19 T.C. 548">*549 Respondent rejected petitioner's application for relief from excess profits taxes under section 722 of the Internal Revenue Code with respect to the taxable years 1941, 1942, and 1943. Petitioner claims it is entitled to relief under section 722 (b) (1) and (b) (4). The basis for its claim under section 722 (b) (1) is a strike which occurred in its plant in 1936. Its claim under section 722 (b) (4) is based upon a change in the character of its business through (1) a difference in its products and (2) a difference in its capacity for production or operation.

1952 U.S. Tax Ct. LEXIS 10">*12 Some of the facts were stipulated.

FINDINGS OF FACT.

The stipulated facts are so found and are incorporated herein.

Petitioner, a New York corporation, has its principal office in New York, New York, and its factory at Youngstown, Ohio. On December 29, 1949, its corporate name was changed to Weatherbee, Coats, Inc., by the filing of a certificate of change of name. Its excess profits tax returns for the taxable years were filed with the collector of internal revenue for the third district of New York.

At all times material hereto petitioner manufactured raincoats. The demand therefor was seasonal in that it was heavy in the fall and slack in the spring. All through its early years petitioner was looking for some item that would stabilize its business on an all-year-round basis. In 1930, it put in a women's coat department which lasted only a few months. In 1932 or 1933, it commenced the manufacture of suedine or sports jackets, an imitation of a fine leather jacket. By 1936, the demand for these jackets had waned and their manufacture was discontinued in 1937. In 1935, it began the manufacture of woolen articles, such as snow and ski suits, mackinaws and misses' jackets. 1952 U.S. Tax Ct. LEXIS 10">*13 In 1937, petitioner began the manufacture of reversible topcoats. Petitioner purchased the material from which these various garments were made, designed the garment, manufactured it into the finished product, and marketed its products.

The manufacture of the garments generally involved the following steps. The material of which the garment was made was selected, 19 T.C. 548">*550 brought from the cloth stock room to the cutting room and cut by machines. It was then sewn and underpressed; the garments were then brought to the finishing department where trimming (such as buttons, buttonholes and similar items) was added. The garments were then pressed, cleaned, examined, ticketed and made ready to be shipped, or placed in stock. These operations called for the use of various machines such as cutting machines, sewing machines, underpressing and finished pressing machines, and buttonhole machines. They also called for operators of such machines, as well as cleaners and examiners.

At all times prior to 1942 the garments manufactured by petitioner, except for $ 17,325 of army orders received in 1941, were exclusively for civilian use.

Petitioner made it a business practice to use the slow1952 U.S. Tax Ct. LEXIS 10">*14 spring season to stock its garments for the heavier fall sales. It commenced production of its fall line in or about April of each year, swinging into volume production around May or June and continuing to build up reserve stocks to its peak season. In the peak months of its operations, namely, August, September, and October, more garments were shipped than produced. The excess quantity shipped was drawn from the reserve stocks accumulated prior to the fall demand. The peak season was usually reached by October but it might continue into November and December, depending upon business conditions and sales activity. By October petitioner could generally determine whether production of its garments should be pushed or eased off.

Each year petitioner printed and distributed a fall catalogue which set forth the styles and designs of the garments produced for its fall trade. In some years petitioner also published a spring catalogue but it relied upon the fall catalogue for the bulk of its business. Preparation of the fall catalogue started in May and was completed, except for swatching, ¹ shortly after the Fourth of July. The swatching usually took place from the beginning of 1952 U.S. Tax Ct. LEXIS 10">*15 July until the end of August. The catalogues were dated August 15, but mailing started on or about August 1 and continued daily until the end of the month. A price list, printed on a separate sheet, was inserted in each catalogue. The price list was separate from the catalogue for the reason that many of petitioner's customers used the catalogues to make their sales, which made it undesirable to show the wholesale prices of the garments depicted therein.

Petitioner did not secure all of its business through its catalogues. Prior to the release of the catalogues and as the new styles for its fall 19 T.C. 548">*551 line were developed, they were shown by petitioner's salesmen on the road, by the New York salesroom, and the Youngstown factory office. Orders for these garments were taken by the salesmen and at the New York salesroom and the Youngstown office.

During the base period years, petitioner's raincoat production consisted of about 80 to 100 numbers in varying styles with an average of three colors1952 U.S. Tax Ct. LEXIS 10">*16 to each style. Its 1936 fall catalogue contained 86 numbers, each number having an average of three different colors, making approximately 270 different type garments. Each of these garments was offered in various sizes averaging seven in number so that in 1936 petitioner carried approximately 2,000 different stock items.

