ES 312b – Engineering Economy 1st Sem S.Y.

2020-2021

DEPRECIATION

Introduction

Depreciation is the decrease in value of physical properties with the passage of

time and use. More specifically, depreciation is an accounting concept that establishes an
annual deduction against before-tax income such that the effect of time and use on an
asset’s value can be reflected in a firm’s financial statements.

Depreciation is a noncash cost that is intended to “match” the yearly fraction of

value used by an asset in the production of income over the asset’s life. The actual amount
of depreciation can never be established until the asset is retired from service. Because
depreciation is a noncash cost that affects income taxes, we must consider it properly when
making after-tax engineering economy studies. Depreciable property is property for
which depreciation is allowed under federal, state, or municipal income tax laws and
regulations. To determine whether depreciation deductions can be taken, the classification
of various types of property must be understood. In general, property is depreciable if it
meets the following basic requirements:

1. It must be used in business or held to produce income.

2. It must have a determinable useful life, and the life must be longer than one
year.
3. It must be something that wears out, decays, gets used up, becomes obsolete,
or loses value from natural causes.
4. It is not inventory, stock in trade, or investment property.

Depreciable property is classified as either tangible or intangible. Tangible property

can be seen or touched, and it includes two main types called personal property and real
property. Personal property includes assets such as machinery, vehicles, equipment,
furniture, and similar items. In contrast, real property is land and generally anything that
is erected on, growing on, or attached to land. Land itself, however, is not depreciable,
because it does not have a determinable life. Intangible property is personal property such
as a copyright, patent, or franchise. We will not discuss the depreciation of intangible
assets in this chapter because engineering projects rarely include this class of property.

A company can begin to depreciate property it owns when the property is placed
in service for use in the business and for the production of income. Property is considered
to be placed in service when it is ready and available for a specific use, even if it is not
actually used yet. Depreciation stops when the cost of placing an asset in service has been
recovered or when the asset is sold, whichever occurs first.

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

Additional Definitions

Because this chapter uses many terms that are not generally included in the
vocabulary of engineering education and practice, an abbreviated set of definitions is
presented here. The following list is intended to supplement the previous definitions
provided in this section:

Adjusted (cost) basis - The original cost basis of the asset, adjusted by allowable increases
or decreases, is used to compute depreciation deductions. For example, the cost
of any improvement to a capital asset with a useful life greater than one year
increases the original cost basis, and a casualty or theft loss decreases it. If the
basis is altered, the depreciation deduction may need to be adjusted.
Basis or cost basis - The initial cost of acquiring an asset (purchase price plus any sales
taxes), including transportation expenses and other normal costs of making the
asset serviceable for its intended use; this amount is also called the unadjusted cost
basis.
Book value (BV) - The worth of a depreciable property as shown on the accounting
records of a company. It is the original cost basis of the property, including any
adjustments, less all allowable depreciation deductions. It thus represents the
amount of capital that remains invested in the property and must be recovered in
the future through the accounting process. The BV of a property may not be an
accurate measure of its market value. In general, the BV of a property at the end
of year k is
𝑘

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒𝑘 = 𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝐶𝑜𝑠𝑡 𝐵𝑎𝑠𝑖𝑠 − ∑(𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑑𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛)

𝑗=1
Market value (MV) - The amount that will be paid by a willing buyer to a willing seller
for a property, where each has equal advantage and is under no compulsion to
buy or sell. The MV approximates the present value of what will be received
through ownership of the property, including the time value of money (or profit).
Salvage value (SV) - The estimated value of a property at the end of its useful life. It is the
expected selling price of a property when the asset can no longer be used
productively by its owner. The term net salvage value is used when the owner will
incur expenses in disposing of the property, and these cash outflows must be
deducted from the cash inflows to obtain a final net SV.
Useful life - The expected (estimated) period that a property will be used in a trade or
business to produce income. It is not how long the property will last but how long
the owner expects to productively use it.

