The second class consists of those who, as a rule, have no security for their claims, but who are still willing to advance their capital for a limited period to the managers. They may receive compensation in the way of interest or their compensation may take the form of profits realized merchandise sold to the managers.
The third class consists of those who have had suf ficient confidence in the management and in the enter- , prise to give them title to the use of their property for a specified number of years under a lease, and who have exacted compensation or their share of the profits of the enterprise in the form of a stated armual rental.
The last class embraces those who have risked their capital in the business enterprise for the purpose of reserving to themselves all of the profits that result after their fellow-contributors in the business enter prise have been paid their stated sums.
10. Is interest on capital part of cost of produc tion?—The realization of the foregoing facts in their full significance will do more than anything else to clear up the subject of charging interest on capital as a part of the cost of production. The reader will have noted in the Text on "Cost Finding" that many engineers and accountants favor the method of charg ing interest on capital as a part of the cost of produc tion. The author holds that excepting for statistical purposes this practice is entirely incorrect in prin ciple, for the following reasons : From an economic standpoint the entire profit of a business after the first three classes of contributors to an enterprise mentioned on page 232 have been paid, is profit from business operations. The capital employed by the managers in the venture cannot earn two kinds of income, viz., interest and profit.
'The charge for interest on invested capital as a part of the cost of production necessitates a bookkeeping entry of a debit to interest expense account, and a credit to an interest earning account. These entries cancel each other in the profit and loss summary, so the net result as far as the ultimate profit is con cerned is the same whether the entry has been made or not. There is this important difference, however; a fictitious entry has been made in the account for interest expenses that will never be paid in cash, and for an interest income that will never be realized in cash. Moreover, interest on capital investment, being charged as a part of the cost of production, will load the cost of 'production with an element of ex pense for which no liability has been incurred and for which a direct outlay in cash will never be required.
11. Difficulty of selecting correct if it were assumed that the principle under discussion is correct, there is still another difficulty to be confronted in selecting a rate of interest. It is just as reasonable to select four per cent as it is eight per cent, but one can readily see that the computed cost would be dif ferent in different organizations if the same rate of interest were not selected in all cases.
If interest is to be charged for the use of capital the time element must be considered and the charge must be made only for the exact time that the money has been employed in production. The calculations involved in this would be an almost impossible prop osition from a bookkeeping standpoint.
The manner in which capital is provided cannot possibly affect the cost of production, for the methods of financing a business have no connection, direct or indirect, with the cost of making the product.
12. Inflation of inventory values.—One particu larly objectionable feature in charging interest as a part of the cost of production is that such a charge results in inflating inventory values. If these values are allowed to remain on the balance sheet, part of the profits will be anticipated to the extent that the in ventory value includes this specific charge for interest. Therefore a concern that follows this practice com mences to take its profit, weeks or months, perhaps, before the goods are offered for sale. This practice would have a tendency to imperil the credit of any concern that engages in it, because a banker who is approached for the purpose of loaning money to the concern will resent any attempt on the part of a bor rower to anticipate his profits, and to inflate the bor rowing value of his assets.
It is often suggested that the element of interest, included in the inventory, be deducted on the balance sheet by the creation of a suitable reserve to take care of the overvaluation. This position in itself, it would seem, ought to make clear the fallacy of the entire theory. Books of account exist for the purpose of recording what has actually taken place, and not what might have taken place under a set of hypothetical circumstances.
13. Cost and income confused.—Another objec tion to the proposal is that the charge for interest to cost of production, and a corresponding credit to an earning account, has the effect of counting the same thing both as cost and as income. A consideration of the principles of economics will serve to clear up the erroneous reasoning indulged in by those who favor this method. There are four sources of wealth, viz., land, labor, variously employed, and business organization. The income derived from the four sources is known as rent, wages, interest and profit. The same capital cannot be employed to earn two kinds of income, that is, capital invested by the man agers of a business enterprise cannot simultaneously earn both interest and profit. Clear reasoning be comes possible as soon as we come back to the funda mental principles of economics.
The charge for interest on invested capital as a part of the cost of production should not be confused with the charge for interest on capital which would be made in a partnership relation. In the latter in stance it is made for the purpose of adjusting the inequities of capital contributed by the various part ners and not included as a part of the cost.