Castle, Senior Judge, and Cummings and Sprecher, Circuit Judges.
This appeal involves a dispute between taxpayer and the government over the proper method of accounting for the cost of taxpayer's inventory.
Bangor Punta Operations, Inc., the taxpayer, is a Wisconsin manufacturer of diverse types of engines for many different industries. Because it uses the accrual system of accounting, taxpayer employs inventories in determining its annual net income. The method chosen to allocate production costs between inventory and current or "periodic" expenses is important, because those costs assigned to inventory are not deducted from gross income until the respective goods are sold. Thus, if the production costs allotted to inventory are too low, currect expenses are overstated and net income is a lower figure than a more accurate accounting system would produce.
There are three components of inventory costs; two of them, direct labor and direct materials, are not at issue in this case. The third, indirect manufacturing expenses or "burden," is the source of the controversy.
During the period in question, the fiscal years ending July 31, 1953, through July 31, 1958, taxpayer employed the "practical capacity" method of allocating burden between inventory and current expenses. The aim of the practical capacity method is to identify that portion of indirect manufacturing expenses attributable to "idle capacity;" in other words, to ascertain the cost of running a factory at less than its "normal" or "practical" capacity. The theory is that only those burden expenses directly relating to goods produced should be charged to inventory, that otherwise an item produced when the factory is operating at low capacity will be improperly inflated by "idle capacity" expenses and will be valued higher than an item produced at full capacity.
The practical capacity method is implemented in two steps, first by estimating the practical capacity of a plant or department. Practical capacity is maximum capacity, usually based on a 5-day, 8-hour shift, reduced by factors of downtime such as setup, lost time, cleanup, engineering changes, parts conversion and training. A "burden rate" is then established by dividing the estimated indirect manufacturing expenses at practical capacity by the number of labor hours or machine hours at practical capacity.
The second step comes at the end of the accounting period, when the burden rate is multiplied by the number of man-hours and machine-hours actually attained (actual earned hours) during the period. This amount is charged to inventory. If there is any excess of actual expense over the calculated amount, it is deducted as a current expense since it represents "idle capacity" cost. This excess is called "unabsorbed burden."
The following is an illustration of the practical capacity method, taken from one of taxpayer's charts:
1. At beginning of period:
Anticipated burden expense $20,000
Anticipated production stated
Normal burden rate ($20,000
Actual burden expense $19,000
Actual earned hours 9,000
Burden charged to inventory
Unabsorbed burden ($19,000 --
During the years in question, taxpayer deducted the following amounts of unabsorbed burden from its gross income:
The government disallowed these deductions because of alleged errors in the use of the practical capacity method and adjusted taxpayer's accounts for costs of goods sold and ending inventory so that the full amount of burden was charged to inventory. The taxpayer sued for refund of some $400,000 in excess ...