Definition and explanation
A manufacturing company may decide to construct an asset for its own use rather than purchase it from another source. Two financial accounting issues must be considered in dealing with this situation: (a) identification of cost and (b) treatment of costs in excess of the purchase price. In associating costs with the self-constructed asset, the direct material costs, direct labor costs, and interest are always included. However, practice is not settled with respect to overhead costs. At one extreme, some advocate the inclusion of only the incremental overhead costs. That is, only those additional costs that are incurred because of the decision to construct should be added to the asset account.
This practice would exclude such indirect costs as depreciation and salaries of supervisors that would be incurred with or without the project. Others advocate assigning overhead on the same basis used for regular production and have suggested that anything less will understate the asset’s cost and overstate the cost assigned to the routinely manufactured goods.
Guidance may be provided by observing whether the construction effort curtailed production of marketable goods. If production was not displaced, it is argued, only the incremental costs should be debited to the asset account. If production was displaced, then overhead should be allocated to the asset on the same basis used for the regular production.
At the other extreme, some accountants have argued that the cost of the asset be increased to include the markup that an outside manufacturer would have charged. The proponents of this approach argue that the resulting higher cost will more closely approximate the value of the asset and thus provide more comparable numbers. This position is not generally accepted.
Example below shows the cost of a self-constructed building erected by the Sample Company under the three possible approaches.
In dealing with costs incurred in excess of an estimated purchase price, the accountant must seek to identify which of two reasons caused the overrun to occur. If the self-constructed asset is of higher quality or more efficient than commonly available versions, the higher cost may well be justified and should be added to the asset account.
On the other hand, if the assets are of comparable quality or efficiency, then the excess costs should probably be attributed to the periods in which the asset was constructed. This treatment is based on the concept that an asset should never be recorded at an amount higher than a determinable fair value when it enters the firm.