Ellis Coat Co. v. Secretary of War

Ellis Coat Company, Inc., Petitioner, v. the Secretary of War, Respondent Ellis Coat Co. v. Secretary of War Docket No. 276-R. United States Tax Court 9 T.C. 1004; 1947 U.S. Tax Ct. LEXIS 22; November 28, 1947, Promulgated *22 The petitioner and corporation A, both principally owned by the same family, manufactured and sold women's coats and suits under an unwritten agreement whereby petitioner supplied the materials, designing, managerial services, and marketing, and corporation A manufactured the garments according to petitioner's orders. Petitioner performed renegotiable contracts for coats, jungle hammocks, etc., which were manufactured by corporation A under the existing arrangement, petitioner's officers and executives supplying managerial services. Corporation A also performed a renegotiable contract for parachute packs. The Secretary of War recomputed petitioner's reported profit, and determined it excessive. 1. Reasonable salaries for officers and executives determined. 2. That part of the salaries paid by petitioner to officers and executives for managerial services rendered to corporation A, held a proper deduction in computing profit to the extent that such services applied to performance of petitioner's contracts, but not proper to the extent that they applied to contracts of corporation A. 3. In allocating general expenses between renegotiable and nonrenegotiable business for purposes*23 of computing renegotiable profit, the parties agree that a prime cost ratio is the proper basis for allocation. Petitioner includes in such prime costs the full value of materials furnished free of charge by the War Department. Respondent excludes from prime costs the value of such free issue material. Held, the values of the free issue material should be excluded from prime costs in determining the "prime cost ratio." 4. Petitioner's profit from renegotiable contracts, held, on the evidence, to be excessive to the extent of $ 107,800. Stanley Worth, Esq., and Peter P. Morrell, C. P. A., for the petitioner. Harland F. Leathers, Esq., and William T. Becker, Esq., for the respondent. Hill, Judge. Johnson, J., dissenting. *24 HILL *1005 The Secretary of War determined that excessive profits of $ 120,000 were realized by petitioner during the fiscal year ended June 30, 1943, on contracts and subcontracts subject to renegotiation under section 403 of the Sixth Supplemental National Defense Appropriation Act of 1942, as amended, and advised petitioner of this determination by notice dated June 4, 1945. Petitioner assails the determination, charging error in the allocation of costs and expenses between renegotiable and nonrenegotiable business and in the disallowance of a large portion of the compensation paid to officers and executives. In an amended answer respondent affirmatively alleges that petitioner realized excessive profits from renegotiable sales in an amount not less than $ 164,000, and prays that the determination be accordingly increased. In an amended petition the bar of the statute of limitations was pleaded but later abandoned by petitioner. FINDINGS OF FACT. Petitioner, a Connecticut corporation with principal place of business at Manchester, Connecticut, is engaged in the sale of women's coats and suits. It was incorporated on July 1, 1939, as the reorganization in form only of a*25 New York corporation of the same name organized in 1929, which in turn had taken over and conducted a business begun in 1900 by petitioner's principal shareholder, J. G. Ellis. Originally Ellis manufactured the coats and suits which he sold, but after 1919 the cutting, sewing, finishing, and pressing were done by others under contract, and later by a corporation which did work only *1006 for him. In 1937 the Independent Cloak Co. (hereinafter referred to as Independent) was organized for that purpose, rented a factory, purchased machinery and equipment, and began to manufacture exclusively for the New York corporation and later for petitioner, under an arrangement whereby the latter furnished the materials, designed the garments, and sold and shipped the completed merchandise, while Independent manufactured the garments according to petitioner's specifications from the sponging and cutting of the cloth to finishing and pressing for shipment. Petitioner and Independent are separate corporations, file separate income tax returns, and keep separate books on the basis of a different fiscal year. Their respective shares of stock are owned as follows: Petitioner's stock (100,000 common Per cent Independent's stock Shares and 100,000 preferred shares) (97 shares) J. G. Ellis [50] Sidney Ellis [71] Sidney Ellis [25] David Elkin [24] Charles Miller [25] Freda Ellis [1] H. M. Greenberger [1] *26 The shareholders of each corporation are also its officers and directors. J. G. Ellis had owned 60 per cent of the shares of the predecessor New York corporation and Sidney Ellis and Charles Miller 20 per cent each. In its normal civilian business petitioner employed from 35 to 40 persons, who were engaged in designing and styling, purchasing materials, accounting and cost computing, planning, supervising, and selling. Its operations were closely integrated with those of Independent, which upon the receipt of materials, sponged, cut, sewed, finished, and pressed the garment for shipment by petitioner to customers. Although Independent employed about 700 workers, it had only two executives; its president and principal shareholder, Sidney Ellis, and its factory superintendent, David Elkin. No other employees were above the rank of supervisors. In practice petitioner's executives performed many functions in the conduct and management of Independent's business and, although neither they nor petitioner were directly compensated for them, under the operating arrangement it was understood that petitioner would supply the managerial services required by Independent. For its services*27 in manufacturing, Independent had no written contract with petitioner, but made daily work reports and submitted weekly bills, based on the units of garments or other articles produced. The unit price was fixed at the beginning of work on a given contract and was computed to reflect estimates of direct labor cost made in the light of experience, time studies on prior work, and new conditions, plus an allocated part of indirect costs such as rent, light, maintenance, etc., and a profit of about 10 per cent. Allocations of indirect costs were made by petitioner's *1007 accountant, Lewis H. Wintz, and an employee's wages were treated as an expense of petitioner or Independent, according to the function performed. The profits thus realized by Independent were never questioned by shareholders or by the Commissioner of Internal Revenue. Petitioner had three officers and six executives actively engaged in the conduct of its business and in directing and assisting Independent's operations. Its founder and principal shareholder, J. G. Ellis, gave counsel and supervision on general policy, styling, manufacturing, and selling. His son, Sidney Ellis, was thoroughly familiar with all*28 phases of manufacture and selling and served in a general managerial capacity for both corporations, receiving a salary from both. Charles Miller was active in directing manufacturing operations at Independent's factory and in styling and sales. A. Welber purchased cloth, linings, and other materials for petitioner and machinery and equipment for Independent. M. N. Fandel served as production manager at Independent's factory, receiving the materials supplied by petitioner and routing them to the several sections in the process of manufacture. Lewis Wintz, a certified public accountant, kept the books and prepared the tax returns for both corporations. He also kept records of materials, cuttings, and merchandise produced and shipped, prepared time studies for cost computations, and ordered the flow of work so that all sections of the factory would be steadily occupied. H. Rosenberg was in charge of the New York City sales office. H. E. Coffey supervised petitioner's traveling salesmen and developed new styles and designs. H. M. Greenberger, an attorney, gave advice on legal matters and had general charge of personnel for both corporations. Petitioner's predecessor, the New *29 York corporation, sold its goods principally to chain stores. In July 1937 the International Ladies' Garment Workers Union called a strike of Independent's factory employees because of the employer's refusal to recognize the union. After lasting over seven months, the strike ended in failure, and the union began a boycott, threatening to picket retail stores selling the goods. This labor difficulty resulted in a serious curtailment of production, a diminution in orders, and increased expenses. An attempt to circumvent the boycott by sales through four newly organized corporations proved unsuccessful, and in 1939 petitioner concentrated on the production of better type suits and coats under the trade name of Manchester Modes. It was very successful in marketing these garments by salesmen to retail stores throughout the United States, its gross sales rising to over $ 5,000,000 a year by 1942. During 1942 and 1943 petitioner submitted bids for war contracts to the Quartermaster's Depot, War Department, Philadelphia, Pennsylvania. It