Economics and Project Management By Dr.Eng. Abdelsalam M. Sharaf Eldien

CHAPTER 3 Depreciation

REFERENCES Blank, L. T., A. Tarquin: Engineering Economy, 6th ed., McGraw-Hill, New York. Canada, J. R., W. G. Sullivan, D. Kulonda, and J. A. White: Capital Investment Analysis for Engineering and Management, 3d ed., Pearson Prentice-Hall, Upper Saddle River, NJ. PMAC Consulting Private Limited ,Advanced Project Management Course, Global R.E.P., PMI , USA. Leland Blank, P. E., Basics of Engineering Economy, Industrial and Systems Engineering Texas A&M University. Jeremy Jay V. Lim, Project Management, Concepts and Cases. Donald G. Newnan and Ted G. Eschenbach , Engineering Economic Analysis ,Oxford University Press ,New York. Mohamed Khalifa Hassan, Project Management, Egypt.

Basic Aspects of Depreciation The word depreciation is defined as a "decrease in value."This is not an entirely satisfactory definition, for value has several meanings. In the context of economic analysis, value may refer either to market value-that is, the monetary value others place on property or value to the owner.

For example, an assembly line is far more valuable to the manufacturing firm that it was designed for, than it is to a used equipment market. Thus, we now have two definitions of depreciation: a decrease in value to the market or a decrease to the owner.

Deterioration and Obsolescence A machine may depreciate because it is deteriorating or wearing out and no longer performing its function as well as when it was new. Many kinds of machinery require increased maintenance as they age, reflecting a slow but continuing failure of individual parts.

In other types of equipment, the quality of output may decline owing to wear on components and resulting poorer mating of parts. Anyone who has worked to maintain an auto has observed deterioration due to failure of individual parts (such as fan belts, mufflers, and batteries) and the wear on components (such as bearings, piston rings, and alternator brushes).

Depreciation is also caused by obsolescence Depreciation is also caused by obsolescence. A machine is described as obsolete when it is no longer needed or useful a machine that is in excellent working condition may still be obsolete. In the 1970s, mechanical business calculators with hundreds of gears and levers became obsolete. The advance of integrated circuits resulted in a completely different and far superior approach to calculator design. Thus, mechanical calculators rapidly declined or depreciated in value.

If your auto depreciated in the last year, that means it has declined in market value. It has less value to potential buyers. On the other hand, a manager who indicates that a piece of machinery has depreciated may be describing a machine that has deteriorated because of use and/or because it has become obsolete compared with newer machinery. Both situations indicate a decline in value to the owner.

Although in everyday conversation we are likely to use "depreciation" to mean a decline in market value or value to the owner, accountants define depreciation as allocating an asset's cost over its useful or depreciable life. Thus, we now have three distinct definitions of depreciation: 1. Decline in market value of an asset. 2. Decline in value of an asset to its owner. 3. Systematic allocation of an asset's cost over its depreciable life.

Depreciation and Expenses Business costs are generally either expensed or depreciated. Expensed items, such as labor, utilities, materials, and insurance, are part of regular business operations and are "consumed" over short periods of time (sometimes recurring).

These costs do not lose value gradually overtime These costs do not lose value gradually overtime. For tax purposes they are subtracted from business revenues when they occur. Expensed costs reduce income taxes because businesses are able to write off their full amount when they occur. In contrast, business costs due to depreciated assets are not fully written off when they occur. A depreciated asset does lose value gradually and must be written off over an extended period.

For instance, consider a plastic injection- molding machine used to produce the beverage cups found at sporting events. The plastic pellets melted into the cup shape lose their value as raw material directly after manufacturing. The raw material cost for production material (plastic pellets) is written off, or expensed, immediately.

On the other hand, the plastic injection mold machine itself will lose value over time, and thus its cost (purchase price and installation expenses) are written off (or depreciated) over a period of years. The number of years over which the machine is depreciated is called its depreciable life or recovery period, which is often different from the asset's useful or most economic life.

Depreciable life is determined by the depreciation method used to spread out the cost-depreciated assets of many types operate well beyond their depreciable life. Depreciation is a noncash cost that requires no exchange of dollars. Companies do not write a check to someone to pay their depreciation expenses. Rather, these are business.

Expenses that is allowed by the government to offset the loss in value of business assets. Depreciation is important to the engineering economist on an after-tax basis because, even though it is a noncash cost, it does change the cash flows due to taxes. Depreciation deductions reduce the taxable income of businesses and thus reduce the amount of taxes paid.

In general business assets can be depreciated only if they meet the following basic requirements: 1. The property must be used for business purposes to produce income. 2. The property must have a useful life that can be determined, and this life must be longer than one year. 3. The property must be an asset that decays, gets used up, wears out, becomes obsolete, or loses value to the owner from natural causes.

Types of Property The rules for depreciation are linked to the classification of business property as either tangible or intangible. Tangible property is further classified as either real or personal. Tangible property can be seen, touched, and felt. Real property includes land, buildings, and all things growing on, built upon, constructed on, or attached to the land.

Personal property includes equipment, furnishings, vehicles, office machinery, and anything that is tangible excluding assets defined as real property. Intangible property is all property that has value to the owned but cannot be directly seen or touched. Examples include patents, copyrights, trademarks, trade names, and franchises.

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