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(
DIRECT COSTING FOR EXTERNAL
FINANCIAL REPORTING
by
EIxDON LEON FROST, B.B.A.
A THESIS
IN
ACCOUIN TING
Submitted to the Graduate Faculty of Texas Technological College
in Partial Fulfillment of the Requirements for
the Degree of
MASTER OF BUSINESS ADMINISTRATION
August, 1968
i so
205-73 l^i>» No. ii4
Cap. 2.
n(^ nit^^
ACKN OWLEDGlvIEN T S
I am deeply indebted to Professor William
Whittington for his helpful aid and criticism in the
direction of this thesis.
11
TABLE OP CONTENTS
Page
ACKNOWLEDGFiENTS ii
I. INTRODUCTION 1
Statement of the Problem 1
Definition of Terms 2
Limitations and Delimitations 4
Historical Development of Direct Costing . . 5
II. DIRECT COSTING IN EXTERNAL EINANCIAL REPORTS . 8
Direct Costing and Basic Accounting Theory . 8
The Acceptability of Direct Costing for
External Reporting 14
Summary and Conclusion 24
III. DIRECT COSTING IN EXTSPLNAL PINAI\^CIAL REPORTS—
THE NEGATIVE VIEWPOINT 27
The Theory of Manufacturing Costs 27
Basic Accounting Assumptions 32
The Theory of Income Measurement 33
Producing and Standing Ready to Produce . . 40
IV. SUIMARY AINID CONCLUSION 43 BIBLIOGRAPHY 47 APPENDIX 51
1 1 1
CHAPTER I
INTRODUCTION
In 1936, Jonathan Harris introduced the controver
sial concept of direct costing in his article, "What Did
V/e Earn Last Month?"-'- Since that time a running battle has
been fought between the advocates of direct costing and the
supporters of the more conventional absorption costing.
However, "there is some reason to believe that the main 2
battle is yet to be fought."
Statement of the Problem
Before launching directly into a discussion of
direct costing, a brief statement of the purpose and objec
tives of accounting will aid in better understanding the
topic under discussion.
Purpose and Objectives of Accounting
In broad terms, the purpose of accounting is to
provide financial data for internal (management) and
external (investors, government, and the general public)
Jonathan Harris, "What Did We Earn Last Month?" NAA on Direct Costing, ed. by Raymond P. Marple (New York: The Ronald Press Company, 1965), pp. 17-40.
2 David Green, Jr. "A Moral to the Direct Costing
Controversy?" The Journal of Business, XXXIII (July, I960), 218.
1
uses. As long as the resulting data is useful and accep-
table to management, the procedures used to gather and
interpret financial injformation for internal purposes need
not conform to any prescribed rules. Before an accounting
method can be used for external purposes, it must conform
with generally accepted accounting principles.
Purpose of This Thesis
A controversy arises among theorists concerning
direct costing. The opinion of some theorists is that
•direct costing does not conform to generally accepted
accounting principles. Other theorists, however, feel
that direct costing does conform to generally accepted
accounting principles and should be allov/ed for inventory
valuation in external reporting. This thesis will re
view the literature supporting both opinions of the direct
costing controversy and a conclusion will be made concern
ing direct costing's conformity with generally accepted
accounting principles.
John J, Braush, "Progress or Folly," The Journal of Accountancy, CXII (August, 1961), 53.
American Accounting Association, Accounting and Reporting Standards for Corporate Financial Statements— 1957 Revision"~(Columbus: American Accounting Association, 1957), p. 11.
5 Charles T. Horngren and George H. Sorter, "'Direct'
Costing for External Reporting," The Accounting Review, XXXVI (January, 1961), 84.
Definition of Terms
Before any study can be made, it is necessary to
understand the meaning of the terms used v/ithin the study.
Therefore, a few important terms are defined below.
Direct Costing
Direct costing is the doctrine that variable cost
is the basis for valuing output. Variable costs are
assigned to the goods produced and fixed overhead costs
are expensed as a period cost when a direct costing system
is used. "Direct costing is not a complete costing plan
in itself, but it is a. feature that may be introduced into
either process or job order cost systems, and in standard 7
costs may or may not be employed."' Under direct costing,
net income will vary directly voth sales volume.
A term which is often used instead of direct cost
ing is "variable costing." "Variable costing" is more
descriptive of v hat takes place under direct costing, and
its adoption is highly desirable.
Eric L. Kohler, A Dictionary For Accountants— Second Edition, (Englewood Cliffs, New Jersej: Prentice-Hall Inc., 1957), p. 178.
^Ibid., p. 179. o James M. Fremgen, "The Direct Coscing Contro
versy—An Identification of Issues," The Accounting Review, XXXIX (January, 1964), 44.
4
Absorption Costing
Absorption costing is the exact opposite of direct
costing. Under absorption costing both variable and fixed
costs are assigned to the goods and services produced,^
Terms often used as a substitute for absorption costing
are "conventional costing" and "full costing."
Limitations and Delimitations
Concern With External Reports
Direct costing has already attained the status of
10 acceptability for internal reports to management. In
external reporting there is no such general acceptance.
This thesis is concerned only with the implications of
direct costing on external reports.
Historical Cost Assumption
The valuation of inventories at historical cost is
another constraint within which this thesis is written.
There is some feeling among accountants that inventories
should be carried on the financial statements at replace
ment cost rather than historical cost. If inventories were
carried at replacement cost, there would be no need to know
for statement purposes the historical cost of goods pro
duced. Direct costing and absorption costing are methods
Q
^Kohler, A Dictionary For Accountants, p. 2. 10 Fremgen, "The Direct Costing Controversy—An
Identification of Issues," p. 43.
of assigning historical costs to goods manufactured; there
fore, an abandonment of historical cost would render both
direct costing and absorption costing worthless.
Historical Development of Direct Costing
Early Pioneers
The first article publicly published on the subject
of direct costing was "What Did We Earn Last Month?" by
Jonathan Harris v/hich appeared in the NAA Bulletin for
January 15, 1936. In his article, I/Ir. Harris, controller
of the Dewey & Almy Chemical Company, described why his
company installed on January" 1, 1934, a standard direct
costing system, Mr. Harris' article has become an ac
counting classic and occupies first place among readings
on direct costing.
LVen though Mr, Harris' article was the first
article publis.hed publicly, it may not have been the first
article published on direct costing. In 1937> G* Charter
Harrison published for private circulation a group of six
articles entitled "New Wine in Old Bottles." These six
articles are claimed to be reprints of six previously
printed articles also published for private circulation; 12
however, no dates for the original printings are given.
• •'•Raymond P. Marple, ed., NAA on Direct Costing— Selected Papers (New York: The Ronald Press "Company,
•'- Ibid., p. 8.
Clem N. Kohl, controller of the Gates Rubber Corj-
pany, wrote an article which appeared in the NAA Bulletin
in 1937. In his article entitled "What is Y/rong With Most
Profit and Loss Statements," Ivlr. Kohl stated that his
company had been using direct costing since 1919, Mir. Kohl
felt justified, based upon his experience, to state that
"the proposal of eliminating fixed charges from the usual
calculations is not an untried thing, but a thoroughly
tried, practical and down-to-earth idea," *
'A Pause in the Action
The years between 1937 and 1950 were the dormant
years vvith respect to direct costing. Jonathan Harris'
article did result in a few letters to the editor pub
lished in subseqiient issues of the NAA Bulletin, and di.rect
costing was the topic of a few NAA coriferences during the
1940's, but little real advance v/as made.
During the latter portion of the 1940's, several
articles were published on direct costing. These articles
included Philip Kramer's, "Selling Overhead to Inventory,"
Cecil L. Clark's "Fixed Charges in Inventories," and two
additional articles by Jonathan Harris. These articles
• - Clem N. Kohl, "What Is Wrong With Most Profit and Loss Statements," in NAA on Direct Costing—Selected Papers by Raymond Marple X'i'ew York: The Ronald "Press Company, 1965), p. 51.