represented that 80 per cent of its plant's capacity was *1008 being utilized for commercial work and 20 per cent was available for Government *30 business. The following contracts were awarded to it: Contract No. Date Unit Total price price W 669 QM 18149 4/29/92 10,000 Nurses' overcoats with removable linnings at. $ 8.15 $ 81,500 W 669 QM 18402 5/ 5/42 5,000 do 8.10 40,500 P. O. 13454 6/26/42 20,000 do 7.65 153,000 P. O. 3113 9/16/42 20,000 Jungle hammocks 7.15 143,000 W 669 QM 22566 10/30/42 25,000 do 7.00 175,000 W 669 QM 25838 1/21/43 2,000 do 6.75 13,500 P. O. 11390 2/12/43 3,000 do 6.50 19,500 W 669 QM 21381 9/21/42 15,500 Overcoats, parka, reversible pile liner at 16.95 262,725 W 669 QM 22145 10/17/42 40,000 do 16.95 678,000 W 669 QM 25657 1/18/43 150,000 Insect field bars at 1.50 195,000 W 669 QM 25773 1/20/43 40,000 Battle trousers at 2.00 80,000 P. O. 11312 2/11/43 [400] Women's field coats at 11.25 4,500 W 669 QM 26437 2/13/43 9,000 WAAC utility coats at 7.25 65,250 Subcontract No. W 669 QM 22568 (E) 2,850 Jungle hammocks at 7.00 19,950 W 669 QM 22572 (E) 1,500 do 7.00 10,500 The nurse's overcoat with removable lining was similar to a civilian coat which constituted half of petitioner's sales *31 when the Government's order was received, but it involved many more difficult and intricate manufacturing operations, required a belt, a zipper, more stitches to the inch, a closer inspection, and 2 3/4 times the time of the direct labor required to produce the civilian coat. The jungle sleeping hammock, made of cotton duck cloth with zipper netting against insects and a rifle container, was an entirely new article which necessitated special machinery for its manufacture; the insertion of 30 yards of heavy rope for suspension, the use of a special thread, and a laborious painting of seams, for which a proofing spray was later substituted. The overcoats with parka reversible linings were not produced commercially, but were somewhat similar to articles previously sold by petitioner. In the manufacture of them and of the hammocks double needle machines were acquired, for which no civilian use has since been found. The battle trouser was a new product for petitioner, but, by virtue of having dealt in women's slacks, it represented to the War Department that it had produced a similar article. The insect field bar involved principally sewing operations. The women's field and utility*32 coats differed in several details from civilian coats, and required hand-sewing and stitching unnecessary on the latter. After acquiring the contracts, petitioner continued its operating and billing arrangement with Independent, making adjustments for the somewhat different character of work involved, but Independent was responsible to petitioner only and not to the War Department. J. G. Ellis moved from New York to Manchester, Connecticut, in order to be constantly at the factory, and all of petitioner's officers and executives devoted increased time and effort to production, normally holding daily conferences in the evenings. A second shift of factory *1009 workers was initiated, and the plant was kept in operation until midnight. Coffey prepared the bids for submission to the War Department; solicited and procured the contracts, and thereafter spent several days a week in Philadelphia, conferring with the Quartermaster Depot officers about specifications, the procurement of cloth and other materials which the Government issued for the manufacture of its orders, and problems connected with methods and production. Wintz, in addition to his accounting and recording duties, *33 took charge of the manufacture of jungle hammocks in conjunction with Independent's superintendent, Elkin. Greenberger continued his functions as personnel director, but, while the labor supply had been static and easy to procure in peace times, keen competition made recruitment during the war period very difficult, and his task was complicated by requirements of the War Manpower Commission and the Wage Stabilization Board and by employees' absences from work. He made repeated trips to eighteen towns in the vicinity of the factory, seeking workers, and secured many by direct contact. He also reviewed employment applications, discussed personal problems with employees, inaugurated a complaint department, and provided rest periods. In these activities, to which he devoted 95 per cent of his time, he was assisted by Fandel. During war production Independent employed 985 workers. As the Government's orders were received, it was necessary to test machinery and train workers for the various new operations; to procure the Quartermaster's approval of samples produced; to estimate