ACQUISITION, USE AND RETIREMENT OF CAPITAL ASSETS IN INDUSTRY DISCUSSION OF ASSUMPTIONS WHEN ESTIMATING THE CAPITAL STOCK

Jan Karlsson, UN/ECE Statistical Division, Geneva

F:\USERS\KARLSSON\CAPSTOCK\short.DOC

9 February 1999

CONTENT 1. 2.
2.1 2.2 2.3 2.4

INTRODUCTION CHANGING COMPOSITION IN INVESTMENT

From stand alone machines to flexible manufacturing cells and flexible manufacturing systems Costing structure Shift towards machine investment Shift towards R&D expenditures

3.
3.1 3.2 3.3 3.4 3.5 3.6 3.7

HYPOTHESIS ABOUT OUTPUT STREAMS AND DEGREE AND MODE OF UTILIZATION OF CAPITAL ASSETS
Constant output An example Most machines are integrated into systems Replacement of whole systems Increasing degree of utilization - higher ratio of machine investment Comments to an inventory of age-, type- and technology distribution of the 1989 stock of metalworking equipment in the United States Implications for measuring the value of capital stock

4
4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9

INVESTMENT BEHAVIOUR AND ASSUMPTIONS ON DECAY, SERVICE LIVES AND MODE OF RETIREMENT
A criterion for investment decision - internal rate of return Flows of income and costs for maintenance and repair Decay and ageing Input decay Output decay A process of continuous replacement investment, often according to plan Desired capital stock Most investment projects are interdependent Service lives for assets: primary and secondary service lives

5. 6.

A SUMMARY OF PRACTICES IN BUSINESS ACCOUNTING CONCLUSIONS References

ANNEX 1: ANNEX 2:

Traditional methods for investment calculations Notes on the theory for investment behaviour

1.

INTRODUCTION

The difficulties of accurately measuring capital stocks are well known. Direct surveys would be preferable but are deterred by their high costs as well as by the fact that many companies do not keep up-to-date records of all their assets. This is in particular the case concerning retirement of assets (scrapped or sold or just left idle). When a company has written off an asset, it is not unusual that it disappears from the records as well as from companies financial account. Gross fixed capital formation (GFCF) on the other hand can be rather accurately measured. On the bases of GFCF and certain assumptions concerning service lives of assets, the Perpetual Inventory Method (PIM) is used to estimate the capital stock. Despite the uncertainty of asset life assumptions of PIM it is, as is pointed out in [1], widely used in statistical offices. Several different approaches have been recommended in order to improve the accuracy. One approach suggests the use of a combination of direct observation of capital assets and PIM. Another approach focuses on simulation of different types of mortality functions, based on various assumptions of retirement of asset. For the calculation of the net capital stock a further set of assumptions concerning depreciation are simulated. In this article it is argued that many of these assumptions seem even less appropriate than hitherto, given present day investment behaviour in industry and how the assets are actually used. It is also argued that when models of measuring capital stock are developed, much more solid and hard facts must be gathered about the present day investment behaviour, investment planning and production organization in industry, which in turn determines the length of service life, degree of utilization and patterns of retirement. Based on observations of present-day production and investment behaviour in industry, a number of hypothesis is postulated in this paper concerning input and output decay and mode of retirement for key production systems (large integrated manufacturing systems). These hypothesis differ somewhat from those discussed at the Second Meeting of the Canberra Group on Capital Stock Statistics at the OECD, September/October 1998. The limitation to key production system is important to note because capital goods are heterogeneous - even within the same category of asset.1 Conclusions for key production system can, however, radically differ from, say, simple stand alone machines, hand-held tools and other types of investment
1

A manual lathe for instance cannot be compared with a computerized-numerically controlled (CNC) lathe. A stand alone CNC lathe can not be compared with a CNC lathe integrated into a computer controlled cell. In [2] Diewert notes the tremendous amount of heterogeneity in the composition of output from different firms in the same industry. He concludes that this heterogeneity makes comparisons of real output and productivity across firms in the same industry somewhat dubious, since their outputs may not be comparable. The combination of various types of assets with a certain amount of labour and labour skill structure is determined not only by the type output but also on volume of outputs, range of output variants and batch sizes. There is thus also a heterogeneity in the use and configuration of capital assets between firms within the same industry branch.