7
reflected the interest that v/as beginning to be generated -| /
and resulted in the activity of the 1950's. ''
Direct Costing Develops: The Fifties
The period from 1951-1960 indicated that interest
in direct costing had not died during the 1940's. The
NAA Topical Index lists 44 major articles dealing v/ith
direct costing topics. David Green refers to the decade
of the fifties as the "Ten Years' War on Direct
Costing."-'-
The Present
During the period from I960 to 1968, there have
been many articles written on direct costing, but the
subject v/as not as controversial as during the fifties.
In January, 1961, the National Association of Accountants
issued Research Series No. 37 which replaced Research
Series No. 23 on "Direct Costing" issued in April, 1953.
The American Institute of Certified Public Accountants,
however, has not issued a pronouncement on direct
costing.
^Marple, NAA on Direct Costing, p. 10.
15 via. v./v.^.to. ,
troversy?" p. 2l8. Green, "A Moral to the Direct Costing Con-
CHAPTER II
DIRECT COSTING IN EXTERNAL
FINANCIAL REPORTS
Direct Costing and Basic Accounting Theory
The difference between direct costing and absorp
tion costing is ultimately one of timing. Proponents
of direct costing feel that fixed overhead costs should
be expensed during the period incurred while opponents
think it should be capitalized in inventory and become
an expense of a future period. The issue then is the
nature of an asset.
The Nature of e<.n Asset
The term "asset" is derived from the French
azsaz, meaning "enough," v/hich in turn comes from the
Latin ad satis, "to satisfy." The term was'originally
used in connection with the adequacy of an estate to
bear the charges and legacies of a-deceased person.
Early definitions of "asset" carried v/ith them heavy
legal overtones because of the early use of the term.
1 f~j
Paul-Joseph Esq.uerre, The Applied Theory of Accounts (New York: The Ronald Press Co.Lpany, 1914), p. 135.
8
In its modern use, "asset" can be defined as
follows:
Assets are economic resources devoted to business purposes within a specific accounting entity; they are aggregates of service potentials available for or beneficial to expected operations.- ''
Any type of cost may be deferred if it originates in a justifiable expenditure and represents a factor from which future benefit or contribution can reasonably be anticipated.1°
It can be assujned from the above definitions that costs
are assets "if they can justifiably be carried forward
.to the future, if they bear revenue producing power,
if they are beneficial to future operations—if they
possess service potential. -
The Concept of Service Potential
The concept of service potential depends upon
some basic assiomptions about the future before it becomes
meaningful and measurable. Expectations or anticipa
tions are very important in determining whether a cost
contains service potential and therefore should be held
back as an asset, or v/hether that cost should be released
9
17 American Accounting Association, Accounting
and Reporting Standards for Corporate Financial Statements, p. 3.
-1 o
W, A. Paton and A. C. Littleton, An Introduction to Corporate Accounting Standards (Urbana, 111.: American Accounting Association, 1940), p. 65.
19 -^Horngren and Sor ter , " ' D i r e c t ' Costing for
External Reporting," p, 85.
10
as an expense or loss. The assumptions made that underlie
decisions to capitalize certain costs must be reasonable
and widely acceptable. The going concern postulate is the
major assumption made in determining v/hether a cost is an
asset or an expense.
The "going concern" concept assumes the continuance of the general situation. In the absence of evidence to the contrary, the entity is viewed as remaining in operation indefinitely. Although it is recognized that business activities and economic conditions are changing constantly, the concept assujnes that controlling environmental circumstances will persist sufficiently far into the future to permit existing plans and programs to be carried to completion.20
"The going concern postulate is surprisingly ,the only
assumption about the future needed to demonstrate service
potential for an unexpired cost—except in the case of
21 fixed factory overhead." Before fixed factor r overhead
can possess service potential there must be two other
22 assumptions made about the future.
Assujuption one: Future production at maximum
capacity v/ith future sales in excess of maximum production
capacity. If this situation should develop, inventories
would have to be accumulated in the present period in
20 American Accounting Association, AccoLinting and
Reporting Standards for Corporate Financial Statements, p. 4.
21 Horngren and Sorter, "'Direct' Costing for
External Reporting," p. 85.
Ibid., p. 88.
11
order to prevent the need for increasing capacity or
subcontracting to meet the demand for goods in the futiire
period. The increasing of plant capacity and subcontract
ing v/ould both, require extra cost incurrence in the future
period which v/ould be avoided by the inventory build-up.
Fixed factory overhead would be deferred in this situa
tion because future cost incurrence is reduced. Fixed
factory overhead v/ill be incujrred in the future period,
but the point here is that the inventory build-up will
reduce costs of another type.
Assumption tv/o: Variable costs are expected to
increase. The build-up of inventories will save production
costs amounting to the difference between incurred variable
costs and expected variable costs. This difference may
justifiably be capitalized since it contains service poten
tial. Stated differently, the increased present utiliza
tion of fixed facilities v/ill result in future cost
savings.
Conclusion. Y/hen conditions are such that the
above two ass\;imptions can be made, it may be permissible
to capitalize a portion of fixed factory overhead. The
assumptions, hov/ever, are in addition to the going concern
assiomption, and accounting has alv/ays treated as expenses
all sorts of costs that require assujnptions about the
future other than the going concern concept. Thus, research
12
studies, and management training programs are all treated
as period costs even though ass"umptions about the future
could be made so that they would contain service potential.
Yet, fixed factory overhead is consistently capi
talized as the result of assumptions other than the going
concern postulate. The behavior of fixed selling, admin
istrative, and factory costs are basically the same. None
of them reduce future cost incurrence. Conventional cost
ing, however, chooses to single out factory overhead for
special treatment instead of ranking these three costs
abreast and treating them the same. -
Relevant Costs. Accounting is a tool for decision
making. Accounting data must be of such nature that it
aids managem^ent, investors, and other interested parties
in making rational decisions about future actions. The
only costs that have a bearing upon these decisions are
relevant costs.
Relevant costs are those costs that will be dif
ferent betv/een two or more future actions. They are
those that may be avoided by not \indertaking a given
alternative. Irrelevant costs are those that have no
influence on the future and are not helpful in decision
making. Therefore, only relevant costs should be classed
^^Ibid., p. 90.
13
as assets. Irrelevant costs have no impact on the future
and therefore have no service potential.
A cost has service potential if its incurrence
nov/ v/ill result in future cost avoidance. Stated differ
ently, assets (costs with service potential) represent
costs v/hose recurrence is unnecessary in the future. If
future cost avoida nce v/ill not be affected by the cost in
question, then the cost is an irrelevant cost and cannot
embody any service potential. Given the going concern
concept, irrelevant costs cannot be classified as assets.
The Nature of Fixed Factory Overhead'
Fixed factory overhead does nothing more than
provide capacity to produce. The expenditure for fixed
factory overhead is made every period v/hether capacity
is fully utilized or not. It was stated above that for a
cost to be capitalized, it must contain service potential.
Fixed factory overhead clearly does not contain service
potential since it in no v/ay reduces future cost incur
rence. Fixed costs are irrelevant costs. As tim.e passes,
fixed costs expire, to be replaced by new bundles of fixed r
costs v/hich v/ill enable prodLiction to continue.
Conclu.sion
From the above discussion, it can be concluded
that direct or variable costing is supported by basic ac
counting theory. Fixed costs are by their nature costn
14
that are incurred every accounting period. Their incur
rence in the present period does not reduce the expenditure
required for the subsequent period. In other v/ords, fixed
costs do not contain service potential. Without this
element of service potential, costs cannot be capitalized.
Therefore fixed factory overhead costs should not be in
cluded in the determination of inventory cost.
The Acceptability of Direct Costing rpT External Reporting
Y/hat Determines Acceptability?
A practice is considered acceptable for external
reporting if it is in accordance v/ith generally accepted
24 accounting principles.
