Query No. 20

 

Subject:     

Capitalisation  of  engineering  overheads.1      

 

A. Facts  of  the  case

 

1. A public sector corporation has been constituted by an Act of Parliament for the construction and running of warehouses throughout the country. The construction of warehouses is carried out by the corporation’s own engineering wing which is organised as below:

 

         (i)         Construction cells, headed by a superintending engineer or an executive engineer, which directly supervise the work at different sites                       under their jurisdiction. At the different construction sites, assistant engineers and junior engineers are posted.

 

         (ii)        The engineering wing, headed by chief engineer level officer, which is stationed at the corporate office to supervise the entire                                engineering activity on an all-India basis.

 

2. The  construction  cells  incur  expenditure  on  the  construction  of warehouses, minor capital projects and maintenance of existing warehouses. The salaries and other expenses at the construction cells are allocated to the respective works in proportion to the value of work done. As such, these expenses are capitalised along with the completed works.  The expenses of the engineering wing of corporate office are also allocated to the respective works by way of engineering overheads.

 

3. The proportion of the engineering overheads to the value of work done at the respective construction cells varies from one construction cell to another, depending upon the distribution of work amongst the cells.

 

4. The activity to be performed by any construction cell is directly related to the work requirements (additional construction or repairs). As such, the activity performed by one construction cell will always be at variance with the  activity performed  by another  construction  cell  as also  by the  same construction  cell  over  different  years.  It  is  also  possible  that  no  major construction activity may be undertaken at any construction cell due to non- requirement of additional constructed capacity in any particular year.   In case there is no additional requirement for a number of years, the corporation even  resorts  to  closing down  a  particular  construction  cell.  Due  to  this disproportionate activity performance amongst the various construction cells, the percentage of engineering overheads to the works outlay varies to a significant extent over different years. As a result, the expenses at each construction  cell,  to  the  extent  it  exceeds  the  ‘all-India  average’  (of engineering overheads percentage), is being treated as abnormal and charged to revenue.

 

5. The entire exercise of charging of engineering overheads to revenue is being done at the corporate office. Once a warehouse is constructed and completed, the same is handed over to the ‘commercial wing’.

 

6. The  querist  had  earlier  sought  an  opinion  of  the  Expert  Advisory Committee on the methodology to be adopted for capitalisation of engineering overheads  which  is  published  as  Query  No.  1.48  in  Volume  XI of  the Compendium of Opinions. The Expert Advisory Committee in the said opinion had held the view that the “excessive indirect costs can be arrived at by determining a normal overhead absorption rate on the basis of the normal level of construction activity. The normal level of activity can be determined keeping in view various factors, such as, the existing facilities for construction of godowns available with the company in question, past experience, etc. The normal level of construction activity can be expressed in appropriate terms,  for  example,  number  of  working  hours,  etc.”   Accordingly,  the Committee had opined that the relevant indirect cost should be absorbed in the cost of construction of warehouses by using the following formula:

 

 Relevant indirect costs of construction

 ____________________________             X       Actual construction activity during the year

Normal construction activity

   

The Committee had further opined that the indirect cost which can not be absorbed may be charged to the profit and loss account.  Basis of absorption of indirect cost on the basis of all-India average may not be proper.

 

7. The corporation presently has 18 construction cells spread all over India to look after its warehousing infrastructure as well as the construction activities. According to the querist, considering the variation in the requirements of constructed warehouses, complexity of the activities and vast network, which is not exclusively for construction of new warehouses but also for repairs to existing warehouses, it is not feasible to determine the level of ‘normal construction activity’ and that too individual construction cell-wise. As per the querist, it is also not feasible to express the normal level of activity in terms of working hours, etc. The details of capacity constructed by the corporation during the last six years has been provided by the querist to substantiate the corporation’s stand, as below:

 

 

 

Accordingly, based on ‘past experience’, the ‘all-India average’ overhead rate of the relevant year was considered by the corporation to be the most appropriate and the corporation continued to absorb the indirect costs on the basis of ‘all-India average’ overhead rate of the relevant year. However, in cases where the actual overheads of a construction cell happen to be less than the ‘all-India average’, the total of such overheads is absorbed.

 

8. The C&AG, during the audit of accounts of the corporation for the year 2000-01, observed that the corporation had neither followed the opinion given  by  the  Expert  Advisory  Committee  of  the  Institute  of  Chartered Accountants of India, nor had approached the Institute again for an alternative method.

 

9. The corporation is continuing with the practice of absorption of overheads on the basis of ‘all-India average’.  The overheads over and above the ‘all- India average’ are charged to profit and loss account.

 

B. Query

 

10. Keeping in view the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

 

        (a)        In view of the complexity of activities, vast network and variation in the construction requirements from year to year, it is not feasible                    to determine the ‘normal construction activity’ on the basis of working hours or on any other basis.  As such, based on its past                            experience, whether the corporation should continue with the present system of capitalisation of overheads on an ‘all-Indi a average’                    basis since the corporation is of the view that the procedure being currently followed by the corporation is the only logical and best                    possible way for absorption of overheads in the present scenario.

 

        (b)        Any alternative method, more appropriate to ensure an equitable mode of capitalisation of overheads, may be suggested which can be                    worked out without correlating the same to the normal level of activity (working hours, etc.), keeping in view the peculiar situation in                    which the corporation is operating.

