contrary he may be benefited by that sale in that the additional earnings will enable a reduction in the domestic price. 173. THE IMPORTANCE OF ADDED BUSINESS IN MACHINE INDUSTRY' [NOTE. In the railroad industry indirect costs are a very large part of the total costs. One writer estimates that the following statement of the case is fairly typical. The "fixed charges" are of course all indirect costs. The different parts of "operating expenses" are made up of direct and indirect costs in varying proportions, as shown in the table. The figures of Column III, showing the percentage of total expenses chargeable to each specified class of expenditures, are divided in such a way as to indicate how much in each instance must be paid out regardless of the volume of traffic (Column I) and how much bears a relation to the volume of traffic (Column II). Dividend payments are not considered in this table. The selection taken from Wellington does not make use of precisely the foregoing figures, but it is founded on the same general considerations and shows why it is, in such businesses, that seemingly trifling changes in prices or in volume of business make very great changes in the rate of profit.] We will assume the case of a fairly prosperous line of the second grade whose income and outgo we shall find distributed in something like the following manner: Taken by permission from A. M. Wellington, The Economic Theory of Railway Location, pp. 111-12. (John Wiley & Sons, Inc., 1891.) Per Cent Per Mile $7,000 Gross revenue. Operating expenses, unaffected by either alignment or volume of traffic (50 per cent of operating expenses) Operating expenses, increasing directly with consider able changes in alignment or volume of traffic, but not with trifling changes (40 per cent)........ Operating expenses, increasing directly with the less important changes in alignment or traffic (10 per cent).... Total of nominal operating expenses.... Add to the latter the rental or interest charge (6 per cent on $30,000 per mile, assumed cash cost of road and plant)..... Total cash cost of producing the transportation sold...... Surplus available for dividends, being the business profit resulting from operation.. Let us now see the effect of increasing or decreasing the gross revenue 10 per cent, as it is frequently possible to do (one might perhaps more fairly say by probable differences of alignment alone). We have, if it has been increased: Gross revenue.. Operating expenses unaffected by either alignment or volume of traffic remain at... Operating expenses increasing directly with considerable changes in traffic, but not with trifling changes, remain at... Operating expenses increasing directly with less important changes in alignment or traffic increase 10 per cent and become. Total of normal operating expenses.. Add to these the fixed rental or interest charge which remains at..... Total cash cost of producing the transportation sold becomes.. Surplus available for dividends becomes.. 16.9 $1,186 The surplus available for dividends is more than doubled. On the other hand, if there has been 10 per cent loss of traffic the expenses are a little over the receipts, and the road is on the way to a receivership. 174. SIMPLE VERSUS COMPLEX INDUSTRY It has become the fashion to refer to industry prior to the industrial revolution, particularly that of the fourteenth and fifteenth centuries, as simple industry, whereas the industry of today is termed complex. Let us see precisely what is involved in this antithesis. The outstanding features of industry of the fourteenth and fifteenth centuries were these: It was small-scale industry; both worker and master, even those of limited intelligence, could survey and understand the processes involved. Markets were of small scale, with respect both to space area and to time area, and simple commercial organization would suffice. It was tool industry, so that the technique involved was simple and understandable. The social structure was relatively simple. Industrial control was primarily local, and society lacked its modern interdependence. A man of but ordinary intelligence and training could appreciate with some accuracy his relationship to the rest of organized society. It was industry where the total costs were almost entirely direct costs, so that the master could know, and would know without the necessity of a complex accounting system, his costs of operation. It was industry where the initial capital outlay involved was exceedingly small. Very different things are true of our modern complex industry. It is large-scale industry, so that practically no one in a great organization can know the details of all the processes involved. The market area, both time and space, is tremendous and the commercial organization of society correspondingly intricate, complex, and difficult to understand. It is machine industry as opposed to tool industry with all that this involves in intricacy of processes, in difficulty of the determination of costs, and in the complexities of social control. It is a complex interdependent society, so that even the most intelligent master has difficulty in fully appreciating his relationship to the rest of society. It is an industry where a large part of the total cost is made up of supplementary cost, so that pressure is brought upon