Chapter 5 : Depreciation | PRINCIPLES OF ENGINEERING ECONOMICS & MANAGEMENT TEC...

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PRINCIPLES OF ENGINEERING ECONOMICS & MANAGEMENT TECHNIQUES (PEEMT)

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Home Topics Chapter 1 : Cost Analysis Chapter 2 : Replacement Studies Chapter 3 : Economic Analysis of Investment Alternatives Chapter 4 : Cost Estimation Chapter 5 : Depreciation Chapter 6 : Human Resource Management Chapter 7 : Procurement and Placement Chapter 8 : Training and Development Chapter 9 : Job Satisfaction Chapter 10 : Integration and Maintainence

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Chapter 5 : Depreciation

Q. 1. Describe Depreciation. Ans. To reduction in value and efficiency of the plant, machines of any fixed asset because of wear and tear, due to passage of time, use and climatic conditions is known as depreciation. Depreciation may also be defined as a method for spreading the cost of a fixed asset over the life or expected years of use, of the assets. Most of the fixed assets are worn out while in use over a period of time. This wear and tear is unavoidable but it can be minimized to some extent by proper care and maintenance the efficiency of these assets also reduces with the passage of time and at one time it becomes uneconomical to be used further and requires replacement. The amount of money charged for replacement is depreciation. Some money must be set aside yearly from the profits earned by the equipment itself, so that when the unit becomes uneconomical, it can be replaced by new one. For this purpose, the initial cost of the machine or equipment + installation charges + repair charges-scrap value is charged over the economical life of the machine of equipment. Q. 2. What are the causes of Depreciation? Ans. Causes of Depreciation. -They are: (a) Physical causes. (b) Custom or usage. (c) Abnormal occurrences. (d) Technological developments and changes. (a) Physical causes (i) Normal physical wear and tear, due to friction, pull, impact, fatigue, twisting, etc. (ii) Lack of maintenance and timely repairs of fixed assets. (iii) Action of chemical elements on the component- pars. (iv) Passage of time. (b) Custom or usage With some types of fixed assets, e.g., cars and other vehicles, there are customs which have been established on the rate of wear and tear normally expected every year. There is definitely a correlation between the price of a second-hand car and the likely extent of depreciation. (c) Abnormal occurrences, such as: (i) Accidents (ii) Defects m materials

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(iii) Excessive wear and tear (iv) Contingent occurrence e.g., appearance of hairline cracks in a pressure vessel adequately tested. (d) Technological developments and changes (i) New equipments which supersede the existing ones, start coming in the market e.g., calculators have superseded the slide-rules to a major extent. (ii) Change in manufacturing methods which necessitates the use of another type of equipment. (iii) Improved and automated machine tools which render the use of existing ones uneconomical (obsolescence). (iv) Inadequacy of the existing equipment perform the necessary function such increased output, more precision and better quality. Q. 3. Name the various depreciation methods. Ans. The following methods may be employed for calculating depreciation. (a) Straight line method. (b) Reducing balance method. (c) Production based methods. (i) per unit; and (ii) per hour. (d) Repair provision method. (e) Annuity method. (1) Sinking fund method. (g) Endowment policy method. (h) Revaluation method. (1) Sum of the digits method. Q. 4. Describe the various methods of Depreciation. Ans. 1. Straight line method. *This method is also called fixed installments method.. *In this method every year a fixed amount is kept aside as depreciation charges during the economical life of the equipment or machinery. *The amount of depreciation i.e. initial cost of machine + erection and installation charges scrap .value is distributed over the useful life of the machine in equal periodic installement. Let C = Initial cost of the machine in rupees S Scrap value in rupees N = Estimated life of the machine in years

2. Diminishing balance method *The machine or equipment depreciate fast in the early years and later on slowly. Therefore, according to this method the depreciation fund is more during the early years, when repair and renewals are not costly.

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This method is also called reducing balance method or percentage on book value method. The book value of the machine goes on decreasing as its existence continues. Hence in this method, a certain percentage of the current book value is taken as depreciation. Let C = Initial cost S = Scrap value N = Estimated life in years X = Fixed % for calculating yearly depreciation.

3. Sinking fund method: In this method, a depreciation fund equal to the actual loss in the value of the asset is estimated for each year. *This amount is invested elsewhere other than in the business itself and the interest will be earned on the fund Therefore, the sinking fund investment will grow year by year with the amount of annual depreciation plus the interest earned on the part investment. Let S = Scrap value N = No. of years/of life of the asset D = Rate of depreciation per year R = Rate of interest on invested fund

(i) Sum of the Digits Method. The method provides for depreciation by means of differing periodic rates calculated as follows : If N is the estimated life of a machine, the rate is calculated for each period as a fraction in which the denominator is always the sum of the series 1, 2, 3, 4 N and the numerator for the first period is N, for the second Ni, for the third N2 and so on. The effect of this method is to charge depreciation at a decreasing rate each year Advantages: (1) It is a method of quick depreciation for motor vehicles, (ii) It realistically takes account of the immediate drop in value of a new vehicle, even recently purchased. (iii) It makes the decision to sell the repurchase before the estimated time, easier. (g) Endowment (Insurance) Policy Method. The method involves charging depreciation and their investing it in the form of an endowment policy. Each year the sum charged is paid as a premium to an insurance company. At the end of the life of the asset the sum payable should be equal to the original cost. The method is similar in effect to the sinking fund method. cash is taken out of the business to pay the insurance premiums and is made available again at the end of the period for the purchase of another asset, when the policy matures. (h) Revaluation Method. Revaluation method provides for depreciation by means of periodic charges, each of which is equal to the difference between the values assigned to the asset at the beginning and end of each year, for example: If the value of a machine on April 1, 1974 is Rs. 7,000 and on march 31, 1975 it is revaluated as Rs. 6,000, then the depreciation for this period is Rs. 7,000 - Rs. 6,000= Rs. 1000. (e) Annuity Method. It considers original cost and interest on the written down value of the fixed assets.

