Depreciation CH 10

(c) 2001 Contemporary Engineering
Economics
1
Chapter 10
Depreciation
Asset Depreciation
Factors Inherent to
Asset Depreciation
Book Depreciation
Tax Depreciation
Depletion
Repairs or
Improvements to
Depreciable Assets
Economics
2
Depreciation
Definition: Loss of value for a fixed asset
Example: You purchased a car worth $15,000 at
the beginning of year 2000.
D
e
p
r
e
c
i
a
t
i
o
n

End of
Year
Market
Value
Loss of
Value
0
1
2
3
4
5

$15,000
10,000
8,000
6,000
5,000
4,000

$5,000
2,000
2,000
1,000
1,000
p
Economics
3
Why Do We Need to Consider
Depreciation?
Gross Income -Expenses:
(Cost of goods sold)
(Depreciation)
(operating expenses)

Taxable Income

- Income taxes

Net income (profit)
Business
Expense:
Depreciation is
viewed as part
of business
expenses that
reduce taxable
income.
Economics
4
Depreciation Concept
Economic Depreciation

Purchase Price Market Value
(Economic loss due to both physical
deterioration and technological obsolescence)

Accounting Depreciation
A systematic allocation of cost basis over a
period of time.

Economics
5
Asset Depreciation
Depreciation
Economic depreciation
the gradual decrease in
utility in an asset with
use and time
Accounting depreciation
The systematic allocation
of an assets value in
portions over its
depreciable lifeoften
used in engineering
economic analysis
Physical
depreciation
Functional
depreciation
Book
depreciation
Tax
depreciation
Economics
6
Factors to Consider in Asset
Depreciation
Depreciable life (how long?)

Salvage value (disposal value)

Cost basis (depreciation basis)

Method of depreciation (how?)
Economics
7
What Can Be Depreciated?
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. Can you depreciate land?
Economics
8
Cost Basis
Cost of new hole-punching
machine (Invoice price)

$62,500
+ Freight 725
+ Installation labor 2,150
+ Site preparation 3,500
Cost basis to use in
depreciation calculation
$68,875
Economics
9
Cost Basis with Trade-In Allowance
Old hole-punching machine (book value) $4,000
Less: Trade-in allowance 5,000
Unrecognized gains $1,000
Cost of new hole-punching machine $62,500
Less: Unrecognized gains (1,000)
Freight 725
Installation labor 2,150
Site preparation 3,500
Cost of machine (cost basis) $67,875
Economics
10
Asset Depreciation Range ADRs (years)
Assets Used Lower Limit Midpoint Life Upper Limit
Office furniture, fixtures, and equipment
8 10 12
Information systems (computers)
5 6 7
Airplanes
5 6 7
Automobiles, taxis
2.5 3 3.5
Buses
7 9 11
Light trucks
3 4 5
Heavy trucks (concrete ready-mixer)
5 6 7
Railroad cars and locomotives
12 15 18
Tractor units
5 6 7
Vessels, barges, tugs, and water transportation
system
14.5 18 21.5
Industrial steam and electrical generation and or
distribution systems
17.5 22 26.5
Manufacturer of electrical and nonelectrical
machinery
8 10 12
Manufacturer of electronic components, products,
and systems
5 6 7
Manufacturer of motor vehicles
9.5 12 14.5
Telephone distribution plant
28 35 42
Economics
11
Types of Depreciation
Book Depreciation
In reporting net income to investors/stockholders
In pricing decision
Tax Depreciation
In calculating income taxes for the IRS
In engineering economics, we use depreciation in
the context of tax depreciation
Economics
12
Book Depreciation Methods
Purpose: Used to report net income to
stockholders/investors
Types of Depreciation Methods:
Straight-Line Method
Declining Balance Method
Sum of the Years Digits Method
Unit Production Method
Economics
13
Straight Line (SL) Method
Principle
A fixed asset as providing its service in a uniform
fashion over its life

Formula
Annual Depreciation
D
n
= (I S) / N, and constant for all n.
Book Value
B
n
= I n (D)
where I = cost basis
S = Salvage value
N = depreciable life
Economics
14
Example 10.3 Straight-Line Method
n D
n
B
n
1 1,600 8,400
2 1,600 6,800
3 1,600 5,200
4 1,600 3,600
5 1,600 2,000
I = $10,000
N = 5 Years
S = $2,000
D = (I - S)/N
D1
D2
D3
D4
D5
B1
B2
B3
B4
B5
$10,000
$8,000
$6,000
$4,000
$2,000
0
0 1 2 3 4 5
T
o
t
a
l

d
e
p
r
e
c
i
a
t
i
o
n

a
t

e
n
d

o
f

l
i
f
e

n
Annual Depreciation
Book Value
Economics
15
Declining Balance Method
Principle:
A fixed asset as providing its service in a
decreasing fashion
Formula
Annual Depreciation

Book Value
1
=
n n
B D o
1
) 1 (
=
n
o o
n
B ) 1 ( o =
where 0 < o < 2(1/N)
Note: if o is chosen to be the upper bound, o = 2(1/N),
we call it a 200% DB or double declining balance method.
Economics
16
Example 10.4 Declining Balance Method
n
0
1
2
3
4
5

