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Cost Accounting

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Interest on Capital

There is a great deal of controversy about the treatment of interest on capital in cost accounts. Some regard it is an element of cost, while others contend that it should be excluded from cost. We are giving below arguments both for and against the inclusion of a charge for interest:

For inclusion

(1) Interest is a production cost similar to wages. Wages is the reward for labour, interest is the reward for capital. True profits cannot be calculated unless interest is taken into consideration. For example, suppose A starts manufacturing business with a capital of $ 10,000 which he gets by selling his investments giving him as yield of 6%. At the end of the year after allowing a reasonable charge for his services he makes a profit of $ 600. As a matter of act he has earned no profit because $ 600 could have been earned otherwise also if he had continued his investments. Now-inclusion of interest as a charge will naturally give fallacious conclusions.

(2) The comparison of operations, different processes etc. without due consideration of the interest factor may give misleading conclusions. This is, particularly, true in case of stocks held for maturing such as timber, whisky, beet etc. which cost more on account of rent and interest.

Example

A, a timber merchant, purchases 1,000 ft. of timber @ $ 10 per cft, and puts it into his godown for six months for seasoning. B, another merchant, purchases seasoned timber in the same quantity @ $ 10.50 per cft. Apparently it seems that A has purchased timber at cheaper rates but if we take interest @ 12% p.a. on the capital invested, the cost of timer of A comes to $ 10,600 while that to B only $ 10,500. This is because A’s capital has unnecessarily been locked up for a period of six months.

(3) The question whether hand labours should be replaced by installing expensive machinery cannot be correctly decided without taking the interest factor into consideration.