Engineering

Economy
 Depreciation
4.1 Depreciation Concepts
Depreciation is the decrease in the value of physical property due to physical or
economic reasons. Physical property shall include both tangible and intangible business
property except for real estate. Property which may be seen or touched such as
transportation, machinery, furniture, and office equipment, are classified as tangible.
Intangible property on the other hand, includes franchise, copyright, or patent. This chapter
gives emphasis only on the depreciation of tangible property since engineering projects
usually include this type of property.

Amortized cost which is the accounting viewpoint for depreciation considers

depreciation as the cost of a useful property which is periodically charged as an operating
expense over its useful life, as such, depreciation charges are deductible from gross income
before income taxes are paid.

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 Depreciation
4.1 Depreciation Concepts
In general, a given property is considered subject to depreciation if it meets the
following requirements:

1. it must be used in business and not for personal use.

2. it must have a determinable useful life that is longer than one year.

3. it is not product inventory, stocks, bonds, or other assets of investment.

4. it must be a property that loses its value due to deterioration, obsolescence, and other
natural causes.

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 Depreciation
4.2 Types of Depreciation
1. Physical Depreciation
results in the decrease in the ability of a physical property to perform its intended
service, which is caused by corrosion, abrasion, decay, impact, heat, stress, and vibration.

2. Functional Depreciation
results from obsolescence or inadequacy of the property to meet the demand
required, which occurs when new and better equipment is available that is more efficient
and less expensive to operate. This also occurs when the property can no longer satisfy the
current or anticipated demand or when demand no longer exists.

3. Accident
results when the property becomes a casualty of fire, flood, or any accident.

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 Depreciation
4.3 Purpose of Depreciation Studies
1. To Provide for the replacement of tangible property.
2. To provide for the recovery of invested capital.
3. To enable the cost of depreciation to be charged to the cost of manufacturing products or
services rendered.

4.3 Terminologies
Value
Is the measure of the worth that an individual ascribes to a property or service.

Market Value
Is the amount that a willing buyer pays a willing seller for the purchase of his
property, where neither buyer nor seller is compelled to buy or sell.
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 Depreciation
4.3 Terminologies
Fair Value
Is the worth of a property to a disinterested third party, to establish a price that is
fair to both buyer and seller.

Book Value, BV
Is the worth of a property at a given time as reflected in the accounting records of a
business. It is the acquisition cost of the property, plus any adjustments, less the
accumulated depreciation charges for a given period.

Assessed Value
Is the reported value used for property tax purposes. It is usually obtained by appraisal.

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 Depreciation
4.3 Terminologies
Salvage Value, S
Is the price of a property when it can no longer operate at a profit. It is the
estimated worth of the property at the end of its productive life.

Scrap Value, S
Is the value of the property after it can no longer perform its intended function. It is the
price that the property can command if it is sold as junk.

Physical Life
Is the period in which a given property is able to perform the function for which it was
designed for.

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 Depreciation
4.3 Terminologies
Economic or Useful Life, L
Is also referred to as the property's depreciable life. It is the period during which a
property may be operated at a profit.

Acquisition Cost, P
Is also referred to as first cost, it includes the purchase price of the property plus any
expenses incurred (shipping, installation, improvement, and repair) prior to initial service or
operation of the property.

Yearly Depreciation Charge, dn

Is the depreciation charge for a given year of the property.

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 Depreciation
4.3 Terminologies
Accumulated Depreciation, Dn
Is the total depreciation expense charged to a property after n years of service.

Depreciation Table
Is a tabulated depreciation schedule showing the yearly and accumulated
depreciation charges, together with the book value at the end of each year of the property's
useful life.

Wearing Cost, (P-S)

Is the accumulated depreciation of a property at the end of its useful life.

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 Depreciation
4.3 Terminologies
Depreciation Funds
Are funds that are set aside out of profit so that capital is available for replacing
essential equipment at the time of retirement.

Depreciation Rate, k
Is the decrease in property value for a given year expressed as a percentage.

Recovery Period
Is the time or period required for capital cost recovery. This period is usually shorter
than the economic life of the property in order to encourage capital investment and
improve productivity.

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 Depreciation
4.5 Depreciation Methods

4.51 Straight-Line Method (SLM)

The SLM is the simplest and most used depreciation method. It assumes that the loss of value is directly
proportional to the age of the property so that the annual depreciation charge, d, and the depreciation rate, k, is
constant. Hence, the book value, BV, of the property decreases each year at a uniform rate.

