Lecture No. 30
Chapter 9
Contemporary Engineering Economics
Copyright © 2010
Contemporary Engineering Economics, 5 th edition, © 2010

 Robotic pill dispenser makes life easier for pharmacists - A hospital pharmacy gets a
$250,000 robotic pill dispenser to prepare prescriptions.
 How does the cost of this robot be recognized in reporting the financial position of the pharmacy?
 How long will this robot be the state of the art?
 When will the competitive advantage the pharmacy has jest acquired become a competitive disadvantage through obsolescence?
 At issue : Know what it costs to own a piece of equipment
Contemporary Engineering Economics, 5 th edition, © 2010

 Definition : Loss of value for a fixed asset
 Example : You purchased a vehicle worth $25,000 at the beginning of year
2010.
 Changes in Market Value
End of
Year
0
1
2
3
4
5
Market
Value
$25,000
19,000
16,000
14,000
12,000
10,000
Loss of
Value
$6,000
3,000
2,000
2,000
2,000
Contemporary Engineering Economics, 5 th edition, © 2010


Economic depreciation =
Purchase price – market value

Based on matching concept – a fraction of the cost of the asset is chargeable as an expense in each of the accounting period
Contemporary Engineering Economics, 5 th edition, © 2010

Business
Expense :
Depreciation is viewed as a part of business expenses that reduce taxable income.
Gross Income -Expenses:
(Cost of goods sold)
( Depreciation )
(operating expenses)
Taxable Income
- Income taxes
Net income (profit)
Contemporary Engineering Economics, 5 th edition, © 2010

 Depreciable life ( how long?)
 Salvage value ( disposal value )
 Cost basis ( depreciation basis )
 Method of depreciation ( how?
)
Contemporary Engineering Economics, 5 th edition, © 2010

 Assets used in business or held for production of income
 Assets having a definite useful life and a life longer than one year
 Assets that must wear out , become obsolete or lose value
A qualifying asset for depreciation must satisfy all of the three conditions above.
Contemporary Engineering Economics, 5 th edition, © 2010

 Without Trade-In Allowance  With Trade-In Allowance
Cost of a new hole-punching machine (Invoice price)
+ Freight
+ Installation labor
+ Site preparation
Cost basis to use in depreciation calculation
$62,500
725
2,150
3,500
$68,875
Old hole-punching machine (book value)
Less: Trade-in allowance
Unrecognized gains
Cost of a new hole-punching machine
Less: Unrecognized gains
Freight
Installation labor
Site preparation
Cost of machine (cost basis)
$4,000
5,000
$1,000
$62,500
(1,000)
725
2,150
3,500
$67,875
Contemporary Engineering Economics, 5 th edition, © 2010

 Useful life – Adopt the
Asset Depreciation
Ranges (ADR) published by the IRS.
 Salvage value – Asset’s estimated value at the end of its useful life.
Every effort should be made to estimate a reasonable residual value of the asset, but if not possible, a 10% rule
(10% of the initial value) could be adopted for depreciation purpose.
Contemporary Engineering Economics, 5 th edition, © 2010



In reporting net income to investors/stockholders

In pricing decision


In calculating income taxes for the IRS

In engineering economics, we use depreciation in the context of tax depreciation
Contemporary Engineering Economics, 5 th edition, © 2010

Depreciation
Book Depreciation Tax depreciation (MACRS)
Cost basis
Based on the actual cost of the asset, plus all incidental costs such as freight, site preparation, installation, etc.
Same as for book depreciation
Salvage value
Estimated at the outset of depreciation analysis. If the final book value does not equal the estimated salvage value, we may need to make adjustments in our depreciation calculations.
Salvage value is zero for all depreciable assets
Contemporary Engineering Economics, 5 th edition, © 2010

Component of
Depreciation
Depreciable life
Method of depreciation
Book Depreciation Tax depreciation (MACRS)
Firms may select their own estimated useful lives or follow government guidelines for asset depreciation ranges (ADRs)
Firms may select from the following:

Straight-line

Accelerated methods
(declining balance, double declining balance, and sum-of- years’ digits)

Units-of-proportion
Eight recovery periods–
3,5,7,10,15,20,27.5,or 39 years– have been established; all depreciable assets fall into one of these eight categories.
Exact depreciation percentages are mandated by tax legislation but are based largely on DDB and straightline methods. The SOYD method is rarely used in the U.S. except for some cost analysis in engineering valuation.
Contemporary Engineering Economics, 5 th edition, © 2010




The entire cost of replacing a machine cannot be properly charged to any one year’s production; rather, the cost should be spread (or capitalized ) over the years in which the machine is in service.
The cost charged to operations during a particular year is called depreciation .
From an engineering economics point of view, our primary concern is with accounting depreciation ;
The systematic allocation of an asset’s value over its depreciable life.
Contemporary Engineering Economics, 5 th edition, © 2010



Accounting depreciation can be broken into two categories:
1. Book depreciation—the method of depreciation used for financial reports and pricing products;
2. Tax depreciation—the method of depreciation used for calculating taxable income and income taxes; it is governed by tax legislation.
The four components of information required to calculate depreciation are:
(a) cost basis, (b) salvage value, (c) depreciable life , and (4) depreciation method.
Contemporary Engineering Economics, 5 th edition, © 2010