SPECIFIC MANAGEMENT DECISIONS
MAKE OR BUY
When a business concern requires a product or any part or component of the product for its existing unit, it has to decide whether it should make the product, part or component or buy it from other manufacturers. There are many costing and non-costing considerations guiding the decision towards make or buy it. Some of the important factors affecting such decision are :
1. Whether for manufacture infra-structural facilities are available.
2. Whether the present capacity of the undertaking is fully utilised. If not, it can be utilised in making the required product.
3. If an additional unit is required for manufacture the required product, the concern possesses adequate funds for establishing the unit and the whole production of the unit will be consumed by the concern or there is market for the sale of extra production.
4. Whether the product is available in the market easily and at reasonable terms.
5. If the cost of manufacture of a product/component is lower than the cost of purchase, it may be manufactured.
6. If the product is not manufactured it has to be imported then import trade control regulations and foreign exchange control regulations have also a role.
7. If there is change in technology in production of that product, the concern will be in a position to acquire the new technology without much difficulty. If the product has to be imported, if not manufactured, and such product may tell upon the security of the country, it must be manufactured in the country, whatever the cost of manufacture may be.
1. If a concern has surplus capacity and even decide to buy a product it may require to sell a part of its plant and machinery. In such a case it may be liable to capital gains tax.
2. If a new industrial undertaking (unit) is established to make the product, which fulfils the conditions laid down in Section 80IB/80IC/80IE of the Act, a deduction will be allowed in computing the income of the undertaking (unit) for tax purposes.
3. If the product, either manufactured or purchased, is a capital asset, its cost will not be allowed as a deduction in computing the income However, if the asset is such on which depreciation is allowed, it will be allowed in both the cases i.e., manufactured or purchased.
4. If the product is a consumable one, raw material or required to replace a worn out part at the time of repair, its cost will be treated as revenue expenses and deductible in computing the income.
OWN OR LEASE
A lease of property is a transfer of right to enjoy such property, made for certain time, in consideration of a price payable periodically to the transferor by the transferee.
In other words, leasing is an arrangement that provides a person with the use and control over an asset, for a price payable periodically, without having a title of ownership. In case of lease agreement the owner of the asset is called the lessor and the user is called the lessee.
When a person needs an asset for his business purposes, he has to decide whether the asset should be purchased or taken on lease. While taking this decision he should keep in mind the following factors :
1. Cash position. When a person has sufficient cash or he can borrow funds at a reasonable rate of interest to purchase an asset or can acquire the asset under hire purchase/instalment system, he may decide to buy it. The cost of own asset is not deductible in computing the income but the interest on borrowed funds or under hire purchase/instalment system is deductible in computing the income. If he neither has sufficient cash nor he can borrow due to stringent credit control, he has to take the asset on lease. The lease rent is deductible in computing the income.
2. Depreciation. When the asset is purchased or acquired under hire purchase/instalment system, the depreciation is allowed in computing income. When the asset is taken on lease the depreciation is not allowed to the lessee, because he is not the owner of the asset, but it is allowed to the lessor. Non-availability of depreciation to the lessee will increase his tax liability.
If the asset is such on which depreciation is not allowed, e.g. land, the increase or decrease in the value of the asset in future must be considered. If the asset is such where increase in the value is expected, it may be purchased otherwise it may be taken on lease.
3. Obsolescence risk. When a plant or machinery is purchased and it becomes obsolete earlier than its expected working life, it has to be replaced. The replacement cost can be met partly out of depreciation fund and partly by arranging further cash. In case of lease the asset will be replaced by the lessor. However, the lessor will also keep in mind the risk of obsolescence and increase the lease rent to offset such a loss.
4. Residual Value. When a person purchases an asset, he has full rights to the value of the asset at the end of any given period. In the case of asset with large residual value it is better to purchase it rather than taken on lease.
5. Profit margin. Where profit margin is low, it is better to purchase the asset. If the asset has been purchased by borrowed funds the cash outflow would be equal to loan instalment, interest payment and slightly higher tax. On the other hand, in case of leasing the lease rent would be equal to part of the cost of asset to lessor, interest on investment and profit to the lessor. The cash outflow will be equal to lease rent less nominal tax saving. In case of lease, the profit of the lessor will be the loss to the lessee.
6. Consider profit after tax. It is an important consideration in tax planning. The assessee should follow such a method for obtaining an asset which reduces his tax liability and the profits after tax are greater. For this purpose some people suggest that own funds should not be used in purchase of an asset because interest on own funds is not deductible in computing the income, whereas interest on borrowed funds is deductible. But one should keep in mind that if own funds are invested outside the business, the interest earned will offset the interest payment. Further, he must consider the difficulty involved in raising loans and the cost factors incidental thereto.
The conditions for tax benefit under sections 80IB 80IC, 10A and 10B are the same. The deduction/exemption is available to an industrial undertaking if the plant or machinery (whether owned or leased) used by it, has not been previously used for any purpose. If an industrial undertaking is established in Free Trade Zone or in Software Technology Park or in Electronic Hardware Technology Park its income is deductible upto certain limit for ten assessment years u/s 10A.
Income of Hundred percent export undertaking is deductible upto certain limit for ten assessment years u/s 10B.
In case of newly established industrial undertaking in Integrated Infrastructure Development Centre or Industrial Growth Centre located in the North-Eastern Region etc., its income is deductible upto certain limit for ten assessment years u/s 80IC.
However, when exemption/deduction is claimed under section 1OA or 10B unabsorbed depreciation allowance, unabsorbed capital expenditure on scientific research and family planning, unabsorbed business loss and loss under the head capital gains relevant to assessment years ending before 1.4.2001 cannot be carried forward and set-off. Further the deduction u/s 80IB or 80IC will not be allowed to the aforesaid undertaking. If an undertaking is not claiming exemption/deduction u/s 10A or 10B, it is entitled to deduction for 10 assessment years at the prescribed rate from its gross total income and entitled to carry forward and set-off of aforesaid allowances, expenses and losses for the period as provided in the Act.
When an undertaking claims exemption/deduction u/s 10A or 10B, from tax point of view it will be beneficial to acquire assets on lease basis during the period of tax holiday. Because if the assets are acquired on purchase basis, there will be no use of claiming depreciation and other tax benefits during the tax holiday period as the income is exempt/deductible.
Conclusion. As far as possible the asset should be purchased and not taken on lease because the cost of use of the asset purchased is less than the cost of lease asset.
However, where the assessee is suffering from a liquidity crunch and cannot invest in an asset nor can he avail substantial credit from the suppliers or money-lenders, he should take an asset on lease.