ES301 – Engineering Economics
Chapter 5
Depreciation and Depletion
Definitions
Depreciation – is the decrease in the value of physical property with the
passage of time. More specifically, depreciation is an accounting
concept that establishes an annual deduction against before tax income
such that the effect of time and use on the asset’s value can be reflected
in a firm financial statement.
Value – in a commercial sense, is the present worth of all the future
profits that are to be received through ownership of a particular property.
Market Value of Property – is the amount which a willing buyer will pay
to a willing seller for the property where each has equal advantage and
is under no compulsion to buy or sell.
Utility or Use Value of a Property – is what the property is worth to the
owner as an operating unit.
Fair Value – is the value which is usually determined by a disinterested
third party in order to establish a price that is fair to both seller and buyer.
Book Value - sometimes called depreciated book value, is the worth of
a property as shown on the accounting records of an enterprise.
Salvage or resale – is the price that can be obtained from the sale of
the property after it has been used.
Scrap Value is the amount of the property would sell for, if disposed off
as junk.
Purpose of Depreciation
1. To provide for the recovery of capital which has been invested in
physical property.
2. To enable the cost of depreciation to be changed to the cost of
producing products or services that results from the use of the property.
3. To enable to cost of depreciation to be included as a cost in the
production of goods and services.
4. Annual cost of depreciation are being put in a fund called depreciation.
5. Provide as an additional capital termed as depreciation reserve
Types of Depreciation
1. Normal depreciation
a) Physical
b) Functional
2. Depreciation due to changes in price levels
3. Depletion
Physical Depreciation
Physical depreciation is due to the lessening of the physical ability of a
property to produce results. Its common causes are wear and
deterioration.
Functional Depreciation
Functional depreciation is due to lessening of the demand for the
function which the property was designed to render. Its common cause
are inadequacy, changes in styles, population-center shifts, saturation of
markets or more efficient machines are produced (obsolescence).
Depreciation due to changes in price levels is most impossible to
predict and therefore is not considered in economy studies.
Depletion refers to the decrease in the value of a property due to gradual
extraction of its contents.
Properties Depreciable Assets:
1. It must have a determinable life and the life must be greater than 1
year.
2. It must be something used in business or held to produce income.
3. It must be something that gets used up, wears out decays, become
obsolete, or loses its value due to natural causes.
4. It must be an inventory or stock in trade or investment.
Physical and Economical Life
Physical life of a property is the length of time during which it is capable
of performing the function for which it was designed and manufactured.
Economic life is the length of time during which the property may be
operated at a profit.
Requirements of a Depreciation Method
1. It should be simple.
2. It should be recover capital.
3. The book value will be reasonably close to the market value at any
time.
4. The method should be accepted by the Bureau of Internal Revenue.
Depreciation Methods
We shall use the following symbols for different depreciation methods.
L = useful life of the property in years
Co = the original cost
CL = the value at the end of the life, the scrap value (including gain or
loss due to removal)
d = the annual cost of depreciation
Cn = the book value at the end of n years
Dn = Depreciation up to age n years
1. The Straight Line Method
The method assumes that the loss in value is directly proportional to the
age of the property. It is the simplest depreciation method. It assumes
that a constant amount is depreciation each year over the depreciable
(useful) life of the asset.
Formula:
𝐶𝑜 − 𝐶𝐿
𝑑=
𝐿
𝑛(𝐶𝑜 − 𝐶𝐿 )
𝐷= 𝐿
𝐶𝑛 = 𝐶𝑜 – 𝐷𝑛
Example
An electronic balance costs P90, 000.00 and has an estimated salvage
value of P8,000.00 at the end of 10 years life time. What would be the
book value after three years, using the straight line method in solving
for the depreciation?
2. The Sinking Fund Formula
This method assumes that a sinking fund is established in which funds
will accumulate for replacement. The total depreciation that has taken
place up to any given time is assumed to be equal to the accumulated
amount in the sinking fund at that time.
Formula:
Example:
A broadcasting corporation purchased an equipment for P53,000 and
paid P1,500 for freight and deliver charges to the job site. The equipment
has a normal life of 10 years with a trade-in value of P5,000.00 against
the purchase of a new equipment at the end of the life.
a) Determine the annual depreciation cost by the straight line method.
b) Determine the annual depreciation cost by the sinking fund method.
Assume interest of 6.5% compounded annually.
A
3. Declining Balance Method
In this method, sometimes called the constant percentage method or the
Matheson Formula, it is assumed that the annual cost of depreciation is
a fixed percentage of the salvage value at the beginning of the year. The
ration of the depreciation in any year to the book value at the beginning
of that year is constant throughout the life of the property and is designed
by k, the rate of depreciation.
This method does not apply, if the salvage value is zero, because k will
be equal to one and d1 will be equal to Co.
Example:
A certain type of machines loses 10% of its value each year. The
machine costs P2000 originally. Make out a schedule showing the
yearly depreciation, the total depreciation and the book value at the end
of each year for 5 years.
4. Double Declining Balance (DDB) Method
This method is very similar to the declining balance method except that
the rate of depreciation k is replaced by 2/L.
