperous business they constitute a protection, warning the management of dangerous policies and practices. For the investor and the executive they provide a course by which to steer their business bark. They insure employees, from the manager down, absolute justice and fair dealing, inasmuch as snap judgment is replaced by scientific analysis, and permanent and accurate records of efficiencies, individually and as a body. On account of their importance in the work of waste reduction they help give the consumer and the public at large greater dollar efficiency.

To manufacture any product we must incur expenses which may be described as labor, material and overhead. As one of the great purposes of an operating cost system is to compare costs, it is vitally important that an analysis be made of every expense to decide its correct place in a comparative statement and to insure a fair comparison made on exactly the same basis each day, week, month or period.