 

C. Points  considered  by  the  Committee

 

11.The Committee notes that the accounting principles for determination of the cost of a self-constructed fixed asset, have been laid down, inter alia, in paragraph 21 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India. According to the said paragraph, “The cost of a self-constructed fixed asset should comprise those costs that relate directly to the specific asset and those that are attributable to the construction activity in general and can be allocated to the specific asset”.  Thus, all direct costs and relevant indirect costs should be included for arriving at the cost of construction of self- constructed warehouses.

 

12. As per the generally accepted accounting principles, the costs that can be directly related to the construction activity include:

 

       (a)        site labour costs, including site supervision;

 

       (b)        costs of materials used in construction;

 

       (c)        depreciation of plant and equipment used on the contract;

 

       (d)        costs of moving plant, equipment and materials to and from the contract site;

 

       (e)        costs of hiring plant and equipment;

 

       (f)         costs of design and technical assistance that is directly related to the contract;

 

       (g)        the estimated costs of rectification and guarantee work, including expected warranty costs; and

 

       (h)        claims from third parties.

 

Costs that may be attributable to construction projects in general and can be allocated to specific projects include:

 

       (a)        insurance;

 

       (b)        costs of design and technical assistance that is not directly related to a specific project; and

 

       (c)        construction overheads.

 

As per the generally accepted accounting principles, such costs are allocated using methods that are systematic and rational and are applied consistently to all costs having similar characteristics.  The allocation is based on the normal level of construction activity.

 

13. The Committee is of the view that for allocation of overheads, use of normal  capacity  is  rational  since  a  business  creates  the  necessary infrastructure to meet the normal level of capacity.   In case a business is unable  to  reach  the  normal  level  of  capacity  for  which  it  has  created infrastructure facilities, it will have to restructure itself for the purpose of its survival and growth. It is, therefore, of utmost importance that every business has to determine either intuitively or formally its normal capacity level.  In view of this, the overheads which cannot be absorbed on the basis of the normal level of capacity are required to be charged off to the profit and loss account  rather  than  absorbing  the  overheads  in  the  cost  of  production (construction of warehouses in the present case).  If a business is not able to attain the normal level of capacity and the overheads are absorbed on a basis which represents the actual utilisation of the capacity, it would result in absorption of inefficiencies in the cost of production (cost of construction in the present case).  The Committee is accordingly of the view that since the average level of construction activity presently used by the corporation is based on the actual capacity utilisation, it is not a rational method unless it approximates the normal level of capacity.  As far as the determination of normal level of capacity is concerned, management of the business has to use its judgement keeping in view the facts and circumstances of the case. In a situation where the capacity utilisation fluctuates substantially, as in the present case, apart from the past experience about the capacity utilisation, etc., as earlier opined by the Expert Advisory Committee, a business may use  other  factors.   For  instance,  the  business  may  determine  how  its infrastructural facilities have been structured to cater to the requirements of its expected level of capacity utilisation in the coming two to three years, based on its plans as reflected by its budgets, etc.  Thus, expected level of capacity utilisation is a rational basis for determination of normal level of capacity.  It may be noted that this principle has been recognised, though in the context of valuation  of inventories, in  Accounting Standard (AS)  2, ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, in paragraph 9 which is reproduced below:

 

“9. The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The actual level of production may be used if it approximates normal capacity. The amount of fixed production overheads allocated to each unit of production is not increased as a consequence of low production or idle plant. Unallocated overheads are recognised as an expense in the period in which they are incurred. In periods of abnormally high production, the amount of fixed production overheads allocated to each unit of production is decreased so that inventories are not measured above cost. Variable production overheads are assigned to each unit of production on the basis of the actual use of the production facilities.”

 

14. With regard to the measure to be adopted by the corporation for normal capacity level, the Committee is of the view that if it finds difficult to measure the capacity on the basis of working hours, it may use the measure of Metric Tonnes as indicated by the querist in paragraph 7 above.  In respect of the allocation of overheads incurred at construction cell level, it would be rational if the overheads are absorbed on the basis of the normal level of capacity determined at the cell level only, since the corporation seems to have created infrastructural facilities to meet the requirements at the construction cell level. While making the estimate with regard to normal level of capacity, an appropriate allowance may be made for the utilisation of the infrastructural facilities for repairs and maintenance, etc.  The allowance can be made on the basis of the utilisation of the manpower and other infrastructural facilities based on past experience.  It is felt that as far as repairs and maintenance is concerned, use of resources may not fluctuate significantly.  The measure for such an allowance can be in terms of standard working hours required which can in turn be represented in terms of Metric Tonnes. The Committee is of the view that in case the corporation does not presently have a system for generation of relevant information, it should develop an appropriate system in this regard. The Committee is further of the view that difficulties in making such estimates cannot be a ground for adoption of a measure of capacity which is not rational.

 

D.  Opinion

 

15.  On the basis of the above, the Committee is of the following opinion in respect of the issues raised by the querist in paragraph 10 above:

 

       (a)        The normal construction activity level should be determined as described in paragraphs 13 and 14 above. The corporation should not                     continue the present system of capacity utilisation of overheads on an ‘all-India average’ basis for the reasons explained in paragraph                      13 above.

 

       (b)        The method explained in paragraphs 13 and 14 above should be followed.

 

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  1Opinion finalised by the Committee on 20.1.2003.