Prior to 1935, petitioner started selling its raincoats to the wholesale department of Montgomery Ward & Co.The latter's wholesale department bought merchandise that was sold through Montgomery Ward catalogues. This account was valuable to petitioner because it provided petitioner with a volume of business during its slack season that could not be obtained from the general retail trade. Competition for the account was very keen and the business that petitioner secured was on such a marginal basis that sometimes it produced a small profit and other times only a part of the costs. Some years after it started to do business with Montgomery Ward's wholesale department, petitioner began to sell to Montgomery Ward's retail department. The merchandise sold to Montgomery Ward's retail department came from petitioner's line of merchandise for its general retail trade, 1952 U.S. Tax Ct. LEXIS 10">*17 whereas the merchandise sold to Montgomery Ward's wholesale department was a specially prepared line for Montgomery Ward's catalogue trade. Petitioner's business with Montgomery Ward's retail department was profitable as the merchandise sold thereto brought a higher price.

In 1935, Montgomery Ward asked petitioner to manufacture snow suits, four or five styles of which were shown to petitioner to copy. Believing that something of this nature might solve the problem of continuous operation of its plant, petitioner set up a woolen department and in the middle of 1935 began manufacturing snow suits exclusively for Montgomery Ward. In 1936, petitioner increased its production of woolen garments by building a line of merchandise for the general retail trade and a line for Montgomery Ward. In building its lines of woolen garments, petitioner sought garments for the general retail trade rather than garments productive of marginal business with Montgomery Ward. Thus, when it commenced to manufacture reversible coats in 1937, petitioner sold the reversibles exclusively to the general retail trade.

19 T.C. 548">*552 By the end of the base period, petitioner was manufacturing, in addition to raincoats, 1952 U.S. Tax Ct. LEXIS 10">*18 snow and ski suits for tots, girls, and misses, mackinaws, and snow pants, misses' jackets, flannel suits, which are identical with misses' or men's suits, and reversible coats for men and women. The reversible coats were worn as topcoats under normal conditions, but were lined with a water-repellent fabric, so that when it rained the coat could be reversed and the water-repellent side exposed to the elements.

The manufacture of woolen garments was more of a tailoring operation of a type used in the clothing industry than the manufacture of raincoats and suedine jackets. The fabrics used in making the latter were stitched together and the seams cemented to make them waterproof. In woolen garments the seams were underpressed after stitching and were not cemented. Woolen garments required more hand work and had to be pressed after the garment was completed. The fabrics used in woolen garments had the same thickness (i. e., ounces per yard) as fabrics used by clothing manufacturers in making topcoats and overcoats. Petitioner waterproofed many different fabrics in manufacturing its rainwear, and its catalogues state that wetproof woolens were used exclusively in its snow suits 1952 U.S. Tax Ct. LEXIS 10">*19 and snow pants, and that many of its fabrics were cravenetted. ² Petitioner made no attempt to transfer employees from its raincoat department to its woolen department; it hired new help and trained them to work in the woolen department. Many of petitioner's raincoat customers also handled its woolen garments, but petitioner acquired some customers for one or more of the items in its line of woolen garments that did not handle raincoats.

Petitioner's net sales, after deduction of returns and discounts, and its profits, before deduction of taxes, for the calendar years 1927 to 1939, inclusive, together with averages for stated periods, are shown by the following table:

1952 U.S. Tax Ct. LEXIS 10">*20 19 T.C. 548">*553 Petitioner's net sales by months before discounts for the period 1936 to 1939, inclusive, were as follows:

Petitioner's total sales and its raincoat and suedine jacket sales during the period 1933 to 1939, inclusive, were as follows:

1952 U.S. Tax Ct. LEXIS 10">*21 Petitioner's sales of woolen articles and reversibles during the period 1933 to 1939, inclusive, were as follows:

Petitioner's wholesale and retail sales of woolen articles to Montgomery Ward & Co., to the outside trade (Retailers), as compared with total woolen sales for the years 1935 to 1939, inclusive, were as follows: 19 T.C. 548">*554

Montgomery Ward's wholesale departments bought raincoats, children's snow suits, mackinaws, jackets, and misses' garments for its catalogue trade. Montgomery Ward's retail departments bought garments for tots and infants, girls, 1952 U.S. Tax Ct. LEXIS 10">*22 and misses.

