WESTERN INSTITUTE OF TECHNOLOGY

Electrical Engineering Department

ECON 1 (Engineering Economics)

❖ DEPRECIATION
- It is the reduction in the value of an asset with the passage of time.
- Depreciation of a property is an example of capitalization.

❖ PURPOSE OF DEPRECIATION
1. To provide for the recovery of capital which has been invested in the property.
2. To enable the cost of depreciation to be charged to the cost of producing the products
that are turned out by the property.

Terms Used in Computing Depreciation

1. Useful in life (n) – the time period over which an asset is productive. Beyond its useful
life, the asset is no longer cost-effective.

ENGR. JOHN PAUL B. BALSOMO, REE, RME, ECT, M.Eng

2. Economic Life – the length of time at which a property can be operated at a profit.
3. Valuation (Appraisal) – it is the process of determining the value or worth of a physical
property for specific reasons.
4. Value – it is the present worth of all the future profits that are to be received through
ownership of the property.
5. First Cost (FC) – includes taxes, shipping and preparation/setup expenses. It is the
total amount invested on the property until it is put into operation.

Values are classified as:

1. Market value – the price that will be 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.
2. Book value – it is the worth of a property as shown in the accounting records of an
enterprise.
3. Salvage Value (SV) – the estimated value of an asset at the end of its useful life. It is
the price of a property when a sold second-hand, also called trade-in value.
4. Scrap value – the price of a property when sold for junk.
5. Fair value – the worth of a property as determined by a disinterested party which is
fair to both seller and buyer.
6. Use value - It is the worth of the property as an operating unit.
7. Face or Par value of a bond – the amount that appears on the bond which is the price
at which the bond is first bought.

TYPES OF DEPRECIATION
A. Physical Depreciation – type of depreciation caused by the lessening of the physical
ability of the property to produce results, such as physical damage, wear and tear.

B. Functional Depreciation – type of depreciation caused by the lessening in the demand

for which the property is designed to render, such as obsolescence and inadequacy.
 METHODS OF COMPUTING DEPRECIATION:
A. Straight Line Method
It is the simplest method of all. Involves simple allocation of an even rate of
depreciation every year over its useful life.

Depreciation Charge
𝐹𝐶 − 𝑆𝑉
𝑑=
𝑛

Where:
FC – first cost
SV – salvage value/scrap value
n – life of the property/economic life
d – annual depreciation

Total depreciation for “m” years

ENGR. JOHN PAUL B. BALSOMO, REE, RME, ECT, M.Eng

𝐷𝑚 = 𝑑 𝑥 𝑚

Book Value at the end of “m” years

𝐵𝑉 = 𝐹𝐶 − 𝐷𝑚

Where:
BV – book
𝐷𝑚 – total depreciation after “m” years
m – mth year

Example:
An underwater camera is purchased for $1,000; it has an expected life of 12 years, at
the end of which the estimated salvage value if $730. Using the straight line
depreciation find the book value of the camera at the end of 8 years.

Solution:
𝑭𝑪 − 𝑺𝑽
𝒅=
𝒏

$1000 − $750
𝑑=
12
= $22.5

𝐃𝐦 = 𝐝 𝐱 𝐦

𝐷8 = $22.5 𝑥 8
= $180

2 𝑩𝑽 = 𝑭𝑪 − 𝑫𝒎
𝐵𝑉8 = $1000 − 180
= $820
 Example:
A machine costs $8,000 and an estimated life of 10 years with a salvage value of $500.
What is its book value after 8 years using straight line method?

Solution:
𝑭𝑪 − 𝑺𝑽
𝒅=
𝒏
8,000 − 500
𝑑=
10
= 750

Solving the Book Value

𝑩𝑽 = 𝑭𝑪 − 𝑫𝒎
𝐵𝑉 8 = 8,000 − 750(8)
= 2,000

ENGR. JOHN PAUL B. BALSOMO, REE, RME, ECT, M.Eng

B. Sinking Fund Method
It is a depreciation method the provides funds for the replacement of an asset at the
end of its useful life. In this method of computing depreciation, it is assumed that a
sinking fund is established in which will accumulate for replacement purpose. The
initial depreciation is low.

Depreciation Charge
(𝐹𝐶 − 𝑆𝑉)𝑖
𝑑=
(1 + 𝑖)𝑛 − 1

Where:
i – interest rate or worth of money

Total depreciation for “m” years

𝑑[(1 + 𝑖)𝑚 − 1]
𝐷𝑚 =
𝑖

Book Value at the end of “m” years

𝐵𝑉 = 𝐹𝐶 − 𝐷𝑚

Example:
A unit of welding machine cost $45,000 with an estimated life of 5 years. Its salvage
value is $2,500. Assuming that you deposit your annual depreciation to a bank giving
8.5%, solve for the deposit.