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

The Classical (Historical) Depreciation Methods

Straight-Line (SL) Method

SL depreciation is the simplest depreciation method. It assumes that a constant

amount is depreciated each year over the depreciable (useful) life of the asset. If we define

N = depreciable life (recovery period) of the asset in years;

B = cost basis, including allowable adjustments;
d = annual depreciation deduction (SLM)
dk = annual depreciation deduction in year k(1 ≤ k ≤ N) (DBM);
BVk = book value at end of year k;
SVN = estimated salvage value at end of year N; and
𝑑𝑘∗ = cumulative depreciation through year k,

Then:

𝐵 − 𝑆𝑉𝑁
𝑑=
𝑁

𝑑𝑘∗ = 𝑘 × 𝑑 𝑓𝑜𝑟 1 ≤ 𝑘 ≤ 𝑁

𝐵𝑉𝑘 = 𝐵 − 𝑑𝑘∗

Note that, for this method, you must have an estimate of the final SV, which will also
be the final BV at the end of year N. In some cases, the estimated SVN may not equal an
asset’s actual terminal MV.

Example:

A laser surgical tool has a cost basis of $200,000 and a five-year depreciable life.
The estimated SV of the laser is $20,000 at the end of five years. Determine the annual
depreciation amounts using the SL method. Tabulate the annual depreciation amounts
and the book value of the laser at the end of each year.

Annual depreciation, d.

𝐵 − 𝑆𝑉𝑁 $200,000 − $20,000

𝑑= = = $36,000/𝑦𝑒𝑎𝑟
𝑁 5𝑦𝑒𝑎𝑟𝑠
Accumulated depreciation at the end of year 3.

𝑑3∗ = 3 × $36,000.00 = $108,000

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

Book Value at the end of year 3.

𝐵𝑉3 = 𝐵 − 𝑑3∗ = $200,000 − $108,000 = $92,000

The depreciation and BV amounts for each year are shown in the following table.

EOY, k Annual depreciation, d Book Value at year k, BVk

0 - $200,000
1 $36,000.00 $164,000
2 $36,000.00 $128,000
3 $36,000.00 $92,000
4 $36,000.00 $56,000
5 $36,000.00 $20,000

Note that the BV at the end of the depreciable life is equal to the SV used to
calculate the yearly depreciation amount.

Declining-Balance (DB) Method

In the DB 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 BV
at the beginning of the year. The ratio of the depreciation in any one year to the BV at the
beginning of the year is constant throughout the life of the asset and is designated by R (0
≤ R ≤ 1). In this method, R = 2/N when a 200% DB is being used (i.e., twice the SL rate of
1/N), and N equals the depreciable (useful) life of an asset. If the 150% DB method is
specified, then R = 1.5/N. The following relationships hold true for the DB method:

d1 = B(R),
dk = B(1 − R)k−1(R),
d∗k = B[1 − (1 − R)k],
BVk = B(1 − R)k.

Example:

A new electric saw for cutting small pieces of lumber in a furniture manufacturing
plant has a cost basis of $4,000 and a 10-year depreciable life. The estimated SV of the saw

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

is zero at the end of 10 years. Use the DB method to calculate the annual depreciation
amounts when
(a) R = 2/N (200% DB method)
(b) R = 1.5/N (150% DB method).
Tabulate the annual depreciation amount and BV for each year.

Solution:
Sample calculation for 6 years are as follows:

(a)
2 2
𝑅= = = 0.2
𝑁 10

𝑑6 = 𝐵(1 − 𝑅)𝑘−1 𝑅 = $4000(1 − 0.2)6−1 (0.2) = $262.14

𝑑6∗ = 𝐵(1 − (1 − 𝑅)𝑘 ) = $4000(1 − (1 − 0.2)6 ) = $2,951. 42

𝐵𝑉6 = 𝐵(1 − 𝑅)𝑘 = $4,000(1 − 0.2)6 = $1,048.58.