D
n

$4,000
2,400
1,440
864
518
B
n
$10,000
6,000
3,600
2,160
1,296
778
I
N
S
D B
I
B I
n n
n
n
n
= $10,
= years
= $778
=
= ( -
000
5
1
1
1
1
o
o o
o

)
=
( )
D1
D2
D3
D4
D5
B1
B2
B3
B4
B5
0
0 1 2 3 4 5
T
o
t
a
l

d
e
p
r
e
c
i
a
t
i
o
n

a
t

e
n
d

o
f

l
i
f
e

n
$10,000
$8,000
$6,000
$4,000
$2,000
Annual Depreciation
Book Value
Economics
17
Example 10.5
DB Switching to SL
SL Dep. Rate = 1/5
o (DDB rate) = (200%) (SL rate)
= 0.40
Asset: Invoice Price $9,000
Freight 500
Installation 500
Depreciation Base $10,000
Salvage Value 0
Depreciation 200% DB
Depreciable life 5 years
Economics
18

n

Depreciation
Book
Value
1
2
3
4
5
10,000(0.4) = 4,000
6,000(0.4) = 2,400
3,600(0.4) = 1,440
2,160(0.4) = 864
1,296(0.4) = 518
$6,000
3,600
2,160
1,296
778

n
Book
Depreciation Value
1
2
3
4
5
4,000 $6,000
6,000/4 = 1,500 < 2,400 3,600
3,600/3 = 1,200 < 1,440 2,160
2,160/2 = 1,080 > 864 1,080
1,080/1 = 1,080 > 518 0
(a) Without switching (b) With switching to SL
Note: Without switching, we have not depreciated the entire
cost of the asset and thus have not taken full advantage of
depreciations tax deferring benefits.
Case 1: S = 0
Economics
19
Case 2: S = $2,000
End of Year Depreciation Book Value
1 0.4($10,000) = $4,000 $10,000 - $4,000 = $6,000
2 0.4(6,000) = 2,400 6,000 2,400 = 3,600
3 0.4(3,600) = 1,440 3,600 1,440 = 2,160
4 0.4(2,160) = 864 > 160 2,160 160 = 2,000
5 0 2,000 0 = 2,000
Note: Tax law does not permit us to depreciate assets below
their salvage values.
Economics
20
Sum-of-Years Digits (SOYD) Method
Principle
Depreciation concept similar to DB but with
decreasing depreciation rate.

Charges a larger fraction of the cost as an expense
of the early years than of the later years.
Formula
Annual Depreciation

Book Value
SOYD n N S I D
n
/ ) 1 )( ( + =
=
=
n
j
j n
D I B
1
where SOYD=N(N+1)/2
Economics
21
Example 10.7 Sum-of-years digits method
D1
D2
D3
D4
D5
B1
B2
B3
B4
B5
$10,000
$8,000
$6,000
$4,000
$2,000
0
0 1 2 3 4 5
T
o
t
a
l

d
e
p
r
e
c
i
a
t
i
o
n

a
t

e
n
d

o
f

l
i
f
e

Annual Depreciation
Book Value
I = $10,000
N = 5 years
S = $2,000
SOYD = 15
n
1
2
3
4
5
D
n
(5/15)(8,000)=$2,667
(4/15)(8,000)=$2,133
(3/15)(8,000)=$1,600
(2/15)(8,000)=$1,067
(1/15)(8,000)=$533
B
n
$7,333
5,200
3,600
2,533
2,000
n
Economics
22
Units-of-Production Method
Principle
Service units will be consumed in a non
time-phased fashion

Formula
Annual Depreciation

D
n
= Service units consumed for year
total service units
(I - S)
Economics
23
Tax Depreciation
Purpose: Used to compute income taxes for the IRS

Assets placed in service prior to 1981

Use book depreciation methods (SL, BD, SOYD)

Assets placed in service from 1981 to 1986

Use ACRS Table

Assets placed in service after 1986

Use MACRS Table
Economics
24
Modified Accelerated Cost Recovery Systems
(MACRS)

Personal Property
Depreciation method based on DB method
switching to SL (see page 468)
Half-year convention
Zero salvage value

Real Property
SL Method
Mid-month convention
Zero salvage value

Economics
25
MACRS Property Classifications
Recovery Period ADR Midpoint Class Applicable Property
3-year Special tools for manufacture of plastic
products, fabricated metal products, and motor
vehicles. (ADR =Asset Depreciation Range)
5-year Automobiles, light trucks, high-tech equipment,
equipment used for R&D, computerized
telephone switching systems
7-year Manufacturing equipment, office furniture,
fixtures
10-year Vessels, barges, tugs, railroad cars
15-year Waste-water plants, telephone- distribution
plants, or similar utility property.
20-year Municipal sewers, electrical power plant.
27.5-year Residential rental property
39-year Nonresidential real property including elevators
and escalators
ADRs4
4 10 < s ADR
10 16 < s ADR
16 20 < s ADR
20 25 < s ADR
25s ADR
Economics
26
MACRS Table
Economics
27
MACRS Rate Calculation
Example 10.9
Asset cost = $10,000
Property class = 5-year
DB method = Half-year convention, zero salvage value,
200% DB switching to SL
20%

