Depriciation.pdf

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PRINCIPLES OF ENGINEERING ECONOMICS & MANAGEMENTTECHNIQUES (PEEMT)

Chapters

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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 andDevelopment

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 assetbecause of wear and tear, due to passage of time, use and climatic conditions isknown 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 worout while in use over a period of time. This wear and tear is unavoidable but it can beminimized to some extent by proper care and maintenance the efficiency of theseassets also reduces with the passage of time and at one time it becomes uneconomicto be used further and requires replacement. The amount of money charged forreplacement is depreciation.

Some money must be set aside yearly from the profits earned by the equipment itseso 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 ofequipment.

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 customswhich have been established on the rate of wear and tear normally expected everyyear. There is definitely a correlation between the price of a second-hand car and thelikely 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 vesseladequately tested.

(d) Technological developments and changes

(i) New equipments which supersede the existing ones, start coming in the markete.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 onesuneconomical (obsolescence).

(iv) Inadequacy of the existing equipment perform the necessary function suchincreased 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 o f 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 installationcharges scrap .value is distributed over the useful life of the machine in equalperiodic 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 earlyyears, when repair and renewals are not costly.




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This method is also called reducing balance method or percentage on book valuemethod.

The book value of the machine goes on decreasing as its existence continues. Hence this method, a certain percentage of the current book value is taken as depreciation.

Let X = Fixed % for calculating yearly depreciation.

C = Initial cost

S = Scrap value

N = Estimated life in years

3. Sinking fund method:

In this method, a depreciation fund equal to the actual loss in the value of the asset estimated for each year.

*This amount is invested elsewhere other than in the business itself and the interestwill be earned on the fund

Therefore, the sinking fund investment will grow year by year with the amount ofannual depreciation plus the interest earned on the part investment.

Let D = Rate of depreciation per year

R = Rate of interest on invested fund

S = Scrap value

N = No. of years/of life of the asset

(i) Sum of the Digits Method. The method provides for depreciation by means ofdiffering 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 alwaysthe sum of the series 1, 2, 3, 4 N and the numerator for the first period is N, for thesecond 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, everecently purchased.

(iii) It makes the decision to sell the repurchase before the estimated time, easier.

(g) Endowment (Insurance) Policy Method. The method involves charging depreciatioand their investing it in the form of an endowment policy. Each year the sum chargedis paid as a premium to an insurance company. At the end of the life of the asset thesum payable should be equal to the original cost.

The method is similar in effect to the sinking fund method. cash is taken out of thebusiness to pay the insurance premiums and is made available again at the end of th

period for the purchase of another asset, when the policy matures.(h) Revaluation Method. Revaluation method provides for depreciation by means ofperiodic charges, each of which is equal to the difference between the values assigneto 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 isrevaluated 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 valuethe fixed assets.




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It assumes that the purchase of .a fixed asset is an investment on which interest isearned.

Therefore, the investment for the purpose of the method is the written down valueplus interest earned to date.

The annuity method is generally used for the redemption of leases over a fairly longperiod, since money invested for a lengthy period in a capital asset should be deemeto 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 (infractions) 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 salesrenewals and additions tend to make the annuity method difficult to apply.

(iii) Production Method. Involving a uniform charge per unit of output, the method iscommonly used in extractive industries. For example the usefulness of mine headinstallations is closely linked to size of the ore deposit. Depletion, the specific term fothe amortization of natural resource costs, is normally computed in this manner.

In cases where physical deterioration or exhaustion is the probable limiting factor oneconomic usefulness, the life forecast necessarily depends upon an estimate of theassets, total service capacity. However, if absolescence is the limiting factor, a lifeestimate can be made without projecting service capacity and estimating the latterrequires an additional forecast of the demand for assets services over the expected l-span. Therefore, this further complication has inhibited adoption of the productionmethod in those industries where obsolescence is an important consideration.

Example 5.1. An industrial p lant w ith initial value of Rs. 400,000 has thesalvage value of Rs. 40,000 at the end of 10 years but is sold for Rs. 250,000at the end of 5 years What is the profit or loss if sinking fund depreciationmethod at 10% compounded interest (annually) w as adopted.

Solution.

A : per sinking fund method (Page 68)

Annual rate of depreciation,




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Example 5.2. A boiler w as purchased in Rs. 45,000 on 1st January 2946, theerection and installation cost w as Rs. 7,000. The boiler was replaced by a neone on 31st Dec. 1965. If the scrap value w as estimated as Rs. 15,000 whatshould be the rate of depreciation and the depreciation fund on 15th June1955. (b) If after 12 years of runn ing, some boiler tubes are replaced and threplacement cost is Rs. 1,500 what w ill be the new rate of depreciation.

Solution.

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

Solution.

Example 5.4 Estimate the rate of depreciation from the follow ing data, usingsinking 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 follow ing

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 10years and scrap value is Rs. 2,000. If the depreciation is charged bydiminishing balance method, calculate the percentage by which value of lathis 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) W hat are depreciation charges?

(b)A machine is costing Rs. 11,000 and is expected to run for 10 years at thend of w hich 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 pehour of themachine.

Solution.

Example 5.8. A car w as purchased for Rs. 32,000. Its life w as estimated asten years and the scrap value as Rs. 8,000. Using the Reducing balancemethod.

(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 i s Rs.6,000 and i ts scrap value after 4years is Rs 3,000 Assuming an interest rate of 4% per year find depreciationrate per year

Solution. Given C = Rs. 6,000

S = Rs. 3,000

N=4years

I = 4% = 0.04

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 unitper hour. Using the production unit method calculate the rate of depreciatioAssume 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 athe end of 10 years of its serviceable life. If the machine runs fo r 2,100 houper day, calculate the depreciation rate per hour o f the machine and the totaannual depreciation.

Solution.

Example 5.12. A machine costing Rs. 2,00,000 has a scrap value of Rs. 10,00

after 1.0 years of service. The estimated rate of production is 12 units perhour. Using the productive unit method calculate the rate of depreciation analso depreciation per year. Assume 50 w eek per year and 48 work ing hoursper week.

Solution.




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Example 5.13. Suppose the cost of machine, when purchased w as 24,000 anit was expected to past for 10 years. The Junk value after 10 years would beRs. 4,000/ -. Find out depreciation by straight line method.

Solution.


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Depriciation.pdf