American Corporation received a $400,000 low bid from a reputable manufacturer for the construction of special production equipment needed by American in an expansion program. Because its own plant was not operating at capacity, American decided to construct the equipment itself and recorded the following production costs related to the construction:

Services of consulting engineer . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000

Work subcontracted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000

Plant labor normally assigned to production . . . . . . . . . . . . . . . . . . 65,000

Plant labor normally assigned to maintenance . . . . . . . . . . . . . . . . 100,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $395,000

Management prefers to record the cost of the equipment under the incremental cost method. Approximately 40% of the corporation’s production is devoted to government supply contracts, which are all based in some way on cost. The contracts require that any self-constructed equipment be allocated its full share of all costs related to the construction. The following information also is available.

(a) The preceding production labor was for partial fabrication of the equipment in the plant. Skilled personnel were required and were assigned from other projects. The maintenance labor amount ($100,000) represents the cost of nonproduction plant employees assigned to the construction project. Had these workers not been assigned to construction, the $100,000 cost would still have been incurred for their idle time.

(b) Payroll taxes and employee fringe benefits are approximately 30% of labor cost and are included in manufacturing overhead cost. Total manufacturing overhead for the year was $5,630,000, including the $100,000 maintenance labor used to construct the equipment.

(c) Manufacturing overhead is approximately 50% variable and is applied on the basis of production labor cost. Production labor cost for the year for the corporation’s normal products totaled $6,810,000.

(d) General and administrative expenses include $22,500 of executive salary cost and $10,500 of postage, telephone, supplies, and miscellaneous expenses identifiable with this equipment construction.

Instructions:

1. Compute the amount that should be reported as the full cost of the constructed equipment to meet the requirements of the government contracts.

2. Compute the incremental cost of the constructed equipment.

3. What is the greatest amount that should be capitalized as the cost of the equipment? Why?