On August 17, 1936, about 20 of petitioner's employees walked off the job and started picketing petitioner's plant in Youngstown, Ohio. The number of strikers increased daily and by the end of the week approximately 100 of petitioner's 200 or more employees were out on strike. Petitioner's plant was picketed not only by its own employees but also by a group of truckmen who had just achieved union recognition and were endeavoring to procure union recognition for petitioner's employees. The picketing interfered with petitioner's nonstriking employees to such an extent that violence occurred. Petitioner, fearing further violence, stopped production in both its raincoat and woolen shops so that during the last week of the strike there was no production.

The strike was settled on August 27, 1936, by petitioner's recognition of the union, granting a 10 per cent wage increase to its employees effective August 17, 1936, to December 31, 1936, an additional 5 per cent wage increase, the effective date of which was to be determined by an arbitrator mutually selected, and an agreement to further negotiate for a final contract. The sheriff of the county, who was selected by the1952 U.S. Tax Ct. LEXIS 10">*23 parties as arbitrator, fixed October 19, 1936, as the effective date for the additional 5 per cent increase. The additional wages paid by petitioner under this agreement for the period August 17 to December 31, 1936, totaled $ 7,453.49. In February 1937, in its final contract with the union, petitioner was obliged to give its employees another 10 per cent increase in wages.

On Monday, August 31, 1936, petitioner's raincoat and woolen shops were reopened and most of its employees came back to work with the result that the strike partially closed the shops for one week and completely closed them for another. Petitioner's plant was not completely shut down at any time during the strike as its shipping, receiving, and administrative departments continued to function. During the period of the strike, petitioner continued to make shipments from its plant via its private railroad siding, by parcel post, and by railway express.

19 T.C. 548">*555 Petitioner's monthly production of raincoats and woolens for the years 1935 to 1939, inclusive, was as follows:

1952 U.S. Tax Ct. LEXIS 10">*24 During 1936, petitioner's estimated inventories of merchandise on hand, which represented cloth, garments in process, and finished goods, as of the end of each month from January through December, were as follows:

Prior to the base period, petitioner had been selling raincoats to the Princess Garment Company which sold its goods through house-to-house canvassers. It printed up and supplied its canvassers with cards containing a picture of the garment, samples of the fabric in the 19 T.C. 548">*556 garment, and the price. These canvassers would sell from door to door taking orders for the exact size, color and style of garment selected and taking a cash deposit.

In May or June of each year, Princess Garment Company started buying its fall line of raincoats from petitioner. Its basic order would be for a certain number of styles in different colors and sizes. The misses' sizes would range from 14 to 20 with some women's sizes1952 U.S. Tax Ct. LEXIS 10">*25 36 to 44 added; the men's sizes would be from 34 to 46; the boys' from 6 to 16 or 18; the girls' from 7 to 14; and the tots' from 3 to 6x. Reorders by Princess Garment Company were keyed to the sales made by its canvassers early in the fall season.

In 1936, Princess Garment Company placed its basic order with petitioner in June with delivery to be made on or before August 15. Petitioner failed to make timely delivery on this basic order, delivering some of the raincoats in July, some in August, and some in September. Normally deliveries to Princess Garment Company on its reorders were made within two or three weeks, but in 1936 petitioner serviced the reorders on this account "very badly."

Sales of raincoats by petitioner to the Princess Garment Company for the years 1934 to 1940, inclusive, were as follows:

During the base period years, competition was very keen in the industry of which petitioner was a member. Under the circumstances that existed in 1936, the proper pricing of petitioner's merchandise was essential in order to successfully meet competition. The difference1952 U.S. Tax Ct. LEXIS 10">*26 of a few cents in the price of a garment would make a difference in the number that could be sold. In the case of large marginal customers, such as Montgomery Ward & Co., such a difference could result in a complete shifting of their business from one supplier to another. Petitioner's 1936 prices had been fixed with such competitive conditions in mind prior to the strike. Its fall catalogue and price lists had been published prior to the strike, and petitioner was unable to increase its prices to take care of the increased costs that resulted from settlement of the strike.

The unit selling prices of petitioner's raincoats, suedine jackets, woolens other than reversibles, and reversibles for the years 1933 to 1939, inclusive, were as follows: 19 T.C. 548">*557

In 1928, petitioner moved to its present factory premises in Youngstown, Ohio. At that time it subleased the top floor of a four-story and basement building, 1952 U.S. Tax Ct. LEXIS 10">*27 having 10,000 square feet of space per floor. Later it subleased an additional 4,000 square feet on the floor below, thus occupying 14,000 square feet in the building. In 1933, petitioner leased the entire building, took over the occupancy of the two top floors, or an area of 20,000 square feet, and sublet a part of the building. In 1935, when petitioner started the manufacture of snow suits, it took over the occupancy of the entire building. Prior thereto petitioner's manufacturing facilities had been located on the top floor.

