UNIVERSITY OF SANTO TOMAS

Faculty of Engineering
Department of Mechanical Engineering

ENG2010 – ENGINEERING ECONOMY

DEPRECIATION
ROGELIO O. ALMIRA JR., PME ASEAN ENG.
 DEPRECIATION

Depreciation is the decrease in the value of physical property with

the passage of time.

Definition of Value
Value, in a commercial sense, is the present worth of future profits
that are to be received through ownership of a particular property.
The utility or use value of a property is what the property is worth to
the owner as an operating unit.
Salvage, or resale, value is the price that can be obtained from the
sale of the property after it has been used.

Scrap value is the amount the property

would sell for if disposed off as junk?
 DEPRECIATION

Book value, sometimes called depreciated book value, is the worth of a property as shown on the accounting
records of an enterprise.

The market value of a property is the amount which a willing buyer will pay to a willing seller for the property
where each has equal advantage and is under no compulsion to buy or sell.

Fair value is the value which usually determined by a disinterested third

party in order to establish a price that is fair to both seller and buyer.
 DEPRECIATION

Purposes of Depreciation
1. To provide for the recovery of capital which has been invested in physical property.
2. To enable the cost of depreciation to be charged to the cost of the producing products or service that
results from the use of the property.

Types of Depreciation:
1. Normal depreciation
(a) Physical
(b) Functional
2. Depreciation due to changes in price levels.
3. Depletion
 DEPRECIATION

Physical depreciation is due to the lessening of

the physical ability of a property to produce
results. Its common causes are wear and
deterioration.

Functional depreciation is due to the lessening

in the demand for the function which the property
was design to render. Its common causes are
inadequacy, changes in styles, population centers
shift, saturation of markets or more efficient
machines are produced.

Depreciation due to changes in price levels is almost impossible to

predict and therefore is not considered in economy studies.

Depletion refers to the decrease in the value of a property due to the

gradual extraction of its contents.
Depletion of Natural Resources
 DEPRECIATION

Physical and Economic Life

Physical life of the property is the length of time during which it is capable of performing the function for which
it was designed and manufactured.
Economic life is the length of turn time during which the property may be operated at a profit.
Requirements of a Depreciation Methods
1. It should be simple.
2. It should recover capital.
3. The book value will be reasonably close to the market
value at any time.
4. The method should be accepted by the Bureau of Internal
Revenue.
 DEPRECIATION

Depreciation Methods
We shall use the following symbols for the different depreciation methods.

L = useful life of the property

Co or FC = the original cost or First Cost Straight Line Method is the simplest
CL or SV = the value at the end of the life, the salvage value or and most used depreciation method.
scrap value (including gain or loss due to removal) It is best for smaller businesses that
d = the annual cost of depreciation are looking for a simple way to
Cn or BV = the book value at the end of n years calculate depreciation.
Dn = depreciation (total) up to age n years

STRAIGHT LINE METHOD (SLM)

This method assumes that the loss in value is directly proportional to the age of property.

d = Co – CL Dn = n d = n ( Co – CL ) Cn = Co – Dn
L L

Straight-line rate = 1 / Useful Life = 1 / L

 DEPRECIATION

(3-1) An electronic balance cost P90,000 and has an estimated salvage value of P8,000 at the end of its 10
years value life time. What would be the book value after three years, using the straight line method in solving
for the depreciation.
Solution:
P90,000
Given: Co = P90,000 CL = P8,000 L = 10 n=3
P65,400

Depreciation cost/charge every year

P8,000
d = Co – CL = P90,000 – P8,000 = P8,200
L 10
0 1 2 3 4 5 6 7 8 9 10 years
Total depreciation charge after 3 years The book value after 3 years

Dn = n (d) Cn = Co – Dn

D3 = 3 (P8,200) = P24,600 C3 = Co – D3 = P90,000 – P24,600 = P65,400

 DEPRECIATION
#1 A machine shop purchased 10 years ago a milling machine for P60,000. A straight line depreciation reserve had been
provided on a 20 year life of the machine. The owner of the machine shop desires to replace the old milling machine with a
modern unit of many advantages costing P100,000. It can sell the old unit for P20,000. How much new capital will be
required for the purchase?
Solution: ➢ Book value (old milling machine) after 10 years,
Co = P60,000 CL = 0 L = 20 C10 = Co – D10 = P60,000 – P30,000 = P30,000