"Generally accepted accounting principles" are those principles v/hich have substantial authoritative support. Opinions of the Accounting Principles Board (of the American Institute of Certified P\iblic Accountants) constitute "substantial authoritative support." "Substantial authoritative support" can exist for accounting principles that differ from Opinions of the Accounting Principles Board. No distinction should be made between the Bulletins issued by the former Committee on Accounting Procedure on matters of accounting principles and the 25 Opinions of the Accounting Prirxciples Board.
Norman J. Lenhart and Philip L. Defliese_, Montgom-ery ' s Auditing, eighth edition (New York: Ronald Press Company, 195TTT p. 76.
^American Institute of Certified Accountants, "Opinions of the Accounting Principles Board No. 6" (Nev/ York: American Institute of Certified Public Accountants, 1965), p* 45.
15
Substantial authoritative support for an accounting prin
ciple can also exist as the result of acceptance by the
Internal Revenue Service for income tax purposes, accep
tance of the Securities and Exchange CoEMission, and
through pronouncements of the American A.ccounting Associa
tion. In suumiary, acceptance comes from tliree places:
(l) the professional organizations; (2) the Internal
Revenue Service; and (3) the Securities and Exchange
Commission.
The Attitude of the Professional Organizations
The opinion of the American Institute of Certi
fied Public Accountants will be considered first to try
to determine the status of direct costing. There have
been no "Opinions of the Accounting Principles Board"
issued on direct costing; therefore, it is necessary to
refer to Bu.lletin 43 to obtain the thoughts of the Amer-
ican Institute on direct costing.
Bulletin 43 contains the following statements
concerning inventories:
The primary basis of accounting for inventories is cost....As applied to inventories, cost means in principle the sujn of the a plicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location....It should also be recognized that the
American Institute of Certified labile Accountants, Accounting Research Bulletin No. 43 (Nev/ York: AmerTcan Insxitute of Certified Pu'Dlic Accountants, 1953), P. 28.
16
exclusion of all overheads from, inventory costs does not constitute an accepted procedure....Cost for inventory purposes may be determined under any one of several assumptions as to the flow of cost factors...; the major objective in selecting a method should be to choose the one. v/hich, under the circumstances, most clearly reflects periodic income.^7
Proponents of direct costing like to use the above state
ments to conclude that direct costing is acceptable.
Their arguments u.sually follow in this order:
1. The exclusion of all overhead inventory is unacceptable; since direct costing does not exclude all overheads, it is not clearly eliminated.
2. The Research Bulletin states that selection of a method means choosing the one v/hich most clearly reflects periodic income.
3. It follov/s that since direct costing is the only method that clearly reflects periodic income, ijoi^ "^® only cost method to be employed.' ^
Despite the fact that supporters of direct
costing try to prove the acceptability of direct costing
with the above arguments, the fact remains that it is
the result of taking a fev/ sentences out of context
and slanting them toward the desired ccnclusion. "Going
back to the statements of principles, it must be recog
nized that the plirasing calling for selection of a m-ethod
v/hich 'most clearly reflects periodic income' is a part
of the statement concerning the several possible assumptions
^^Ibid., pp. 28-29.
Frank L. Traver, "Improving the Status of Direct Costing for External Reporting," National Association of Accountants Bulletin, XIII '(196(7], 21.
17
as to the flov/ of costs, such as first-in first-out,
2Q average, or last-in first-out." - In conclusion, it can
be said that the American Institute of Certified Public
Accountants statements on inventory pricing have not been
interpreted to condone direct costing. At best, it can
be said that the American Institute has not ruled direct
costing out entirely.
The pronouncements of the American Accounting
Association also gives some indication as to whether
there is substantial authoritative support for direct
costing. The American Accounting Association deals
v/ith the cost of manufactured assets in the following
manner:
...the cost of a manufactured product is the sum of the acquisition costs reasonable traceable to that product and should fnclude both direct and indirect factors. The omission of any element of manufacturing cost is not acceptable.30
In other v/ords, the American Accounting Association feels
that direct costing is unacceptable for external purposes.
The dissenting opinion of tv/o of the seven members
of the American Accounting Association's Committee on
Concepts and Standards Underlying Corporate Financial
29 Ibid., p. 21.
30 American Accounting Association, Accounting
and Reporting Standards for Corporate Financial Statements, p. 4.
18
Statements is also of interest. Mr. Hill and Mr. Vatter
state in their dissent that:
The definition of product cost given in Section III (stated above) is so framed as to deny the acceptability, with reference to published financial reports, of those procedures known as "direct costing." "Direct costing" does not exclude from product inventory those manufacturing costs directly attributable to current production, that is, varying v/ith changes in the rate of manufacturing operations; it does exclude fixed manufacturing costs, on the ground that such invariant elements (like general administrative costs) ought to appear as expense of the period in. v/hich they are incurred. 31
In its conclusion the dissent states the follov/ing:
They therefore conclude that direct costing is at least as acceptable in accounting theory as is the conventional "full costing" concept. Moreover, they believe that the use of direct costing procedures will, in many cases, yield results more useful to investors as well as management.32
Although the majority opinion of the American Accounting
Association is that direct costing is not acceptable
for external reporting, the dissent must be kept in mind
when considering the future acceptability of direct
costing.
The Income Tax Status of Direct Costing
Before direct costing can become widely accepted
as a method for valuation of inventories, it must be
accepted by the Internal Revenue Service for income tax
• Ibid., p. 11. 2 Ibid., p. 11
19
reporting. In the follov/ing section, the acceptability
of direct costing for income tax: reporting v/ill be
discussed.
The Code and Regulations
The follov/ing principle as stated in the Internal
Revenue Code is to be applied v/hen dealing with inventories:
Whenever in the opinion of the Secretary or his delegate the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary or his delegate may prescribe, as conforming as nearly as may be to the best accounting practice in the trade or -.-. business and as most clearly reflecting the income.- "
The regulations explain that when considering merchandise
produced by the taxpayer, cost includes three items:
(l) The cost of tne materials and supplies used in con
nection with the product; (2) Expenditures for direct
labor; (3) Indirect expenses necessary for the production
of the pa rticular article, including in such indirect
expenses a reasonable proportion of management expenses,
but not including any cost of selling or return on cap
ital.* The first tv/o items above are direct material
and direct labor and are both included in inventory v/hen
direct costing is being used. The "indirect expenses,"
• Internal Revenue Code of 1954, Section 471 (Englev/ood Cliffs, New Jersey: Prentice-Hall, inc. 1965), p. 25204.1.
-^Income Tax Reg-ulation 1.471-3. (Englewood Cliffs, New Jersey: PrerrLice-Hall, Inc., 1968) p. 20,673.
20
hov/ever, are described broadly and require interpretation
before a conclusion can be reached about direct costing
and income taxes.
The Courts' Interpretation of the Code and Ptegulations
Court decisions might be expected to give inter
pretations of the tax law and regulations v/hich aid in
determining the status of direct costing. The following
are cases that are relevant to the question at hand.
Montreal Mining Co.- ^ In this case, the Com
missioner of Internal Revenue ruled that inclusion of
certain taxes in inventory v/as not within the meaning
of the tax law and regulations. The taxes in question
v/ere real and personal property taxes, state income
taxes, franchise taxes, social security taxes, and un
employment insurance taxes. The Commissioner said that
these taxes v/ere not indirect expenses. The exclxision
of these expenses resulted in a reduction in^"gross in
come from property" and consequently to reduce the deduc
tion for depletion. The court upheld the Commissioner
by ruling that these taxes v/ere not indirect expenses.
Frank G. Wikstrom & Sons, Inc.^ The Commissioner
^^Montreal Mining Company, 2 T.C. 688, affirmed on this issue C C A . 6, 1944, 33 A.F.T.R. 1660.
^^Frank G. Wikstrom & Sons, Inc., 20 T.C I\o. 45, May 15, 1953.