Upon taking occupancy of the entire building, petitioner moved its cutting tables to the second floor, set up a line of machines for the manufacture of woolen garments on that floor, and installed a few pressing machines. Petitioner used the first floor (later the basement) for receiving raw materials and as storage for rags, clippings, and bulk woolen materials.

At some time undisclosed by the record, the city of Youngstown raised the level of the street in front of the premises occupied by petitioner. As a result what had previously been the first floor of the building containing five stores became the basement. The original basement became a sub-basement, 1952 U.S. Tax Ct. LEXIS 10">*28 the second floor became the street or first floor, the third floor became the second, and the top floor became the third floor. After the street level was raised, the basement contained five useless stores separated from each other by walls of tile or concrete.

Between 1935 and 1937, the materials purchased by petitioner were received and stored in the basement. When the materials had to be cut, they were brought from the basement to the cutting department located on the street or first floor. After the materials were cut, the woolen garments went to adjacent sewing machines, but raincoat materials went to the top floor. After the woolen garments were sewn, they were underpressed and sent to the finishing department on the top floor where buttons, buttonholes, and similar items were added. The garments were then pressed, cleaned, and examined after which they were placed in the stockroom on the second floor. After the raincoats 19 T.C. 548">*558 were manufactured on the top floor, those that had to be pressed (such as gabardines) were returned to the pressing department where they were underpressed. They were then returned to the top floor to finish the stitching, after which they 1952 U.S. Tax Ct. LEXIS 10">*29 were returned to the pressing machines where they were pressed. These raincoats were then returned to the top floor where buttons and buttonholes were added. The raincoats were then cleaned, examined, and sent to the stockroom. Petitioner's manufacturing procedures during this period required a constant shifting of its operations from floor to floor involving a loss of time and expense.

In 1936, as the result of the strike and its inability to completely utilize its factory building, petitioner considered moving to another location. Petitioner's general manager visited other locations, as a result of which he realized that the physical set-up of petitioner's plant was inefficient. In the spring of 1937, petitioner convinced its landlord that if petitioner were to remain certain alterations would have to be made to the building. Petitioner's lease expired in 1937 or 1938, and the landlord agreed to make certain alterations at his own expense. These alterations included opening up windows on one wall in the basement, building a connecting stairway between the basement and the floor above, putting down new flooring in most of the basement, and breaking down some of the walls separating1952 U.S. Tax Ct. LEXIS 10">*30 the five stores originally on this floor. The alterations were completed during the first half of 1937 at an estimated cost to the landlord of $ 5,000 or $ 6,000. After this remodeling, petitioner moved its pressing department to the basement and utilized the additional manufacturing space thus acquired to enlarge its cutting department which had been operating under cramped conditions.

The moving of the cutting tables and machines and their resetting was done by petitioner's machinist and odd help around the shop. The moving of this equipment was done from time to time as the machinist was able to make the moves. In 1939, the landlord installed overhead heaters in the basement; and petitioner moved its button, buttonhole, examining, and finishing operations from the top floor to the basement. After these changes were made, petitioner eliminated some of the loss of time and expense that existed prior to 1937. Manufacturing operations started on the street floor, went to the top floor, then to the basement floor, and then to the stockroom on the second floor.

In 1936 or 1937, petitioner changed its system of identifying parts of garments from a manual to an automatic system by1952 U.S. Tax Ct. LEXIS 10">*31 the installation of Soabar marking machines. The Soabar machine punched a pin ticket to every part or piece of material that goes into the manufacture of the garment. The garment had a serial number which appeared 19 T.C. 548">*559 on each pin ticket, and the operator identified the parts she put together to make the garment by this serial number. When a garment came through production, it had from 12 to 40 or 50 pin tickets on it. The installation of the Soabar machines reduced the number of employees in petitioner's cutting department and effected a savings in its labor costs.