and order manufacture so that deliveries could be made on schedule time. The factory was partitioned into*34 sections for production of the several articles. The ordering of work was complicated by delays in the Quartermaster's delivery of materials and by defects found in some after delivery. For the manufacture of hammocks the installation of new machines required a shifting of factory equipment, and employees had to master new techniques. Some changes were made in specifications and more economical methods of production were devised. The contract, supplemented by a pattern and a sample, prescribed that hammock seams be painted, a cumbersome operation, one employee being occupied an entire day in painting 40. To obviate the consequent delay in production, Coffey sought and found a coloring chemical applied by sprayer, which the Quartermaster approved for use and which made it possible for one employee to spray 450 to 475 units in a day. The time and labor consumed in whipstitching the hammock's two ropes was also materially reduced by double needle machines which were procured from the Singer Sewing Machine Co. and adapted to that operation. Petitioner was delivering hammocks, urgently needed in the Pacific theater of operations, more rapidly than other contractors, and at an Army*35 contracting officer's request it accepted *1010 and filled, as a subcontractor, a part of the hammock orders placed with two other firms. In 1942 Independent procured a subcontract from the Pioneer Parachute Co. to manufacture parachute packs for the War Department, thereby aiding the contractor to make quicker delivery of the entire item of equipment. Sidney Ellis, Wintz, Fandel, and Greenberger cooperated in procuring the subcontract and in organizing and starting manufacture. Later petitioner had the head of the Bergen Binder Co. examine the methods used, and he and Welber were instrumental in finding that several hand operations could be successfully performed by machinery. Independent procured the machines, and their use increased the speed of producing packs to such an extent that Independent put out 2,000 a day. During the fiscal year ended June 30, 1943, Independent had net sales of $ 1,601,619.84, of which $ 1,301,078.08 was billed to petitioner and $ 300,541.76, or 18.8 per cent, resulted from its contracts with others. While petitioner and Independent were engaged in work on Government contracts they also produced and sold goods for civilian use. All their officers*36 and employees, however, participated to some extent in the performance of Government contracts except Rosenberg and two or three women employees in the New York sales office. Six salesmen of civilian goods were dismissed by petitioner after war work began, and about $ 50,000 of expense was thereby eliminated. Most of the materials and all of the patterns and specifications used in the performance of Government contracts were issued free to petitioner by the Quartermaster's Depot, Philadelphia, advice was sometimes given by officers from the Quartermaster's Depot, and a Government inspector was constantly at the factory. After completing all contracts, petitioner returned materials of a value of $ 75,767.02, not having used all of the excess provided for damage and other contingencies. Petitioner's officers' and executives' salaries were normally fixed at the beginning of each year at $ 65 a week and later augmented by quarterly bonuses. There were no written contracts and salaries paid were ratified by the directors later. For the fiscal year ended June 30, 1943, petitioner so paid the following amounts: Fixed salary Bonus Total Officers: J. G. Ellis $ 3,445 $ 50,000 $ 53,445 Sidney Ellis 3,445 35,000 38,445 Charles Miller 3,445 35,000 38,445 Executives: A. Welber 3,445 14,000 17,445 M. N. Fandel 22,500 22,500 Lewis Wintz 3,445 10,250 13,695 H. Rosenberg 3,445 14,000 17,445 H. E. Coffey 3,445 20,500 23,945 H. M. Greenberger 3,445 5,500 8,945 Miscellaneous compensation 6,235 6,235 Total 240,545 *37 *1011 For the fiscal year 1943 a reasonable salary for each of petitioner's three officers was $ 27,880, or a total of $ 83,640, and reasonable total compensation for its officers and executives was $ 193,850. For accounting and computation purposes petitioner allocated the salaries paid to the following services: Total Manufacture Sales Administration Officers: J. G. Ellis $ 53,445.00 $ 26,722.50 $ 26,722.50 Sidney Ellis 38,445.00 12,815.00 $ 12,815.00 12,815.00 Charles Miller 38,445.00 34,600.50 3,844.50 Executives: A. Welber 17,445.00 17,445.00 M. N. Fandel 22,500.00 22,500.00 Lewis Wintz 13,695.00 10,956.00 2,739.00 H. Rosenberg 17,445.00 17,445.00 H. E. Coffey 23,945.00 