21
of Internal Revenue, in this case, objected to including
only direct labor and direct material in inventory. Other
exjjenses v/ere treated as period costs. The court upheld
the Commissioner v/hen he recomputed petitioner's inventory
including an allocated share of officers' salaries, rent,
taxes, depreciation, repairs, light, heat, power, insurance,
employees' welfare, factory stores, indirect factory labor,
vacation, holiday, and bonus pay.
The Geometric Stamping Co. The Commissioner
of Internal Revenue had accepted the tax returns of The
Geometric Stamping Co. for the years 1946-1948 v/hich were
prepared on the direct costing basis. For 1948, an over-
assessment of tax was discovered and petitioner received
a refund. In 1949-1950, the Coimnissioner found that
Geometric's taxable income had been understated by 1113,368
because of failure to include certain indirect expenses
in inventory. This finding reversed the position taken
in the previous years. The Tax Court ruled that the method
of reporting by the petitioner was acceptable because it
had been previously accepted by the Commissioner and had
been consistently applied through the years. The court
did not discuss the propriety of direct costing in its
• 'The Geometric Stamping Company, 26 T.C 301, May 22, 1956.
22
decision but ruled only on the grounds of consistency of
application.
Neil Machine and Engineering Cc^ The taxpayer
in this case was a corporation v/hich had acquired another
corporation that had reported on the direct costing basis
since 1937. McNeil accounted for the acquired corporation,
Lincoln Engineering Company, as a separate division. Tax
able income for the Lincoln Division was determined on
the direct costing method as had been done in the past.
The District Director of Internal Revenue at Cleveland,
Ohio, advised the taxpayer that deficiencies v/ould be
determined in plaintiff's federal income tax returns for
its taxable years ending December 31, 1956, 1957, and 1959.
The deficiencies v/ere based primarily on the Lincoln
Division's inventory for tax purposes. The District
Director adjusted Lincoln's inventory siich that the result
v/as the some as it would have been under absorption costing.
The Coimnissioner of the Court of Claims became
directly involved in the question of v/hether direct costing
was in accordance v/ith generally accejjted accounting prin
ciples and thus allowable for tax purposes. After much
discussion the Commissioner of the court of claims stated
in his recommiended decision the following summary:
"3 O
• McNeil Machine & Engineering Company v. U.S. U.S. Court of Claims, No. 66-63, March 29, 1967.
23
In summiary, the Lincoln method of valuing inventories prior to the merger clearly reflected income. It v/as a correct method because: (1) it had been consistently applied over a lengthy period of time; (2) it reflected an inventory valuation method supported by a substantial body of accounting authority and practice, and thus was v/ithin the scope of generally accepted accounting principles; and (3) it was in conformity v/ith income tax regulations.39
Conclusion. After reading the above cases, it
is difficult to determine the exact viev/ of the courts
concerning direct costing. In cases where it was to
the benefit of the Internal Revenue Service to allow
direct costing (Montreal Mining Co. ) it did so. V/hen
it v/as advantageous to the ta ipa er, direct costing
was not'allowed (Franlc Wikstrom & Sons, Inc.). • When
the taxpayer did v/in against the Internal Revenue Service,
it was because the method had been consistently applied
for a number of years. The most recent case stated above
is the McNeil Machine & Engineering Co. case. The fact
that the Commissioner of the Court of Claimis states -in
his recoimnended decision that direct costing is allov/able
for income tax purposes may indicate that direct costing
may, in the near future, become generally accepted for
income tax and other external reporting purposes.
^^Ibid., pp. 9-10.
24
The S.E.C and Direct Costing
Although the Securities and Exchange Commission
has-the authority given it by the Securities Act of 1933
to prescribe its own accounting principles, it has been
content to rely on generally accepted accounting principles
in most instances.^ The S.E.C requires that statements
filed with it must be corrected for "material" items not
in accordance v/ith generally accepted accounting principles.
It is not sufficient merely to disclose the fact in a
footnote. It is a fundamental rule in S.E.C v/ork that dis
closure of an improper accounting practice does not obviate
the need for correcting the statement.
Louis H. Rappaport, in his book S.E.C Accounting
Practice and Procedure, states that:
Sometim.es the omission of overhead from inventory does not have a material effect either on the financial position or on the results of operations during the period under report. In that case the S.E.C has accepted registration statements containing financial statements v/hich disclosed the facts and stated that the statements had not been adjusted.42
It is knov/n that at least one compan y has succeeded
in reporting on a direct costing basis for S.E.C filings.^"^
Louis H. Rappaport, S.E.C Accounting Practice and Procedure—Second Edition (Nev/ York: The Ronald Press Company, 1962), pp. 3.1-3.2.
" • Ibid., p. 9.3.
^^Ibid., p. 9.3.
•^Robert W. Hirsliman, " D i r e c t C o s t i n g and t h e Law," Account ing Review, XL, No. 1 ( J a n u a r y , 1962) , 179.
25
It is believed, hov/ever, that these filings are few in
number since inventories with an omission of manufacturing
costs v/ould be subject to close scrutiny by the S.E.C in
its determination of a material effect on financial posi
tion and results of operations during the period.' ^
Conclusion. S.E.C regulations, like tax regula
tions, do not state wjiether direct costing is or is not
acceptable. It v/ould seem, however, that a company could
omit certain manufacturing overhead from inventories if
it did not have a material effect upon the statements and
provided that proper disclosure was made.
Summary and Conclusion
The incurrence of a cost in t.he present period
must reduce a future cost before that present cost can
justifiably be carried to future periods in the form of an
asset. This future benefit is called service potential.
The going concern assumption is the only assujuption about
the future needed to demonstrate service potential for
most unexpired costs. Hov/ever, to demonstrate service
potential for fixed factory overhead, two oxher assump
tions must be made. These assujiiptions are that future
sales v/ill be in excess of maximum production capacity
and that variable costs v/ill increase. Accounting,
" Ibid., pp. 179-180.
26
hov/ever, has consistently disallov/ed assumiptions about
the future other than the going concern assumption; there
fore, the above two assumptions are not justified.
Fixed vactory overhead by its very nature expires
each accounting period to be replaced the next period by
nev/ costs. Fixed costs do not contain service potential
since they do not reduce cost incurrence in future periods.
Without service potential a cost cannot be capitalized.
Therefore, fixed factory overhead should not be included
in the cost determination of inventories. Since direct
costing does exclude fixed factory overhead from inven
tories, it is consistent v/ith basic accoLinting theory.
Companies and accounting practitioners look to
three places to determine if an accounting procedure is
acceptable for external reporting. These are the American
Accounting Association, the Internal Revenue Service, and
the Securities and Exchange Commission. It v/as pointed
out that both the A.I.CP.A. and the A.A.A. are generally
opposed to direct costing. The I.R.S. and S.E.C both
take about the same stand on the subject. Both will allov/
direct costing but only under certain conditions. Although
it is difficult to generalize, it must be concluded that
under most circumstances, direct costing is unacceptable
for external reporting.
CHAPTER' III
DIRECT COSTING IN EXTERNAL FINANCIAL
REPORTS—THE NEGATIVE VIEVvPOINT
In the preceeding chapter it was decided that
fixed factory overhead costs do not benefit future periods;
therefore, these fixed costs should not be included in the
cost determination of inventory. It v/as also indicated
that since the American Institute of Certified Public
Accountants does not feel that direct costing is consist
ent with generally accepted accounting principles, direct
costing is unacceptable for external reporting. In this
chapter the arguments of those who are opposed to direct
costing are presented.
The Theory of Manufacturing Costs
Philip E. Fess, in his paper entitled "The Theory
of Manufacturing Costs," examines the conceptual basis
of manufacturing costs." ^ Dr. Fess attempts to determine
if there is a significant difference betv/een fixed and
variable manufacturing costs v/hich justifies the treat
ment of fixed manufacturing costs as a period cost and
variable manufacturing cost as a product cost.
