Depreciation

ISE 182112 – Ekonomi Teknik

Referensi
❑ Donald G. Newnan, Enginering Economic Analysis, Engineering Press
Inc. (Chapter 11)
Introduction
❑ In the previous section we have avoided taxes
❑ Government tax individuals and business to support public
activities-infrastructure, educating students, enforcing the law, etc
❑ Taxes are always present, they must be included in economic
analyses
❑ We are focus on calculating the cash flow due to taxes
❑ For capital equipment, depreciation are required to compute
income and property taxes
Depreciation
❑ Is a decrease in value (deterioration and obsolescence)
❑ 3 distinct definitions :
❑ Decline in market value of an asset
❑ Decline in value of an asset to its owner
❑ Systematic allocation of the cost of an asset divided by its depreciable life

Book Value
Is the remaining unallocated cost of an asset.

Book Value = Cost – Depreciation charges made

Depreciation
❑ A noncash cost that requires no exchange of money from one hand
to another
❑ These are business expenses that are allowed by the government to
offset the loss in value of business assets
❑ Depreciation deductions reduce the taxable income and property
value of businesses and thus reduce the amount of taxes paid
❑ Since taxes are cash flow, depreciation must be considered in after-
tax economic analyses
Depreciation
In general, business assets can only be depreciated if they meet this
requirements:
❑ The property must be used for business purposes to produce
income
❑ The property must have a useful life that can be determined, and
this life must be longer than one year
❑ The property must be an asset that decays, gets used up, wears out,
becomes obsolete, or loses value to the owner from natural causes
Basic Methods
1. Straight Line
2. Declining Balance
3. Sum of Years Digits
4. Unit of Production
 Straight Line Depreciation
The depreciation charge is constant :
1
Annual depreciation charge = (P − S)
N

P : cost of the asset

S : salvage value
N : useful life
 1
DC = (P - S)
N

Example 1
A computer is purchased for $7,000. It should have a useful life of 5
years and no salvage value.
Compute the annual depreciation charge.

Depreciation charge = 1/5 x ($7000 - 0)

= $1400 per year
Example 2
P = $7000, S = 0, N = 5 years.
Calculate the book value at the first and third year.

Book Valuet = Book Valuet-1 – Depreciation charget

BV1 = BV0 – DC1

= $7000 - $1400
= $5600

BV3 = BV2 – DC3

= ($5600 - $1400) - $1400
= $2800
Straight Line Depreciation
Straight line depreciation charge for year t:
BVt -1 − S
Depreciation charget =
Remaining useful life at beginning of year

t
BV at the end of year t = P - (P − S)
N
 BVt -1 − S
Depreciation charget =
Remaining useful life at beginning of year

t
BV at the end of year t = P - (P − S)
N

Example 3
P = $7000, S = 0, N = 5 years. Calculate the depreciation schedule.
t DCt BVt
0 P = 7000
1 1400 5600
2 1400 4200
3 1400 2800
4 1400 1400
Book Value at the end of useful life =
5 1400 0=S
Salvage Value
Total DC = $7000
 Declining Balance
❑ Amortizing an asset at an accelerated rate early in its life, with
corresponding lower annual charges near the end of service.
❑ The depreciation charge is:
R
Depreciation charge = (Cost - Depreciaton charges to date)
N
R
Depreciation charge = (BV)
N
R = constant depreciation rate, can be 1.5 or 2.0.
❑ When R = 2.0 is used, it is called Double Declining Balance (DDB)
method.
Declining Balance
Depreciation charge and book value for year t:

t −1
RP  R
Depreciation charget = 1 − 
N  N
t
 R
BV at the end of year t = P1 - 
 N
 t −1
RP  R
Depreciation charget = 1 − 
N  N
t
 R
BV at the end of year t = P1 - 
 N

Example 4
P = $7000, S = 0, N = 5 years.
Using Double Declining Balance (DDB) method, calculate the depreciation charge at the
3rd year and book value at the 4th year.
3−1
(2)(7000)  2 
DC3 = 1 −  = 1008
5  5
4
 2
BV4 = 70001 −  = 907.2
 5
 2
DCt = BVt-1
N
Example 5
P = $7000, S = 0, N = 5 years.
Using Double Declining Balance (DDB) method, calculate the depreciation schedule.

t DCt BVt
0 P = 7000
1 2/5 x 7000 = 2800 4200
2 2/5 x 4200 = 1680 2520
3 2/5 x 2520 = 1008 1512 Salvage value is not considered in DDB.
4 2/5 x 1512 = 604.8 907.2
5 2/5 x 907.2 = 362.9 544.3
Total DC = $6455.7
Implication of Depreciation
❑ Depreciation is a deduction of taxable income.