Solution
3
(𝐹𝐶 − 𝑆𝑉)𝑖
𝑑=
(1 + 𝑖)𝑛 − 1
 (45,000 − 2,500)(0.085)
𝑑=
(1 + 0.085)5 − 1
= $7,172.54

Example:
A dump truck was bought for $30,000 six years ago. It will have a salvage value of
$3,000 four years from now. It is sold now for $8,000. What is the sunk cost if the
depreciation method is sinking fund method at 6%

Solution:
Note: Sunk cost is the difference between the Book Value on that year and the sold
amount on that year.

𝑆𝑢𝑛𝑘 𝑐𝑜𝑠𝑡 = 𝐵𝑉𝑛 − 𝑆𝑜𝑙𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑛 𝑡ℎ𝑒 𝑛𝑡ℎ 𝑦𝑒𝑎𝑟

(𝐹𝐶 − 𝑆𝑉)𝑖
ENGR. JOHN PAUL B. BALSOMO, REE, RME, ECT, M.Eng

𝑑=
(1 + 𝑖)𝑛 − 1

($30,000 − $3,000)(0.06)
𝑑=
(1 + 0.06)10 − 1

= $2,048.43

𝑑[(1 + 𝑖)𝑚 − 1]
𝐷𝑚 =
𝑖

$2,048.43[(1 + 0.06)6 − 1]
𝐷6 =
0.06

= $14,288.45

𝐵𝑉 = 𝐹𝐶 − 𝐷𝑚

𝐵𝑉6 = $30,000 − $1,288.45

= $15,711.45

𝑆𝑢𝑛𝑘 𝑐𝑜𝑠𝑡 = 𝐵𝑉𝑛 − 𝑆𝑜𝑙𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑛 𝑡ℎ𝑒 𝑛𝑡ℎ 𝑦𝑒𝑎𝑟

𝑆𝑢𝑛𝑘 𝑐𝑜𝑠𝑡 = $15,711.45 − $8,000

= $𝟕, 𝟕𝟏𝟏. 𝟓𝟓

4
C. Declining Balance Method
It is also known as Diminishing Balance Method or Constant Percentage Method, is
an accelerated depreciation method that records larger depreciation expenses during
the earlier years of an asset’s useful life and smaller in the later years. This method is
sometimes known as constant percentage method or the Matheson Formula.

Constant Percentage
𝑛 𝐹𝐶
𝑘 = 𝑐𝑜𝑛𝑡𝑎𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = 1 − √
𝑆𝑉

Book Value at the end of “m” years

𝐵𝑉 = 𝐹𝐶(1 − 𝑘)𝑚 = 𝐹𝐶 − 𝐷𝑚

Salvage Value
𝑆𝑉 = 𝐹𝐶(1 − 𝑘)𝑛

ENGR. JOHN PAUL B. BALSOMO, REE, RME, ECT, M.Eng

Depreciation Charge
𝑑𝑚 = 𝐹𝐶(1 − 𝑘)𝑚−1 𝑘

𝑑1 = 𝑘(𝐹𝐶)
𝑑2 = 𝑘(𝐹𝐶)(1 − 𝑘)
𝑑3 = 𝑘(𝐹𝐶)(1 − 𝑘)2
𝑑4 = 𝑘(𝐹𝐶)(1 − 𝑘)3
𝑑𝑛 = 𝑘(𝐹𝐶)(1 − 𝑘)𝑛−1

Example:
A machine has a selling price of $400. If its selling price is expected to decline at a rate
of 10% per annum due to obsolescence, what will be its selling price after 5 years?

Solution:

Using Matheson Formula:

𝑛 𝐹𝐶
𝑘 = 𝑐𝑜𝑛𝑡𝑎𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = 1 − √
𝑆𝑉
5 𝐹𝐶
5
0.10 = 1 − √
400
𝐹𝐶5
= 0.905
400

𝐹𝐶5 = $236.5
5
 Example:
An equipment cost $45,000 is estimated to have a book value of $4,350 when retired at
the end of 6 years. Depreciation cost is computed using a constant percentage of the
declining book value. What is the annual rate of depreciation?

Solution:
𝑛 𝐹𝐶
𝑘 = 𝑐𝑜𝑛𝑡𝑎𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = 1 − √
𝑆𝑉

5 $150,000
𝑘 =1− √
$560,000
= 0.2316 = 23.16%

𝑑2 = 𝑘(𝐹𝐶)(1 − 𝑘)
ENGR. JOHN PAUL B. BALSOMO, REE, RME, ECT, M.Eng

𝑑2 = (0.2316)($560,000)(1 − 0.2316)

= $99,658.41

D. Sum – of – Years Digit Method

It is an accelerated depreciation technique which is based on the assumption that
assets are generally more productive when they are new and their productivity
decreases as they becomes old. It is a method

Note: SYD Method starts with the highest amount of depreciation at the start of the
period with a gradual decrease until the last period has the smallest amount of
depreciation.