" Philip E, Fess, "The Theory of Maiiufacturing Costs," The Accounting Review, XXXVI (July, 1961), 446-
27
28
Before costs can be divided into fixed and vari
able, there must be a time period involved. A cost is
fixed in total for some period of tim.e and a cost is
variable in total for some period of time. If there v/ere
no time factor, there would be no such thing as fixed
costs. Over a long enough period of time, all costs would
be variable. Because of the demand for periodic statements,
the accounting profession is tied to time periods; there
fore, certain costs are treated as fixed costs and others
as variable costs.
Dr. Fess discusses the nature of manufacturing
costs from three viewpoints in an attempt to determine
whether costs are fixed or variable because of an inh.erent
characteristic of that cost or whether t.his fixed and
variable classification is the creation of the user.
Costs are examined (l) as a beneficial interest in assets,
(2) as cash outflov/s, and (3) as an expense or a loss.
Cost as a Beneficial Interest in Assets
Assets, other than cash and receivables, are
bundles of services that will be used by the business
to accomplish its objectives. These assets are acquired
for the future service that the asset contains. The
business, in turn, makes these services available to its
customers. Tor these services the business receives other
assets and the potential services that are embodied in
them. This exchange results in revenue and expense.
29
Revenue is the m-oney measure of the services transferred
to customers and expense is the money measure of the ser
vices exchanged with the customers in retu-rn for the
revenue.
Basically, the prirae consideration for a business in contemplating the purchase of an asset is the services which the business believes an asset v/ill render and the future contribution these assets can make to the achievement of the business goals. For example, a plant is not purchased for the sake of ov/ning masonry but for the services it will provide, machinery is purchased for the services the machine v/ill furnish, and so forth.46
Dr. Fess then concludes that since all assets are
purchased for the benefit that can be derived from those
assets, all asset costs should be divided betv/een the goods
produxed by the manufacturing process v/hich benefit from
those asset services. The cost of a iinit produced would
be found by a determination of the amount of benefit that
a unit received from all other assets of the firm. Ac
countants, hov/ever, in trying to furnish management with
useful cost data do not classify all costs in terms of
benefits because of the inability to determine to what
extent units are benefited by asset services. The result
is the division of manufacturing costs into the fixed—
variable classification. The point made here is that all
costs are incurred because of the service potential that
they contain v/ith no differentiation betv/een fixed and
^^Ibid., p. 448.
30
variable costs. The accountant divides costs into fixed
costs and variable costs because of the inability to measure
the benefits received by a unit of product.
In the real sense the use of expected services
represents the basis for the charge-off of asset cost.
Both the so-called fixed and variable costs are used to produce revenue. Accountants may choose to spread the asset cost over periods of time, and in fact they often do so, but this does not make real the assimption that fixed costs expire v/ith periods of time. Therefore the fixed cost concept is more an accounting creation than reality of the situation.4/
Cost as Cash Outflows
Dr. Fess, in changing from the benefits viewpoint
to the cash, outlay viewpoint, divides manufacturing costs
into three categories: (l) current cash outflov/s, (2)
near ca,sh outflow items, and (3) distant cash outflow
items. Current cash outflov/s v/ould be represented by
salaries and other resources that are used as acquired.
Near cash outflow items are supplies and materials that
v/ere just previously acquired by cash and will be used in
the current year. Distant cash outflow items are buildings
and machinery which provide services beyond the current
period.
Although the second and third categories are not
directly related to outflows of cash, they represent
^^Ibid., p. 448.
31
outflov/s of service values that help produce revenue.
Both current cash outflov/s and the near and distant cash
outflows represent an outflov/ of value and there should be
no supposition that one is more important than the other.
In this viev/ it seem.s illogical to conclude that assets
of a distant cash nature should in no way be considered
an element of product cost.
Cost as an Expense or Loss
Dr. Fess states that there might be an attem.pt to
support the assignment of fixed costs as period costs and
variable costs as product costs on the grounds tha,t fixed
costs represent losses and are therefore proper period
charges while variable costs represent services purposely
used to provide revenue. Dr. Fess cites supervisory
salaries as a fixed cost v/hich represents services pur
posely used to repudiate such a distinction between fixed
and variable costs, "Only in the sense that service re
sources d-eteriorate or expire v/ith the passage of time can
any V8,lid distinction be made among service resources on a
time basis, and this distinction is not the one used in
separating manufacturing costs into fixed and variable / o
elements."
^^Ibid., p. 449.
32
Conclusion of Dr. Fess
This section attempted to determine v/hether there
is a significant difference between fixed and variable
manufacturing costs that justify treating one as a period
cost and other as a product cost. Dr. Fess concluded that
the distinction between fixed and variable costs cannot
be supported through viev/ing cost as a beneficial interest
in assets, nor can the distinction betv/een service re
sources used and lost, nor betv/een cash and non-cash
resources used. Therefore, there is no supportable dis
tinction betv/een fixed and variable manufacturdng costs on
the theoretical level. In other v/ords, the nature of
manufacturing costs indicated that there is no significant
difference betv/een fixed and variable costs that would
warrant different accounting treatment.
Basic Accounting Assumptions
The going concern assiimption which was explained
earlier in this thesis is the most important assumption
involved in the discussion of direct costing. The going
concern concept assLimes the long run, and in the long run,
all costs are variable costs. Thus, under the going con
cern approach, all mianufactuning costs are costs of
production. Absorption costing treats all manufacturing
as product costs.
Direct costing viev/s manufacturing costs as part
fixed and part variable. The variable costs attach to the
33
product and fixed costs are v/ritten off in the period
incurred. From the going concern or long run view, all
costs are variable and any purchased services left unused
at the end of the accounting period should be deferred
until future periods since an accounting period is only one
segment in the life of the business. Direct costing then
is in violation of the going concern concept since it does
not defer fixed manufacturing costs to be matched v/ith the
revenue that the cost produces. Absorption costing does
defer the fixed cost and therefore adheres to the going
concern concept.
It is the duty of accounting to report in the ac
counts and statements only transactions that are supported
50 by verifiable, objective evidence. In other v/ords, the
accou-ntant should report transactions as they really happen,
All manufacturing costs, whether fixed or variable, are
incurred for the purpose of contributing towa.rds produc
tion. Therefore, to obtain the highest degree of reality,
all manufacturing costs should be assigned to the product.
Absorption costing and not direct costing comes closer to
what actually happens in the production of goods.
p. 450. ^^Fess, "The Theory of Manufacturing Costs,"
^^Paton and Littleton, Aii Introduction to Corporate Accounting Standards, p. 4^
34
The Theory of Income Measurement
This section attempts to show that direct costing
is not appropriate for income determination. To do this
it reconsiders the process of income measurement and
develops the following cost categories relevant to income
measurement:
(1) costs of unused service potentials, (2) costs of used service potentials related to
future inco2iie transactions, (3) costs of used service potentials related to
current income transactions, and c-i
(4) costs of wasted service potentials.
The discussion of the process of income measurement
is an attempt to determine v/hen income is earned. In other
words, is income earned at a point in time, that is at the
point of sale, or is income earned over a period of time,
that is during the entire process of production and sale?
It will be seen that income is earned as utility or
value is added to the factors of production.
Time and place utility are added to the factors
of production by bringing the factors of production to
gether. Combining the factors of production results in
form utility. Delivery to a customer adds place utility
resulting in an increased value to the factors of produc
tion. The addition of utility throughout the production
^Philip E. Fess and William L. Ferrara, "The Period Cost Concept for Income Mea^surement—Can it be Defended?" The Accounting Review, XKXVI (October, 1961), 602.
35
and selling process has been Called the "value added"
approach to income determination.-^
From another point of view, it can be said that in
come is earned by the totality of all business operations.