Equations:
(𝑃 −𝑆)
d= ; d=dn
𝐿
(Eq 5-1)

𝑑
k=
𝑃
(Eq 5-2)

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 Depreciation
Equations:
𝑛
Dn = nd = (P – S)
𝐿
(Eq 5-3)

BVn = P - Dn
(Eq 5-4)
4.52 Sinking Fund Method or Formula (SFF)
The SFF assumes that a sinking fund earning interest is created for replacement purposes. The fund is
established by depositing equal amounts at the end of each year for years at an interest rate of i % per year.
i, % Dn (P – S)
1 2 3 ……

d d d Fig 4-1 d d

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 Depreciation
Equations:
1+𝑖 𝐿 −1
(P – S) =d
𝑖

𝑖
d =(P – S) ; annual replacement deposit
1+𝑖 𝐿 −1
(Eq 5-5)
1+𝑖 𝑛 −1 1+𝑖 𝑛 −1
Dn =d = (P – S)
𝑖 1+𝑖 𝐿 −1
(Eq 5-6)
1+𝑖 𝑛−1 −1
dn = (P – S)
1+𝑖 𝐿 −1
(Eq 5-7)
BVn = P - Dn

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 Depreciation
4.53 Declining Balance Method (DBM) or Matheson Method
This method is also referred to as the constant percentage method. The DBM assumes that the
depreciation charge for a given year is a fixed percentage of the book value at the start of the year, such that, the
depreciation charge decreases as the property nears the end of its useful life.
Equations:
dn = BVn - 1 ∙ k = P (1 – k)n – 1 k
(Eq 5-8)
BVn = P (1 – k)n
(Eq 5-9)
S = P (1 – k)L
(Eq 5-10)
1 1
𝑆 𝐿 𝐵𝑉𝑛 𝑛
k=1- =1-
𝑃 𝑃
(Eq 5-11)

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 Depreciation
4.54 Double Declining Balance Method (DDBM)
In this method, the depreciation rate, k, is computed as 200%/L, such that k is replaced by the value 2/L in
equations 5-8 to 5-10. For this method, the estimated useful life of the property must exceed 2 years so that k<1.
Equations:
2 2 𝑛−1 2
dn = BVn - 1 ∙ = P 1 − ∙
𝐿 𝐿 𝐿
(Eq 5-12)
2 𝑛
BVn = P 1 −
𝐿
(Eq 5-13)
2 𝐿
S=P 1 − 𝐿
(Eq 5-14)

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 Depreciation
4.55 Sum of the Years-Digits Method, SYD
This method requires that the digits corresponding to the number of each year of the property life first be
listed in reverse order. The depreciation rate for a given year is found by taking the corresponding number from the
reversed listing and dividing it by the sum of the years digits, Y.
Equations:
𝐿 (𝐿+1)
y= 2
(Eq 5-15)
Reverse order = (L – n + 1)
(𝐿 −𝑛+1)
dn = (P – S)
𝑦
(Eq 5-16)

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 Depreciation
4.56 Units-of-Production Method
The Units-of-Production method is used to determine the depreciation of property not as a function of
time, in years, but as a function of use. In this method, depreciation is charged in proportion to units of production,
or time of use, or the amount of work performed. Thus, welding equipment in a car assembly plant may be
depreciated on the basis of the number of units welded, or motor vehicles may be depreciated in proportion to
kilometers traveled.
Equations:
(𝑃 −𝑆) 𝑃 −𝐵𝑉𝑛
d= ==
𝑃𝑂𝑙 𝑃𝑂𝑙
(Eq 5-17)

Dn = (POn) d
(Eq 5-18)

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 Depreciation
Sample Problems
1. A machine cost P8000 and has an estimated life of 10 years with a salvage value of P500. What is its book value
after 8 years using straight line method.
2. An engineer bought an equipment for P500,000.00. Other expenses including installations amounted to
P30,000. At the end of its estimated useful life of 10 years, the salvage value will be 10% of the first cost. Using
straight line method of depreciation, what is the book value after five years.
3. A service vehicle costs P960,000 and is expected to be used for 10 years after which it will have a salvage value
of P160,000. Find the book value at the end of the third year using (a) Straight line method, (b) 8% sinking fund
method.
4. A diesel generator unit worth P650,000 is purchased to provide power to a remote town. Shipping cost is
P20,000 and the cost of installation is P30,000. If the salvage value of the unit at the end of 20 years is
expected to be P50,000, determine the annual depreciation cost and the book value of the unit after five years
using sinking fund formula with 7% interest.
5. A machine costing P720,000 is estimated to have a book value of P40, 545.73 when scraped at the end of 10
years . Depreciation cost is computed using a constant-percentage of the declining book value. What is the
annual rate of depreciation in %.

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