Methods of Depreciation

Four Methods

Straight Line
Declining Balance
Sum of the Years Digits
Units of Production

Straight Line
Annual Depreciation = Cost Salvage Value
Years of Useful Life
Example: You purchase a truck that costs
$19,000. It has a salvage value of $5,000
and a useful life of 5 years. What is the
annual depreciation?
Annual Depreciation = 19,000-5,000
5
Annual Depreciation = $2,800

Declining Balance
Declining balance is calculated on either 1.5 X
0r 2 X the straight line amount (Percentage)
Straight line percentage is calculated by
dividing 1 by the number of years of useful
life.
Each consecutive year, the depreciation
amount is calculated by multiplying the
percentage by the book value (Cost
accumulated depreciation)

Declining Balance Example

Example: You purchase a truck that costs $19,000. It has a salvage value of
$5,000 and a useful life of 5 years. What is the annual depreciation
1.
2.

Calculate Percentage 1/5 years = 20% X 2 = 40%

Note: The Book Value may never fall below Salvage Value
Year

Book Value

Depreciation Annual
Depreciation
Rate

Accumulated
Depreciation

19,000

40%

7,600

7,600

11,400

40%

4,560

12,160

6,840

1840

15,000

5,000

15,000

5,000

15,000

Sum of the Years Digits

First add all the digits of the years of useful life. For instance: For 5 years
you would add
1+2+3+4+5=15. Each year make a fraction of the year/sum.

Year

Depreciable
Cost

Years
Fraction

Annual
Depreciation

Accumulated
Depreciation

19,000

5/15

6,333

6,333

19,000

4/15

5,067

11,400

19,000

3/15

2,600

14,000

19,000

19,000

Units of Production
Johnson Company purchases a machine for $500,000.
The machine is expected to produce 2,000,000 units. In
the first year the machine produced 400,000 units.

Calculate cost per unit:

Depreciable Cost/Expected Units of Production
500,000/2,000,000 = .25
Calculate Current Year Depreciation:
Cost per unit X Current Years Units of Production

.25 X 400,000 = $100,000

Accumulated Depreciation

Contra Account to the Asset Account

(Equipment, Buildings, etc.)
Balance Sheet or permanent account
Has normal credit balance
Book Value = Asset Accumulated
Depreciation

Depreciation Expense

Temporary Account
Closed at end of fiscal year
Income Statement Account

Entry to record depreciation

Depreciation Expense
XXXX
Accumulated Depreciation
XXXX

Recording the sale of a depreciable asset

Must remove both the asset and the
associated accumulated depreciation from
the books
Must record gain or loss (use as plug figure)
Example:
Johnson Company sells its equipment that
cost $500, 000 with $200,000 of Accumulated
Depreciation for $350,000.

Recording the sale of a depreciable asset

Johnson Company sells its equipment that
cost $500, 000 with $200,000 of Accumulated
Depreciation for $350,000
Cash in Bank
350,000
Accumulated Depreciation 200,000
Equipment
500,000
Gain on Sale of Equipment
50,000
*A loss is recorded as a debit

Breakeven Analysis Defined

Breakeven analysis examines the short run

relationship between changes in volume and
changes in total sales revenue, expenses
and net profit
Also known as C-V-P analysis (Cost Volume
Profit Analysis)

Uses of Breakeven Analysis

C-V-P analysis is an important tool in terms of

short-term planning and decision making
It looks at the relationship between costs,
revenue, output levels and profit
Short run decisions where C-V-P is used include
choice of sales mix, pricing policy etc.

How many units must be sold to breakeven?

How many units must be sold to achieve a
target profit?
Should a special order be accepted?
How will profits be affected if we introduce a
new product or service?

Key Terminology: Breakeven

Analysis

Break even point-the point at which a company

makes neither a profit or a loss.
Contribution per unit-the sales price minus the
variable cost per unit. It measures the
contribution made by each item of output to the
fixed costs and profit of the organisation.

Key Terminology

Margin of safety-a measure in which the

budgeted volume of sales is compared with the
volume of sales required to break even
Marginal Cost cost of producing one extra
unit of output

Breakeven Formula
Fixed Costs
*Contribution per unit

*Contribution per unit = Selling Price per unit Variable Cost per
unit

Breakeven Chart

Margin of Safety

The difference between budgeted or actual

sales and the breakeven point
The margin of safety may be expressed in
units or revenue terms
Shows the amount by which sales can drop
before a loss will be incurred

Example 1
Using the following data, calculate the
breakeven point and margin of safety in
units:
Selling Price = 50
Variable Cost = 40
Fixed Cost = 70,000
Budgeted Sales = 7,500 units

Example 1: Solution

Contribution = 50 - 40 = 10 per unit

Breakeven point = 70,000/10 = 7,000 units
Margin of safety = 7500 7000 = 500 units

Target Profits

What if a firm doesnt just want to breakeven

it requires a target profit
Contribution per unit will need to cover profit
as well as fixed costs
Required profit is treated as an addition to
Fixed Costs

Example 2
Using the following data, calculate the level
of
sales required to generate a profit of
10,000:
Selling Price = 35
Variable Cost = 20
Fixed Costs = 50,000

Example 2: Solution

Contribution = 35 20 = 15
Level of sales required to generate profit of
10,000:
50,000 + 10,000
15
4000 units

Limitations of B/E analysis

Costs are either fixed or variable

Fixed and variable costs are clearly discernable
over the whole range of output
Production = Sales
One product/constant sales mix
Selling price remains constant
Efficiency remains unchanged
Volume is the only factor affecting costs

Absorption and Marginal Costing

Compared
Absorption

Fixed costs included in

Product Cost
FC not treated as period cost
closing/opening stock values
Under/over absorption of costs
Complies with Financial
Accounting standards

Marginal

Fixed costs not included

in Product Cost
FC treated as period cost
No under/over absorption
of costs
Does not comply with
Financial Accounting
standards