27 T.C. 70">*70 This proceeding involves a disallowance of claims for excess profits tax relief under section 722 (b) (4) based on an alleged change in capacity for production made in 1941 pursuant to a 1956 U.S. Tax Ct. LEXIS 61">*62 course of action to which petitioner was committed prior to January 1, 1940. The years involved and the amounts of taxes in controversy are as follows.

FINDINGS OF FACT.

Petitioner is a manufacturer of tool steel with its principal office and place of business located at Chicago Heights, Illinois. Its returns for the years involved were filed with the then collector of internal 27 T.C. 70">*71 revenue for the first district of Illinois. The returns were made on an accrual basis and for a calendar year.

Petitioner has been engaged in the manufacture and sale of tool steel since its organization in 1904. During the base period it was the only manufacturer of tool steel in the United States located west of Pittsburgh, Pennsylvania.

Tool steel is used principally in the manufacture of tools and dies for cutting and shaping metals and various other materials.

The process of manufacturing tool steel during the base period may be described briefly as follows: First, the component metals, such as iron and steel, together with the necessary alloys, known as a "batch," 1956 U.S. Tax Ct. LEXIS 61">*63 are melted down in a furnace. The molten material is then poured off or "teemed" from the furnace into a mold to form an "ingot." After cooling, the ingot is reheated and rough hammered or "cogged" and the outside defects and imperfections are trimmed or ground off, and thus the ingot becomes a "billet." The billet is then heated and processed by hammers or rolling mills into a "bar." The bars are of various sizes and shapes, according to the use for which the product is intended.

The final process, called annealing, consists of reheating the bar in an annealing furnace under controlled temperatures to make it soft and pliable. The tempering of the finished tool to the desired hardness is done by the toolmaker, i. e., the purchaser of the tool steel. There is a shrinkage or loss in weight of about 20 per cent in reducing the ingot to a billet, and about the same loss in converting the billet to bars. Thus, 100 pounds of melted steel produces only 60 pounds of finished product.

Until about the end of World War I, the crucible method of melting steel was generally used in the tool steel industry. By that time the crucible furnaces were being largely replaced by electric furnaces. 1956 U.S. Tax Ct. LEXIS 61">*64 The industry-wide changeover began about 1920 and was practically completed by 1926.

For some time after most other tool steel manufacturers had changed to electric furnaces, petitioner continued to use its crucible furnaces. It had three of these furnaces with a total maximum melting capacity of 8,100 tons a year. About 1924 it began losing ground in the industry due, in the opinion of its directors, to its continued use of the crucible furnaces. In 1927 petitioner contracted for a 3-ton electric furnace. It had a total maximum melting capacity of 3,600 tons a year. The melting capacity of a furnace is determined by the number of pounds or tons of metal it can melt and pour in a given length of time. The electric furnace was installed and put into production in 1929. It replaced one of the three crucible furnaces which petitioner then had in use.

27 T.C. 70">*72 Thereafter, petitioner used both the electric furnace and the two remaining crucible furnaces until about the middle of 1930 when the remaining crucible furnaces were dismantled. From that time, and throughout the base period, petitioner used only the single electric furnace.

A tool steel plant consists of three separate1956 U.S. Tax Ct. LEXIS 61">*65 departments, melting, forging, and a rolling mill. The forging and rolling mill departments combined determine the finishing capacity of the mill.

It is petitioner's practice, and the custom of the industry, to make an annual estimate of its plant capacity both as to each separate department and its allover or "effective capacity." The effective capacity is necessarily limited to the capacity of the lowest essential operation. For instance, with a melting capacity of a given amount and a finishing capacity of a lesser amount, the effective capacity would be limited to the finishing capacity. The calculated effective capacity of petitioner's plant was 3,600 tons per year from 1920 to 1926, 4,350 tons from 1927 through 1929, 2,880 tons in 1930, 2,066 tons in 1931, and 2,535 tons for 1932 through 1939.

For the years 1920 through 1929 the effective capacity of petitioner's plant was limited by the finishing department capacity. The melting capacity of the three crucible furnaces was 8,100 tons per year. For the period 1930 to 1939 the effective plant capacity was limited by the melting department capacity. The finishing capacity was increased in 1927 by the acquisition of a 4-ton1956 U.S. Tax Ct. LEXIS 61">*66 hammer with a finishing capacity of 750 tons. The installation of the electric furnace in 1929 did not change the effective capacity of the plant which was then limited to the finishing department capacity. The change in the effective capacity in 1932 resulted from an increase in the melting capacity of the electric furnace from 3 to 3 1/2 tons. The single electric furnace in use by the petitioner during the period 1933 to 1939 had an estimated melting capacity of 4,200 tons per year. This would have amounted, after shrinkage, to approximately 2,500 tons. Petitioner's finishing department at the end of the base period had a capacity of 4,350 tons per year.

