As real estate projects often span long time periods until their completion, it is of critical importance to evaluate at the outset of a real estate project whether — for cost allocation purposes — a project should be divided into two or more phases. For example: a real estate development company may purchase a large tract of land to be developed over several years; portions of the land will be developed and sold before the project as a whole is completed. If that real estate development project is not divided into phases, the appropriate allocation and monitoring of costs is diffi cult, and project costs relating to the earlier stages of the development may inappropriately be allocated to a later stage, thereby overstating profits in the earlier years. Certain project costs may benefit one individual unit (such as a lot, home, or condominium unit) or a group of units within one phase; other costs may benefit one or more phases of a project or more than one project, such as utilities or access roads. As such, the allocation of costs to individual units, between different phases of one project, or to different projects generally involves several cost pools and multiple steps.
When allocating project costs, one needs to consider costs already incurred, as well as costs to be incurred in current and future periods. For example: in a master – planned community, individual homes are often sold before amenities (for example, golf courses, swimming pools, or parks) have been completed. To appropriately reflect the cost of sales that relates to one individual home sold, a portion of the costs expected to be incurred in future periods for the construction of the amenities must be allocated to that home.
Selecting an appropriate cost allocation method requires judgment. As a general rule, costs should be allocated to the portions of a project that benefit from the costs. The intent is to achieve a constant gross margin on sales for the project, irrespective of the point in time sales occur. FASB Statement No. 67 outlines three different ways to allocate costs:
- Specific identification method
- Relative value method
- Area methods or other value methods
Specific Identification Method
Where practicable, the costs of a real estate project are assigned to individual components of a project based on specific identification. The specific identification method is most frequently used for “the allocation of acquisition costs and direct construction costs in small projects“. For example: costs charged by a contractor to install a staircase in a new home directly relate to that home. The amount invoiced by the contractor should be included in the cost basis of that home.
Relative Value Method
If specific identification is not feasible or is impracticable, as is the case for indirect costs or common costs, costs should be allocated based on the relative value of the components, if possible. Under this method, costs are allocated based on the relative fair values of the individual components of a project, based on either “Allocation Based on Relative Fair Value before Construction“. Land costs and all other common costs incurred before construction occurs (including the costs of any amenities) are allocated to the land parcels benefited, with cost allocation based on the relative fair value before construction. For example: a developer that purchases a tract of land on which to build a master planned community, a shopping center, and an office building would allocate the cost of the land based on estimates of the relative fair value of the land parcels of (1) the master – planned community, (2) the shopping center, and (3) the office building, prior to the construction of the structures. A cost allocation based on the size of the parcels would not reflect any differences in values and is generally not considered appropriate. Unusable land and land that is donated to municipalities or other governmental agencies that will benefit the project are allocated as common costs of the project.
Allocation Based on the Relative Sales Value of the Units. Under the relative value method, construction costs for a project, such as a condominium complex, are allocated to the individual units (for example, homes, condominium units) based on the relative sales value of the units. 56 When allocating costs based on the relative value method, the sales values of the units must be comparable. This is achieved by assuming that all of the units will be completed and ready for sale at the same point in time; any expected price increases for units that will be completed in future periods are not taken into consideration.
The relative sales value method results in allocating greater costs to more valuable components of a project. In practice, the relative value method is often implemented through the application of a “gross profit method“. Under the gross profit method, a cost – of – sales percentage is calculated by dividing the sum of capitalized project costs and project costs to be incurred in the current and future periods by the estimated sales value of the unsold units. When a unit is sold, the cost – of – sales amount attributable to that sale is determined by multiplying the sales value of that unit by the cost – of – sales percentage.
Area Methods Or Other Value Methods
If the relative value method cannot be applied, as would be the case if a real estate development company has not determined the ultimate use of the land, another method for cost allocation has to be used. FASB Statement No. 67 suggests the use of the area method, such as the allocation of costs to parcels based on square footage, or “another reasonable value method”.
Under the area method, costs are allocated based on lot sizes, the square footage of a structure, or the number of units in a development. The use of the area method is appropriate only if the allocation is not materially different from an allocation that is based on relative value methods, or if the application of the relative value method is impracticable.
Cost Allocation Case Example
Developers C purchases land for $10 million, which it intends to divide into three parcels. On Parcel 1, which is along the highway, it plans to construct a shopping center. On Parcel 2, which is behind the shopping center, C plans on building a row of 40 townhouses. Parcel 3 will be developed into a master-planned community. The fair value of the land before construction has been determined to be $4 million, $1 million and $5 million for parcels 1, 2, and 3, respectively. The sales prices for the shopping center, the town houses, and the master-planned community are estimated to amount to $40 million, $12 million, and $100 million. How much land cost should be allocated to Townhouse Unit 1, which has an estimated sales price of $500,000?
The first step is to allocate the cost of the land to the individual parcels based on the relative fair value before construction; accordingly, an amount of $1 million is allocated to Parcel 2. The land value allocated to the parcel on which townhouses are to be constructed then becomes part of the common cost pool for the townhouse, which is allocated to each townhouse based on its relative sales value. As such, Townhouse Unit 1 will be allocated land costs of $41,667. That amount is calculated as follows:
The sales value of Townhouse Unit 1 divided by the sales value of all Townhouses, multiplied by the cost of land allocated to the townhouse development: $0.5 million/$12 million multiplied by $1 million.
The allocation of costs needs to be reviewed every reporting period to ensure that changes in circumstances, such as a change in estimate of project costs or sales prices or in the design of the project, are taken into consideration. Cost reallocations within or between phases of a project are not uncommon, as the design of a project may evolve.