$2000
32%

$3200

Full
19.20%

$1920

Full
11.52%

$1152

Full
11.52%

$1152

Full
5.76%

$576
1 2 3 4 5 6
Half-year Convention
Economics
28
Year (n)

1
2

3

4

5
6

Calculation in %

(0.5)(0.40)(100%) 20%
(0.4)(100%-20%) 32%

SL = (1/4.5)(80%) 17.78%

(0.4)(100%-52%) 19.20%

SL = (1/3.5)(48%) 13.71%

(0.4)(100%-71.20%) Switch to SL 11.52%
SL = (1/2.5)(29.80%) 11.52%

SL = (1/1.5)(17.28%) 11.52%
SL = (0.5)(11.52%) 5.76%

MACRS (%)
DDB
DDB
DDB
SL
SL
Economics
29
Conventional DB Switching to SL
MACRS with half-year convention
2,000 3,200 1,920 1,152 1,152 576
4,000 2,400 1,440 1,080 1,080
Economics
30
MACRS for Real Property
27.5-year (Residential)
39-year (Commercial)

SL Method
Zero salvage value
Mid-month convention

Example: placed an asset (residential property) in March

D
1
= (9.5/12)(100%/27.5)
= 2.879%
Economics
31
Percentage Depletion vs. Cost Depletion
Gross income from sale of
45,000 ounces
$16,425,000
Depletion percentage
Computed percentage
depletion
$2,463,750
15%
Gross income from sale of
45,000 ounces
$16,425,000
Less mining expenses 12,250,000
Taxable income from mine 4,175,000
Deduction limitation
Maximum depletion deduction $2,088,000
50%
Cost depletion
= ($30,000,000/300,000)(45,000)
= $4,500,000
Allowable deduction
= $2,088,000
Select cost depletion
with $4,500,000
Percentage Depletion
(Example 10.12)
Economics
32
Calculating the Allowable Depletion
Deduction
Economics
33
Percentage Depletion Allowances for Mineral
Properties
Deposits Percentage
Oil and gas wells (only for certain domestic and gas production) 15
Sulfur and uranium, and, if from deposits in the United States,
asbestos, lead, zinc, nickel, mica, and certain other ores and
minerals
22
Gold, silver, copper, iron ore, and oil shale, if from deposits in the
United States
15
Coal, lignite, and sodium chloride 10
Clay and shale to be used in making sewer pipe or bricks 7.5
Clay (used for roofing tile), gravel, sand, and stone 5
Most other minerals; includes carbon dioxide produced from a well
and metallic ores.
14
Economics
34
Repairs and Improvements
Principle: Any repairs
or improvements extends
the life of the asset, the
depreciation amount also
needs to be adjusted.
Book Depreciation: Change
the current book value and
spread the value over the
extended life.
Tax Depreciation: Treat the
repairs or improvements as
separate MACRS properties.
Economics
35
Summary
The entire cost of replacing a machine cannot be
properly charged to any one years 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 assets value over
its depreciable life.
Economics
36
Accounting depreciation can be broken into two
categories:
1. Book depreciationthe method of depreciation
used for financial reports and pricing products;
2. Tax depreciationthe 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:
1. The cost basis of the asset,
2. The salvage value of the asset,
3. The depreciable life of the asset, and
4. The method of its depreciation.
Economics
37
Because it employs accelerated methods of
depreciation and shorter-than-actual depreciable
lives, the MACRS (Modified Accelerated Cost
Recovery System) gives taxpayers a break: It
allows them to take earlier and faster advantage
of the tax-deferring benefits of depreciation.
Many firms select straight-line depreciation for
book depreciation because of its relative ease of
calculation.
Economics
38
Depletion is a cost allocation method used
particularly for natural resources. Cost depletion
is based on the units-of-production method of
depreciation. Percentage depletion is based on a
prescribed percentage of the gross income of a
property during a tax year.
Given the frequently changing nature of
depreciation and tax law, we must use whatever
percentages, depreciable lives, and salvage values
mandated at the time an asset is acquired.
Economics
39
Component
of
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
Economics
40
Component
of
Depreciation
Book Depreciation Tax depreciation (MACRS)
Depreciable
life
Firms may select their
own estimated useful lives
or follow government
guidelines for asset
depreciation ranges
(ADRs)
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.
Method of
depreciation
Firms may select from the
following:
Straight-line
Accelerated methods
(declining balance, double
declining balance, and
sum-of- years digits)
Units-of-proportion
Exact depreciation percentages are
mandated by tax legislation but are
based largely on DDB and straight-
line methods. The SOYD method is
rarely used in the U.S. except for
some cost analysis in engineering
valuation.

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(c) 2001 Contemporary Engineering

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