ENGINEERING ECONOMICS

ES 219|| Engineering Economics

part 3
DEPRECIATION
Depreciation is the decrease in the value of physical
property with the passage of time.
Definitions of Value
Value in a commercial sense, is the present worth of all future profits that are to be
received through ownership of a particular property.

Market value of a 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. The 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 value is the price that can be obtained from the sale
of a property after it has been used.

Scrap value is the amount the property would sell for if disposed off as
junk.
Purposes 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 charged

to the cost of producing products or services that
results from the use of the property.
TYPES OF DEPRECIATION
1)Normal depreciation
a) Physical
b) Functional
2)Depreciation due to changes in price levels
3)Depletion
• 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 is due to the lessening in the
demand for the function which the property was designed to render.
Its common causes are inadequacy changes in styles, population
centers shift, saturation of markets or more efficient machines are
produced.
• Depreciation due to changes in price levels is almost impossible to
predict and therefore is not considered in economy studies.
• Depletion refers to the decrease in the value of a property due to the
gradual extraction of its contents.
Physical and Economic 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.
Depreciation Methods
1. Straight Line Method
2. Declining Balance Method
3. Double Declining Balance Method
4. Sum of the Years Method
5. The Service-Output Method
1. Straight Line Method
This method assumes that the loss in value is directly proportional to the age
of the property.

𝐶𝑜−𝐶𝐿
𝐿
d=
𝑛(𝐶𝑜−𝐶𝐿)
𝐶𝐿
D=

𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛
Sample#1
An electronic balance costs P90,000 and has an estimated salvage value of P8,000 at the
end of its 10 years life time. What would be the book value after three years, using the
straight line method in solving for the depreciation?

Solution:

𝐶𝑜 = P90,000 𝐶𝐿= P8,000 L = 10 n=3

𝐶𝑜−𝐶𝐿 90,000−80,000
𝐿 10
d= = = P8,200

𝐷3 = (n) (d) = (3) (P8,200) = P24,600

𝐶3 = 𝐶𝑜 - 𝐷3 = 90,000 – 24,600 = P65,400
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.

d=
= d ()
=
Sample#2
A broadcasting corporation purchased an equipment for P53,000 and paid P1,500 for freight and
delivery charges to the job site. The equipment has a normal life of 10 years with a trade-in value of
P5,000 against the purchase of a new equipment at the end of the life.
a) Determine the annual depreciation cost by straight line method
b) Determine the annual depreciation cost by the sinking fund method. Assume interest at 6-12%
compounded annually.
Solution:

𝐶𝑜 = P53,000 + P1,500 = P54, 500 𝐶𝑜−𝐶𝐿 54,000−5,000

𝐿 10
a) d = = = P4,950
𝐶𝐿 = P5,000
𝐶𝑜−𝐶𝐿 54,000−5,000
(1+.065)10 −1
b) d = 𝐹
, 𝑖% , 𝐿
= = P3,668
𝐴 .065
Sample#3
A firm bought an equipment for P56,000. Other expenses including installation amounted to P4,000. The
equipment is expected to have a life of 16 years with a salvage value of 10% of the original cost.
Determine the book value at the end of 12 years by a) straight line method and b) sinking fund method
at 12% interest.

Solution: a) Straight Line Method

𝐶𝑜−𝐶𝐿 60,000−6,000
𝐶𝑜 = P56,000 + P4,000 = P60,000 d=
𝐿
=
16
= P3,375

𝐶𝐿 = P60,000 (.10) = P6,000 𝐷12= (d) (n) = 3375 (12) = P40,500

L = 16 n = 12 i= 12% 𝐶12 = 𝐶𝑜 - 𝐷12 = P60,000 – P40,500 = P19,500

a) Sinking Fund Method

𝐶𝑜−𝐶𝐿 60,000−6,000 54,000
(1+.12)16 −1
d=𝐹 𝐹
, 𝑖% , 𝐿 , 12% , 16
= = = P1,263
𝐴 𝐴 .12

𝐷12 = d ( , 𝑖% , 𝑛) = 1,263 (24.1331) = P30,480

𝐹
𝐴

𝐶12 = 𝐶𝑜 - 𝐷12 = 60,000 – 30,480 = P29,520

2. 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 ratio
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 designated by k,
the rate of depreciation.
𝑑𝑛 = 𝐶𝑜(1 − 𝑘)𝑛−1k

𝐶𝑛 = 𝐶𝑜(1 − 𝑘)𝑛 = 𝐶𝑜( 𝐿)𝐿

𝐶 𝑛
𝐶𝑜

𝐶𝐿 = 𝐶𝑜(1 − 𝑘)𝐿

k = 1 -ට = 1 -ට
𝑛 𝐶𝑛 𝐿 𝐶𝐿
𝐶𝑜 𝐶𝑜
Sample#4
A certain type of machine loses 10% of its value each year. The machine costs P2,000 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.

