The Role of Cost-Plus Contracts and Target Costing in Wartime: A Case Study from World War II

 

Introduction

During periods of conflict, particularly in large-scale wars like World War II, governments face immense pressure to ramp up production of military supplies, weapons, and equipment. The urgency and scale of such demands often make traditional fixed-price contracts impractical due to the unpredictability of costs. This is where cost-plus contracts come into play. These contracts guarantee that manufacturers are reimbursed for their costs and receive a fixed profit margin, thus ensuring rapid production without the financial risk associated with fluctuating material, labour, and overhead expenses. This method proved vital in World War II, particularly in the U.S., where it allowed for unprecedented military expansion. A key example is the production of the B-17 Flying Fortress by Boeing.

Understanding Cost-Plus Contracts
Cost-plus contracts are agreements where a contractor is paid for all incurred costs, plus an additional amount for profit. This structure includes:

• Direct Costs: Such as materials and labour directly involved in production.
• Overhead Costs: Indirect expenses like administrative costs, utilities, and depreciation.
• Profit Margin: A fixed percentage or fixed amount added to the total costs as profit.

The Boeing Example: Aircraft Production During WWII
One of the clearest applications of cost-plus contracts during World War II was in the U.S. aircraft manufacturing sector, particularly with companies like Boeing. In the early 1940s, the U.S. military required thousands of aircraft to fight in both the European and Pacific theatres. The production of bombers such as the B-17 Flying Fortress was critical to the success of the U.S. Air Force.

However, the costs associated with building these planes were highly uncertain. Factors such as material shortages, changing labour demands, and unforeseen production challenges meant that fixed-price contracts would have been risky for Boeing and other manufacturers. The cost-plus contract eliminated this uncertainty. Boeing was reimbursed for all its production expenses and received a guaranteed profit, typically a percentage of the total cost. This allowed Boeing to focus on increasing production speed and quality without worrying about cost overruns.

For instance, if Boeing estimated that the production cost of a B-17 bomber would be $300,000, the U.S. government agreed to pay that amount, plus a fixed percentage profit, say 10%. Even if production costs rose to $350,000 due to unforeseen issues, the government would cover those costs, and Boeing would still receive a $35,000 profit based on the 10% margin.

Advantages of the Cost-Plus Method in Wartime

1. Incentivizes Production: By removing the financial risks, cost-plus contracts incentivize manufacturers to produce at full capacity without fear of losses from cost overruns.
2. Accommodates Unpredictability: War often creates volatile markets for raw materials and labour, and the costs of production can vary widely. A cost-plus contract accommodates these fluctuations, ensuring production continues even when costs are unpredictable.
3. Speeds Up Procurement: Governments can quickly engage contractors, knowing that any unexpected costs will be covered. This is crucial in wartime when delays could mean losing strategic advantages.
4. Encourages Large-Scale Projects: Major projects, such as building fleets of bombers or ships, involve complex logistics and high risks. The cost-plus system allows for large-scale mobilization of resources without requiring manufacturers to bear the full financial burden.
5. Assured Profit for Contractors: Manufacturers are more willing to invest in war production because their costs are covered, and they are guaranteed a profit. This secures long-term partnerships between the government and industries crucial to the war effort.

Disadvantages of the Cost-Plus Method
While the cost-plus contract system helped facilitate rapid production during World War II, it was not without criticisms:

1. Lack of Incentive to Control Costs: Since contractors were reimbursed for all costs and still earned a profit, there was little incentive to control or reduce spending. This occasionally led to inefficiencies and waste.
2. Potential for Overpricing: Contractors might inflate costs, knowing they would still be reimbursed, leading to potential abuse of the system.
3. Administrative Burden: Cost-plus contracts often require extensive record-keeping and audits to ensure that all expenses are legitimate, which can lead to administrative challenges for both the government and contractors.

