DEPRECIATION

Introduction
Plants and capital equipment are installed in order to produce the product with a view to delivering
the same to the customer at right quality, at right time, and at reasonable price. Under the changing
environment in the manufacturing world, it is essential for the operations managers to keep the
schedule of delivery as per contract. Any deviation, either in quality of products or shipment of
goods, may cause disaster to the organization. Irrespective of whether it is automobile industry,
textile, pharmaceutical industry or thermal power plant, there will be loss in value of plant and
equipment due to constant usage, wear and tear.
There may be a loss of economic efficiency because of technological advances, or sudden change
in government policy or economic conditions. Therefore a company lays aside enough money per
year in order to accumulate a fund to replace the obsolete or worn-out equipment. This allowance
for loss of value with time is called depreciation. It can also be stated as the diminishing value of
an engineering system with time. Depreciation is such a valuable tool that investors can use to
maximize their return on investment.
Depreciation acts as a tax shield. It is also a cost of production. In a capital intensive industry,
depreciation can have a strong influence on the amount of taxes that must be paid.
Taxable Income = [Total Income] [allowable expenses] [depreciation]
Here we consider capital recovered as depreciation and return as interest on undepreciated balance
as a cost of ownership. These two forms of earning are collectively referred to as capital recovery
plus return.

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Depreciation calculation is primary: (i) according to time, or (ii) according to uses.

Figure 1 shows the different depreciation methods.

Depreciation

According to
time

Straight line
depreciation

Reducing
balance
depreciation

Sinking fund
method

According to
use

Sum-of-Years
Digits (SOYD)
depreciation

Output
method

Fig. 1. Taxonomy of depreciation calculation

Straight line method
In straight line depreciation, an equal amount of money is kept aside yearly. The annual
depreciation charge D is calculated as follows:

initial cost salvage value Ci Cs

;

operating life of equipment

n

(1)

where: Ci = cost of acquisition including cost of transportation, cost of installation and cost of
training;
Cs = salvage value of equipment;
n = operating life of equipment (in years)

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It is kept constant throughout the operating life of the equipment, because it assumes that the wear
and tear of the plant which is not true in real life. It is easy to calculate.
As an example of the application of straight line method, assume that the equipment has a first
cost of 8000, as expected life of 6 years, an estimated salvage value of 2000, and the desired
rate of return on undepreciated balance is 9%. Table 1 shows the capital recovered, capital
unrecovered, return and (capital recovered + return) for each year of the equipments life.
Table 1. Example of straight line depreciation model.
I
II
Year Capital
Recovered,
1
1000
2
1000
3
1000
4
1000
5
1000
6
1000

III
Capital unrecovered
beginning of year,
8000
7000
6000
5000
4000
3000

IV = III x 0.09
Return on the capital
unrecovered,
720
630
540
450
360
270

V
Capital recovered
plus return,
1720
1630
1540
1450
1360
1270

Column II represents the annual depreciation charge, which has been shown in Figure 2.

Depreciation Expense;

1200
1000
800
600
400
200
0
0

Year

Fig. 2. Straight line method of depreciation

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Capital recovery plus return is shown in Column V. Column IV is obtained by multiplying Column
III by the desired rate of interest (i.e. 9%).
Reducing Balance Method
The reducing balance depreciation model assumes that the reduction in the value of an equipment
decreases at a decreasing rate. In other words, more depreciation amount is accumulated during
the early part of the life of the equipment and less amount at the later part.
If D = rate of depreciation (%) collected per year on an engineering system, then:

D 1 n

Cs
Ci

(2)

Here, depreciated amount collected at the end of the 1st year D Ci

Similarly, depreciation cumulated at the end of the 2nd year

D Ci Ci Ci D D Ci 1 1 D

Therefore, at the end of the nth year, total depreciation collected Ci 1 1 D

C C
i

Now, Ci 1 D Cs
n

1 D
n

D 1 n

Cs
Ci

Cs
Ci

The same data [Ci = 8000; Cs = 2000; n = 6 years; i = 9%] is used here to calculate the
depreciation, undepreciated balance, return and capital recovered plus return, as shown in Table 2.
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From the given data, the value of D can be calculated as: D 1 6

2000
20.6%
8000

Table 2. Example of reducing balance depreciation model.