Petitioner was in existence throughout the base period years 1936-1939, inclusive. It is entitled to compute its excess profits tax credit on an income basis. It computed its excess profits tax credit on the basis of its invested capital, since such computation produced a higher credit than the average base period net income computation. The base period net income as reported, computed without regard to section 722 but with regard to section 713 (e) (1) is as follows:

1952 U.S. Tax Ct. LEXIS 10">*32 Petitioner's excess profits net income, its excess profits tax liability as determined by respondent, and its excess profits tax credit, as hereinbefore determined on the invested capital basis and without the benefit of section 722 for the taxable years 1941, 1942, and 1943, are as follows:

Petitioner's average base period net income was not an inadequate standard of normal earnings.

OPINION.

In determining petitioner's excess profits tax liability for the taxable years 1941, 1942, and 1943, respondent computed petitioner's excess profits credit on the invested capital method as provided in section 714 of the Code because that method resulted in a larger credit than a computation on the income method under section 713 of the Code. Our findings show that the credit used by respondent for each taxable year exceeded $ 12,000, whereas petitioner's actual average base period net income, as reported, amounted to only $ 7,157.87, and 19 T.C. 548">*560 if computed under section1952 U.S. Tax Ct. LEXIS 10">*33 713 (e) (1) such net income amounted to only $ 8,698.73. Under these circumstances if petitioner is to secure any relief under a subsection of section 722, it must prove that its actual average base period net income was an inadequate standard of normal earnings, the amount that would constitute a fair and just amount representing normal earnings to be used as a constructive average base period net income, and that such amount would result in a larger credit than the credit computed under the invested capital method. Petitioner recognizes its burden for it states on brief that to secure relief it must enlarge its actual average base period net income by more than $ 5,000.

We will consider, first, petitioner's contention that it qualifies for relief under section 722 (b) (1), the pertinent portions of which appear in the margin. ³ Petitioner contends that during its first base period year its normal production, output, or operation was interrupted or diminished by a strike which was an event unusual and peculiar in its experience within the meaning of the statute. Petitioner contends further that because of such strike its actual average base period net income is an inadequate1952 U.S. Tax Ct. LEXIS 10">*34 standard of normal earnings, which resulted in an excessive and discriminatory tax, and it submits a constructive average base period net income of $ 19,882.50, which it contends would be a fair and just amount representing its normal earnings.

Respondent concedes that the strike at petitioner's1952 U.S. Tax Ct. LEXIS 10">*35 plant in August 1936 is an unusual event within the meaning of section 722 (b) (1), and that petitioner is entitled to reconstruct its base period net income, if it has established the further requirement that because of the strike its actual average base period net income was an inadequate standard of normal earnings. The necessity of proving that the inadequacy of its earnings was a result of the strike is recognized by petitioner and is required by prior decisions of this Court. Matheson Co., 16 T.C. 478 (1951); Monarch Cap Screw & Manufacturing Co., 5 T.C. 1220 (1945).

The petitioner relies upon the following as proving that its earnings for the base period were inadequate: (1) that it lost an estimated production of 32,000 units or garments because of the strike which 19 T.C. 548">*561 could have been sold for approximately $ 83,000; (2) that it lost one of its most profitable customers (Princess Garment Co.) due to the strike; and (3) that settlement of the strike increased its labor costs in 1936 by $ 7,453.90, which costs could not be offset by increased prices as its prices were fixed in its catalogues.

Petitioner's1952 U.S. Tax Ct. LEXIS 10">*36 only witness was its general manager, who estimated the production lost in 1936. He allocated the estimated loss as follows: 2,500 units or garments in the last week of July; 20,000 units in August; 4,000 to 5,000 units in September; and 4,000 to 5,000 units in October. The general manager's estimate assumes that there was a slow down of production for 4 weeks before the strike and a continuing effect on production for 9 weeks after the strike. The tables in our findings showing petitioner's monthly production do not, in our opinion, support petitioner's estimate of the amount of production lost as a result of the strike. Petitioner's production in 1936 exceeded its production for any other year during the period 1934 to 1939, inclusive. A comparison of its production for the last half of these years indicates that production in the last 6 months of 1936 was at about the same rate as the aggregate for the other 5 years in this period. It is, of course, true that petitioner lost production during August due to the strike, but, on this record, the lost production was either taken care of through inventories, the estimated monthly amount of which appears in our findings, or the1952 U.S. Tax Ct. LEXIS 10">*37 production lost because of the strike was made up by increased production after the strike, or the loss in production was taken care of through a combination of inventories built up before the strike and increased production after the strike.