objects, which can be acquired more or less "over the counter" and instantly replace similar worn out or otherwise retired equipment. Before discussing the hypothesis mentioned above, attention should be drawn to the radically new production technologies and production organisations, which have been developed in the last 30 years. The main structural change in this respect is the shift from stand-alone machining systems, set up according to a functional work organisation, to computer-integrated manufacturing processes where the material flow and the information flow are organised in well-balanced system which produces the right amount of goods and services at the right time for current demand. These are issues which are illustrated in detail in a more extended version of the present paper. This text might, however, be somewhat too lengthy for readers primarily interested in capital stock statistics in a national accounts environment and is therefore not included here. Nevertheless, it is important to be aware of the reality one is trying to measure, in particular when such important changes have taken place as in this area, which, moreover, is already laden with measurement problems. This information is essential when making assumptions, which by their nature have to be generalised, about issues such as length of service life, income flows, input and output decay and depreciation. A short section is also devoted to issues of methods of investment calculation and investment behaviour. An implication of the new production methods is a sharply increased degree of the machine utilisation and, which as will be shown below, significant changes in the composition of total investment in industry.

2. 2.1

CHANGING COMPOSITION IN INVESTMENT From stand alone machines to flexible manufacturing cells and flexible manufacturing systems

The configuration of production systems, in particular in batch-producing industries, have gradually changed from stand-alone machines, arranged according to functional layouts, to flexible computerized manufacturing cells and systems (typical machine configurations of cells and systems are illustrated in [3]). Such cells and systems constitute today a very large part of total machine investment. Certainly, industry is still investing in individual stand alone machines but the share of such machines is diminishing rapidly. When a cell has been developed, tested and certified, it will normally be integrated with several other cells which together constitute the computer-controlled manufacturing system. The extended version of the present paper illustrates with concrete examples the effects which can be realized when companies switch from conventional systems, consisting mainly of stand alone machines - where both the "one-hoss shay" and input and output decay were possible and frequent - to computerized production systems, based on product-oriented organizations, in which every stage in production is demand driven.

2.2
(a)

Costing structure
A typical cell consists of: a number of different types of machines, material handling systems and computers and control systems of different sizes, with a cost share of some 4060%; peripherals, special tools and other system specific equipment, sometimes developed in-house, with a typical cost share of 20-30%; and systems engineering and integration, including various types of software, with a typical cost share of 20-30%.

(b) (c)

When the cell after its primary service life, denoted by T, is replaced by a new cell, what happens then with the various components of the first cell? Some of the machines, usually the larger and expensive ones, are overhauled and refurbished for integration into new cells. Others are either scrapped, sold (which seems to be quite marginal judging from information in annual report by companies) or used as standalone machines for special purpose production, often with a very low degree of utilization. Peripherals, special tools and other system specific equipment, on the other hand, have hardly any remaining value after T. Car companies, for instance, record separately special tooling, which has a much shorter depreciation period than other equipment. Systems engineering and integration have hardly any market value unless the user company would go into that business. It becomes, like goodwill, part of the general capital of the company.

2.3

Shift towards machine investment

During the last 30 years, the share of machine investment in total investment in the manufacturing industry has increased significantly. In Sweden, for instance, it increased from some 70% in the early 1970s to 85% in the middle of 1990s as concerns total industry (ISIC rev.2: 2+3). For the engineering industries (ISIC rev.2: 38), it increased from about 65% to almost 90% in the same period (see figure 1). It is likely that many other OECD countries show ratios with similar trends and magnitude. This shift in machine investment is to a large degree the result of the new production technologies and organizations described above. Another way of putting it is that there has been a very significant increase in the output per factory m 2 .

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Figure 1 The share of m achine investm ent in total investment in the Swedish engineering industries and total industry
100

95

90

Percentage share

85

80

75

70

65

60
19 74 19 77 19 80 19 84 19 76 19 75 19 78 19 87 19 81 19 71 19 90 19 91 19 94 19 73 19 83 19 85 19 88 19 96 19 97 19 72 19 82 19 79 19 86 19 93 19 70 19 95 19 89 19 92

Y ear

Engineering industries (ISIC rev. 2: 38; as from 1992 ISIC rev. 3: 28-35) Total indus try (ISIC rev. 2: 2+3; as from 1992 ISIC rev. 3: C+D)

Source: Statistics Sweden.