d = Co – CL = P60,000 – 0 = P3,000
L 20
Total depreciation reserve after 10 years,
D10 = n(d) = 10 (P3,000) = P30,000
Depreciation reserves are funds established by a
business for items that depreciate overtime and must
be replaced. The business puts money into the reserve
every year according to the amount the item
depreciates and its salvage value.
➢ Present selling price (market value) of old milling machine = P20,000
If the cash received is greater than the asset's book value, the
difference is recorded as a gain. If the cash received is less than the
asset's book value, the difference is recorded as a loss.
Total funds the shop have after selling the old milling machine,
= P30,000 + P20,000 = P50,000
Therefore the new capital will be required for purchase,
= New Machine Price – Total funds
= P100,000 – P50,000 = P50,000
 DEPRECIATION

SINKING FUND METHOD (SFM)

This method assumes that the sinking fund is established in
which funds will accumulate for replacement.
d = (Co – CL) i .

(1 + i)L – 1
Co – CL
Dn
The total depreciation Dn, that has taken place up to
any given time is assumed to be equal to the
0 1 2 3 n L accumulated amount in the sinking fund at that time.

Dn = d (F/A, i%, n)
d d d d d

Dn = d (1 + i) n – 1
i
d = Co – CL = (Co – CL) (A/F, i%, L)
F/A, i%, L
Cn = Co – Dn
 DEPRECIATION

SINKING FUND METHOD (SFM)

In the sinking fund method of depreciation, a fixed depreciation

charge is made every year and the interest is compounded on it
annually. The constant depreciation charge is such that the sum of
annual investment and the interest accumulations is equal to the cost
of replacement of equipment after its useful life.

Sinking Fund Method Cash Flow

This method is particularly beneficial for high-cost assets that will eventually need replacement.

It is also most applicable to long-term, established industries where it is most likely that the same assets will need to be
replaced, over and over again.
 DEPRECIATION

(3-3) A firm bought an equipment for P56,000. Other expenses including installation amounted to P4,000. The equipment is
expected to have life of 16 years with a salvage of 10% of the original cost. Determine the book value at the end of 12 years
by (a) the straight line method and (b) sinking fund method at 12% interest.
Solution:

Given: Co = P56,000 + P4,000 = P60,000 (b) Sinking Fund Method

CL = (0.10) (P60,000) = P6,000 i
d = (Co – CL) .

L = 16 n = 12 i = 12% (1 + i)L – 1

d = (P60,000 – P6,000) 0.12 .

(a) Straight Line Method (1.12) 16 – 1

d = P1,263
d = Co – CL = P60,000 – P6,000 = P3,375
L 16 Dn = d (1 + i) n – 1
i
D12 = n d = 12 (P3,375) = P40,500
D12 = P1,263 (1.12)12 – 1 = P30,480
C12 = Co – D12 = P60,000 – P40,500 = P19,500 0.12
C12 = Co – D12 = P60,000 – P30,480 = P29.520
 DEPRECIATION
DECLINING BALANCE METHOD (DBM)
In this method, sometimes called
the constant percentage method Co C1 C2 C3 Cn-1 Cn CL-1 CL
or the Matheson formula it is 0 1 2 3 n-1 n L-1 L
assumed that the annual cost of
the depreciation is a fixed d1 = kCo d2 = kC1 d3 = kC2 dn = kCn-1 dL = kCL-1
percentage of the salvage value at
the beginning of the year. The ratio
of the depreciation in any year to dn = depreciation during the nth year
the book value at the beginning of
that year is constant throughout
the life of the property and
designated by k, the rate of
depreciation.
 DEPRECIATION

Cn = Co (1-k)n

Cn = (1-k)n
Co
Cn 1/n = (1-k)
Co

CL = (1-k)L
dn = kCn-1
Cn = Co – Dn Co
dn = Co(1-k)n-1 k CL 1/L = (1-k)
Dn = Co – Cn
Co
This method does not apply, if the
salvage value is zero, because k will
Cn = Co (1-k)n CL = Co (1-k)L Cn = Co CL n/L
be equal to 1 and d1 will be equal to Co.
Co
 DEPRECIATION
DECLINING BALANCE METHOD (DBM)
The declining balance method is an accelerated depreciation system of recording larger depreciation expenses during the
earlier years of an asset's useful life and recording smaller depreciation expenses during the asset's later years.

The declining balance method, also known as the reducing balance method, is ideal for assets that quickly lose their
values or inevitably become obsolete.
 DEPRECIATION
DOUBLE DECLINING BALANCE METHOD (DDBM)
This method is very similar to the declining balance method except that the rate of depreciation k is replaced by 2/L.