23,945.00 H. M. Greenberger 8,945.00 8,050.00 894.50 Miscellaneous 6,235.05 1,308.76 4,926.29 Total 240,545.05 158,343.26 35,186.29 47,015.50 A further allocation was made between civilian and Government contracts, designated "Non-renegotiable" and "Renegotiable": Total Nonrenegotiable Renegotiable Sales $ 35,186.29 $ 35,186.29 Manufacture $ 158,343.26 Administration 47,015.50 Allocated on prime cost ratio 205,358.76 42,447.65 $ 162,911.11 Total 240,545.05 77,633.94 162,911.11 *38 For their services during the fiscal years 1938-1942 petitioner's officers and executives received the following compensation: [1942] Officers: J. G. Ellis $ 15,102.20 $ 25,880.00 $ 28,500.00 $ 27,880 $ 53,380 Sidney Ellis 7,302.20 14,880.00 20,000.00 27,880 38,380 Charles Miller 14,880.00 20,000.00 27,880 38,380 Executives: A. Welber 4,805.20 10,630 17,380 M. N. Fandel 22,500 Lewis Wintz 6,049.53 6,360 12,375 H. Rosenberg 4,805.20 7,507.48 10,759.07 10,480 17,380 H. E. Coffey 7,652.48 10,759.07 10,380 23,880 H. M. Greenberger 2,730 8,610 The above amounts consist of weekly salaries of $ 65 ($ 55 for Wintz and $ 60 for Rosenberg) and additional amounts paid quarterly; figures are given only if services were rendered for the whole year. For the fiscal year ended August 31, 1943, Independent paid its officers the following compensation: *1012 Sidney Ellis $ 6,000 David Elkin 17,500 Freda Ellis 7,500 Total 31,000 The amounts of total assets and of surplus shown by the books, the amounts charged by petitioner to surplus as dividends, and the amounts paid*39 to its officers, who were also shareholders, during the fiscal years 1936-1943 were as follows: Year Total assets Surplus Dividends Officers' compensation [1936] $ 288,686.72 $ 30,530.84 $ 42,225 $ 25,390.00 [1937] 337,132.04 56,713.26 41,000 34,500.00 [1938] 274,731.87 49,493.13 6,000 22,404.40 [1939] 365,681.31 89,266.46 6,000 55,640.00 [1940] 356,855.33 82,912.46 22,000 68,500.00 [1941] 644,584.43 163,406.01 12,000 83,640.00 [1942] 1,086,517.37 378,470.49 12,000 130,140.00 [1943] 940,675.46 496,487.77 12,000 130,335.00 The following schedule reflects the profits and losses (exclusive of Federal income and excess profits taxes and adjustments therein), as shown by the books of petitioner and its predecessor New York corporation, for the fiscal years ended June 30, 1936-1942: Year Sales Purchases Charges by Gross Independent income [1942] $ 5,264,475.29 $ 2,942,389.44 $ 1,343,640.60 $ 1,036,054.53 [1941] 3,268,398.81 2,174,889.32 842,639.42 394,428.79 [1940] 2,304,177.95 1,458,004.89 568,461.51 321,265.98 [1939] 1,744,641.61 1,044,473.40 495,798.48 209,313.25 [1938] 1,925,535.72 1,095,901.31 553,820.98 100,832.83 [1937] 2,408,362.43 1,673,516.79 595,419.67 226,620.48 [1936] 2,146,099.39 1,455,451.94 499,371.85 122,644.09 *40 Year Officers' Other Net Percent salaries expenses income of sales [1942] $ 130,140.00 $ 415,412.03 $ 620,642.50 11.79 [1941] 83,640.00 262,915.57 131,513.22 4.02 [1940] 68,500.00 197,726.36 123,539.62 5.36 [1939] 55,640.00 151,821.42 57,491.83 [1938] 22,404.40 102,082.77 (1,249.94) [1937] 34,500.00 140,252.40 86,368.08 [1936] 25,390.00 114,496.85 8,147.24 For the fiscal year ended June 30, 1943, petitioner's books show total sales of $ 3,138,790.06, of which $ 1,276,025.34 were made to civilian customers and $ 1,862,764.72 resulted from the Government contracts above listed. For work on these contracts the Government furnished petitioner with "free issue" materials invoiced for an aggregate of $ 2,270,754,78, which petitioner was not required to pay. Petitioner purchased other materials of an aggregate cost of $ 1,124,352.10, of which $ 463,611.81 related to those used in the performance of Government contracts and subcontracts and $ 660,740.29 related to civilian sales. The opening and closing inventories for the year, $ 391,778.64 and $ 250,559.50, respectively, related exclusively to civilian business. For the year Independent charged*41 petitioner $ 1,301,078.08, of which billings of $ 1,103,321.05 were designated as on account of work under Government contracts and $ 197,757.03 on account of civilian business. By including the invoice value of the Government's free issue materials received by it in the amount of total sales and by use of figures *1013 and allocations above set forth, petitioner computes the following result of its operations for the fiscal year 1943 and, for comparison, the results of its operations for 1942, 1944, and 1945, as shown by its books: Year Sales Gross sales Per cent Net income Per cent profit [1943] $ 5,409,544.84 $ 555,768.93 10.27 $ 247,477.34 4.57 [1942] 5,264,475.29 1,035,909.49 19.67 620,642.50 11.79 [1944] 4,609,472.60 974,588.88 21.14 