2.4

Shift towards R&D expenditures

GFCF and R&D expenditures are highly complementary and the boundaries between these two variables are becoming more and more blurred. While the long term trend of GFCF as a percentage of value added has been rather stable there has been a significant increase in share of R&D to value added. This is, in particular, the case in the engineering industries. In 1993, R&D in the Swedish engineering industries (ISIC rev. 2: 38) was 1.5 times larger than GFCF. In the telecommunications and semiconductor industries it is not unusual to find large international companies that spend twice as much on R&D as on GFCF (example of R&D/GFCF ratios for 1997 for a few companies: Microsoft 3.9; Ericsson 3,2; Hewlett-Packard 1.5; IBM 0.8). Some companies have even started to capitalize parts of their R&D expenditures. In SNA 93, on the other hand, all the outputs of R&D are "treated as being consumed as intermediate inputs even though some of them may bring future benefits". This might indeed seem very strange to the companies mentioned above as well as to, for instance, large pharmaceutical companies. They would without doubt consider R&D as an essential part for their future benefits and survival.

3.

HYPOTHESIS ABOUT OUTPUT STREAMS AND DEGREE AND MODE OF UTILIZATION OF CAPITAL ASSETS Constant output

3.1

Based on the discussion in section 2 above, it is reasonable to assume (and to test the hypothesis) that most of the advanced types of industrial machines being installed in recent years have constant output over their primary service life (this concept to be defined below). Present day production organizations would not allow otherwise. A very large share of the machines in an enterprise, at least those that have a high degree of utilization, are computer-controlled and integrated into computer-controlled production system. In such systems, flows of services from individual pieces of equipment are not allowed to diminish over time. Each component of the system must be balanced and stable. The mean-time-betweenfailure for the system as a whole is a function of the mean-time-between-failure for the individual components of the system. In the transport equipment industry and electrical and electronics industry, to take some examples, the production system must satisfy very rigorous specifications concerning quality and tolerances. A subcontractor, for instance, will only be chosen as a supplier if he satisfy ISO 9000 certification concerning quality. This in turn implies that each component of the system must have constant performance during it is effective usage. General assumptions that some machines through physical deterioration causes a diminishing output of services while others have a constant flow until it breaks (one-hoss shay) are simply not realistic today. No serious company would use one-hoss shay type of equipment. Retirement is usually done in a planned manner, years ahead. It is definitely not the case that companies wait to replace machines until they break. Given that specified and regular services are carried out, machines and machine systems normally have rather well defined length of service life. Unless they are overhauled companies do not risk using them longer than the planned life time, in particular if they are key machines in a production system.

3.2.

An example

An industrial robot, for instance, used in stand-alone mode or integrated into a system with 100 other robots and many other types of equipment, is usually designed for remaining in operation for, say 40,000 hours (provided regular service is carried out). During these 40,000 hours, the output is practically constant. Normally, with proper maintenance its accuracy, speed etc. do not deteriorate. After 40,000 hours it is either refurbished with new drives and other types of overhaul and can work 20,000-30,000 hours more, or taken out of operation (scrapped, sold to another company for overhaul, or standing idle: that it would be used as reserve capacity in the unlikely event that it may be needed) because a new generation of robots is on the market with more powerful control system, better accuracy etc.

3.3

Most machines are integrated into systems

As was discussed above, a very large share of machines and equipment in industry, in particular those with less than 5-10 years old, are integrated into computer controlled production and administrative systems. In 1994, about 42% of total GFCF in machines in the Swedish engineering industries (ISIC rev.3: 28-35) consisted of computer-controlled machines, 31% for the total manufacturing industry (Source: Statistics Sweden). In 1993, computer and other information technology goods, measured in inflation-adjusted dollars, made up almost half of total business spending on equipment in the United States (source: Business Week, June 13, 1994 based on data from Commerce Dept. and BLS). The share for industrial machinery fell from 32% in 1975 to 18% in 1993. The rapidly rising importance of computers (which is more narrowly defined as in the source above) in total business investment, which normally accounts for well over 50% of total fixed investment, was analysed in detail in the OECD Economic Outlook, Volume 57, June 1995. In real terms, computers increased their share from 4.7% of total business investment in 1985 to 20% in 1994. In that publication a very important conclusion was drawn with respect to service lives of assets:The rising importance of computers and related equipment, which are subject to particular rapid rate of scrapping and obsolescence, has contributed to what appears to be a general trend towards shorter-lived capital equipment in the business sector. This trend has existed since at least the 1960s and has been reflected in steadily rising rates of fixed capital consumption in many countries .

3.4

Replacement of whole systems

Sometimes various pieces of a system are replaced individually but more often the whole system is taken out of operation and replaced by a new one when its predetermined length of service life has been reached.