Overcoming the Disadvantages of Cost-Plus Contracts
To address these issues, governments and contractors can adopt several strategies to improve cost control and reduce inefficiencies:

1. Incentive Clauses for Cost Reduction: One solution is to include incentive clauses that reward contractors for meeting cost-saving targets. For instance, if a contractor reduces production costs below a certain level, they could receive a bonus or a higher profit margin. This encourages contractors to minimize costs while still adhering to the contract terms.
2. Auditing and Monitoring: Governments can establish more rigorous auditing and monitoring systems to ensure that contractors are not inflating costs or overspending unnecessarily. Periodic audits and stricter expense approval processes can reduce the likelihood of waste and overpricing.
3. Target Cost Contracts: Another alternative is to move towards target cost contracts with shared savings. In these contracts, the government and contractor agree on a target cost, and if the contractor manages to reduce costs below the target, both parties share the savings. This creates a win-win scenario, incentivizing cost control.
4. Fixed Profit Margins: Instead of using profit percentages based on actual costs, the government can offer fixed profit margins. This way, contractors have no incentive to increase costs, as their profit will remain constant regardless of how much they spend.
5. Progressive Penalties for Cost Overruns: Governments can also introduce penalty clauses that apply when costs exceed certain thresholds. If costs rise above a pre-determined limit, contractors could face reduced profits or other penalties, encouraging them to keep costs under control.
6. Collaboration and Transparency: Establishing a collaborative relationship between governments and contractors, where transparency and communication are prioritized, can help prevent overpricing and inefficiencies. Both parties need to align their interests toward the common goal of cost efficiency.

Certification of GST refund - Key Areas to be checked before Certification of GST Refund

Hello Friends ...Welcomes you in a new blog. Today's blog is more relevant for those who are in practice of GST. An authentication or certification ensure government that particular things are right as authorized by a Independent professional having integrity and objectively. So it's our duty that we maintain the integrity and will able to ensure government that what we have certified is correct and true in every manner. As I told earlier today's blog is about certification in GST and if I make it more precise and particular, I am talking about GST refund certification. No need to mention the section which empower a cost accountant to certify the same but we will discuss about the some  key areas that a cost accountant must check before certifying a refund. We can follow these steps to avoid any discrepancies. 

Step 1 

The First step is first you need to check client eligibility for refund. The following situations are only eligible for refund :-

1. Zero-rated supplies: Ensure the refund claim relates to zero-rated supplies (export of goods/services or supplies to SEZ).

2. Excess Input Tax Credit (ITC): Check if the taxpayer has accumulated ITC due to the inverted duty structure.

3. Refund of excess balance in the electronic cash ledger: Verify if the taxpayer is claiming a refund of excess balance in their cash ledger.

4. Deemed exports: Confirm if the refund claim is for deemed exports, if applicable.

5. Others: Refund claims for wrong payment of tax or any other eligible ground. 

After checking eligibility as mentioned in step 1 we need to move to step 2 which is Reconciliation of Turnover.

Step 2 

Reconciliation of Turnover 

1. Taxable Turnover: Verify the reconciliation of the taxable turnover declared in the refund application with the turnover in the books of accounts and GSTR-1, GSTR-3B.

2. Zero-rated Turnover: Check for proper classification and reconciliation of zero-rated supplies.

After completion of Step 2 we will move forward in step 3 where we will ensure matching of ITC.

Step 3 

Matching of input tax credit 

1. ITC in Refund Claim: Ensure that the ITC claimed as refundable is matching with the ITC ledger and GSTR-2A/GSTR-2B.

2. Proper Classification of ITC: Confirm that the ITC used for zero-rated supplies or refunds under inverted duty structure is properly accounted for and not used for other purposes.

After completion of Step 3 we must move forward toward step 4 which is more crucial and that is supporting documents. 

Step 4 

Supporting documents 

1. Ensure all required documents, such as invoices, export documentation (if applicable), bill of exports, and shipping bills, are available and valid.

2. Verify documents for proof of payment of taxes for deemed exports or other claims.

Step 5. 

Compliance with time limit

 

- We need to ensure that application is filed within the allowed time frame as per GST act which is 2 years from the relevant date.