(b)
1.5 1.5
𝑅= = = 0.15
𝑁 10

𝑑6 = 𝐵(1 − 𝑅)𝑘−1 𝑅 = $4000(1 − 0.15)6−1 (0.15) = $266.22

𝑑6∗ = 𝐵(1 − (1 − 𝑅)𝑘 ) = $4000(1 − (1 − 0.15)6 ) = $2,491. 40

𝐵𝑉6 = 𝐵(1 − 𝑅)𝑘 = $4,000(1 − 0.15)6 = $1,508.60

The depreciation and BV amounts for each year, when R = 2/N = 0.2, are shown in the
following table:

200% DB Method Only

EOY, k dk BVk
0 --- $4000
1 $800 3200
2 640 2560
3 512 2,048
4 409.60 1,638.40
5 327.68 1310.72

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

6 262.14 1048.58
7 209.72 838.86
8 167.77 671.09
9 134.22 536.87
10 107.37 429.50

DB with Switchover to SL

Because the DB method never reaches a BV of zero, it is permissible to switch from

this method to the SL method so that an asset’s BVN will be zero (or some other
determined amount, such as SVN).

The table below illustrates a switchover from double DB depreciation to SL

depreciation for Example above. The switchover occurs in the year in which an equal or a
larger depreciation amount is obtained from the SL method.

The 200% DB Method with Switchover to the SL Method

Depreciation Method
Year, (1) (2) (3) (4)
k Beginning of year BV (a) 200% DB Method SL Method (c) Depreciation Amount
(b) Selected (d)
1 $4,000.00 $800 >$400.00 $800
2 3,200.00 640 >355.56 640
3 2,560.00 512 >320.00 512
4 2,048.00 409.60 >292.57 409.60
5 1,638.40 327.68 >273.07 327.68
6 1,310.72 262.14 =262.14 262.14 (Switch)
7 1,048.58 209.72 <262.14 262.14
8 786.44 167.77 <262.14 262.14
9 524.30 134.22 <262.14 262.14
10 262.16 107.37 <262.14 262.14
$3,570.50 $4,000.00

a Column 1 for year k less column 4 for year k equals the entry in column 1 for year k + 1.

b 200%DB (R= 2/10) of column 1.

c Column 1 minus estimated SVN divided by the remaining years from the beginning
of the year through the 10th year.
d Select the larger amount in column 2 or column 3.

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

Units-of-Production Method

When the decrease in value is mostly a function of use, depreciation may be based
on a method not expressed in terms of years. The units-of-production method is normally
used in this case.
This method results in the cost basis (minus final SV) being allocated equally over
the estimated number of units produced during the useful life of the asset. The
depreciation rate is calculated as

𝐵 − 𝑆𝑉𝑁
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 =
𝐸𝑠𝑖𝑚𝑎𝑡𝑒𝑑 𝑙𝑖𝑓𝑒𝑡𝑖𝑚𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑢𝑛𝑖𝑡𝑠

Example:

A piece of equipment used in a business has a basis of $50,000 and is expected to

have a $10,000 SV when replaced after 30,000 hours of use. Find its depreciation rate per
hour of use, and find its BV after 10,000 hours of operation.

Solution:

𝐵 − 𝑆𝑉𝑁
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 =
𝐸𝑠𝑖𝑚𝑎𝑡𝑒𝑑 𝑙𝑖𝑓𝑒𝑡𝑖𝑚𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑢𝑛𝑖𝑡𝑠

$50,000 − $10,000 $1.33

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 = =
30,000 ℎ𝑜𝑢𝑟𝑠 ℎ𝑟

After 10,000 hours, 𝐵𝑉𝑡 = 𝐵 − (𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡)(𝑡)

$1.33
𝐵𝑉10,000 ℎ𝑟𝑠 = $50,000 − ( )(10,000 ℎ𝑟𝑠)
ℎ𝑟

𝐵𝑉10,000 ℎ𝑟𝑠 = $36,700

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

DEPLETION

When natural resources are being consumed in producing products or services,

the term depletion is used to indicate the decrease in value of the resource base that has
occurred. The term is commonly used in connection with mining properties, oil and gas
wells, timberlands, and so on. In any given parcel of mineral property for example, there
is a definite quantity of ore, oi, or gas available. As some of the resource is extracted and
sold, the reserve decreases and the value of the property normally diminishes.