3.5

Increasing degree of utilization - higher ratio of machine investment

Production systems in batch-producing industries (engineering industries, furniture, saw mills etc.) are more and more being operated in two or more shifts many systems operate unmanned or with limited manning. In the process industries (pulp and paper, iron and steel, chemical industry etc.), the production system is often dominated by one gigantic system that operates around the clock with down time for overhaul only at Christmas and summer vacation. A paper company can basically consist of one or several half-a-$billion machine systems. In the process industry, which is characterized as capital intensive and knowledge poor (with the exception of the chemical industry), the capital stock has

for long time been used as described above. As a result of increasing share of machine investment also in batch producing industries, which can be characterized as knowledge intensive but poor on capital assets (e.g. engineering industries), there has been a shift from traditional one-shift operations to using the equipment in two or even three shifts per day (in some countries this flexibility has been obtained by reducing the work week to 35 hours).

3.6

Comments to an inventory of age-, type- and technology distribution of the 1989 stock of metalworking equipment in the United States

Every five year the magazine American Machinist used to carry out very detailed surveys for the United States of the stock and age distribution of metal working machine tools for a wide range of types of machines. Unfortunately, this type of survey ceased after the completion of the 1989 survey whose results are briefly summarised below. In view of the continuous shift towards numerically controlled (NC) machines and towards machining systems rather than stand-alone machines, it is reasonable to assume that the present age distribution has been significantly compressed, compared with the 1989 distribution. In other words, an increasing share of stand alone conventional machines, with a much lower unit value than NC machines, have been retired. 3.6.1 1. Summary of the results

In 1989, about 26% of all metal cutting machines in the United States were 20 years old or more (see table 1). 16% were less than 5 years. Metal forming machines followed more or less the same age distribution. Joining and assembly equipment and the aggregate other equipment had a lower mean age. Metal cutting machines : Numerically Controlled (NC) machines accounted for 11% of all machine but for 27% of all machines which were less than 5 years old (40% of all NC machine were less than 5 years). For certain types of metalcutting machines, the NC share was much higher: 22% of all boring machines were of NC type and 52% of all boring machines with less than 5 years were of NC type (see table 2).

2.

3.

4.

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Table 1 Stock of metal cutting machines, metal forming machines, joining and assembly equipment and other equipment */ in the United States at mid 1989, broken down by age and , when applicable on NC and non-NC machines. Number of units Total 0 - 4 yrs 5 - 9 yrs 10 - 19 yrs 20 - yrs Selected metal cutting machines: NC turning machines 74,077 30,949 26,048 14,999 2,081 Non-NC turning machines 330,357 28,526 52,497 121,836 127,498 NC boring machines 10,688 2,917 3,376 3,039 1,356 Non-NC boring machines 37,372 2,688 6,239 14,449 13,996 NC drilling machines 10,383 2,921 2,823 3,459 1,180 Non-NC drilling machines 274,623 31,103 60,017 100,811 82,692 NC machining centers 53,585 23,813 19,548 8,729 1,495 NC milling machines 28,260 10,064 11,357 5,771 1,068 Non-NC milling machines 220,846 27,354 53,609 82,484 57,399 NC gear cutting machines 804 443 98 89 174 Non-NC gear cutting&finishing machines 28,705 911 1,994 10,553 15,247 NC grinding machines 12,747 5,285 3,341 3,111 1,010 Non-NC grinding machines 422,100 57,791 104,487 148,143 111,679 Total metal cutting machines 1,870,753 292,163 449,681 640,864 488,045 % age distribution 100.0 15.6 24.0 34.3 26.1 Total NC metal cutting machines 197,072 79,231 68,628 40,402 8,811 % NC share of all machines 10.5 27.1 15.3 6.3 1.8 % age distribution 100.0 40.2 34.8 20.5 4.5 Total non-NC metal cutting machines 1,673,681 212,932 381,053 600,462 479,234 % NC share of all machines 89.5 72.9 84.7 93.7 98.2 % age distribution 100.0 12.7 22.8 35.9 28.6 Total metal forming machines 456,028 51,593 94,847 171,002 138,586 % age distribution 100.0 11.3 20.8 37.5 30.4 Total NC metal forming machines 17,888 7,514 6,001 3,363 1,010 % NC share of all machines 3.9 14.6 6.3 2.0 0.7 % age distribution 100.0 42.0 33.5 18.8 5.6 Total non-NC metal cutting machines 438,140 44,079 88,846 167,639 137,576 % of all machines 96.1 85.4 93.7 98.0 99.3 % age distribution 100.0 10.1 20.3 38.3 31.4 Joining & assembly equipment 395,273 83,208 135,951 122,287 53,827 % age distribution 100.0 21.1 34.4 30.9 13.6 Other equipment */ 712,217 349,926 198,763 116,624 46,904 % age distribution 100.0 49.1 27.9 16.4 6.6 Source: American Machinist, November 1989, 14th inventory of metalworking equipment. */ Plastic moulding machines, heat treatment equipment, baking and drying ovens, cleaning & finishing

