Question

CASE 9‐4 Self‐Constructed Assets

Jay Manufacturing, Inc., began operations five years ago producing the probo, a new type of instrument it hoped to sell to doctors, dentists, and hospitals. The demand forprobos far exceeded initial expectations, and the company was unable to produce enough probos to meet that demand. Jay was manufacturing probos on equipment it built at the start of its operations, but it needed more efficient equipment to meet demand. Company management decided to design and build the equipment because no equipment currently available on the market was suitable for producing probos.

In 2017, a section of the plant was devoted to development of the new equipment and a special staff of personnel was hired. Within six months, a machine was developed at a cost of $170,000 that increased production and reduced labor cost substantially. Sparked by the success of the new machine, the company built three more machines of the same type at a cost of $80,000 each.

Required:

1. In addition to satisfying a need that outsiders cannot meet within the desired time, what other reasons might cause a firm to construct fixed assets for its own use?
2. In general, what costs should be capitalized for a self‐constructed asset?
3. Discuss the appropriateness (give pros and cons) of including these charges in the capitalized cost of self‐constructed assets:
   1. The increase in overhead caused by the self‐construction of fixed assets
   2. A proportionate share of overhead on the same basis as that applied to goods manufactured for sale (consider whether the company is at full capacity)
4. Discuss the proper accounting treatment of the $90,000 ($170,000 – $80,000) by which the cost of the first machine exceeded the cost of the subsequent machines.

Answer 1

Part A

Other reasons might cause a firm to construct fixed assets for its own use includes:

• To utilization of available idle facilities and personnel.
• To achieve the level of expected cost savings
• To meet the requirement of special knowledge, skills and talent that is developed within the company and is hard to get from the outside.

Part B

All direct as well as indirect material and labor costs that can be identified with construction should be capitalized for self constructed fixed assets. Few examples of Costs that should be capitalized for self constructed fixed assets are depreciation on construction equipment, permits, legal fees, insurance and taxes, etc.

Part C-1

If the increase in overhead is due to self-construction of fixed assets, then it should be capitalized. The fact is that if there would have been no construction of assets, then there would have been no cost. Whether the plan operates at full capacity or not, this proposition ill not change. If the construction cost of such fixed assets is significantly higher than their business benefits, then the costs which are in excess are reported as a loss rather than capitalizing them.

Part C-2

While capitalizing costs of self-constructed assets, the proportion of overhead that should be included should same as the proportion applied to goods manufactured for sale, considering the plant is operating at full capacity while the construction of fixed assets. If there is any idle plant capacity, there is variation in opinions regarding the proportion of overhead. For the allocation of overhead, goods for which production was foregone should not be considered.

Part D

$90000 should be treated as capitalized costs as machine is expected to generate future benefits by its use. Thus, all development costs are required to be capitalized in association with the sales revenue of products manufactured. If the production machine does not give beneficial results, the excess costs is to be reported as an extraordinary loss.