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It assumes that the purchase of .a fixed asset is an investment on which interest is earned. Therefore, the investment for the purpose of the method is the written down value plus interest earned to date. The annuity method is generally used for the redemption of leases over a fairly long period, since money invested for a lengthy period in a capital asset should be deemed to be earning interest. The mathematical relation used to calculate rate of depreciation, R.O.D. is:

Where C, S and N are same as in equation (7) and is fixed rate of interest (in fractions) determined before hand and charged throughout the life of the asset. Advantages: Money invested in fixed asset is not idle, rather it is earning certain rate of interest. Disadvantages: In most cases the interest a such never materialises. With plant, machinery and similar fixed assets the changes which take place as sales, renewals and additions tend to make the annuity method difficult to apply. (iii) Production Method. Involving a uniform charge per unit of output, the method is commonly used in extractive industries. For example the usefulness of mine head installations is closely linked to size of the ore deposit. Depletion, the specific term for the amortization of natural resource costs, is normally computed in this manner. In cases where physical deterioration or exhaustion is the probable limiting factor on economic usefulness, the life forecast necessarily depends upon an estimate of the assets, total service capacity. However, if absolescence is the limiting factor, a life estimate can be made without projecting service capacity and estimating the latter requires an additional forecast of the demand for assets services over the expected life -span. Therefore, this further complication has inhibited adoption of the production method in those industries where obsolescence is an important consideration. Example 5.1. An industrial plant with initial value of Rs. 400,000 has the salvage value of Rs. 40,000 at the end of 10 years but is sold for Rs. 250,000 at the end of 5 years What is the profit or loss if sinking fund depreciation method at 10% compounded interest (annually) was adopted. Solution. A : per sinking fund method (Page 68) Annual rate of depreciation,

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Example 5.2. A boiler was purchased in Rs. 45,000 on 1st January 2946, the erection and installation cost was Rs. 7,000. The boiler was replaced by a new one on 31st Dec. 1965. If the scrap value was estimated as Rs. 15,000 what should be the rate of depreciation and the depreciation fund on 15th June 1955. (b) If after 12 years of running, some boiler tubes are replaced and the replacement cost is Rs. 1,500 what will be the new rate of depreciation. Solution.

Example 5.3. A shaper was purchased for Rs. 30,000. Its useful life was estimated as 10 years and the salvage value as Rs. 6000. Using the diminishing balance method, calculate the depreciation factor. Also find the depreciation fund at the end of two years. Solution.

Example 5.4 Estimate the rate of depreciation from the following data, using sinking fund method. Cost of the machine = Rs. 50,000

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Scrap value = Rs. 5,000 Rate of interest = 8% compound Useful life of machine = 5 years Solution.

Example 5.5. Calculate the annual rate of depretiation from the following data, using the sinking fund method. Cost of asset = Rs. 6,000 Scrap value = Rs. 3,000 Interest at the rate of 4% (compound) Useful life period 3 years Solution. Using equation (13)

Example 5.6. A lathe is purchased for Rs. 8,000 and the assumed life is 10 years and scrap value is Rs. 2,000. If the depreciation is charged by diminishing balance method, calculate the percentage by which value of lathe is reducing every year and depreciation funds after 2 years. Solution. According to Reducing or Diminishing Balance method

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Example 5.7. (a) What are depreciation charges? (b)A machine is costing Rs. 11,000 and is expected to run for 10 years at the end of which its scrap value is likely to be Rs. 1,000. Machine is expected to run 2,000 hours / year on the average. Estimate the depreciation charge per hour of the machine. Solution.

Example 5.8. A car was purchased for Rs. 32,000. Its life was estimated as ten years and the scrap value as Rs. 8,000. Using the Reducing balance method. (a) Calculate the depreciation rate (%) (b) Estimate the depreciation fund of the end of two years. Solution. (a) Using equation (66.2) S = Rs. 8,000; C= Rs. 32,000 and N = 10

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Example 5.9. The cost of a machine is Rs.6,000 and its scrap value after 4 years is Rs 3,000 Assuming an interest rate of 4% per year find depreciation rate per year Solution. Given S = Rs. 3,000 N=4years I = 4% = 0.04 C = Rs. 6,000

Example 5.10. A machine costing Rs. 2,00,000 has a residual value of Rs. 1,00,000 after 10 years of service. The estimated rate of production is 8 units per hour. Using the production unit method calculate the rate of depreciation. Assume a 50 week year and 46 hours week. Solution.

Example 5.11. A machine costing Rs. 15,000 has a scrap value of Rs. 5,000 at the end of 10 years of its serviceable life. If the machine runs for 2,100 hours per day, calculate the depreciation rate per hour of the machine and the total annual depreciation. Solution.

Example 5.12. A machine costing Rs. 2,00,000 has a scrap value of Rs. 10,000 after 1.0 years of service. The estimated rate of production is 12 units per hour. Using the productive unit method calculate the rate of depreciation and also depreciation per year. Assume 50 week per year and 48 working hours per week. Solution.

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Example 5.13. Suppose the cost of machine, when purchased was 24,000 and it was expected to past for 10 years. The Junk value after 10 years would be Rs. 4,000/-. Find out depreciation by straight line method. Solution.

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