The financial accounting term self-constructed assets refer to those built by the company and appearing on its balance sheet. The cost of self-constructed assets would include direct costs such as materials and labor associated with its construction. Companies can optionally allocate a portion of indirect costs to the asset too.
Determining the cost of an asset that is self-constructed is more difficult than one that is purchased directly from a vendor or supplier. Without a written agreement as to the purchase price or a contract, the company must allocate cost to the construction of the asset.
Costs such as materials and labor are easy to identify since they can be captured by assigning these directly to the work and material orders dedicated to the capital project.
Accounting rules allow companies to allocate indirect costs such as building space, equipment, electricity, taxes, as well as labor such as supervision. Here the company has three options with respect to indirect costs:
- No Assignment: the company can take the position that most overheads are fixed costs and exist even if the asset was not constructed. If a portion of these fixed costs were charged to the asset, it would understate expense and overstate net income during construction.
- Pro-Rata Share: more commonly, accountants employ a full cost approach that allocates a portion of overheads to the asset. Advocates believe failure to allocate overheads understates the total cost to produce the asset.
- Lost Production: alternatively, the company could choose to allocate the lost opportunity cost due to the use of company resources to construct the asset. For example, the company could have produced 100 widgets with the 1,000 hours of labor charged to the capital project. While this concept is sound, determining the lost opportunity costs are time consuming and, at times, impractical to determine.
Given the guidance of accounting standard such as the matching principle, most companies assign a pro-rata share of overhead costs to self-constructed assets. However, it is inappropriate for a company to capitalize costs in excess of the asset’s market value. If the overheads result in a total cost that is greater than the price of a commercially-produced asset, the excess overhead charges should be expensed and not capitalized.