Straight-line rate = 1 / Useful Life = 1 / L Double Declining = 2 / Useful Life = 2 / L

dn = Co(1-k)n-1 k Cn = Co (1-k)n CL = Co (1-k)L Declining Balance Method

dn = Co 1 – 2 n-1 2 Cn = Co 1 – 2 n CL = Co 1 – 2 L Double Declining Balance

L L L L Method

When the DDB method is used, the salvage value should not be subtracted from the first cost when calculating the
depreciation charge.
 DEPRECIATION
(3-4) A certain type of machine loses 10% of its value each year. The machine costs P2,000.00 originally. Make out a
schedule showing the yearly depreciation, the total depreciation and the book value at the end of each year for 5 years.
Solution:
 DEPRECIATION
(3-5) Determine the rate of depreciation, the total depreciation up to the end of the 8th year and the book value at the end of
8 years for an asset that costs P15,000 new and has an estimated scrap value of P2,000 at the end of 10 years by (a) the
declining balance method and (b) the double declining balance method.
Solution:

Given: Co = P15,000 CL = P2,000 L = 10 n=8

(a) Declining Balance Method (b) Double Declining Balance Method

Cn = Co 1 – 2 n
Dn = Co – Cn
Cn = Co (1-k)n Dn = Co – Cn L
 DEPRECIATION
SUM-OF-YEARS-DIGIT (SOYD) METHOD MACRS – which stands
for Modified Accelerated
Cost Recovery System – is
Let dn = depreciation charge during the nth year. the tax depreciation system
used in the U.S.
dn = (depreciation factor) (total depreciation)

dn = reverse digit (Co – CL) For example, for a property whose life is 5 years.
sum of digits

Sum of digits = L (L + 1)
2

Reverse digit = L + 1 – n

Sum of reverse digits = (Reverse digit + L) n

up to n year 2
 DEPRECIATION
SUM-OF-YEARS-DIGIT (SOYD) METHOD

SUM OF YEARS DIGIT (SOYD or SYD) Depreciation method is an

accelerated method of depreciation in which depreciation in initial years is
more than in later years.

SOYD provides company with tax shield in the initial years.

SOYD is used when asset is more productive in the earlier years than in later years (for eg : automobiles)
SOYD is used when an asset will lose most of its value toward the beginning of its useful life or asset becomes obsolete
quickly.
A problem with using SOYD or any other accelerated depreciation method is that it artificially reduces the reported profit of a
business over the near term. The result is excessively low profits in the near term, followed by excessively high profits in later
reporting periods.
 DEPRECIATION
(3-7) A structure costs P12,000 new. It is estimated to have a life of 5 years with a salvage value at the end of life of P1,000.
Determine the book value at the end of each year of life.
Solution:

Co – CL = P12,000 – P1,000 = P11,000

Sum of digits = L (L + 1) = 5 (5+1) = 15
2 2
If n = 4
Reverse digit = L + 1 – n = 5 + 1 – 4 = 2
dn = reverse digit (Co – CL)
sum of digits
d4 = 2 (P11,000) = P1,467
15
Total depreciation at the end of 4th year,
Sum of reverse digits = (Reverse digit + L) n
up to n year 2 D4 = Sum of reverse digits up to 4th year (Co – CL)
Sum of the reverse digit
Sum of reverse digits = (2 + 5) 4 = 14
D4 = 14 (P11,000) = P10,267 C4 = Co – D4 = P12,000 – P10,267
up to 4th year 2 15 = P1,733
 DEPRECIATION

(3-8) A consortium of international telecommunication companies contracted for the purchase and installation of a fiber optic
cable linking two major cities at a total cost of US$960 million. This amount includes freight and installation charges
estimated at 10% of the above contract price. If the cable shall be depreciated over a period of 15 years with zero salvage
value:
(a) Given the sinking fund deposit factor of 0.0430 at 6% interest where n = 15, what is the annual depreciation charge?
(b) What is the depreciation charge during the 8th year using the-sum-of-the-years’-digits method?
Solution: (b) Sum-of-years digit
Co = $960,000,000 CL = 0 L = 15 Sum of digits = L (L + 1) = 15 (15 + 1) = 120
2 2
(a) Sinking Fund Method
Reverse digit = L + 1 – n = 15 + 1 – 8 = 8
dn = (Co – CL) i .

