HUM 2115: Engineering Economy
DEPRECIATION
Rafat Rahman
Lecturer, Industrial & Production Engineering
Ahsanullah University of Science and Technology
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Depreciation
❑ Decrease in value of physical properties with passage of time and use.
❑ It’s an accounting concept that establishes an annual deduction against before-tax income such that
the effect of time and use on an asset’s value can be reflected in a firm’s financial statements.
❑ The actual amount of depreciation can never be established until the asset is retired from service.
❑ Because depreciation is a noncash cost that affects income taxes, we must consider it properly when
making after-tax engineering economy studies.
❑ Income taxes usually represent a significant cash outflow
that cannot be ignored in decision making.
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Types of Depreciation
▪ Depreciation can be classified in two types-
Fig: Classification of types of depreciation.
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Types of Depreciation
▪ Physical or functional depreciation can be caused for several reasons:
Deterioration
Physical
depreciation
Wear and Tear
Technological
obsolescence
Functional
Depreciation
Declining need
for product
Failed to meet
increasing
quantity
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Depreciable Property
When is a Property Depreciable?
❑ In general, property is depreciable if it meets the following basic requirements:
✓ It must be used in business or held to produce income.
✓ It must have a determinable useful life which is longer than one year.
✓ It must be something that wears out, decays, gets used up, becomes obsolete, or loses value from
natural causes.
✓ It is not inventory, stock in trade, or investment property.
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Depreciable Property
❑ Depreciable property is classified as either tangible or intangible.
▪ TANGIBLE - can be seen or touched
✓ Personal property - includes assets such as machinery, vehicles, equipment, furniture, etc.
✓ Real property - anything erected on, growing on, or attached to land
▪ INTANGIBLE - personal property, such as copyright, patent or franchise
Though the term amortization is sometimes used interchangeably with the term depreciation, they are
different. Depreciation is applied to tangible assets, while amortization is used to reflect the decreasing value
of intangibles.
Unlike depreciation and amortization, which mainly describe the deduction of expenses due to the aging of
equipment and property, depletion is the actual physical reduction of natural resources by companies.
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Depreciable Property
Machine-------Wear, tear
Automobile------Fall apart/Breakdown
You can never depreciate land!
Since land does not have
a determinable life itself,
it is not depreciable.
Building-----Gets older with time
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Depreciation Concepts
❑ Basis, or cost basis -- The initial cost of acquiring an asset (purchase price plus any sales taxes),
including transportation expenses and other normal costs of making the asset serviceable for its
intended use.
▪ also called the unadjusted cost basis
❑ Adjusted cost basis -- The original cost basis of the asset, adjusted by allowable increases or decreases,
is used to compute depreciation deductions.
❑ Book Value (BV) – The worth of a depreciable property as shown on accounting records of a company.
▪ Original cost basis of the property, including adjustments, less all allowable depreciation deductions
▪ Represents amount of capital remaining invested in property and must be recovered in future through
accounting
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Depreciation Concepts
❑ Market Value (MV) -- Amount paid by a willing buyer to a willing seller for a property where each has equal
advantage and is under no compulsion to buy or sell.
▪ Approximates present value of what will be received through ownership of property, including time-value of
money (or profit).
❑ Recovery Period -- Number of years over which the basis of property is recovered through the accounting process.
▪ Normally the useful life for classical methods of depreciation.
❑ Salvage Value (SV) -- Estimated value of property at the end of useful life.
▪ Expected selling price of property when asset can no longer be used productively
❑ Useful life -- Expected (estimated) period that a property will be used in a trade or business to produce income.
▪ Sometimes referred to as depreciable life.
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The Classical (Historical) Depreciation Methods
❑ There are classical, internationally accepted depreciation methods used to determine book
depreciation✓ Straight line (SL)
✓ Declining balance (DB)
✓ Sum-Of-Years digits (SYD)
✓ Unit-Of-Production depreciation
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Straight Line (SL) Depreciation
▪ Straight Line depreciation is the simplest depreciation method.
▪ It assumes that a constant amount is depreciated each year over the depreciable life of the asset.
B
▪ This method requires an estimate of the final SV (which will also be the final book value at the end of year N)
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Straight Line (SL) Depreciation
Example-1:
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Straight Line (SL) Depreciation
The depreciation and BV amounts for each year are shown in the following table.