583,223.78 12.65 [1945] 4,573,651.60 1,017,683.73 22.25 597,847.45 13.07 In the course of its renegotiation with the War Department petitioner submitted statements which excluded from its total sales figure for 1943 the $ 2,270,754.78 invoice value of free issue material and disclosed on the contrary total sales of $ 3,138,790.06 and a net profit of $ 249,503.86, of which $ 186,774.54 was attributed to civilian*42 business and $ 80,729.32 to Government contracts. Petitioner now submits the following computation as correct: Total Civilian Government products contracts Sales $ 3,138,790.06 $ 1,276,025.34 $ 1,862,764.72 Costs and expenses 2,891,312.72 1,105,491.01 1,785,821.71 Profit 247,477.34 170,534.33 76,943.01 Costs and expenses are computed as follows: Total Civilian Government products contracts Charges by Independent $ 1,301,078.08 1 $ 197,757.03 2 $ 1,103,321.05 Materials 1,124,352.10 660,740.29 463,611.81 Inventory increase 141,219.14 141,219.14 Travel 3,641.63 3,641.63 Freight, insurance and general expenses as allocated on prime cost ratio 65,972.66 3 13,636.55 4 52,336.11 Bad debts 4,450.52 4,450.52 Selling expense 10,053.54 10,053.54 Salaries of officers and executives as allocated on prime cost ratio 240,545.05 77,633.94 162,911.11 2,891,312.72 1,105,491.01 1,785,821.71 The "prime cost ratio" used for allocation as above indicated is computed as follows: Total Civilian Government products contracts Charges by Independent $ 1,301,078.08 $ 197,757.03 $ 1,103,321.05 Materials purchased 1,124,352.10 660,740.29 463,611.81 Inventory increase 141,219.14 141,219.14 Free issue material 2,270.754.78 2,270,754.78 Total 4,837,404.10 999,716.46 3,837,687.64 100.00% 20.67% 79.33% *43 *1014 For its fiscal years ended September 1, 1936-1942, Independent submitted to the War Department statements disclosing the following sales and operating profits: Year Total sales Net operating Per cent profit [1936] $ 505,387.45 $ 10,656.61 2.11 [1937] 622,038.66 10,918.76 1.76 [1938] 511,708.35 (loss) 2,808.44 [1939] 514,554.23 9,511.88 1.85 [1940] 616,588.89 7,368.45 1.20 [1941] 958,957.65 16,457.88 1.72 1942 (10 mos.) 1,222,344.65 143,992.32 11.78 For the fiscal year ended September 1, 1943, Independent reported total sales of $ 1,520,936.86, of which $ 309,184.29 was derived from civilian business and $ 1,211,752.57 from war contracts. On these sales it showed a loss of $ 55,133.05, or 17.8 per cent on nonrenegotiable contracts and a profit of $ 118,920.32, or 9.8 per cent, on renegotiable contracts. Petitioner claimed before the renegotiating agency of the War Department that the contracts of it and of Independent should be renegotiated on a consolidated basis. The agency did not consolidate them, however, and those of Independent have been separately renegotiated for its fiscal year ended August 31, 1943. Independent was given "a Clearance" *44 whereby it was permitted to retain profits as reported upon renegotiable contracts performed by it. Petitioner's profit from renegotiable contracts for the fiscal year ended June 30, 1943, amounted to $ 173,095.87, of which $ 107,800 was excessive. The following schedule indicates petitioner's costs for 1943 as between renegotiable and nonrenegotiable business: Total Civilian Government products contracts Charges by Independent $ 1,301,078.08 1 $ 197,757.03 2 $ 1,103,321.05 Materials 1,124,352.10 660,740.29 463,611.81 Inventory increase 141,219.14 141,219.14 Travel 3,641.63 3,641.63 Freight, insurance and general expenses as allocated on prime cost ratio 65,972.66 3 25,696.35 4 40,276.31 Bad debts 4,450.52 4,450.52 Selling expense 10,053.54 10,053.54 Salaries 5 of officers and executives as allocated on prime cost ratio 129,104.10 50,286.05 78,818.05 Total 2,779,871.77 1,090,202.92 1,689,668.85 *45 *1015 The "prime cost ratio" used in the above computation is derived as follows: Total Civilian Government products contracts Charges by Independent $ 1,301,078.08 $ 197,757.03 $ 1,103,321.05 Materials purchased 1,124,352.10 660,740.29 463,611.81 Inventory increase 141,219.14 141,219.14 Total 2,566,649.32 999,716.46 1,566,932.86 100% 38.95% 61.05% Based on the above cost computation, petitioner's profit from renegotiable contracts is derived as follows: Sales $ 1,862,764.72 Costs and expenses 1,689,668.85 Profit 173,095.87 OPINION. We must determine first, how much profit petitioner made in 1943 on its renegotiable contracts and, secondly, what part of such profit, if any, is excessive. There are three questions affecting the determination of how much profit petitioner made: (1) The reasonableness of salaries paid by petitioner to its officers and executives, (2) what part of such salaries, if any, must