A tool steel plant should have a considerably larger melting capacity than finishing capacity. This is desirable in order to have the desired flexibility in handling the customers' orders. Since melting is the first step in the manufacturing process, any delay in that department holds up the entire process. Also, a safe margin between effective capacity and utilization of capacity is desirable so that prompt attention can be given to special orders and sporadic demands for tool steel.

Tool steel mills ordinarily operate 1956 U.S. Tax Ct. LEXIS 61">*67 at considerably less than their full capacity. There is no steady flow of orders, such as might keep all of the departments in steady operation. The same is true of the closely related steel mill industry, although it usually has a higher 27 T.C. 70">*73 rate of utilization of plant capacity than the tool steel industry. Petitioner's utilization of plant capacity as compared with that of the tool steel industry and the steel mill industry during the period 1933 to 1939, inclusive, was as follows:

In 1927 when petitioner decided to purchase its first electric furnace it intended, eventually, to convert entirely to electrical furnaces, after and when the first one proved satisfactory and business conditions were favorable. It was estimated that 2 electric furnaces of 3-ton capacity each would be required to give the proper melting capacity. Petitioner planned to add the second furnace after the first had been put into production. However, due largely1956 U.S. Tax Ct. LEXIS 61">*68 to the depression which developed in 1929 and continued for several years thereafter, these plans were not carried out as first intended. The only change that was made in petitioner's melting facilities prior to the end of the base period was a mechanical change in the electric furnace in 1932 which increased its capacity from 3 to 3 1/2 tons. Further changes in this furnace were made in 1940 increasing its capacity to 4 tons. During all of the base period petitioner had available funds with which to purchase an additional electric furnace. Its failure to do so prior to December 1939 was due to the opinion of its management that the additional furnace would not bring in enough new business to pay for the investment within a period of 10 years.

In 1932 petitioner's actual melting production was only about 8 per cent of what it was in 1929. The following table shows petitioner's total melting production, in pounds of ingots, the number of heats run in its melting furnace, and the number of months in each year during which the furnace was not operated over the period 1932-1939:

1956 U.S. Tax Ct. LEXIS 61">*69 27 T.C. 70">*74 The 4 months in 1938, during which some melting was done, were March, June, September, and November.

Some of the furnace idleness shown in the above table was for the purpose of saving the cost of current used in the electric furnace. When this furnace was installed, petitioner set up a maximum power rate, called "demand," for each month, and the melters were paid a bonus for observing this limit.

From time to time during the base period, petitioner's officers and directors continued to discuss the expansion of the plant. In 1939 they tentatively agreed upon a plan for purchasing a new 6-ton capacity electric furnace, instead of the additional 3-ton furnace originally contemplated, and using both furnaces in a new melting building to be constructed for that purpose. Under this plan the new furnace and the electric furnace already in use were to be served by the same electrical installations. They could be used consecutively but not simultaneously.

On December 18, 1939, petitioner wrote Pittsburgh Lectromelt Furnace Corporation, as follows:

We acknowledge and thank you for yours of the 14th with further reference to the furnace covered by our order No. J-1039.

We are 1956 U.S. Tax Ct. LEXIS 61">*70 planning to put this furnace in a new building to be erected south of the present building. The furnaces will be erected against a long south wall in the easterly end of the building as per pencil sketch attached. This will mean that the 3-ton furnace will pour in its present direction and the 6-ton furnace is desired with pouring to the left and roof swing to the left (as you stand between the transformer room and the furnace facing the furnace).

If you have any comment on this arrangement, please advise, otherwise it will be satisfactory to proceed with the construction of the 6-ton furnace in this manner.

On September 12, 1939, petitioner wrote to Pittsburgh Lectromelt Furnace Corporation the following letter:

With the developments abroad, we have gone back to our correspondence with you from October, 1935, to June, 1937, concerning the installation of an additional melting unit.

We would be glad at this time to have you quote for our consideration on one Size 0 furnace without removable roof and with removable roof. The last formal quotation you gave us was under date of June 9th, 1936, and it will be satisfactory to use this as a basis for the present charges unless you have1956 U.S. Tax Ct. LEXIS 61">*71 made important changes in the equipment.