Although petitioner's production and operation were interrupted by the strike, it does not appear that the strike had any serious effect on petitioner's 1936 or its average base period net income. Our findings show that 1936 was the most profitable year in petitioner's existence from 1927 to 1940, and that its 1936 sales volume was exceeded only by 1939. This record does not show that petitioner's sales volume or its net income decreased because of the strike. We cannot agree, therefore, with the petitioner that its sales volume would have been approximately $ 83,000 more in 1936 if the strike had not occurred. Nor can we agree that if an additional estimated 32,000 units had been produced, and sold, petitioner's 1936 net income would have been increased proportionately. The general manager's testimony that the garments could have been sold at an average price of $ 2.594 ($ 83,000 divided by 32,000) is a conclusion unsubstantiated by any1952 U.S. Tax Ct. LEXIS 10">*38 persuasive evidence. The evidence shows that petitioner operated in a keenly competitive market. Whether this market could and would have absorbed an additional 32,000 garments has not been 19 T.C. 548">*562 demonstrated. The favorable conclusions that petitioner draws from a comparison of production and sales for selected months and periods in 1936 with 1939 are refuted by an over-all comparison of production and sales for the two years. The difference in sales volume may well have resulted from the higher unit prices received for woolens and the 17,663 reversibles sold in 1939. In any event, it does not follow that a higher sales volume will necessarily result in an increased net income because the comparison of 1936 with 1939 shows that although 1939 sales exceeded 1936, the 1936 net income exceeded 1939 net income.

Petitioner's second contention on the 722 (b) (1) issue deals with its account with the Princess Garment Company. It is contended that because of the strike, petitioner was unable properly to service this customer with the raincoats ordered and as a result the account was lost. This contention is based almost entirely upon the testimony of petitioner's general manager, 1952 U.S. Tax Ct. LEXIS 10">*39 who testified that he had "always contended" that this account --

* * * would have stayed as a major account if it had not been for the bad service that we gave them during the year of the strike. They were more vulnerable to poor service than the average account.

After testifying that the Princess Garment Company might have taken their raincoat business to a competitior or competitors, or might have decided to gradually ease away from petitioner as a source of supply, the general manager testified as follows:

I cannot answer what was in their mind, but the net result of it is we lost their account. It hung over for several years in a declining amount. * * *

The testimony upon which petitioner relies does not establish that the Princess Garment Company account was lost because of the strike. On the contrary, it establishes that petitioner does not know and is only speculating as to the reasons for the loss of the account. This seems odd in view of the fact that petitioner's sales to Princess Garment Company, in 1935, constituted over 15 per cent of its total sales for that year. An account of this size, in a competitive market, is nourished and protected; it is not allowed1952 U.S. Tax Ct. LEXIS 10">*40 to dwindle away because an unusual circumstance has temporarily interferred with normal operations. It is difficult to believe that if the strike, with its resulting poor service, was the cause of petitioner's losing the account, that affirmative evidence thereof could not have been produced. The absence of such affirmative evidence, together with the numerous other possible reasons for the loss of the account, precludes any determination in petitioner's favor on this contention.

Petitioner's final contention on the 722 (b) (1) issue is that the increased wages paid as a result of the strike increased its 1936 cost of operations, and that such costs could not be offset by a corresponding increase in sales price because its prices had been fixed by the issuance 19 T.C. 548">*563 of its catalogues. There can be no question about the existence of the strike or that petitioner agreed to and did pay increased wages in settlement of the strike. But this is beside the point. Relief under 722 (b) (1) is granted where an unusual event exists and as a result thereof the average base period net income is an inadequate standard of normal earnings. Petitioner's 1936 earnings have not been shown 1952 U.S. Tax Ct. LEXIS 10">*41 to be inadequate, and what petitioner is saying here is that if it had not paid the increased wages its 1936 profits before taxes would have been $ 7,453.49 more than they were. A similar assumption could be made with respect to almost any factor entering into the computation of net income. While section 722 computations require certain assumptions to be made, such assumptions must comport with reason when associated with known facts. D. L. Auld Co., 17 T.C. 1199 (1952). Petitioner has failed to establish that the brief interruption and diminution of production, output, and operation, caused by the strike, resulted in an inadequate standard of normal earnings. On this issue, therefore, we hold for the respondent.

Petitioner's second claim for relief is based upon a "change in the character of its business" within the meaning of section 722 (b) (4), the pertinent provisions of which appear in the margin. ⁴ It claims that because of (1) a difference in the products furnished and (2) a difference in the capacity for production or operation, its business did not reach, by the end of the base period, the earning level it would have reached had the change1952 U.S. Tax Ct. LEXIS 10">*42 been made two years earlier. These claims will be considered separately in the order above stated.