...revenue is "earned" during the entire process of operation reflected in the accumulation of costs assignable to product. This viev/ is in accord v/ith the basic assumption that all necessary activities, including distribution as well as technical production in all its phases, contribute to the final result, and hence to revenue...53
Under the "value added" approach to income measure
ment, income is measured in terms of the value added to
the factors of production from the initial raw material
purchase, through the production process, to the point of
sale. Matching becomes the process of comparing total
factor costs plus value added to date v/ith total factor
costs plus value added at the beginning of the period.
This matching process results in income which is the amount
54 of value added during the period. To sujmnarize, income
is considered earned v/hen and to the extent that utility
is added to the factors of production.
In a company v/ith no inventories, there would be
no problem in income measurement since there v/ould be no
^^Ibid., p. 599.
• Paton and Littleton, An Introduction to Corporate Accounting Standards, p. 4b-
54 Fess and Ferrara, "The Period Cost Concept for
Income Measurement—Can it be Defended?" p. 599.
36
value added in the form of time, place, and form utility
to any factors of production other than those sold. Income
v/ould be determined by comparing sales v/ith the cost of
obtaining those sales, V/hen inventories are involved, the
problem of valuation of xhat inventory arises. In keeping
v/ith the value added approach, the valuation of the three
types of inventories v/ould be as follows:^^
Type of Inventory
Raw Materials
Y/ork-In-Process
Finished Goods
Basis of Valuation
56 Cost plus time and place utility added since purchase.
Cost56 plus time and place utility added since purchase plus form utility proportionate to stage of com.pletion.
Cost56 plus time and place utility added since purchase plus form, utility.
Stated in another v/ay, one v/hich associates the valuation of trade receivables and inventories, asset valuation v/ill be as follov/s:
Type of Asset
Trade Receivables Finished Goods
Y/ ork- In-Pr o c e s s
Basis of Valuation
Sales Price Sales price less costs of dis
position and utility acquired through sale and delivery.
Sales price less costs of completion, costs of disposition, form utility related to incomplete portion, and utility
^^Ibid., p. 599.
56 Cost includes all costs of input factors. Rav/
materials cost includes the costs of rav/ miaterials. Work-in-Process and finished goods includes rav/ material costs as well as applicable labor and overhead costs. Thus, utility as used here is a net concept, i.e., it includes the net valiie added to the factors of production during the operating cycle.
37
acquired through sale and delivery.
Close evaluation of the above v/ould result in the con
clusion that inventory valuation is based on cost plus
value added to date. Income earned during the period v/ould
be equivalent to the value added to productive factors dur-
ing the period.-^
Current Practice and the Value Added Concept
It appears that the value added concept and what
is currently practiced are unrelated. Both methods, hov/-
ever, support a matching process v/here the cost of obtain
ing a certain revenue is matched against that revenue. The
only difference betv/een v/hat is currently practiced and the
value added aiDproach is the point at v/hich revenue is
considered earned. The value added concept considers
revenue earned as value is added to the factors of pro
duction throughout the production and selling process.
Current practice considers revenue earned at -the point of
sale. In other v/ords, it delays the recognition of revenue
until it can be objectively determined. The delay is
justified because of the inability to measure the utility
increments and value the public would place on those
• Fess and Ferrara, "The Period Cost Concept for Income Measurement—Can It Be Defended?" p. 599.
38 58 utility increments. Thus, the value added concept
measures t.he amount of revenue thought to be earned rather
than the amount of revenue actually'- earned as determ.ined
by values placed on goods in the market.
The value added concept recognizes only tv/o types
of assets; (l) cash-type assets and (2) costs of unused
59
service potentials related to unearned revenue. - Cash-
type assets include cash, receivables, and those invento
ries with some form of place, form, or time utility lacking.
The costs of imused service potential are those that are
related to factors of production. If revenue recognition
is to be delayed to obtain objectivity, then the costs
incurred to earn that revenue m-ust also be delayed. Once
the service potential of costs are used up, those costs
must be matched with the revenue those costs produce.
The current practice of delaying revenue recogni
tion until it can be objectively determined results in
three categories of assets; (l) cash-type assets, (2) costs
of unused service potential related to unearned revenue,
and (3) costs of used service poten-tial related to earned
^ Paton and Littleton, An Introduction to Corporate Accounting Standards, p. 49.
^%ess and Ferrara, "The Period Cost Concept lor Income Measurement—Can It Be Defended?" p. 600.
' Paton and Littleton, A:n Introduction to Corpo-rate Ac c ount ing St and ard s, p. 15.
39
but unrecognized revenue. The third category of assets
is the result of the delay of revenue recognition. The
assets in the third category, rav/ material v/ork~in-process,
and finished goods inventories, represent factor costs that
are delayed until revenue is recognized. The delayed costs
have not.hing to do v/ith future benefit. They are related
to the entire process of production and sale and represent
the costs of form, time, and place utility v/hich have been
used up in the acquiring of delayed revenue.
Those v/ho claim that only variable costs of manufacturing should be inventoried on the basis that only variable costs are beneficial to the firm in terms of reducing future cost outlays misunderstand the very nature of revenue measurement v/hen the recognition of income is delayed. Future benefits have nothing to do v/ith the valuation of inventories. Inventories are simply an expression of all costs used up in the process of acquiring revenue which has not yet been recognized.62
Manufacturing costs can be classified into more
than just fixed and variable costs. For example, costs
can be divided into controllable and non-controllable,
avoidable and unavoidable, et cetera. However, these
categories are not relevant to income measurement. The
only categories v/hich are relevant are the following:
(l) costs of unused service potentials, (2; costs of used service potentials related to
future income transactions,
61 Fess and Ferrara, "The Period Cost Concept
for Income Measurement—Can It Be Defended?" p. 600.
^^Ibid., p. 600.
40
(3) costs of used service potentials related to current income transactions, and ^^
(4) costs of wasted service potentials. -
Categories one and tv/o are balance sheet items
v/hile categories three and four are income statement items.
If the service potential has not been used (category one),
the cost must be treated as an asset. If the service
potential has been used but is related to revenue that is
delayed (category tv/o), the cost must be treated as an
asset. If the service potential is used for the acquiring
of current revenue (category three), the cost must be
treated as an expense for the current period. If the
service potential has been v/asted (category four), the
cost must be expensed in the current period.
Costs in category four are the only true period
costs. The other categories are costs v/hich should be
recognized when the revenue which they helped to earn is
recognized. If costs are not treated as stated above,
income canjiot be properly measured.
Producing a.nd Standing Ready to Produce
When presenting the arguments for direct costing
in chapter tv/o, it was stated that fixed factor ?- overhead
costs are not costs of producing, but are costs of standing
• Ibid., p. 601.
^^Ibid., p. 602.
41
ready to produce and will be incurred v/hether production
takes place or not. This argument indicates to LII*. Kenneth
Lerake that "proponents of variable costing for income
determination seem to confuse the use made of services
65 acquired by the incurrence or accrual of these costs,"
Mr. Lemke agrees that if facilities remain idle, fixed
costs do represent standing ready to produce. This
results in idle capacity expense; but, to the extent that
facilities are utilized, they have ceased to be standing
ready to produce, but are in fact producing.
Standing ready to produce is not an end in itself
but a means to an end. To say that certain costs are costs
of producing v/hile other costs are costs of standing ready
to produce is "a play on v/ords v/hich fails to sever the 66
connection with products." Both fixed and variable
manufacturing costs are incurred in anticipation of produc
ing goods v/hich will result in revenue; both costs are
necessary to earn that revenue. It seems logical then
to state that both fixed and variable costs are product
costs.
...if one v/ere to say that the "used up" fixed manufacturing costs v/ere not to be charged to product, he v/ould in effect be saying that there was no service potential in.herent in fixed
^Kenneth W. Lerake, "The Fallacy of Income Determination by Variable Costing," The Australian Accountant, XXIV (June, 1964), p. 315.
