Lecture No. 30 Chapter 9 Contemporary Engineering Economics Copyright © 2010 Contemporary Engineering Economics, 5 th edition, © 2010

Chapter Opening Story  Robotic pill dispenser makes life easier for pharmacists - A hospital pharmacy gets a $250,000 robotic pill dispenser to prepare prescriptions.  How does the cost of this robot be recognized in reporting the financial position of the pharmacy?  How long will this robot be the state of the art?  When will the competitive advantage the pharmacy has jest acquired become a competitive disadvantage through obsolescence?  At issue: Know what it costs to own a piece of equipment Contemporary Engineering Economics, 5 th edition, © 2010

Depreciation  Definition: Loss of value for a fixed asset  Example: You purchased a vehicle worth $25,000 at the beginning of year Changes in Market Value Contemporary Engineering Economics, 5 th edition, © 2010 Depreciation End of Year Market Value Loss of Value $25,000 19,000 16,000 14,000 12,000 10,000 $6,000 3,000 2,000

Classification of Types of Depreciation  Economic Depreciation: Economic depreciation = Purchase price – market value  Accounting Depreciation: Based on matching concept – a fraction of the cost of the asset is chargeable as an expense in each of the accounting period Contemporary Engineering Economics, 5 th edition, © 2010

Why Do We Consider Depreciation? Contemporary Engineering Economics, 5 th edition, © 2010 Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as a part of business expenses that reduce taxable income.

Factors to Consider in Asset Depreciation Contemporary Engineering Economics, 5 th edition, © 2010  Depreciable life (how long?)  Salvage value (disposal value)  Cost basis (depreciation basis)  Method of depreciation (how?)

What Can Be Depreciated? Contemporary Engineering Economics, 5 th edition, © 2010 Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above.

Cost Basis  Without Trade-In Allowance  With Trade-In Allowance Contemporary Engineering Economics, 5 th edition, © 2010

Useful Life and Salvage Value  Useful life – Adopt the Asset Depreciation Ranges (ADR) published by the IRS.  Salvage value – Asset’s estimated value at the end of its useful life. Every effort should be made to estimate a reasonable residual value of the asset, but if not possible, a 10% rule (10% of the initial value) could be adopted for depreciation purpose. Contemporary Engineering Economics, 5 th edition, © 2010

Types of Depreciation Contemporary Engineering Economics, 5 th edition, © 2010 Book Depreciation  In reporting net income to investors/stockholders  In pricing decision Tax Depreciation  In calculating income taxes for the IRS  In engineering economics, we use depreciation in the context of tax depreciation

Book versus Tax Depreciation – An Overview Contemporary Engineering Economics, 5 th edition, © 2010 Component of Depreciation Book DepreciationTax depreciation (MACRS) Cost basis Based on the actual cost of the asset, plus all incidental costs such as freight, site preparation, installation, etc. Same as for book depreciation Salvage value Estimated at the outset of depreciation analysis. If the final book value does not equal the estimated salvage value, we may need to make adjustments in our depreciation calculations. Salvage value is zero for all depreciable assets

Contemporary Engineering Economics, 5 th edition, © 2010 Component of Depreciation Book DepreciationTax depreciation (MACRS) Depreciable life Firms may select their own estimated useful lives or follow government guidelines for asset depreciation ranges (ADRs) Eight recovery periods– 3,5,7,10,15,20,27.5,or 39 years– have been established; all depreciable assets fall into one of these eight categories. Method of depreciation Firms may select from the following: Straight-line Accelerated methods (declining balance, double declining balance, and sum-of- years’ digits) Units-of-proportion Exact depreciation percentages are mandated by tax legislation but are based largely on DDB and straight- line methods. The SOYD method is rarely used in the U.S. except for some cost analysis in engineering valuation.

Contemporary Engineering Economics, 5 th edition, © 2010 Summary The entire cost of replacing a machine cannot be properly charged to any one year’s production; rather, the cost should be spread (or capitalized) over the years in which the machine is in service. The cost charged to operations during a particular year is called depreciation. From an engineering economics point of view, our primary concern is with accounting depreciation; The systematic allocation of an asset’s value over its depreciable life.

Contemporary Engineering Economics, 5 th edition, © 2010 Accounting depreciation can be broken into two categories: 1. Book depreciation—the method of depreciation used for financial reports and pricing products; 2. Tax depreciation—the method of depreciation used for calculating taxable income and income taxes; it is governed by tax legislation.  The four components of information required to calculate depreciation are: (a) cost basis, (b) salvage value, (c) depreciable life, and (4) depreciation method.