In the operation of many natural resource businesses, the depletion funds may be
used to acquire new properties, such as new mines and oil-producing properties, and thus
give continuity to the franchise.

There are two ways to compute depletion allowances: (1) the cost method and (2)
the percentage method. The cost method applies to all types of property subject to depletion
and is more widely used method. Under the cost method, a depletion unit is determined
by dividing the adjusted cost basis of the property by the number of units remaining
to be mined or harvested. (Units may be feet of timber, tons of ore, etc.) The deduction
or depletion allowance for a given tax year is then calculated as the product of number
of units sold during the year and the depletion unit.

Depletion allowances on mines and other natural deposits, including geothermal

deposits, may be computed as a percentage of gross income, provided that the amount
charged for depletion does not exceed 50% of the net income (100% for oil and gas
property) before deduction of the depletion allowance. The percentage method can be
used for most types of metal mines, geothermal deposits, and coal mines but not for
timber. Generally, the use of percentage depletion for oil and gas is not allowed except for
certain domestic oil and gas production. Some examples of depletion allowances are as
follows:

Sulfur and uranium; domestically mined lead, zinc, nickel, and asbestos 22%
Gold, silver, copper, iron ore, and oil shale from U.S. deposits; 15%
geothermal wells in the United States
Coal, lignite, and sodium chloride 10%
Clay, gravel, sand, and stone 5%

It is possible that the total amount charged for depletion over the life of a property
under this procedure may be far more than the original cost. When the percentage method
applies to a property, depletion allowances must be calculated by both the cost method

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

and the percentage method. The larger allowance may be taken and used to reduce the
basis of the property for purposes of refiguring the depletion unit as necessary.

The figure below provides the logic for determining whether percentage or cost
depletion is allowable in a given tax year.

Compute percent Compute 50 percent of

depletion (appropriate % taxable income without
x gross income) depletion allowance

Select the smaller as

Allowed Percentage
Depletion

Compute cost depletion Select the larger as the

(based on suitable Depletion Allowance
depletion unit)

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

Example:

The XYZ Zinc Company recently bought an ore-bearing parcel of land for
$2,000,000. The recoverable reserves in the mine were estimated to be 500,000 tons.
(a) If 75,000 tons of ore were mined during the first year and 50,000 tons were sold,
what is the depletion allowance for year one?
(b) Suppose at the end of year one reserves were reevaluated and fond to be only
400,000 tons. If 50,000 additional tons are sold in the second year, what is the
depletion allowance for year two?

Solution:

(a)

𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑐𝑜𝑠𝑡 𝑏𝑎𝑠𝑖𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦 $2,000,000

𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑢𝑛𝑖𝑡 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑡𝑜 𝑏𝑒 𝑚𝑖𝑛𝑒𝑑 = 500,000 𝑡𝑜𝑛𝑠 = $4.00/𝑡𝑜𝑛

𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝐴𝑙𝑙𝑜𝑤𝑎𝑛𝑐𝑒 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑥 𝑑𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑢𝑛𝑖𝑡

$4.00
𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝐴𝑙𝑙𝑜𝑤𝑎𝑛𝑐𝑒 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 1 = 50,000 𝑡𝑜𝑛𝑠 ( ) = $200,000
𝑡𝑜𝑛

(b) The adjusted cost basis at the beginning of the second year would be $2,000,000 –
$200,000 = $1,800,000.

𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑐𝑜𝑠𝑡 𝑏𝑎𝑠𝑖𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦 $1,800,000

𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑢𝑛𝑖𝑡 = = = $4.50/𝑡𝑜𝑛
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑡𝑜 𝑏𝑒 𝑚𝑖𝑛𝑒𝑑 400,000 𝑡𝑜𝑛𝑠

$4.50
𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝐴𝑙𝑙𝑜𝑤𝑎𝑛𝑐𝑒 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 2 = 50,000 𝑡𝑜𝑛𝑠 ( ) = $225,000
𝑡𝑜𝑛

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