There is one point that does not seem to be covered and that is the possibility and cost of installing the removable roof apparatus at a date subsequent to the installation of the furnace. We would appreciate your comment on this.

We would also like to know what delivery you could make of the additional equipment.

For your information, our present thought is to install the furnace in our existing building and we have abandoned at least for the time being the thought of erecting a melting building as last discussed with you.

27 T.C. 70">*75 Petitioner placed its order for the new 6-ton furnace with Pittsburgh Lectromelt Furnace Corporation on September 21, 1939, and the order was accepted September 23, 1939. In the meantime, it had decided to erect the new melting building as first planned. A contract for the erection of this building was let on March 22, 1940. The building was completed and the new furnace installed and put into operation about March 14, 1941.

Petitioner also made other changes in its plant arrangement and equipment in connection with the installation of the new furnace, including moving the old electric furnace to the new location, 1956 U.S. Tax Ct. LEXIS 61">*72 the relocation of the transformer so that it could serve both furnaces, the installation of a new mechanical-type crane in the melting building, and the construction of a railroad track to and from the new melting building. The total cost of the new furnace, the melting building, and equipment was as follows:

Under this arrangement petitioner could operate either of the electric furnaces singly but not both at the same time. To operate them simultaneously would have required the installation of a new transformer system at an additional cost of not less than $ 15,000.

Petitioner classified its various grades of tool steel either as "regulars" or "specials." The regulars were the standard grades which petitioner kept in stock both in finished sizes and shapes and also in ingots and billets. The specials were made to customers' specifications for a particular purpose and were not carried in stock. During the base period petitioner manufactured about 15 regular grades and 23 special1956 U.S. Tax Ct. LEXIS 61">*73 grades. Petitioner's annual production and monthly average of ingots and of finished products for each of the base period years were as follows:

27 T.C. 70">*76 There were some months during the base period when petitioner's furnaces were not used at all, and other times when petitioner would be overloaded with melting orders, depending upon how the customers' orders came in.

Petitioner's inventory of finished products, referred to as "bar stock," consisted of about 50 or more different grades of steel in various sizes and shapes. About two-thirds of petitioner's sales were made from finished stock inventories. Petitioner maintained storage warehouses in Chicago, Milwaukee, Detroit, Cleveland, Cincinnati, and Chicago Heights, with a total capacity of 3,525,000 pounds. It also had sales representatives with available stocking facilities in several other large cities. The inventory of finished products, 1956 U.S. Tax Ct. LEXIS 61">*74 however, was not complete and was sometimes inadequate for large orders, so that production was required from time to time according to the general economic conditions. This was true of the ingot and billet inventories as well as the inventory of finished products. About one-third of petitioner's orders could not be filled from its finished stock inventories. About 55 per cent of the orders that could not be filled from finished products inventories were filled from billet and ingot inventories. About 17 or 18 per cent of all orders required special melting. ¹ At December 31, 1939, there was an ingot inventory totaling 841,800 pounds and a billet inventory of 751,499 pounds. These inventories were out of balance in that they both were topheavy with grades and sizes for which there was slack demand. The scarcity of proper sizes and grades of ingots and billets sometimes held up the finishing work and delayed production. The 600-pound ingots were most in demand and were the most economical size. The smaller and larger sizes which were in less demand had a tendency to accumulate. The accumulation of these undesirable sizes and grades sometimes had to be remelted at an additional1956 U.S. Tax Ct. LEXIS 61">*75 cost. This condition existed throughout the base period. For the grades most in demand, petitioner maintained a 2 or 3 months' supply of ingots and billets. This unbalanced condition of petitioner's inventories was not caused by a lack of melting capacity and was not appreciably helped by the installation of the larger furnace in 1941.

Petitioner's total inventories of raw materials, work in process, finished goods, and supplies, on a cost basis, at the end of each of the years 1919 to 1945, inclusive, were as follows: 27 T.C. 70">*77

1956 U.S. Tax Ct. LEXIS 61">*76 One of the major problems of the tool steel manufacturer is furnace contamination, resulting from melting in succession in the same furnace different grades and types of steel in which different and sometimes incompatible alloys are used. Some of these types are compatible to a limited degree, while others are not. Before melting incompatible types the furnaces would have to be thoroughly cleaned after each melt. This is a time-consuming and expensive operation. Contamination beyond a narrow point of tolerance might result in the rejection of the entire melt. To minimize this risk, petitioner, along with other tool steel manufacturers, whenever possible follows an established sequence of melting, designed to give succession to the more compatible types. This procedure is one of the reasons for the desirability of extra melting capacity in a tool steel plant. After the installation of the larger furnace, petitioner used it for the melting of low alloy die steels and carbon steels, and used the smaller furnace for the melting of high alloy steels such as Tungsten hot work steel.

