ENGINEERING ECONOMY

Physical Life of an Equipment – is the length of time during

WHAT IS DEPRECIATION? which it is capable of performing the function for which it was
designed and manufactured.
Defined as the
decrease in the value Economic Life of an Equipment – is the length of time
of property due to during which it will operate at a satisfactory profit.
passage of time.
Life of Any Property – is usually difficult to determine
Depreciation must accurately. The determination of life is dependent to a great
always be included in extent upon the experience of the men managing the
the cost of enterprise in the use of similar equipment.
production of any
product or the rendering of any service where equipment is First Cost of Any Property – includes the original purchase
used for the following reasons: price, freight and transportation charges to the site, installation
expenses, initial taxes and permits to operate and all other
 To provide for the replacement of the equipment either expenses needed to put the equipment into operation.
at the end of its physical or economic life or at the time
when its operation no longer results in a satisfactory The Amount to be Recovered (Depreciation Cost) – the
profit. difference between the first cost and the salvage or scrap value
of the equipment.
 To provide for the maintenance of capital to replace the
decrease in the value of equipment caused by physical Salvage Value (Second Hand Value) – defined to be the
or functional causes. amount for which the equipment or machine can be sold at
second hand.
Types of Depreciation
Scrap Value (Junk Value) – the amount of the equipment
1. Normal Depreciation that can be sold for, when disposed off as a junk.

 Physical Depreciation – due to the lessening of the Depreciation Methods:

physical ability of a property to produce results. Its
common causes are deterioration and wear.
Deterioration due to the effects of various chemical and
mechanical factors on the materials composing the
property. Wear and Tear due to abrasion, friction
between moving parts of equipment, impact vibration
or fatigue of the materials in the property, it is
determined by use rather than by age.

 Functional Depreciation – 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 counter shift, saturation
of markets or more efficient machines are produced.

2. Depreciation due to changes in price levels

3. Depletion – it refers to the decrease in the value of a

property due to the gradual extraction of its contents.

DEPRECIATION COST

Depreciation Cost – depends upon the physical or economic Figure 1: Methods used to determine Annual Depreciation
life of the equipment and its first cost. Cost
 ENGINEERING ECONOMY

Other Methods Formulated in Recent Years:

 Straight-line Plus Average Interest Formula

 Double-Rate-Declining Balance Method

 Operating Day Method

 Retirement Method

 Annual Inventory Method

Requirements for A Depreciation Method:

Figure 2: Graphical Representation of Payments to Sinking
1. Payments to the depreciation fund should be equal to the Fund
loss in value due to depreciation.
𝒊
2. The method should be simple. 𝒅 = (𝑪𝑶 − 𝑪𝑳 )
(𝟏 + 𝒊)𝑳 − 𝟏
3. Prior to its adoption, approval of the method should be
secured from the Bureau of Internal Revenue. (𝟏 + 𝒊)𝒏 − 𝟏
𝑫𝒏 = (𝑪𝑶 − 𝑪𝑳 )
(𝟏 + 𝒊)𝑳 − 𝟏
4. To be satisfactory, the actual value of the equipment
should at all times, be equal to the book value. It will be
necessary from time to time to check the actual value 𝑪 𝒏 = 𝑪 𝑶 − 𝑫𝒏
against the book value and in case the two values are not
in agreement, adjustments should be made.

STRAIGHT LINE METHOD DECLINING BALANCE METHOD

In this method, the loss in value is considered to be directly In this method, sometimes called the constant percentage
proportional to the age of the property. No interest is assumed method or the Matheson Formula, it is assumed that the
to be paid on the amounts set aside in the depreciation fund. 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
𝑪𝑶 − 𝑪𝑳 constant throughout the life of the property and is designated
𝒅=
𝑳 by “k”, the rate of the depreciation.

𝑫𝒏 = 𝒏𝒅 𝒏 𝑪𝒏 𝑳 𝑪𝑳
𝒌=𝟏− 𝒌=𝟏−
𝑪𝑶 𝑪𝑶

𝑪 𝒏 = 𝑪 𝑶 − 𝑫𝒏
𝑪𝒏 = 𝑪𝑶 (𝟏 − 𝒌)𝒏

SINKING FUND METHOD

𝑪𝑳 = 𝑪𝑶 (𝟏 − 𝒌)𝑳
In this method, it is assumed that a sinking fund is established
in which funds will accumulate for replacement purposes and
will bear interest. The total depreciation which has occurred
up to any given time is assumed to equal the amount in the
sinking fund at that time.
 ENGINEERING ECONOMY

SUM OF THE YEAR DIGIT METHOD Where:

 It provides very rapid depreciation during the early years
of life of the property and therefore enables faster
recovery of capital.
 It is easier to use than the Matheson Formula.
 Properties can be depreciated to zero value.
 The basic assumption for the method is that the value
of the property decreases at a decreasing rate.
d – the annual cost of depreciation
L – useful life of the property in years
CO – original or first cost
CL – book value at the end of life of the property (salvage or
scrap value
Dn – depreciation up to n years
Cn – the book value at the end of n years
k – the ratio of depreciation in any year to the book value at
the beginning of that year. This is constant throughout the life
of the property.

The steps in this method are:

1. Determine the sum of the years (∑Years) of the life of the

property. If “L” is the life of the property in years, and
noting that the digits 1,2,3,….(L-1), L form an arithmetic
progression, then

𝑳
𝒀𝒆𝒂𝒓𝒔 = (𝑳 + 𝟏)
𝟐

2. Determine the loss in value due to depreciation, CO - CL

3. The respective annual charges are:

𝑳
𝟏𝒔𝒕 𝒀𝒆𝒂𝒓 = (𝑪𝑶 − 𝑪𝑳 )
∑ 𝒀𝒆𝒂𝒓𝒔

𝑳−𝟏
𝟐𝒏𝒅 𝒀𝒆𝒂𝒓 = (𝑪𝑶 − 𝑪𝑳 )
∑ 𝒀𝒆𝒂𝒓𝒔

𝟏
𝑳𝒕𝒉 𝒀𝒆𝒂𝒓 = (𝑪𝑶 − 𝑪𝑳 )
∑ 𝒀𝒆𝒂𝒓𝒔

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.

𝑪𝑶 − 𝑪𝑳
𝒅𝒏 = (𝑸𝒏 )
𝑻

Prepared by: E.S.Fuentiblanca, ME