engineering economics, lecture # 11, ejaz gul, fuiems, 2009 engineering economics depreciation

Engineering Economics, Lecture # 11, Ejaz Gul, FUIEMS, 2009

ENGINEERING ECONOMICSENGINEERING ECONOMICS

DepreciationDepreciation


Physical assets lose value with passage Physical assets lose value with passage of time, it is said that they depreciate of time, it is said that they depreciate in value. With the possible exception of in value. With the possible exception of land, this phenomenon is the land, this phenomenon is the characteristics of all physical assets characteristics of all physical assets

Depreciation is the loss in Depreciation is the loss in value of asset over timevalue of asset over time


Depreciation Depreciation • The allowance for wear and tear on equipment and The allowance for wear and tear on equipment and

machinerymachinery

• You can depreciate an item only if it meets the following You can depreciate an item only if it meets the following

requirements:requirements:

– It is used in business or held for the production of incomeIt is used in business or held for the production of income

– It must have a useful life that extends substantially It must have a useful life that extends substantially

beyond the year it was placed in servicebeyond the year it was placed in service

– It wears out, decays, gets used up, becomes obsolete, or It wears out, decays, gets used up, becomes obsolete, or

looses value from natural causeslooses value from natural causes


TypesTypes• Physical depreciationPhysical depreciation

– The physical depreciation is the total loss in The physical depreciation is the total loss in market value which is caused due to some of market value which is caused due to some of the physical damagethe physical damage

– In this depreciation there are two kinds, one In this depreciation there are two kinds, one that is curable and the other that is incurable that is curable and the other that is incurable

– The curable is the one, which can be corrected The curable is the one, which can be corrected economically economically

– The incurable, involves huge amounts of costThe incurable, involves huge amounts of cost

– Deterioration due use of parts, corrosion, Deterioration due use of parts, corrosion, rotting, breakagerotting, breakage

– Wear and tearWear and tear


TypesTypes• Functional Depreciation Functional Depreciation

– is the total loss caused by inadequate designis the total loss caused by inadequate design

– Work with the current machine is not profitableWork with the current machine is not profitable

– Change in the need of an assetChange in the need of an asset

– Availability of superior asset in the marketAvailability of superior asset in the market

– Inadequacy or inability of the current asset to Inadequacy or inability of the current asset to

meet the demand meet the demand

Functional depreciation is more serious than Functional depreciation is more serious than

physicalphysical


Types of AssetsTypes of Assets

• TangibleTangible – which can be seen, touched – which can be seen, touched

and quantified (machines, land, goods)and quantified (machines, land, goods)

• IntangibleIntangible – which can not be seen, – which can not be seen,

touched and quantified (software, touched and quantified (software,

trademarks etc)trademarks etc)


MethodsMethods

• Depreciation methods based on timeDepreciation methods based on time– Straight line methodStraight line method– Declining balance method Declining balance method – Sum-of-the-years'-digits methodSum-of-the-years'-digits method

depreciation is the reduction in the value of an asset depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, due to usage, passage of time, wear and tear, technological outdating or obsolescence, depletion, technological outdating or obsolescence, depletion, inadequacy, rot, rust, decay or other such factors inadequacy, rot, rust, decay or other such factors


Straight Line Depreciation MethodStraight Line Depreciation Method

• Value of the asset decreases at the constant rateValue of the asset decreases at the constant rate• D(t) = {First cost (P) – salvage Value (F)}D(t) = {First cost (P) – salvage Value (F)}

Time (n)Time (n)

Declining balance methodDeclining balance method• Asset depreciate faster in early age and slower in the Asset depreciate faster in early age and slower in the

laterlater• Rate of depreciation is determinedRate of depreciation is determined• D(t) = D(t) = (1- (1- ) )t-1t-1P , where P , where is the rate of depreciation is the rate of depreciation

Sum of the year digits is the combine effect of Sum of the year digits is the combine effect of timetime


Straight Line Depreciation Straight Line Depreciation MethodMethod

• On April 1, 2006, Company A purchased an equipment at the On April 1, 2006, Company A purchased an equipment at the cost of $140,000. This equipment is estimated to have 5 year cost of $140,000. This equipment is estimated to have 5 year useful life. At the end of the 5th year, the salvage value useful life. At the end of the 5th year, the salvage value (residual value) will be $20,000. Calculate the depreciation (residual value) will be $20,000. Calculate the depreciation expenses for 2006, 2007 and 2008 using straight line expenses for 2006, 2007 and 2008 using straight line depreciation method. depreciation method.