be allocated to Independent, and (3) what part of certain general expenses including salaries must be allocated to renegotiable business. In 1943 petitioner paid its officers and executives a total of $ 240,545.05*46 as compensation. Respondent contends that a total of $ 87,000 before allocation is reasonable. After considering the nature and extent of the services performed by the personnel involved and the history of the compensation paid these men prior to 1943, and in view of the relationship such compensation bears to volume of business and profits, and having given effect to other pertinent facts and circumstances, we have concluded and found as a fact that $ 193,850 represents reasonable compensation. This conclusion involves allowing the officers the rate of compensation they received in 1941, which was $ 27,880 each, or an aggregate for the three officers of $ 83,640. The total aggregate compensation actually paid the executives in 1943 we consider reasonable, which aggregate amounted to $ 110,210. Adding $ 83,640, deemed reasonable for the officers, to the $ 110,210, actually paid the executives and considered as reasonable compensation for 1943, totals $ 193,850. What part, if any, of such compensation must be allocated to Independent? We think none need be so allocated, with one exception discussed below. It is true that petitioner's officers and executives performed services*47 for Independent, but these services were in effect *1016 part of the amount petitioner paid for having the manufacturing done by Independent. Since Independent manufactured the items on a cost-plus basis, petitioner's prime cost was reduced to the extent that it furnished executive services free of charge to Independent. If Independent had had to pay for such services it would have charged petitioner with the additional cost. Under these circumstances it is clear that the compensation paid by petitioner to its officers and executives for the work they did for Independent reduced correspondingly the amount of manufacturing cost billed to it by Independent and resulted in an increased margin of the amount of sales over such manufacturing cost. Hence, it is clear that it would result in little, if any, difference in the net profit to petitioner whether a portion of such compensation be allocated to Independent and by it added to cost of manufacture or the whole thereof be deemed an expense of petitioner and deducted by it from its gross profits. This conclusion does not involve the ignoring of corporate entities nor does it consolidate returns. Nor is there any element here*48 of a voluntary assumption of another's obligations or a gratuitous furnishing of services. The conclusion is based on the conviction that the compensation paid by petitioner for services of its officers and executives furnished Independent was, under the facts we have here, an expense of petitioner and an expense contributing to petitioner's ability to make a profit. As such, it is a deductible expense of petitioner and we so hold, with the following exception. Independent was awarded a Government contract for parachute packs. Petitioner did not benefit from this contract. Consequently, such services as petitioner's officers and executives furnished Independent in connection with this contract can not be considered a proper expense of petitioner. Respondent states on brief, without contradiction by petitioner, that 18.8 per cent of Independent's billings for 1943 related to the parachute pack contract. Also, it is agreed between the parties that 14.6 per cent of the total compensation paid by petitioner in 1943 is allocable to sales activities pertaining solely to nonrenegotiable business. Therefore, a total of 33.4 per cent of $ 193,850, found by us as the reasonable amount*49 of compensation paid by petitioner in 1943, is not deductible in resolving the question we have here and must be eliminated from the above stated amount of compensation in determining the amount of compensation to be allocated between renegotiable and nonrenegotiable business. (See explanatory marginal note, supra.) The next problem is the one of allocating petitioner's indirect expenses, such as salaries, freightage, insurance, and so on, as between renegotiable and nonrenegotiable business. Both parties are agreed that a "prime cost ratio" is proper. Petitioner's computation of the "prime cost ratio" has been set out in the findings of fact. Respondent contends that the value of the free issue material must be excluded *1017 in computing such ratio. We agree with respondent. The purpose of applying "prime cost ratio" is to gauge the relative significance of the two types of business in terms of