Ibid,, p. 316,
42
.production factors acquired. This, of course, v/ould be ad.mission that the acquisition of fixed cost factors is an unwise and non-essential spending decision. Fixed costs are obviously necessary to operations as ar y other costs.... All costs, both fixed and variable, contribute to production and add value to the product.67
Services used up in producing nothing should be treated
as idle cax)acity expense—a loss of the period in which
idleness occurs. Services used up in production of 68 goods should be allocated to those goods produced.
Suimnarv M . . f.* II
In this section direct costing in relation to
basic 8.ccounting theory was discussed from the viev/point
of those opposed to direct costing. It v/as stated that
direct costing violated the going concern assumiption
and did not present the facts as objectively as absorption
costing. A theory of income measurement v/as developed
v/here revenue was found to be earned as utility or value
was added to the product even though current practice
delays the recognition of that revenue. The costs of
used service potentials related to the delayed revenue
should also be delayed until the revenue is recognized.
Philip E. Fess, "The Relevant Costing Concept for Incom.e Measurement—Can It Be Defended?" The Accounting Review, XXXVIII (October, 1963), 729.
/TO
Lemke, "The Fallacy of Income Determination by Variable Costing," p. 316.
43
In other words, when facilities are producing revenue,
the cost of those facilities should be assigned to the
goods produced.
CHAPTER IV
SUIMARY Al-D CONCLUSION
In chapter two the case for direct costing v/as
established. It v/as stated that for a cost to be capital
ized by carrying it forv/ard to future periods in inven
tory, the cost incurred v/ould have to contain some future
benefit. This future benefit is called service potential.
Before fixed facxory overhead costs can possess the service
potential necessary to allow it to be capitalized, tv/o
assumptions other than the going concern assumiption have
to be made. These two assumptions are that future produc
tion v/ill be at maximum capacity with future sables in
excess of maximum production capacity and that variable
costs are expected to increase. The fact that assumptions
other than the going concern assumiDtion must be made
indicates that fixed manufacturing overhead costs should
be treated as expenses of the period.
Support for direct costing has also been cD.aimed
through the concept of relevant costs. This cor.cept states
that the only costs relevant to decision making are those
that v/ill be different from one period to the next. Since
fixed factory overhead costs remain the same period after
period, they are irrelevant and have no influence on the
44
45
future. Therefore, fixed vactory overhead costs should be
excluded from inventory cost valuation.
The proponents of direct costing set forth as their
argument the very nature of fixed factory overhead. Fixed
factory overhead is a fixed cost; that is, the cost is
incurred whether production takes place or not and expires
at the end of the accounting period to be replaced by new
costs. Fixed costs then do not contain future service
potential and should not be carried forv/ard to future
.periods in inventory.
Chapter tv/o also discussed .the acceptability of
direct costing for external reporting. It v/as found that
accountants look to three places to determine if a practice
is acceptable for external reporting: (l) the professional
organizations; (2) the Internal Revenue Services; and
(3) the Securities and Exchange Comjnission. Examination
of the literature published by and about the above three
authorities revealed that direct costing has not reached
the status of acceptability for external reporting in most
cases. The American Institute of Certified Public Ac
countants has indorsed absorption costing through Account
ing Research Bulletin No. 43, even though it does not deal
with the siibject directly. The American Accounting Associ
ation deals directly with direct costing and concludes
that it should not be used for external reporting. The
Internal Revenue Service and Securities and s^chcjipie
" ^
46
Commission have about the same opinion concerning direct
costing. They allow the use of direct costing v/here the
difference resulting between it and absorption costing is
immaterial.
Chapter three presented the case against direct
costing. Philip E. Fess' paper entitled "The Theory of
Manufacturing Costs" was presented first. .Dr. Fess tried
to determine if there was a significant difference between
fixed factory overhead costs and variable factory overhead
costs. It was found that the distinction between fixed
and variable costs can.not be supported through viev/ing
cost as a beneficial interest in assets, nor can the dis
tinction between service resources used and lost, nor
betv/een cash and non-cash resources be used. Therefore,
Dr. Fess concluded that there is no supportable distinc
tion betv/een fixed and variable factory overhead costs
that v/ould justify different accounting treatment.
A theory of income measurement was then discussed.
Revenue v/as considered to be earned v/hen utility or value
was added to the product. Hov/ever, due to the inability
to measure the amount of utility added, the recognition
of revenue v/as delayed until the time of sale. The costs
of used service potential related to the delayed revenue
should also be delayed until the revenue is recognized.
This is what absorption costing doss that direct costing
does not.
47 Conclusion
The proponents of direct costing have a tempting
argument when they state that fixed costs expire furing '
the period and therefore should be treated as an expense
of the period incurred. However, they are also stating
that fixed overhead costs do not contribute to the
manufacture of the product. It is difficult to conceive
of a large amoimt of fixed cost incurred that does not
contribute to production, then those costs Fiust be dis
tributed among the goods produced.
The follov/ing quote ^Qy Dr. Fess suimnarizes very
v/ell the feelings of the author:
...It can be said that the v/hole direct costing versus absorption costing controversy boils dov/n to the fact that different presentations of costs are needed for different pui poses. A concept of replacement cost may be useful in judging the cost of maintaining plant ana equipment, differential costs "may be helpful for deciding betv/een different alternatives, direct costs may provide valuable cost data for pricing and production plarining purposes, absorption costing is necessary for published financial statements, and so forth. Different concepts of cost for different purposes may be hard for somie accountants to accept because the inlierent nature of the human being seems to urge him to seek the one factor, concept, or v/hatever which will serve as the answer to a multitude of problems. For published financial statements, absorption costing is a requirement; for other uses direct cos'uing may prove beneficial.69
p. 453.
go - Fess, "The Theory of Manufacturing Cos-cs,"
BIBLIOGRAPHY
Books
Brummet, Leer. Overhead Costing, The Costing of Manufactured Products. Ann Arbor., Michigan: Bureau of Bi;.siness Research, University of Michigan, 1957.
Esquerre, Paul-Joseph. The Applied Theory of Accounts. New York: Ronald Press Company, 1914.
Kohler, Eric L. .A Dictionary For Accountants—Second Edition. Englewood Cliffs, New Jersey: Prentice-Hall Inc., 1957.
Lenhart, Norman J., and Defliese, Pliilip L. Montgomery's Auditing—Eighth Edition. Nev/ I'"ork: Ronald Press Company, 1957.
Marple, Raymond P., ed. National Association of Accountants on Direct Costing—Selected Papers. New York: The Ronald Press Company, ISGTi
Moore, Carl L., and Jaedecke, Robert K. Managerial Accounting. Cincinnati, Ohio: South-Western Publishing C ompany, 1963.
Paton, V/. A,, and Littleton, A, C An Introduction to Corporate Accounting Standards. Chicago: American Accounting Association, 1940,
Rappaport, Louis H. SEC Accounting Practice and Procedure—Second Edition. Nev/ York: The Ronald Press Company, 1963.
Reimer, Kenneth Frank. A Case for Direct Costing. Un-' I I • - M I 1 •••.•••I !••• t^um ..• . I - - - - - - - ._i^,<.
published Masters Thesis, Texas Technological College, 1962.
Stettler, Howard F, Auditing Principles. Englewood Cliffs, Nev/ Jersey: Prentice-Hall, Inc., 1961.
V/right, WiImer, Direct Standard Costs for Decision Making and Control. Nev/ "Yorkl McGraw-Hill Book Company.'," Inc., 1952.
48
49 Periodicals
Brausch, John J, "Progress or Folly." Journal of Accountancy. XCII (August, 1961), 5^^=W:
Brecht, David H. "Direct Costing's Acceptability in Relation to Theoretically Sound Accounting Principles." The Texas Certified Public Accountant, XXXVII (April,~T9'F5), 20~2Zr
Bujrrows, C A. "Variable Versus Absorption Costing." Australian Accountant, XXXV (August, 1965),
• ?^5~429.
Ferrara, V/illiam L. "Are Direct Costs Relevant Costs?" Journal of Accountancy, CXII (August, 1961).