Petitioner's contention, that1952 U.S. Tax Ct. LEXIS 10">*43 its base period net income is inadequate because of a difference in the products furnished, is based upon the addition to its line of raincoats and rain garments of a line of woolen garments including a special type of wool coat known as a reversible. It is contended that these woolen items represented a drastic and material change in petitioner's type of production, and that in each year subsequent to the commencement of the change, petitioner's sales of woolen garments increased but had not by the end of 1939 reached the earning level which it would have reached had the change been made two years earlier.

19 T.C. 548">*564 Respondent's position is that petitioner's manufacture of woolen garments did not change the character of its business for the reason that petitioner had been constantly searching over a period of years for an off-season item which would take up the slack in production during the first half of the calendar year. He contends that the entire line of off-season items manufactured by petitioner should be considered as a whole, and that changes in styling and fabrics do not constitute a difference in the products furnished within the meaning of section 722 (b) (4). He relies1952 U.S. Tax Ct. LEXIS 10">*44 upon Stonhard Co., 13 T.C. 790 (1949), Regulations 112, and the Bulletin on Section 722.

Section 35.722-3 (d) of Regulations 112 deals with "Commencement or change in character of business." Among other things it states that for the purposes of section 722 (b) (4) a change in the character of the business

must be substantial in that the nature of the operations of the business affected by the change is regarded as being essentially different after the change from the nature of such operations prior to the change. No change which businesses in general are accustomed to make in the course of usual or routine operations shall be considered a change in the character of the business for the purposes of section 722 (b) (4). Trade custom and practice may be taken into account in determining whether an essential difference in the character of the business has occurred. A change in the character of the business, to be considered substantial, must be reflected in an increased level of earnings which is directly attributable to such change. If such increased level of earnings is not actually realized in the base period, the taxpayer is not precluded from1952 U.S. Tax Ct. LEXIS 10">*45 establishing a change in the character of the business provided it can establish that such increased level would have been attained in the base period but was hindered or delayed by unusual and peculiar events or economic circumstances. Such proof may not take into account any increase in earnings after December 31, 1939, as indicative of the fact that a change in the character of the business was productive of increased earnings.

This Court in Wisconsin Farmer Co., 14 T.C. 1021 (1950), accepted the general principles outlined in the above regulations.

Under the regulations, in order to secure relief under 722 (b) (4) because of a difference in the products furnished, petitioner must show that the change is substantial for the reason that (1) the nature of its operations is essentially different after the change, and (2) a higher level of earnings resulted (with the exception contained therein which is not material here) which is directly attributable to the change in character of its business. Respondent's Bulletin on Section 722, at page 50, points out that the addition of a new product must represent more than a usual or customary event in the1952 U.S. Tax Ct. LEXIS 10">*46 type of business in which the taxpayer is engaged; that in certain types of business it is customary to eliminate unprofitable lines and add new lines, such as a business where the products are affected by changes in the style; and that in such businesses variations in products would not qualify as differences in the products furnished.

19 T.C. 548">*565 In the Stonhard case, supra, the taxpayer claimed that it changed the character of its business during the base period by the introduction of three new products which it contended represented a difference in the products furnished. In denying relief, we pointed out that these three products fitted into the general line of products being sold by the taxpayer, that they were not a departure from and did not represent any change in the character of the taxpayer's business, that they were relatively small new products which the trade would recognize as mere additions to taxpayer's line, and that they did not affect the type of customers solicited, open new markets, change sales policies, affect manufacturing, or materially affect earnings. We distinguished the Stonhard case from Lamar Creamery Co., 8 T.C. 928 (1947),1952 U.S. Tax Ct. LEXIS 10">*47 for the reason that the introduction of a new product by the latter changed it from a small business operator to one of the largest in its area, with new methods of merchandising, solicitation of new customers for its new product, and quantity production of the new product. These changes in the character of the business of Lamar Creamery Co. were considered substantial enough to qualify it for relief under 722 (b) (4), but no such conditions were found to exist in the Stonhard case.

