Occasionally, companies construct their own assets. Determining the cost of such machinery and other fixed assets can be a problem. Without a purchase price or contract price, the company must allocate costs and expenses to arrive at the cost of the self-constructed asset.
Materials and direct labor used in construction pose no problem. A company can trace these costs directly to work and material orders related to the fixed assets constructed.
However, the assignment of indirect costs of manufacturing creates special problems. These indirect costs, called overhead or burden, include power, heat, light, insurance, property taxes on factory buildings and equipment, factory supervisory labor, depreciation of fixed assets, and supplies.
Companies can handle indirect costs in one of two ways:
Assign no fixed overhead to the cost of the constructed asset
The major argument for this treatment is that indirect overhead is generally fixed in nature; it does not increase as a result of constructing one’s own plant or equipment. This approach assumes that the company will have the same costs regardless of whether it constructs the asset or not.
Therefore, to charge a portion of the overhead costs to the equipment will normally reduce current expenses and consequently overstate income of the current period.
However, the company would assign to the cost of the constructed asset variable overhead costs that increase as a result of the construction.
Assign a portion of all overhead to the construction process
This approach, called a full costing approach, is appropriate if one believes that costs attach to all products and assets manufactured or constructed.
Under this approach, a company assigns a portion of all overhead to the construction process, as it would to normal production.
Advocates say that failure to allocate overhead costs understates the initial cost of the asset and results in an inaccurate future allocation.
Companies should assign to the asset a pro-rata portion of the fixed overhead to determine its cost. Companies use this treatment extensively because many believe that it results in a better matching of costs with revenues.
If the allocated overhead results in recording construction costs in excess of the costs that an outside independent producer would charge, the company should record the excess overhead as a period loss rather than capitalize it.
This avoids capitalizing the asset at more than its probable market value.