. "Relevant Costing—Tv/o Points of Viev/." Accounting Review, XXXVII (October, 1963), 7l9-7'22"r
. "Responsibility Reporting vs Direct Costing— Is There a Conflict?" Managemient Accounting, XLVIII (June, 1967), 43 =54
Fess, Philip E. , and Ferrara, Williaifl L. "The Period Cost Concept of Income Measuremxent—Can It Be Defended?" Accounting Review. XXD VI (October, 1961), 598-602.
Fess, Philip E. "The Relevant Costing Concept for Income Measurem.ent—Can It Be Defended?" Accounting Review, XXXVIII (October, 1963), 723-7321 ""
"The Theory of Manufacturing Costs." Account-"~ ing Review, XXXVI (July, 1961), 446-453.
Fremgen, James M. "The Direct Costing Controversy—An Identification of Issues." Accounting Review, XXX]:X (January, 1964), 43-51.
_. "Variable Costing for External Reporting—A Reconsideration." Ac c ount ing Re viev/, X orvll (January, 1962), 76^^1.
Green, David Jr. "A Moral to the Direct Costing Controversy?" The Joirrnal of Business, iSXIII (July, I960), 2l8-2Fb7~~
50
Green, Howard C "Alternatives to Direct Costing." NAA on Direct Costing—Selected Papers. Edited by Raymond P. Marple. New York: "Ronald Press Company, 1965.
Harris, Jonathan N. "What Did We Earn Last Month?" NAA on Direct Costing—Selected Papers. Edited by Raymond P. Marple. New York: Ronald Press Company, 1965.
Hirslunan, Robert W. "Direct Costing and the Law." • Accounting Review, XL (January, 1965), 176-183.
Horngren, Charles T., and Sorter, George H. "'Direct' Costing for External Reporting." Accounting Review, XXXVI (January, 1961), 84-93^ "
Kohl, Clem N. "What Is Wrong With Most Profit and Loss Statements." NA.A on Direct Costing—Selected Papers. Edited by Raymond P. Marple. Nev/ York: Ronald Press Company, 1965.
Lerake, Kenneth V/. "Biased Matching Concepts of Direct Costing." Management Accountino?:, XLVIII (April, 1967), 51-54.
The Fallacy of Income Determination by Variable Costing." Australian Accountant, XXXIV (June, 1964), 314-319.
Ludv/ig, John Y/. "Inaccuracies of Direct Costing." NAA on Direct Costing—Selected Papers. Edited by Raymond P. Marple. Nev/ York: The Ronald Press Company, 1965.
Mauriello, Joseph A. "Convertibility of Direct Costing and Conventional Costing." NAA on Direct Cost-ing--Selected Papers. Mited by Raymond P. Marple. New Nork: ThleTonald Press_ Company, 1965.
Meikirk, Waldo W. "How Direct Costing Can Work for Management." National Association_^f_ Accountants Bulletin, XXKlTTJa^i^ary, T95lTr~523-535 .
Parker, John R. E. "Give Consideration to Direct Costing for i xternal Reporting." NAA on Direct Costing-Selected Papers. Edited by Raymond P. Marple, New York: The Ronald Press Company, 1965.
Shearer, Leonard L. "Direct Costing for Sales Pricing and Profit Planning." Mgmagement Accounting, XLVIII (July, 1967). 17-23". '
51
Traver, Frank L. "Improving the Status of Direct Costing I or External Reporting." National Association of Accountants Bulletin, XLII~ January, 19*'6"0), 19-30.
Wetnight, Robert B. "Direct Costing Passes the Future Benefit Test." NAA Bulletin, XXXIX (August, 1958), 83-84. v e> ,
Others
American Accounting Association. Accounting and Reporting Standards for Corporate Financial Stateinents— 1957 Revision. Columbus: American Accounting Association, 1957,
American Institute of Certified Public Accountants. Accounting Research Bulletin No. 43. New York: American Institute of Certified Public Accountants, 1953.
"Opinions of the Accounting Principles Board No. 6." New York: American Institute of Certified Public Accountants, 1965.
Geometric Stamping Com-pany v U. S. 26 T.C 301.
Income Tax Regulation 1.471-3. Prentice-Hall Federal Tajces,' Vol. 3, Englev/ood Cliffs, Nev/ Jersey: Prentice-Hall, 1968.
Internal Revenue Code of 1954, Section 471. Prentice-Hall Federal Ta:>ces, IriO Volume, Englev/ood Cliffs, Nev/ Jersey: Prentice-Hall, Inc., 1965.
McNeil Machine and Engineering Company v U. S. U. S. Court of Claims*," No."~T5 "6"3", March"29', 19W.
Montreal Mining Company v Commissioner of Internal Revenue. 33 A.F.T.R.' ' I960.
Naticnal Association of Accountants. "Current Application of Direct Costing," Research Series ..No.__3J/_. New York: National Assoc"iation of Accountants, 1962.
, "Direct Costing," Research Series No. 23. Nev/ York: National Association of Accountants, 1953.
Wikstrom, Frank G. & Sons, Inc. v U. S. 20 T.C. 359.
APPENDIX
ILLUSTRATION TO SHOW EFFECT OF VOLUIIS ON NET PROFIT
COMPARISON BETWEEN ABSORPTION COSTING AND
DIRECT COSTING METHODS
Basic Data Assumed For Illustration
Quarterly Budget (In absorption costing form)
Total Per Unit
Sales (30,000 units) 1 30,000 Si.00 Cost of Goods Sold
Variable costs 19,500 .65 Fixed costs _ 6,000 .20
Total 25750O 7B5 Gross Margin 4,5'Od .15" Selling and Administrative Costs 2j_lQ£ .07 Operating Profit . . . OliOO ^ .08*
Actual Production and Sales in Units
. Quarters Year 1st 2nd 3rd Wh
Opening Inventory - - 6,000 2,000
Production . . . . 30,000 34,000 28,000 30,000 122,000
Sales 30,000 28,000 32,000 32,000 122,000
Closing Inventory - 6,000 2,000
Source: National Association of Accountants, "Direct Costing," Research__JerJ^;^J^ (New York: National Association "of Accountants, 19:^3), P- 35.
52
53
Income Statement by Quarters and for Year
1* Using Absorption Costing v/ith Fixed Manufacturing Costs Charged to Production
Quarters Year
Sales
Cost of Goods Manufactured
Add Opening Inventory . . .
Goods Available
Deduct Closing Inventory . .
Cost of Goods Sold . . . .
Gross Me.rsin
1st 2nd 3rd 4 th
$30,000 $28,000 $32,000 $32,000 $122,000
25,500 28,100 24,200 25,500 103,300
4,959 1,729
25,500 28,100 29,159 27,229
4,959 1,729
25,500 23,141 27,430 27,229 103,300
4,500 4,859 4,570 4,771 18,700
Selling and Administrative Costs 2,100 2,100 2,100 2,100 8,400
Net Operating Profit . . . . $ 2,400 $ 2,759 ;2,470 3 2,671 $ 10,300
54
2. Using Direct Costing with Fixed Manufacturing Costs Treated as Period Costs
Quarters Year 1st 2nd 3rd 4th
Sales $30,000 $28,000 $32,000 $32,000 $122,000
Cost of Goods Manufactured . 19,500 22,100 18,200 19,500 79,300
Add Opening Inventory . . . . - ~ 3,900 1,300
Goods Available . 19,500 22,100 22,100 20,800
Deduct Closing Inventory . . . - 3,900 1,300
Cost of Goods
Sold 19,500 18,200 20,800 20,800 79,300
Marginal Income . 10,500 9,800 11,200 11,200 42,700
Fixed Costs
Manufacturing . 6,000 6,000 6,000 6,000 24,000 Selling and Administrative. 2,100 2,100 2 ,100 2,100 8,400
Total 8,100 8,100 8,100 8,100 32,400
Net Operating Profit . . . . $ 2,400 $ 1,700 $ 3,100 $ 3,100 $ 10,300
A