Taxable Income =Gross income - All expenditures except capital expenditures - Depreciation
and depletion charges
❑ The greater the depreciation is, the greater the deduction will be, and the less the taxable
income is.

❑ Earlier example:

t DCt BVt
5 2/5 x 907.2 = 362.9 544.3
S=0

→ The tax savings is not maximized.

DDB with Conversion to Straight Line

❑ Combining DDB method with SL method

→ Use DDB first, then switch to SL

❑ The time to switch:

when the SL depreciation charge on the undepreciated portion exceeds the
DDB allowance.
Example 6
P = $7000, S = 0, N = 5 years.
Calculate the depreciation schedule.
t DCDDB DCSL Switch? BVt
0 P = 7000
1 2800 1/5(7000 - 0*) = 1400 No 4200
2 1680 1/4(4200 - 0**) = 1050 No 2520
3 1008 1/3(2520 - 0) = 840 No 1512
4 604.8 1/2(1512 - 0) = 756 Yes 756
5 756 0=S

Total DC = $7000
* * P - S (≠ BV0)
* * The undepreciated portiont = BVt-1 - S (≠ BVt-1)
Exercise 1
A company has just purchased a railroad tank car for $50,000. It
has 10 years useful life with no salvage value.
Compute the depreciation schedule by each of the following
method:
a. SL
b. DDB
c. DDB with conversion to SL
 Sum-of-Years Digits
❑ Results in larger than straight line depreciation charges during the
early years of an asset, and smaller charges as the asset nears the
end of its estimated useful life.

❑ Depreciation charge for year t:

Remaining useful life
Depreciation charget = (P − S)
SOYD
N
SOYD = (N + 1)
2
 N
SOYD = (N + 1)
2
Remaining useful life
DCt = (P − S)
SOYD
Example 7
P = $7000, S = 0, N = 5 years. SOYD = 5/2(5+1) = 15

t DCt BVt
0 P = 7000
1 5/15(7000-0) = 2333 4667
2 4/15 (7000-0) = 1867 2800
3 3/15 (7000-0) = 1400 1400
4 2/15 (7000-0) = 933 467
5 1/15 (7000-0) = 467 0=S
Total DC = 7000
Method Comparison
❑ Depreciation is a deduction of taxable income.
❑ The greater the depreciation is, the greater the deduction will be, and
the less the taxable income is.
❑ Depreciation methods generally result in the same total depreciation
deductions, so it is the timing of the deductions that characterize the
different methods.
❑ Due to the time value of money, immediate tax savings are more
valuable → a profitable firm prefers to depreciate its assets as rapidly as
possible: select the method with the largest PW of depreciation
charges.
 Unit of Production
❑ Depreciation is related to use, not to time.
❑ Might be useful for machinery that used for a special project and
the project will be finished before the machinery wears out.
❑ Not acceptable for general use in depreciating industrial equipment.
❑ Depreciation charge for year t:
Production for year t
Depreciation charget = (P − S)
Total lifetime production
Example 8
An equipment can be purchased for $900 and has a salvage value of $70. The equipment will
be used to process sand and gravel in an airport reconstruction. The reconstruction will take 5
years and after that time, the equipment will be removed and sold. Compute the depreciation
charge of the equipment for the first year using UOP method.

Year 1 2 3 4 5
Sand & gravel
4000 8000 16000 8000 4000
processed (m3)

Production for year t

DCt = (P − S)
Total lifetime production

4000 m3
DC1 = 3
($900 − $70) = $83
40000 m
Exercise 2
Consider a $6500 piece of machinery, with five-year depreciable life and
an estimated $1200 salvage value. The project utilization of the machinery
when it was purchased is shown below.
Year 1 2 3 4 5
Production (tons) 3500 4000 4500 5000 5500

Compute the depreciation schedule by SOYD and UOP method.

Exercise 3
Consider a $6500 piece of machinery, with five-year depreciable life and
an estimated $1200 salvage value. The project utilization of the
machinery when it was purchased and its actual production are shown
below.
Year 1 2 3 4 5
Projected production (tons) 3500 4000 4500 5000 5500

Actual production (tons) 3000 5000 N/A N/A N/A

Compute the depreciation schedule by UOP method for first 2 years only.
Terima Kasih
Yani Herawati
Program Studi Teknik Industri
UNPAR
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