Petitioner also has established cycles or sequences of 6 or 13 weeks for the fabrication of bars from1956 U.S. Tax Ct. LEXIS 61">*77 billets through its rolling mill operations, starting with a roll set adapted for making bars of certain sizes and shapes (with adjustments possible to obtain changes in thickness and width) and followed by changes of roll sets adapted for the making of bars of other general sizes and shapes. During the base period these sequences were adhered to over three-fourths of the time. Deviations from the established sequences or cycles entailed considerable expense in additional time.

27 T.C. 70">*78 Petitioner's sales, in tons and in dollars, and its net profits, as finally determined for Federal income tax purposes, for the years 1904 to 1942, inclusive, so far as the figures are available, were as follows:

Throughout most of the base period the tool steel market was highly competitive. Few of the manufacturers were operating at capacity. One of the largest factors in securing orders was the time element. Since the products of all reliable tool steel manufacturers and prices were somewhat standardized, the customer usually placed his order where he could get the earliest delivery. Petitioner, like other tool steel manufacturers, suffered losses of both orders and customers during the base period because of its inability to make prompt deliveries.

Shipments of tool steel made by petitioner, compared with the total production of the tool steel industry over the period 1933 through 1939, were as follows: 27 T.C. 70">*79

The addition by the petitioner of the 6-ton electric furnace ordered in 1939 and installed for operation in 1941 gave petitioner greater leeway in the arrangement1956 U.S. Tax Ct. LEXIS 61">*79 of melting sequence and in the types and sizes of ingots. The largest size ingot produced in the 3 1/2-ton furnace was 2,700 pounds, while the 6-ton furnace was capable of producing a 3,500-pound ingot. The large size ingots were sometimes required when, to gain uniformity, the customer specified that an order was to be filled from a single heat.

Petitioner's excess profits net income, excess profits tax credit computed on the income credit method, and excess profits tax liability, as determined by respondent, and the amounts now in controversy, for the years 1940 through 1945, are as follows:

The stipulated facts, insofar as they are not specifically set out above, are incorporated herein by this reference.

OPINION.

This is a so-called commitment1956 U.S. Tax Ct. LEXIS 61">*80 case arising under section 722 (b) (4), Internal Revenue Code of 1939. The petitioner's contentions are that it increased its plant capacity after December 31, 1939, under a course of action to which it was committed prior to January 1, 1940, by approximately 71.5 per cent, and that with such increased capacity its base period production and sales would have increased in the same proportion. Thus, in its proposed reconstruction of base period income, base period capacity is increased from 2,535 tons of tool steel per annum to 4,350 tons. Constructive sales are determined by applying to constructive plant capacity the same percentage of plant capacity utilized by the petitioner in each of the base period years and constructive base period net income by applying 27 T.C. 70">*80 to constructive sales the ratio of net income to sales established by the petitioner in its actual base period experience.

The respondent does not dispute that petitioner was committed to an increase in plant capacity prior to January 1, 1940, as claimed, but he argues that the change was not substantial, measured in terms of potential base period output and net earnings, and in no event could the change have resulted1956 U.S. Tax Ct. LEXIS 61">*81 in base period earnings sufficient to produce a constructive average base period net income which would yield excess profits credit equal to that allowed petitioner for the years 1942 to 1945, inclusive, under the so-called 75 per cent rule of section 713 (e), Internal Revenue Code of 1939. In the adjustment under section 713 (e), petitioner's average base period net income was increased from $ 194,449.69 to $ 221,861.73.

We do not understand respondent's contention to be that the addition of the new 6-ton furnace of nearly twice the melting capacity of the electric furnace then in use, with a stepped-up capacity of 3 1/2 tons, was not a "substantial" increase in melting capacity. His argument is that petitioner suffered no loss of sales in the base period by reason of inadequate melting capacity; that occasional losses of sales in the base period were normal for the petitioner, and the industry; and that in petitioner's case, especially, any appreciable loss of base period sales resulted from incomplete and unbalanced inventories of finished stock from which immediate deliveries could be made, a condition which would not have been helped by an increase in melting capacity. ²

1956 U.S. Tax Ct. LEXIS 61">*82 Respondent contends further that the petitioner decided to add the increased capacity, about the close of 1939, not because of any long overdue need, as petitioner contends, but in anticipation of a war-inflated demand for tool steel.

