How to Calculate Excess Production Expenditures

Excess production expenditures represent the amount of a project’s costs financed by a company’s general debt, rather than by funds specifically borrowed for that project. This concept is a component of the Uniform Capitalization (UNICAP) rules, which govern how certain businesses must treat the costs of creating or acquiring assets. For businesses subject to these rules, a portion of the interest they pay on debts must be added to the cost of a self-constructed asset, a process known as capitalization. This increases the asset’s value on the books, and the cost is recovered over time through depreciation. However, small businesses that are not classified as tax shelters and have average annual gross receipts of $31 million or less for the three preceding tax years are generally exempt from UNICAP.

Identifying Applicable Property

The regulations specify a category of property, known as “designated property,” to which interest capitalization rules apply. Designated property includes any real property, which encompasses land, buildings, and their structural components, that a taxpayer produces. The term “produce” is defined broadly to include construction, building, installation, development, or improvement. The rules apply regardless of whether the property is for the company’s own use or for sale to customers.

The rules also extend to certain types of tangible personal property, a category that includes machinery, equipment, and other physical assets. For tangible personal property to be classified as designated property, it must meet specific criteria. This includes property with a class life of 20 years or more for tax depreciation purposes, property that has an estimated production period of more than two years, or property with a production period exceeding one year and a cost of more than $1 million. For example, the custom manufacturing of a large, specialized piece of industrial machinery could meet these thresholds.

Calculating Accumulated Production Expenditures

Accumulated production expenditures (APE) represent the cumulative total of all direct and certain indirect costs that are required to be capitalized into the cost of that specific unit of property. The measurement of these costs occurs at specific intervals, or measurement dates, throughout the property’s production period.

Direct costs encompass the direct materials and direct labor used in the production process. This includes the cost of raw materials that become part of the finished asset and the wages of employees who work directly on its construction or assembly. For example, in the construction of a building, the costs of concrete, steel, and the wages of the construction crew are all direct costs.

Beyond direct costs, APE also includes a share of allocable indirect costs. These are expenses that support the production activities but are not tied to a single asset. Examples include depreciation on equipment used in construction, rent for production facilities, factory repairs and maintenance, and utilities for the production plant. The regulations require a reasonable method to allocate these indirect costs to the specific designated property being produced.

Determining Excess Production Expenditures

Excess production expenditures represent the portion of the project’s total cost, or APE, that is not financed by debt taken out specifically for that project. To calculate this, a business must first identify its “traced debt,” which is any borrowing that can be directly allocated to the production expenditures of a specific designated property. A common example is a construction loan obtained to finance the building of a new facility.

The calculation for excess production expenditures is a direct subtraction: the average Accumulated Production Expenditures (APE) for the period minus the average balance of traced debt for the same period. This amount is what the tax code presumes is being financed by the company’s other, non-specific borrowings. Suppose a company is constructing a new warehouse, and its average APE for the year is $2 million. If the company secured a specific construction loan and the average outstanding balance of this traced debt was $1.2 million, the excess production expenditures would be $800,000.

Applying the Avoided Cost Method

The “avoided cost method” is used to determine the amount of interest to capitalize. This method operates on the principle that by using general funds to cover the excess expenditures, the company avoided taking on additional debt. Therefore, an amount of interest on its general, non-traced debt must be capitalized to the asset. The process does not involve tracing the actual flow of non-project-specific funds.

The first action is to calculate the weighted-average interest rate for all of the company’s eligible non-traced debt during the computation period. Non-traced debt includes most other borrowings of the company that were not specifically allocated to the designated property, such as general lines of credit or corporate bonds. The weighted-average rate is found by dividing the total interest incurred on these debts by the total average balance of the debts.

The final action is to multiply this weighted-average interest rate by the excess production expenditures. The result is the amount of “avoided cost” interest that must be capitalized as part of the designated property’s cost basis. For instance, if the company from the previous example had $800,000 in excess production expenditures and its weighted-average interest rate on other debts was 5%, the capitalized interest would be $40,000 ($800,000 x 0.05). This $40,000 is added to the warehouse’s cost, rather than being deducted as interest expense for the year.