The present case involves circumstances similar to those existing in the Stonhard case. Petitioner's rainwear were outer garments made out of various waterproofed fabrics. Its woolen garments were also outer garments made of wet-proof or water-repellent woolen materials. The line of woolen merchandise fitted in with and supplemented petitioner's line of raincoats, and the woolens replaced the line of sport jackets which petitioner had been manufacturing as an off-season item. Petitioner's catalogues show that the addition of a line of waterproofed woolen garments represented no substantial departure from its normal operation of manufacturing rainwear from various waterproofed fabrics, including1952 U.S. Tax Ct. LEXIS 10">*48 tweeds, wool and silk tweed, seersucker, percale, crepe de chine, jersey, gabardine, Harris type tweed, leatherette, etc., all of which are described in the merchandise set forth in its 1934-35 catalogue. The manufacture of outer garments from waterproofed woolens was not essentially different from the manufacture of outer garments from other waterproofed fabrics. The woolen garments were accepted by the trade as a normal addition to the line of weatherproofed outer garments manufactured by petitioner. Some new customers were attracted by the addition of the woolen garments, but raincoat customers were also purchasers of the water-repellent woolens. The use of waterproofed woolens in manufacturing its merchandise created no new product for petitioner whereby new markets were opened up or new types of customers acquired. Its products continued to encounter the same highly competitive markets with its woolens that it did with its other rainwear. Petitioner made no change in its sales policies with the introduction of its lines of woolen 19 T.C. 548">*566 garments. On this record, it cannot be said that the nature of petitioner's business operations was essentially different, after the1952 U.S. Tax Ct. LEXIS 10">*49 change, from the nature of such operations prior to the change. Cf. Avey Drilling Machine Co., 16 T.C. 1281 (1951).

Furthermore, petitioner fails to meet the other requirement of the regulations, namely, that a change in the character of the business, to be considered substantial, must be reflected in an increased level of earnings which is directly attributable to such change. Our facts show that the introduction of woolen garments brought about no increased level of earnings. As a matter of fact, petitioner's profits before taxes for 1937, the first year after it had quantity production of its woolen garments, were the lowest during the period 1927 to 1939, inclusive. And in none of the base period years, subsequent to 1936, did petitioner show any increased level of earnings. In our opinion, petitioner has failed to show that it changed the character of its business because of a difference in the products furnished. We, therefore, approve respondent's determination on this portion of the 722 (b) (4) issue.

Petitioner's other claim for relief under section 722 (b) (4) is based upon its contention that it changed the character of its business1952 U.S. Tax Ct. LEXIS 10">*50 during the base period by a difference in the capacity for production or operation. Petitioner contends that a change in capacity occurs under the law and the regulations either when latent capacity is utilized, or when a general rearrangement of machinery occurs which converts an ordinary into an assembly-line method of operation. It is contended that both of these factors are present here due to the rearrangment of petitioner's equipment and the utilization of hitherto unavailable space which resulted in streamlining operations in its plant.

The evidence in this case does not establish that there has been a change in the character of petitioner's business due to a difference in its capacity for production. Petitioner did not show the capacity of its plant prior to or during the base period years. In terms of units or garments produced, 1936 was petitioner's best year. Upon the basis of production figures after 1936, there was no increase in petitioner's capacity as a result of the rearrangement of petitioner's equipment and the utilization of hitherto unavailable space. The record provides us with no unit for measuring petitioner's capacity other than its actual production1952 U.S. Tax Ct. LEXIS 10">*51 figures. Cf. Jacob's Fork Pocahontas Coal Co., 17 T.C. 357, 363 (1951).

Furthermore, the additional space, which petitioner utilized in the building after the landlord remodeled it, was not "latent capacity" within the meaning of the regulations. It was idle capacity. Latent capacity refers to the utilization of hidden or dormant qualities in productive or operative equipment through newly developed techniques, whereby the productive or operative capacities of such equipment 19 T.C. 548">*567 are expanded. ⁵ Nothing of this nature occurred here. Petitioner used the additional space made available by its landlord's expenditures to relieve the cramped quarters occupied by its cutting department, and to change the routing of its work in process so as to eliminate loss of time and some expense. This was normal, routine administration of its business. Naturally, there was a difference in its operations after moving and resetting its equipment, and purchasing the Soabar machines, but the differences were not substantial, and the changes served an economic purpose without any demonstrated increase in petitioner's capacity for production. Farmers Creamery Co. of Fredericksburg, Va., 18 T.C. 241 (1952).1952 U.S. Tax Ct. LEXIS 10">*52

In view of the foregoing, we hold that petitioner has failed to establish that its actual average base period net income was an inadequate standard of normal earnings so as to entitle it to relief under section 722 (b) (1) or (b) (4). It is unnecessary, therefore, to consider petitioner's method of reconstructing average base period net income, or its other contentions.

Reviewed by the Special Division.

Decision will be entered for the respondent.