Depreciation for 2006Depreciation for 2006 = ($140,000 - $20,000) x 1/5 x 9/12 = $18,000 = ($140,000 - $20,000) x 1/5 x 9/12 = $18,000

Depreciation for 2007 Depreciation for 2007 = ($140,000 - $20,000) x 1/5 x 12/12 = $24,000 = ($140,000 - $20,000) x 1/5 x 12/12 = $24,000

Depreciation for 2008 Depreciation for 2008 = ($140,000 - $20,000) x 1/5 x 12/12 = $24,000 = ($140,000 - $20,000) x 1/5 x 12/12 = $24,000


Declining Balance Depreciation Declining Balance Depreciation MethodMethod

• Depreciation = Book value x Depreciation rateDepreciation = Book value x Depreciation rate

Book value = Cost - Accumulated depreciation Book value = Cost - Accumulated depreciation

• Depreciation rate for double declining balance Depreciation rate for double declining balance

methodmethod

= Straight line depreciation rate x 200% = Straight line depreciation rate x 200%

• Depreciation rate for 150% declining balance methodDepreciation rate for 150% declining balance method

= Straight line depreciation rate x 150% = Straight line depreciation rate x 150%


Declining Balance Depreciation Declining Balance Depreciation MethodMethod

On April 1, 2006, Company A purchased an equipment at the cost of On April 1, 2006, Company A purchased an equipment at the cost of

$140,000. This equipment is estimated to have 5 year useful life. At the $140,000. This equipment is estimated to have 5 year useful life. At the

end of the 5th year, the salvage value (residual value) will be $20,000. end of the 5th year, the salvage value (residual value) will be $20,000.

Calculate the depreciation expenses for 2006, 2007 and 2008 using double Calculate the depreciation expenses for 2006, 2007 and 2008 using double

declining balance depreciation method. declining balance depreciation method.

Useful life = 5 years : Straight line depreciation rate = 1/5 = 20% per yearUseful life = 5 years : Straight line depreciation rate = 1/5 = 20% per year

Depreciation rate for double declining balance method Depreciation rate for double declining balance method

= 20% x 200% = 20% x 2 = 40% per year = 20% x 200% = 20% x 2 = 40% per year

Depreciation for 2006Depreciation for 2006

= $140,000 x 40% x 9/12 = $42,000 = $140,000 x 40% x 9/12 = $42,000


= ($140,000 - $42,000) x 40% x 12/12 = $39,200 = ($140,000 - $42,000) x 40% x 12/12 = $39,200


= ($140,000 - $42,000 - $39,200) x 40% x 12/12 = $23,520 = ($140,000 - $42,000 - $39,200) x 40% x 12/12 = $23,520


Sum-of-the-years'-digits method Sum-of-the-years'-digits method

• Depreciation expense = (Cost - Salvage value) x FractionDepreciation expense = (Cost - Salvage value) x Fraction

Fraction for the first year = n / (1+2+3+...+ n)Fraction for the first year = n / (1+2+3+...+ n)

Fraction for the second year = (n-1) / (1+2+3+...+ n)Fraction for the second year = (n-1) / (1+2+3+...+ n)

Fraction for the third year = (n-2) / (1+2+3+...+ n) Fraction for the third year = (n-2) / (1+2+3+...+ n)

... ...

Fraction for the last year = 1 / (1+2+3+...+ n) Fraction for the last year = 1 / (1+2+3+...+ n)

n represents the number of years for useful life. n represents the number of years for useful life.


Sum-of-the-years'-digits method

• Calculation of depreciation expenseCalculation of depreciation expense

Sum of the years' digits = 1+2+3+4+5 = 15 Sum of the years' digits = 1+2+3+4+5 = 15

Depreciation for 2000 = ($100,000 - $10,000) x 5/15 = $30,000Depreciation for 2000 = ($100,000 - $10,000) x 5/15 = $30,000

Depreciation for 2001 = ($100,000 - $10,000) x 4/15 = $24,000 Depreciation for 2001 = ($100,000 - $10,000) x 4/15 = $24,000




engineering economics, lecture # 11, ejaz gul, fuiems, 2009 engineering economics depreciation

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