their drain on indirect cost. Looking in detail and realistically at petitioner's operation, we are impressed that by virtue of the free issue material any appreciable drain on indirect costs was eliminated. For example, the procurement problem, priorities, shipping, storage, *50 in so far as the record indicates, insurance, as well as sales expenses, were entirely eliminated by virtue of the Government's furnishing of the material in question free of cost to petitioner. We are, therefore, unable to conceive of any appreciable drain on indirect costs by virtue of the free issue material and we therefore conclude and hold that the value of such material, which cost petitioner nothing, should be eliminated from prime costs in arriving at a proper ratio for allocating indirect costs as between renegotiable and nonrenegotiable business. So eliminating such material results in an allocation of indirect costs as has been indicated in our findings of fact of 61.05 per cent and 38.95 per cent, respectively, to renegotiable and nonrenegotiable business. Based on the above holdings, petitioner's profit for 1943 amounts to $ 173,095.87, as has been shown in our findings. How much of this is excessive? No precise formula can be availed of for an answer. The act furnishes various factors to be considered in determining whether and to what extent excessive profits exist. Section 403 (a) (4) mentions such factors. They include such items as efficiency, the reasonableness*51 of cost and profits with regard to volume, comparative pre-war and war earnings and products, the amounts and sources of capital, extent of risk assumed, contribution to the war effort, including inventive and developmental contributions, character and extent of subcontracts, etc. We have given careful consideration to these various factors. Generally speaking, petitioner is a service company. It did no manufacturing directly. Its physical equipment is small in amount. No great capital or other risks were involved. There was no substantial change in the nature of its wartime service as compared to its peacetime operation. No important inventive or developmental contributions were made. It can not fairly be said that petitioner's war business was disadvantageous to petitioner economically as compared to its prior peacetime business. On the other hand, it is clear that petitioner did an efficient and effective job in carrying on its war work. In view of these general considerations and others not detailed here, we have concluded that $ 107,800 of petitioner's profit of $ 173,095.87 for 1943 is excessive, and we so hold. An order will be issued in accordance herewith. JOHNSON *52 *1018 Johnson, J., dissenting: The computation of petitioner's profit in the majority's report in my opinion is over-simplified. The findings of fact provide the necessary detail and break-downs of salaries and other expenses for a precise elimination of the amounts attributable to sales activity, and the 18.8 per cent representing the part of Independent's sale proceeds not derived from petitioner should be applied against salaries paid to those officers and executives who rendered services to Independent, not to the total salaries paid. In arriving at the proper fraction for an allocation of salaries and expenses between renegotiable and civilian business, I also believe that the addition of the value of free-issue material to amounts paid by the War Department is necessary properly to reflect the comparative volume of work. The amount held refundable on the majority's profit computation I deem to be excessive. Footnotes 1. 15.20 per cent.↩ 2. 84.80 per cent.↩ 3. 20.67 per cent.↩ 4. 79.33 per cent.↩ 1. 15.20%.↩ 2. 84.80%.↩ 3. 38.95%.↩ 4. 61.05%.↩ 5. The salary figure of $ 129,104.10 used above is derived from the figure of $ 193,850 which we have found as reasonable compensation to petitioner's officers and executives for 1943. The derivation is accomplished by reducing $ 193,850 by 33.4%, which percentage is the sum of 14.6% and 18.8%. The percentage of 14.6 represents that part of compensation allocable to sales activities which pertained only to nonrenegotiable business. This percentage is based on petitioner having allocated $ 35,186.29 to sales activities out of the total compensation paid of $ 240,545.05. The percentage of 18.8 represents that part of the compensation which is allocable to Independent's parachute pack contract from which petitioner derived no benefit. The reasonable compensation figure of $ 193,850 as so reduced to $ 129,104.10 represents that part of the compensation which must be allocated as between renegotiable and nonrenegotiable business on a "prime cost ratio" basis.↩