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Straight Line (SL) Depreciation
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Straight Line (SL) Depreciation
EXAMPLE 2:
A company has purchased an equipment whose first cost is $1,00,000 with an estimated life of 8 years.
The estimated salvage value of the equipment at the end of its lifetime is $20,000.
(i)
Determine the depreciation charge and book value at the end of various years using the straight-line
method of depreciation,
(ii) Compute the depreciation and the book value for period 5.
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Declining-Balance (DB)
• Sometimes called constant percentage method or Matheson formula.
• Assumed annual cost of depreciation is a fixed percentage of the BV at beginning of each year.
• The depreciation charges is higher at the early stages than the later stages i.e. the amount of
depreciation decreases gradually although the depreciation rate is fixed.
•
The maximum annual depreciation rate for the DB method
is twice (200%) the straight line rate, that is, R = 2/N.
Then the method is called double declining balance (DDB).
•
Another commonly used percentage for the DB method is
150% of the SL rate, where R = 1.5/N
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Declining-Balance (DB)
• The following relationships hold true for the DB method:
• Because declining balance method never reaches BV = 0, it’s permissible to switch from this to
straight-line method so asset’s 𝑆𝑉𝑁 will be zero or other desired value.
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Declining-Balance (DB)
Example 1:
(a)
(b)
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Declining-Balance (DB)
Draw the
Graph
Complete the same table for 150% DB method….
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DB with Switchover to SL
The 200% DB Method with Switchover to the SL Method
• Because the DB method never reaches a BV of
zero, it is permissible to switch from this method
to the SL method so that an asset’s 𝐵𝑉𝑁 will be
zero (or some other determined amount, such
as 𝑆𝑉𝑁 ).
• The switchover occurs in the year in which an
equal or a larger depreciation amount is
obtained from the SL method.
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Sum-of-the-years-digits (SYD) Method
• Like declining balance method, sum of years’ digits (SYD) method attempts to charge a higher
depreciation expense in early years of the useful life of the asset and a lower expense in later years.
• Number for each permissible year of life are listed in reverse order. Sum the digits of this reverse order.
• The depreciation factor for any year is the corresponding number from the reverse order listing divided
by the sum of those digits, or the following-
• Depreciation for any year is the product of that year’s SYD depreciation factor and the difference
between BV and the final estimated SV.
𝑑𝑘 = (𝐵 − 𝑆𝑉𝑁 ) * df
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Sum-of-the-years-digits (SYD) Method
• Book value at the end of year k
• The cumulative depreciation through the 𝐾 𝑡ℎ year
𝑑𝑘∗ = 𝐵 − 𝐵𝑉𝑘
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Sum-of-the-years-digits (SYD) Method
Example 1:
Monster Company purchased a machine on January 1, 2022. The relevant information is given below:
• Cost of the machine: $250,000
• Expected useful life of machine: 5 years
• Salvage value: $25,000
Tabulate the annual depreciation amount and BV for each year using sum of years’ digits method.
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Sum-of-the-years-digits (SYD) Method
• Depreciable cost (depreciable base): $250,000 – $25,000 = $225,000
• Depreciation expense at the end of the first year: $225,000 × (5/15) = $75,000
• Book value at the end of the first year: $250,000 – $75,000 = $175,000
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Units-of-Production Method
• Not based on the idea that decrease in value of property is a function of time.
• Decrease in value is mostly a function of use.
• Method results in cost basis (minus final SV) being allocated equally over the estimated number of
units allocated equally over the estimated number of units produced during useful life of asset.
• The depreciation rate is calculated as-
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Units-of-Production Method
Example 1:
Assume that an equipment costing $900,000 has been purchased for use in a sand and gravel pit. The pit
will operate for 5 years, while a nearby construction is in progress and will shut down when this
construction finalizes. The pit will be shut down and sold for $70,000.
Compute the unit of production (UOP) depreciation schedule if that construction schedules for
40,000 m3 of sand and gravel using the following:
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Units-of-Production Method
$900,000 − $70,000
Depreciation per unit of production =
40,000 𝑚3
= 20.75 $/m3
Year
Opening BV
($)
Unit
(m3)
Depreciation Accumulated
Ending BV
Expense ($) Depreciation ($)
($)
1
900000
4000
83000
83000
817000
2
817000
8000
166000
249000
651000
3
651000
16000
332000
581000
319000
4
319000
8000
166000
747000
153000
5
153000
4000
83000
830000
70000
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Units-of-Production Method
Example 2:
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