Petitioner's basic theory in this case is that in the tool steel industry, capacity for production predetermined the sales of the individual manufacturers, or, in other words, that an increase in petitioner's capacity for production would necessarily result in a corresponding increase in petitioner's production, sales, and profits.

We are unable to accept this theory in spite of the testimony of petitioner's expert witness and the conclusions expressed in the testimony of certain other witnesses, particularly the testimony of petitioner's president. To the contrary, we agree with respondent's expert witness that an increase of capacity in the tool steel industry would result from an actual or anticipated increase in the demand for, i. e., sales of, tool steel, rather than that an increase in the sales of tool 27 T.C. 70">*81 steel would be caused by an increase in the capacity of production. See National Grinding Wheel Co., 8 T.C. 1278;1956 U.S. Tax Ct. LEXIS 61">*83 Green Spring Dairy, Inc., 18 T.C. 217. The record indicates that this was also the opinion of petitioner's management and management in the entire tool steel industry during the base period. Petitioner's president testified that while petitioner considered increasing its capacity in the base period, it did not do so because of business conditions, and that as those conditions were in 1938, the new capacity, in his opinion, would not have "capitalized" -- that is, brought in enough new business to pay for the investment within a period of 10 years. The evidence contains no account of any tool steel manufacturer increasing its capacity during the base period and realizing a proportionate increase in business. The evidence is, on the other hand, that during the base period the industry as a whole actually reduced its capacity for production.

It may well be that, with the increased capacity in the base period which would have resulted from the additional furnace and other improvements, the petitioner might have obtained more orders, produced more tool steel, made more sales, and realized larger net profits. The additional facilities gave petitioner 1956 U.S. Tax Ct. LEXIS 61">*84 other advantages than the actual percentage increase in melting capacity. The new 6-ton furnace used interchangeably with the smaller furnace permitted flexibility in the melting sequence, thereby reducing the contamination danger as well as the delivery time on special orders, reduced the melting time on certain types of products, and enabled petitioner to produce larger sized ingots than it could produce with the 3 1/2-ton furnace. The mechanical improvements in the new furnace and the other plant improvements which petitioner made under the commitment increased the efficiency of the entire plant and tended to reduce operating costs.

But it seems obvious to us that the effect of any or all of these betterments on sales and net profits would not have been in direct proportion to the increase in capacity. Since the tool steel market was limited, no amount of increased capacity would have increased the allover industry sales. Less than half of the industry capacity was utilized in the base period. The petitioner utilized, on an average, about 53 per cent of its base period capacity, and the industry as a whole only about 35 per cent of its capacity. As found above, tool steel 1956 U.S. Tax Ct. LEXIS 61">*85 purchasers usually placed their orders where they could get the earliest deliveries. This tended to have a leveling effect on the sales of the different tool steel manufacturers and to keep an even distribution of business over the entire industry. Slack orders for a manufacturer resulted in increased unused capacity, which permitted quicker deliveries which, in turn, brought in more orders. A gain in sales by one manufacturer meant a loss in sales to the others. Even with an increased capacity and greater flexibility of operation in the base period there would still 27 T.C. 70">*82 have been a time limitation on the filling of petitioner's orders which would have become progressively greater as orders increased, until the "leveling off" process asserted itself to divert orders to other manufacturers. Just when that point might have been reached and what would have been the limit on petitioner's ability to divert orders from the other manufacturers, we have no way of knowing. Therefore, while we are of the opinion that an increased melting capacity during the base period might have resulted in petitioner obtaining more orders, making more sales, and realizing larger net profits, the1956 U.S. Tax Ct. LEXIS 61">*86 amount of the additional orders, sales, and profits is not ascertainable on the record. Neither does the record justify us in making a guess or approximation of the probable amount of such additional orders, sales, and profits.

From our study of the entire record, including not only the carefully prepared opinion testimony offered by petitioner's expert witness but also that of the other witnesses, and especially the straightforward, informative testimony of petitioner's president, Arthur T. Claridge, and the mass of statistical data which the parties have submitted, by stipulation or otherwise, we have concluded that had the petitioner made the committed changes in capacity at the beginning of 1938 its constructive average base period net income would not have been greater than its average base period net income determined under section 713 (e).

Therefore, we conclude that the petitioner has not established that the tax computed without the benefit of section 722 resulted in an excessive and discriminatory tax and has not established what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income. See Danco Co., 14 T.C. 276, 290.

1956 U.S. Tax Ct. LEXIS 61">*87 Reviewed by the Special Division.

Decision will be entered under Rule 50.