Step 6

 

 Tax Payment verification 

1. Cross-check if taxes have been paid correctly and reflect in GSTR-3B.

2. Check for any discrepancies in tax payment and filing.

Step 7

 

Refund Formula 

1. For zero-rated supplies, check whether the refund formula as prescribed in the rules has been adhered to: Refund Amount=(Turnover of Zero Rated Supply ×Net ITC)/Adjusted Total Turnover​

2.Confirm the correct computation of ITC and turnover.

Step 8

Check Any pendency's 

Check there are no pending dues such as demand order , penalties or liabilities against the taxpayer that may hinder the assesses. 

Step 9 

Others things need to be considered as well such as related circular, notification that may effect refund process. 

By ensuring these steps the cost accountant can ensure that refund certification has been done as per GST norms. However this list is illustrative purpose only and there can be more aspects that needs to be checked before certifying the refund. Hope this information will assist our beloved colleagues in their practical life and I am also expecting that you will provide your valuable feedback and suggestions on this topic so that we can ensure that A certificate issued by a cost accountant is ultimate guarantee of surety and trust to the stakeholders of information .

Thanks and Regards

CMA Mohit

+91 7678359179,

Disclaimer- This information is education purpose only and should not be considered as legal advice. We shall be not responsible if any discrepancies still remains after following these steps. Professional must use his/her professional skepticism and updated GST rules and circular and notification to adhere the compliances.     

Normal Capacity determination - A Crucial tool of Costing for Decision Making

Hello Friends, Hoping all is fine from your side.  In todays blogger we are going deep into Normal Capacity concept. In layman language  Normal capacity in costing refers to the average production volume that a company expects to achieve over a period of time under normal operating conditions. As per  CAS 2 issued by the The Institute of Cost Accountants of India "The normal capacity is the volume of the production or service achieved or achievable on an average over a period under normal circumstances taking into account the reduction in capacity resulting from planned maintenance. But my friends it is more critical and crucial to understand than as its name suggest. It's a key concept in cost accounting and management accounting as it helps in cost allocation, budgeting and forecasting, performance evaluation and pricing decision. We will understand it one by one with  live examples. 

1. Cost Allocation: It aids in allocating fixed costs to units of production, helping in accurate calculation of product costs. For example, if a factory has fixed costs of INR 100,000 and normal capacity is 10,000 units, the fixed cost per unit is INR 10. If actual production is only 8,000 units, using normal capacity for cost allocation prevents overloading the products with fixed costs, which could distort product costing.

2.Budgeting and Forecasting: Normal capacity is used in preparing budgets and forecasts. It provides a benchmark for expected production levels and helps in planning resources, materials, and labour.

3. Performance Evaluation: By comparing actual capacity with normal capacity, companies can assess their operational efficiency. If actual production consistently falls below normal capacity, it might indicate issues like inefficiencies, low demand, or other operational problems.

4.Pricing Decisions: It helps in setting the prices of products by determining the cost base. When companies understand their normal capacity, they can price their products in a way that covers both fixed and variable costs, ensuring profitability.

Example:

Let's consider a manufacturing company, XYZ Ltd., that produces pens. The company has the following costs:

• Fixed costs: INR 200,000 (costs that do not change with the level of production, such as rent, salaries, etc.)
• Variable costs: INR 5 per unit (costs that vary with the level of production, such as materials, labour, etc.)

The company's normal capacity is 50,000 units per year.