When the DDB method is used, the salvage value should not be
subtracted from the first cost when calculating the depreciation charge.
Example:
Determine the rate of depreciation, the total rate of depreciation up to
the end of the *th year and the book value at the end of 8 years for an
asset that costs P15,000 new and has an estimated scrap value of
P2,000.00 at the end of 10 years by
(a) the declining balance method
(b) the double declining balance method
5. The Sum-of-the-Years-Digits (SYD) Method
Example
A structure costs P12,000.00 new. It is estimated to have a life of 5 years
with a salvage value at the end of life of P1,000. Determine the book
value at the end of each year of life.
6. The Service-Output Method
This method assumes that the total depreciation that has taken place is
directly proportional to the quantity of output of the property up to that
time. This method has the advantage of making the unit cost of
depreciation constant and giving low depreciation expense during
periods of low production.
Let T = total units of output to the end of life
Qn = total number of units of product during the nth year
Example:
A television company purchased machinery for P100,000 on July 1,
1979. It is estimated that it will have a useful life of 10 years; scrap value
of P4,000, production of 400,000 hours and working hours of 120,000.
The company uses the machinery for 14,000 hours in 1979 and 18,000
hours in 1980. The machinery produces 36,000 units in 1979 and
44,000 units in 1980. Compute the depreciation for 1980 using output
method.
What Depreciation Method should be used?
It is worth mentioning what the National International Revenue Code
says about depreciation specifically Section 29(f).
1. General rule. “There shall be allowed as a depreciation deduction a
reasonable allowance for the exhaustion, wear and tear (including
reasonable allowance for the obsolescence) of property used in the
trade or business.
2. Use of certain method and rates. The term “reasonable allowance”
as used in the preceding paragraph shall include (but not limited to) an
allowance computed in accordance with regulations prescribed by the
Secretary of Finance, under the following methods:
(a) The straight line method
(b) Declining balance method, using a rate not exceeding twice the rate
which would have been used had the annual allowance been computed
under the method described in the paragraph (f)(1).
(c) The sum-of-the-years-digits method and
(d) Any other method which may be prescribed by the Secretary of
Finance upon recommendation of the Commissioner of Internal
Revenue.
Notes: Taxpayer may enter into an “agreement in writing specifically
dealing with the useful life and rate of depreciation of any property, the
rate so agreed upon shall be biding”
Valuation
Valuation or appraisal is the process of determining the value of
certain property for specific reasons. The person engaged in the task of
valuation is called an appraiser.
Intangible Values
In the determination of the value of industrial property or equipment, four
intangible items are often encountered.
1. Goodwill is the element of value which a business has earned
through favorable consideration and patronage of its customers arising
its well-known and well conducted policies and operation.
2. Franchise is an intangible item of value arising from the exclusive
right of a company to provide a specific product or service in a stated
region of the company.
3. Going value is an intangible value which an actually operating
concern has due its operation.
4. Organization cost is the amount of money spent in organizing a
business and arranging for its financing and building.
DEPLETION
Depletion is the decrease in the value of a property due to gradual
extraction of its contents. The term is commonly used in connection with
mining properties, oils, and gas wells, timberlands and so on. The
purpose of determining the depletion per year is to recover the capital
invested in the property. Owners of such properties received two types
of income:
a) The profit that has been earned
b) A portion of the owners capital that is being returned, marked as
depletion
These are two ways to compute depletion allowances:
1. The Cost Method
In this method, depletion per units is determined.
𝐶𝑜𝑠𝑡𝐵𝑎𝑠𝑖𝑠
Depletion per unit = 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑𝑛𝑜𝑜𝑓𝑢𝑛𝑖𝑡𝑠𝑡𝑜𝑏𝑒𝑚𝑖𝑛𝑒𝑑
The depletion allowance for a given year is calculated as:
𝐷 = 𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑥 𝑁𝑜. 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑
2. Percentage Method
Depletion allowances on mines and other natural deposits, maybe
computed as percentage of gross income for that year, provided that
the amount charged for depletion does not exceed 50% of the net
income (100% of oils and gas property) before deduction of the
depletion allowance.
Some examples of Max Percentage
depletion allowance
Sulfur and uranium, 22%
domestically mined Lead,
zinc, nickel and asbestos
Gold, silver, copper, iron ore 15%
Oils and gas wells 15%
Coal, lignite, and sodium 10%
chloride
Clay, gravel, sand and stone 5%
Therefore,
D = % gross income or
D = 50% net income
Where:
𝐺𝑟𝑜𝑠𝑠 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝑃𝑟𝑖𝑐𝑒/𝑢𝑛𝑖𝑡 𝑥 𝑛𝑜. 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝐺𝑟𝑜𝑠𝑠 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
Example
1. A gold mine that is expected to produce 30,000 ounces of gold is purchased for
P2, 400, 000. The gold can be sold for P450 per ounce; howerver, it cost P265 per
ounce for mining and processing costs. It 3,500 ounce are produced this year, what
will be the depletion allowance for
(a) Unit Depletion
(b) Percentage Depletion