I
II
Year Capital
recovered,
1
1648
2
1308.50
3
1039
4
825
5
655
6
520

III
Capital unrecovered
beginning of the year,
8000
6352
5043.50
4004.50
3179.50
2524.50

IV
Return on the capital
unrecovered,
720
572
454
360
286
227

V
Capital recovered
plus return,
2368
1880.50
1493
1185
941
747

Column II of Table 2 indicates the depreciation collected annually. It also shows that the amount
of capital recovered (depreciation) is more at the early stage of installation of plant and equipment
but its values diminishes gradually at the latter part of their life. Return on capital unrecovered is
shown in column IV. Column V is obtained by adding the row wise values of columns II and IV.
Figure 3 shows the depreciation expenses for the reducing balance depreciation model.

Depreciation Expense;

1800
1600
1400
1200
1000
800
600
400
200
0
0

Year

Fig. 3. Reducing balance method of depreciation.

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Sinking Fund Depreciation Model

The sinking fund depreciation model assumes that the value of an equipment decreases at an
increasing rate. The features of this method are as follows:
a) An equal amount of money is set aside annually
b) This amount is assumed to be gaining interest at the compound rate
c) Calculation of depreciation is a bit time-consuming.
Let D = the sinking fund amount collected annually
i = desired rate of interest
Ci = initial cost (cost of acquisition including transportation cost, installation and training cost)
Cs = salvage value
n = operating life of plant (in years)
Sinking fund collected at the end of 1st year = D
Sinking fund accumulated at the end of 2nd year = D + D x i + D

2 D Di
D 2 i

i
i

D
2i i 2

i
D
2

1 i 1
i

Therefore, sinking fund cumulated after the nth year

i
D Ci Cs

n
1 i 1

D
n
1 i 1 Ci Cs
i

(3)
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i
The term
is called Sinking Fund Depository Factor (SFDF). It is a dimensionless
n
1

quantity. Therefore, D Ci Cs SFDF

(4)

The same data set [Ci = 8000; Cs = 2000; n = 6 years; i = 9%] is used here to demonstrate the
necessary computations for depreciation, return and recovery plus return, as shown in Table 3.
From the given data, the value of SFDF can be calculated as:

0.09
SFDF
0.133
6
1 0.09 1
Table 3. Example of Sinking Fund depreciation model.
I
II
Year Capital
recovered,
1
798
2
870
3
948
4
1033
5
1126
6
1228

III
Capital unrecovered
beginning of the year,
8000
7202
6332
5384
4351
3225

IV
Return on the capital
unrecovered,
720
648
570
484
392
290

V
Capital recovered
plus return,
1518
1518
1518
1518
1518
1518

Column II of Table 3 shows the depreciation collected for the equipment. Column III is obtained
by subtracting the capital recovered (Column II) from the initial cost, and subsequently in the same
manner: i.e. during the 2nd year, capital unrecovered is 8000 798 = 7202; during the 3rd year,
it is 7202 870 = 6332; and so on. Figure 4 shows the annual depreciation expenses for the
sinking fund model.

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Depreciation Expense;

1400
1200
1000
800
600
400
200
0
0

Year

Fig. 4. Sinking Fund depreciation model.

The Sum-of-Years Digits (SOYD) Depreciation
The sum-of-years digits (SOYD) depreciation is an accelerated method. Here, the depreciation
charge is computed by adding up all the integers from 1 to n and then taking a fraction of that each
year, DSOYD, j.
The denominator is the sum of the digits, the numerator is the digit corresponding to the jth year
when the digits are arranged in reverse order. Table 4 shows the capital recovered, unrecovered
capital, return and capital recovered plus return using the same data set.
Table 4. Example of SOYD depreciation model
I
II
Year Capital
recovered,
1
1714
2
1428
3
1142
4
857
5
571
6
285

III
Capital unrecovered
beginning of the year,
8000
5286
3857
2714
1857
1286

IV
Return on the capital
unrecovered,
720
476
347
244
167
116

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V
Capital recovered
plus return,
2434
1904
1489
1101
738
401

Here, capital recovered at the end of 1st year 8000 2000

6
1714 . The denominator is obtained
21

by adding 1, 2, 3, 4, 5 and 6, which results in 21. The numerator is 6 as reverse order has been
considered. The other columns are same as in earlier models.
Depreciation according to use
Let Q1 = quantity produced in the 1st year,
Q2 = quantity produced in the 2nd year,
Q3 = quantity produced in the 3rd year,
Qn = quantity produced in the nth year.

initial cost salvage value

Depreciation collected in the 1st year
Q1
Q

Q
1
2
n

Ci Cs

Depreciation collected at the end of 2 year

Q2 , where j = no. of years = 1, 2, , n.
n Qj
j 1
nd

C C
Similarly, depreciation collected at the end of nth year i n s Qn
Qj
j 1

(5)

In this method, it is very difficult to predict the life of equipment or plant producing the products
and its output in the forthcoming period. This method is not very suitable for many organizations.

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