(1 + i)L – 1 dn = reverse digit (Co – CL) = 8 ($960,000,000 – 0)

sum of digits 120
d15 = (Co – CL) 0.06 .

(1.06)15 – 1 d8 = P64,000,000 Sum of reverse digits = (Reverse digit + L) n

up to n year 2
d = ($960,000,000 – 0 ) (0.0430)
D8 = Sum of reverse digits up to 8th year (Co – CL) Sum of reverse digits = (8 + 15) 8
Sum of the reverse digit up to 8th year 2
d = $41,280,000
= 92
 DEPRECIATION
SERVICE-OUTPUT METHOD

This 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.

Let T = total units of output up to the end of life

Qn = total number of units of output during the nth year

Depreciation per unit output = Co – CL

T
dn = Co – CL (Qn)
T
 DEPRECIATION
(3-9) A Television Company purchased machinery for P100,000 on July 1, 1979. It is estimated that it will have a useful life of
10 years; scrap value of P4,000, production of 400,000 units and working hours of 120,000.
The company uses the machinery for 14,000 hours in 1979 and 18,000 in 1980. The machinery produces 36,000 units in
1979 and 44,000 units in 1980. Compute the depreciation for 1980 using each method given below.
1. Straight line
2. Working hours
d80 = Co – CL H80
3. Output method
H(T)
Solution:
d80 = P100,000 – P4,000 (18,000 hrs) = P14,400
Given: Co = P100,000 CL = P4,000 L = 10 years 120,000 hrs
(1) Straight Line Method (3) Output method

d = Co – CL = P100,000 – P4,000 = P9,600 T(TOTAL) = 400,000 units

L 10 Q80 = 44,000 units
(2) Working hours
d80 = Co – CL Q80
H(TOTAL) = 120,000 hours T(T)
H80 = 18,000 hours d80 = P100,000 – P4,000 (44,000 units) = P10,560
400,000 units
 DEPRECIATION
(3-11) A machine costs P20,000 and has a salvage value of P2,000 after a useful life of 8 years. Money is worth 12%. If
average inflation is 8% per year during this period. What is the annual cost of depreciation to replace the machine after 8
years? What is the annual cost of depreciation if inflation is not considered?
Solution:
With inflation: Without inflation:
Future cost = PC (1 + f) n = P20,000( 1 + 0.08) 8 = P37,018 0.12
d = (P20,000 – P2,000) .

(1.12) 8 – 1
By Sinking Fund Method
d = P1,463
d = (Co – CL) i .

(1 + i)L – 1

d = (P37,018 – P2,000) 0.12 .

(1.12) 8 – 1
d = P2,847
 DEPRECIATION

Valuation
Valuation or appraisal is the process of determining the value of certain property for
specific reasons. The person engaged in the task of valuation is called an appraiser.

Intangible Values
In the determination of the value of industrial property or equipment, four intangible items
are often encountered.

Goodwill is that element of value in which a business has earned through the favorable
consideration and patronage of its costumers arising from its well known and well
conducted policies and operations.

Franchise is an intangible item of value arising from the exclusive right of a company to
provide a specific product or service in a stated region or country.

Organization cost is the amount of money spent in organizing a business and

arranging for its financing and building.
 DEPRECIATION
Problem Set No. 3

3. On January 1, 1978, the purchasing engineer of a Cement Co. purchased a new machine at a cost of P140,000.
Depreciation has been computed by the straight line method based on an estimated useful life of five years and residual
scrap value of P12800. On January 2, 1981, extraordinary repairs (which were almost equivalent to a rebuilding of the
machinery) were performed at a cost of P30400. Because of the thorough going nature of these repairs, the normal life of
the machinery was extended materially. The revised estimate of useful life was four years from January 1, 1981.
Determine the annual provisions for depreciation for the years 1978 to 1980 and the adjusted provision for depreciation on
December 31, 1981. Assume payment in cash for the machine and extraordinary repairs.
Ans. P25440; P20320

5. An industrial plant bought a generator set for P90000. Other expense including installation amounted to P10000. The
generator set is to have a life of 17 years with a salvage value at the end of life of P5000.Determine the depreciation
charge during the 13th year and the book value at the end of 13 years by the (a) declining balance method, (b) double
declining balance method, (c) sinking fund method at 12% and (d) SYD method.
Ans. (a) P1949; P10118 (b) P2620; P19649 (c) P1943; P45539 (d) P3105; P11209
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