Question

I found the discussion of self constructed assets to be interesting. These would be assets that the company itself builds instead of buys. The book talks about the difficulties in establishing the cost of the asset. How much of the company's overhead should be allocated to the project? How should interest incurred during construction be handled? There are a few options/opinions about how to handle overhead, which do you find to be best?

Answer 1

Self constructed assets, its costing and what is to be capitalized (Overview about total costs and Specifics about overheads and interest costs)

-In order to specifically identify the costs related to an asset the company is developing in-house, the company must make a system like making the construction a SPECIAL PROJECT to identify the costs.
-All costs like employee hours etc. must be specifically marked for the said project for identification purpose.
-Overhead costs - Overhead costs must be allocated to the project using a standard systematic basis. A standard and justifiable methodology must be developed and used without fail. Overheads cost would include costs like salaries of managers who are responsible for multiple projects and materials like glue, grease,oil, nails that are purchased in bulk for all the projects.

There are various methods available to allocate the overhead cost
-it can be allocated on the basis of machine hours
-It can be allocated on the basis of labor hours
-It can be allocated on the basis of labor cost (when labor rates are different, the allocation will be different as compared to labor hours)
-It can be allocated on the basis of activity drivers. (ABC Costing)

ABC costing will give more accurate results as compared to other methods. This would be possible if the number of activities are recorded appropriately and are easily marked project wise.

If there is need to borrow funds to fund the construction of an asset, the interest paid on these borrowings is a cost related to the asset and it must be capitalized as per the GAAP. It is not expensed. But keep in mind, interest incurred only till the construction is complete. The capitalization period for interest begins when purchases are made . This period ends when asset is ready to use.