Calculation of Fixed Cost per Unit:

$\text{Fixed Cost per Unit}=\frac{\text{Total Fixed Costs/}}{\text{Normal Capacity}}=\frac{200,\mathrm{000/}}{50,000}=4\text{ per unit}$

Total Cost per Unit:

$\text{Total Cost per Unit}=\text{Fixed Cost per Unit}+\text{Variable Cost per Unit}=4+5=9$

$If\; the\; company\; only\; produces\; 40,000\; units,\; the\; fixed\; cost\; per\; unit\; calculated\; on\; actual\; production\; would\; be\; higher\; (200,000\; /\; 40,000\; =\; 5).\; However,\; using\; normal\; capacity,\; the\; company\; can\; maintain\; the\; fixed\; cost\; per\; unit\; at\; 4,\; which\; reflects\; more\; realistic\; product\; costing.$

Moving further let's have another example to understand why we need to have critical analysis of Normal Capacity for budgeting and forecasting, performance evaluations and pricing decision 

Company: JKL Furniture (India)

• Fixed Costs: ₹48,00,000 per year (includes rent, salaries, equipment depreciation, etc.)
• Variable Costs: ₹4,000 per chair (includes raw materials, direct labour, etc.)
• Normal Capacity: 20,000 chairs per year

1. Budgeting and Forecasting

Objective: To create an annual budget and forecast based on normal capacity.

Steps:

1. Calculate Total Expected Costs:

   • Fixed Costs: ₹48,00,000
   • Variable Costs at Normal Capacity: $20,000 \text{ chairs} \times ₹4,000 \text{ per chair} = ₹8,00,00,000$
     
   • Total Expected Costs: $₹48,00,000 + ₹8,00,00,000 = ₹8,48,00,000$
     

2. Revenue Forecast:

   • Selling Price per Chair: ₹6,000
   • Revenue at Normal Capacity: $20,000 \text{ chairs} \times ₹6,000 = ₹12,00,00,000$
     

3. Profit Forecast:

• Expected Profit: $₹12,00,00,000 - ₹8,48,00,000 = ₹3,52,00,000$
  

By using normal capacity, JKL Furniture can set realistic financial goals and allocate resources efficiently.

2. Performance Evaluation

Objective: To evaluate operational efficiency by comparing actual production with normal capacity.

Scenario:

• Actual Production: 18,000 chairs
• Actual Costs Incurred:  8,20,00,000

Performance Evaluation:

• Expected Costs at Normal Capacity: ₹8,48,00,000
• Actual Costs: ₹7,20,00,000

In first look its seems that company has outperformed by  ₹28,00,000 but let check on the parameter of normal capacity As we know that normal capacity of the company is  20,000 units at the expected cost on normal capacity is ₹8,48,00,000 i.e. fixed cost + 20,000 x variable cost per unit

Fixed cost per unit to be charged at normal capacity is 48,00,000/20,000 =  ₹240 per unit

Lets allocate this cost to actual production for comparability

Fixed Cost based on normal capacity 18000 units X 240 = ₹43,20,000  

Total Actual variable cost after excluding fixed cost at normal capacity parameter = (8,20,00,000-43,20,000)/18000 = ₹4315.55 which is higher than the expected variable cost shows the inefficiency of the company. The company underperformed the variable cost by ₹315.55 per unit. 

By comparing actual production to normal capacity, JKL Furniture can assess whether they are operating efficiently and identify areas for improvement.

3. Pricing Decisions

Objective: To set a competitive price that covers costs and ensures profitability.

Steps:

1. Calculate Cost per Chair at Normal Capacity:

   • Fixed Cost per Chair: $\frac{\text{₹}48,00,000}{20,000}=\text{₹}240,\; per chair$
   • Variable Cost per Chair: ₹4,000
   • Total Cost per Chair: $₹2,400 + ₹4,000 = ₹6,400 \text{ per chair}$
     

2. Determine Selling Price:

   • Desired Profit Margin: 50%
   • Selling Price: $\text{₹}\mathrm{4,240}\times (1+0.50)=\text{₹}\mathrm{6,360\; per chair<span\; class="base"><br></span>}$

By using normal capacity for cost calculations, JKL Furniture ensures that their pricing strategy is competitive and covers all costs while achieving the desired profit margin.

By above examples hoping that you have understand  why normal capacity calculation is crucial for any company and as a Cost Accountants its our duty to guide to the  managements not about only Normal capacity characteristics but also about the capacity determination characteristics. 

Milte hai next blog main 

Your Costing Friend

CMA Mohit