Solution:

Total
Book value at Depreciation Book value at
depreciation at
YEAR the beginning during the the end of
the end of
of year year 10% year
year
1 2,000 200 200 1,800
2 1,800 180 380 1,620
3 1,620 162 542 1,458
4 1,458 145.80 687.80 1,312.20
5 1,312.20 131.22 819.12 1,180.98
3. Double Declining Balance Method
This method is very similar to the declining balance method except that the rate of
depreciation k is replaced by 2/L

𝑑𝑛 = 𝐶𝑜(1 − )𝑛−1
2 2
𝐿 𝐿

𝐶𝑛 = 𝐶𝑜(1 − )𝑛
2
𝐿

𝐶𝐿 = 𝐶𝑜(1 − 𝐿)𝐿
2

When the DDB method is used, the salvage value should not be subtracted from the first
cost when calculating the depreciation charge.
Sample#5
𝐶𝑜 = P15,000 L = 10
𝐶𝐿 = up
Determine the rate of depreciation, the total depreciation to the end ofn =the
P2,000 8 8th 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 at the end of 10 years by a) the declining balance method and b) the double declining balance
method. a) Declining Balance Method

k = 1 -ට =1- ට
Solution:
𝐶𝐿 2000
𝐶𝑜 = P15,000
𝐿 10
𝐶𝑜 15000
L = 10 = .1825 or 18.25%

𝐶𝐿 = P2,000 𝐶8 = 15,000(1 − .1825) = P2,992

8

𝐷8 = 𝐶𝑜 - 𝐶8 = 15,000 – 2,992 = P12,008

n=8

a) Declining Balance Method b) Double Declining Balance Method

2 2
k = 1 -ට =1- ට
𝐿 𝐶𝐿 10 2000 Rate of Depreciation = 𝐿 = 10 = .20 or 20%
𝐶𝑜 15000
= .1825 or 18.25%
𝐶8 = 𝐶𝑜(1 − )𝑛 = 15,000 (1 − .20)8 = P2,517
2
𝐶8 = 15,000(1 − .1825) = P2,992
8
𝐿
𝐷8 = 𝐶𝑜 - 𝐶8 = 15,000 – 2,992 = P12,008
𝐷8 = 𝐶𝑜 - 𝐶8 = 15,000 – 2,517 = P12,483
b) Double Declining Balance Method

2 2
4. Sum of the Years Method
Book Value at mth year:
𝐶𝑚 = 𝐶𝑜 - 𝐷𝑚
Depreciation charge at mth year:

𝑑𝑚 =
2 (𝑛−𝑚+1)
𝑛 ( 𝑛+1)

Total Depreciation:

𝐷𝑚 =
𝑚 (2𝑛−𝑚+1)
𝑛 ( 𝑛+1)
Sample#6
A structure costs P12,000 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.

- = 12,000 – 1,000 = P11, 000

Year in Depreciation during Book Value at the
YEAR
5
Reverse the year end of year
൬ ൰ ሺ11,000ሻ = 3,667
15
1 5 8,333
4
൬ ൰ ሺ11,000ሻ = 2,933
15
2 4 5,400
3
൬ ൰ ሺ11,000ሻ = 2,200
15
3 3 3,200
2
൬ ൰ ሺ11,000ሻ = 1,467
15
4 2 1,733
1
൬ ൰ ሺ11,000ሻ = 733
15
5 1 1,000
σ 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑖𝑔𝑖𝑡𝑠 = 15
5. 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 up to the end of life
𝑄𝑛 = total number of units of output during the nth year

𝑑𝑛 = (𝑄𝑛 )
𝐶𝑜−𝐶𝐿
𝑇
Sample#7
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
units 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 𝐶𝑜 1980 using each method given below:
= 100,000
a) Straight Line 𝐶𝐿 = 4,000
b) Working Hours
L = 10 years
c) Output Method
T = 400,000 units
Solution: H = 120,000 hours

A) 𝑑10 =
𝐶𝑜−𝐶𝐿 100,000−4,000
𝐶𝑜 = 100,000
𝐿 10
= = P9,600
𝐶𝐿 = 4,000

𝑑10 = (𝐻10) =
𝐶𝑜−𝐶𝐿 100,000−4,000
𝐻 120,000
L = 10 years B) (18,000) = P14,400
T = 400,000 units

𝑑𝑛 = (𝑄𝑛 ) =
𝐶𝑜−𝐶𝐿 100,000−4,000
𝑇 400,000
H = 120,000 hours C) (44,000) = P10,560
A) 𝑑10 =
𝐶𝑜−𝐶𝐿 100,000−4,000
𝐿 10
= = P9,600
end