Your client, Dale, is the president and sole stockholder of a steel fabrication company. He has been planning to buy a new piece of equipment for $500,000. He is upset to learn that the $500,000 cost would have to be depreciated over seven years. He comes to you with an idea from his son, Dale Jr., who is taking an introductory accounting course at the local college. Dale Jr. tells his father that self-constructed assets are accounted for differently from purchased assets and that the company could be better off if it constructed the needed new equipment. Dale figures his regular employees could indeed build the new equipment using the company’s idle capacity. For several years, the company has operated at 80% of capacity, and that level of production is used as the denominator level for allocation of overhead. Overhead is currently charged to production at a rate of 150% of direct labor cost, but Dale Jr. says the new equipment will not have to bear any overhead costs because the company has idle capacity and all overhead costs are already being absorbed by regular production. Dale expects to incur the following incremental costs if his regular employees construct the new equipment:
Direct labor ………. $300,000
Direct materials …….. 120,000
Other direct costs ……… 30,000
Interest on construction loan …. 50,000
Although the cost will be the same regardless of whether Dale makes or buys the equipment, he feels he would be better off under the construction alternative because the interest is deductible in the year incurred. As a result, the depreciable cost would be only $450,000.
Do you agree or disagree with Dale’s analysis? Write a memorandum to Dale explaining your recommendations for optimizing his tax situation.