Sum of the years digit

𝑛(𝑛 + 1)
𝑆=
2

Depreciation Charge
𝑛−𝑚+1
𝑑𝑚 = (𝐹𝐶 − 𝑆𝑉) ( )
𝑆

Total depreciation for “m” years

𝑚(2𝑛 − 𝑚 + 1)
𝐷𝑚 = (𝐹𝐶 − 𝑆𝑉) [ ]
2𝑆

𝑛(𝑛 + 1)
𝑆𝑌𝐷 = 1 + 2 + 3 + 4 + 5 … … … … … + 𝑛 =
2

6 Where:
n – useful life

Respective Depreciation Charge

First Year
𝑛
𝑑𝑒𝑝 1 = 𝑑1 = (𝐹𝐶 − 𝑆𝑉) ( )
𝑆𝑌𝐷

Second Year
𝑛−1
𝑑𝑒𝑝2 = 𝑑2 = (𝐹𝐶 − 𝑆𝑉) ( )
𝑆𝑌𝐷

Third Year
𝑛−2
𝑑𝑒𝑝3 = 𝑑1 = (𝐹𝐶 − 𝑆𝑉) ( ) 𝑎𝑛𝑑 𝑠𝑜 𝑜𝑛.
𝑆𝑌𝐷

Depreciation at any year

𝑛−𝑦+1 𝑠𝑢𝑚 𝑜𝑓 𝑟𝑒𝑣𝑒𝑟𝑠𝑒𝑑 𝑑𝑖𝑔𝑖𝑡
𝑑𝑒𝑝𝑦 = (𝐹𝐶 − 𝑆𝑉) ( ) = (𝐹𝐶 − 𝑆𝑉) ( )
𝑆𝑌𝐷 𝑆𝑌𝐷

ENGR. JOHN PAUL B. BALSOMO, REE, RME, ECT, M.Eng

Book Value at the end of “m” years
𝐵𝑉 = 𝐹𝐶 − (𝑑𝑒𝑝1 + 𝑑𝑒𝑝2 + 𝑑𝑒𝑝3 + ⋯ … … + 𝑑𝑒𝑝𝑚 )
𝐵𝑉 = 𝐹𝐶 − 𝐷𝑚

Example:
An asset is purchased for $120,000. Its estimated life is 10 years, after which it will be sold for
$12,000. Find the depreciation for the second year using the sum-of-the-years-digit method
(SOYD)

Solution:
𝑆𝑌𝐷 = 1 + 2 + 3 + ⋯ … … … + 10 = 55

𝑛−1
𝑑𝑒𝑝2 = 𝑑2 = (𝐹𝐶 − 𝑆𝑉) ( )
𝑆𝑌𝐷
10 − 1
𝑑𝑒𝑝2 = 𝑑2 = ($120,000 − $12,000) ( )
55

= $17,673.00

Example:
An asset is purchased for $9,000. Its estimated economic life is 10 years after which it will be
sold for $1,000. Find the depreciation in the first three years using SYD method.

Solution:
𝑆𝑌𝐷 = 1 + 2 + 3 + ⋯ … … … + 10 = 55

𝑛(𝑛 + 1)
𝑆𝑌𝐷 = 1 + 2 + 3 + 4 + 5 … … … … … + 𝑛 =
2
10(10 + 1) 7
𝑆𝑌𝐷 = 1 + 2 + 3 + 4 + 5 … … … … … + 10 = = 55
2
 First Year
𝑛
𝑑𝑒𝑝 1 = 𝑑1 = (𝐹𝐶 − 𝑆𝑉) ( )
𝑆𝑌𝐷

10
𝑑𝑒𝑝 1 = 𝑑1 = (9,000 − 1,000) ( ) = $1,454.54
55

Second Year
𝑛−1
𝑑𝑒𝑝2 = 𝑑2 = (𝐹𝐶 − 𝑆𝑉) ( )
𝑆𝑌𝐷
10 − 1
𝑑𝑒𝑝2 = 𝑑2 = (9,000 − 1,000) ( ) = $1,309.09
55

Third Year
𝑛−2
𝑑𝑒𝑝3 = 𝑑3 = (𝐹𝐶 − 𝑆𝑉) ( )
𝑆𝑌𝐷
10 − 2
𝑑𝑒𝑝3 = 𝑑1 = (9,000 − 1,000) ( ) = $1,163.64
55
ENGR. JOHN PAUL B. BALSOMO, REE, RME, ECT, M.Eng

𝐷𝑚 = 𝑑1 + 𝑑2 + 𝑑3
= $1,454.54 + $1,309.09 + $1,163.64
= $3,937.27