the manager to retain his present volume of business and to develop new business under conditions where competition is no longer satis factory as the law of trade; and finally, it is industry where large initial capital outlay is required. Some of the consequences of the transition from simple to complex industry may be put as follows: 1. Capital is not as mobile as in the mediaeval period. The railroad industry furnishes an extreme illustration of this fact. This industry is pre-eminently an industry of much fixed, specialized capital. Tracks, locomotives, cars, etc., require tremendous outlay, and when these instruments have been called into being they can be used only for the one purpose. Social capital has been committed to the enterprise in a way that is irrevocable. In both the railway and in other businesses not merely fixed capital but the expensive and intricate organization, both industrial and commercial, make changes difficult unless one is willing to incur heavy costs. Under the régime of simple industry, processes were simple and little capital was required for any new business venture. If the venture proved unsuccessful, the enterpriser could shift fairly readily to some other line of activity. His loss of capital in the old enterprise would not be great nor would his capital requirements in the new enterprise be unduly large. It is self-evident that a very different situation obtains in complex industry. 2. In complex industry a large part of the costs of operation is without any very definite relation to the volume of the business transacted. The preceding selection showed the importance of added business under such circumstances. There are circumstances where the figures used in this selection would be an understatement of the case. This being true, it is not difficult to understand why the railroad manager who will develop new business is eagerly sought after; nor is it difficult to see the justification of building branch lines which are not in themselves profitable, but which bring in a little more traffic for a long haul on the parent line. From the manager's point of view, it is clear that he should give low rates on cheap and bulky commodities in order to induce them to move and thus increase the volume of his business. Thus the significance of the principle of "charging what the traffic will bear" is apparent, as is also the interest of the public in reduced rates as business develops. Failure to reduce rates under such circumstances might mean excessive profits for a public utility. 3. This is perhaps only another way of saying that under complex industry the relation between total cost of production and the price of the product may be neither clear nor definite. Total cost in machine industry may be divided into two parts: (a) those costs specifically incurred for a given unit of business and which are variously known as prime costs, direct costs, or variable costs; (b) those costs which are largely independent of the volume of the business and which have been called supplementary costs, indirect costs, overhead costs, or constant costs. The preceding paragraph showed that it pays to get business at a price which is below total cost, provided that price is above prime cost. In addition to this situation, there are plenty of cases where it will be wise for the manager of a complex industry to continue his business even though the price received for his product does not suffice to cover even the prime cost. For example, it has been asserted that a certain railroad has throughout its history hauled coal at less than prime cost because the railroad believed that this was the policy it must follow in order to develop manufacturing industries along its lines, and thus secure the traffic and profits involved in the hauling of manufactured goods. Another example may be found in the case of a manufacturer who believes that by a short war he may drive one or more of his competitors out of the field, and who accordingly cuts his price below even prime cost. Of course this cannot be expected to continue as a permanent policy. Another and a somewhat more subtle case is to be found when the price is to be cut below prime cost in order to develop added business of the same type. The logic of this situation lies in the fact that the increased volume of business may result in a different proportioning of the prime and supplementary costs through the introduction of special facilities for handling this new business. The consequence is that the price which was formerly below prime cost is now higher than prime cost because the prime cost (per unit) has fallen. 4. It is difficult for the manager to have complete knowledge of the factors involved. On the organization (both commercial and industrial) sides of his work, this is readily seen. The pressure for added business generally brings about a steady increase in the scale of operations so that personal supervision and control are no longer sufficient. Impersonal devices must be called to the rescue. Of these impersonal devices, accounting, and especially costaccounting, stands out prominently. Cost-accounting in simple industry would not be a difficult matter. It would involve no intricate computations. In complex industry, however, the costaccountant must grapple with both direct and indirect costs. He |