Table 2 Percentage share of NC machines within each type of machine in the United States at mid 1989 Total 18.3 22.2 3.6 100.0 11.3 2.7 2.9 0 - 4 yrs 52.0 52.0 8.6 26.9 32.7 8.4 5 - 9 yrs 10 - 19 yrs 33.2 11.0 35.1 17.4 4.5 3.3 17.5 4.7 3.1 6.5 0.8 2.1 20 yrs 1.6 8.8 1.4 1.8 1.1 0.9

Turning machines Boring machines Drilling machines NC machining centers Milling machines Gear cutting machines Grinding machines Source: Op.cit.

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5.

In the middle of 1989, between 27% and 55% of the NC machines, depending on type of machine, in the United States were less than 5 years (see table 3). For non-NC machines the corresponding range was 3% and 14%.
Table 3 Age distribution of selected metal cutting machines in the United States, mid 1989 Total 100 100 100 100 100 100 100 100 100 100 100 100 100 0 - 4 yrs 41.8 8.6 27.3 7.2 28.1 11.3 44.4 35.6 12.4 55.1 3.2 41.5 13.7 5 - 9 yrs 10 - 19 yrs 35.2 20.2 15.9 36.9 31.6 28.4 16.7 38.7 27.2 33.3 21.9 36.7 36.5 16.3 40.2 20.4 24.3 37.3 12.2 11.1 6.9 36.8 26.2 24.4 24.8 35.1 20 yrs 2.8 38.6 12.7 37.5 11.4 30.1 2.8 3.8 26.0 21.6 53.1 7.9 26.5

NC turning machines Non-NC turning machines NC boring machines Non-NC boring machines NC drilling machines Non-NC drilling machines NC machining centers NC milling machines Non-NC milling machines NC gear cutting machines Non-NC gear cutting&finishing machines NC grinding machines Non-NC grinding machines Source: Op.cit.

6.

Table 4 compare the age structure of machine tools in the United States with that of other G-7 countries. The data, which were collected in the period 1975-1983, show similar age distribution for United States, Canada, Germany and France. Japan and to some degree also Italy had a higher share of younger machines (for the United Kingdom a comparison is less clear cut). There are reasons to believe that the age distribution has now been more compressed and more uniform between the G-7 countries, because of the technology shifts discussed above as well as of significant changes in the investment behaviour for machine tools among the countries concerned.

Table 4

Age structure of machine tools in selected countries. Percentage distribution

Age USA Canada Germany France Italy Japan UK structure 1983 1978 1980 1980 1975 1981 1982 0-2 15 0-4 14 15 16 0-5 41 0-7 41 35 0-8 0-9 34 41 34 35 >=13 yrs 37 >=15 yrs 48 29 >=18 yrs >=20 yrs 32 37 32 27 Source: American Machinist, Nov. 1983, 13th inventory of metalworking equipment. Note: The year indicated under the country name refers to the year of meaurement.

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3.6.2 Output from numerically-controlled (NC) machines vis--vis conventional machines A large share of the NC machines is integrated into systems, which are normally in operation 12-24 hours per day. Because of their high degree of utilisation and productivity, a rough guess is that computer-controlled machines (some 20% of all machines) account for 80% or more of output. That companies maximise the utilisation of the NC machines is natural given the large difference in price compared with conventional machines. In 1996, for instance, the average unit value in the apparent consumption of metalworking machine tools in the United States was almost $130,000 compared with less than $2,000 for conventional non-NC machines, see table 5. Non-NC machines are used as stand-alone machines with a low degree of utilisation, in particular the older machines - for certain odd jobs such as development of prototypes, special orders etc.

Table 5

Apparent consumption of machine tools in the United States and Germany in 1996 United States Total value Unit value Number of $1,000 units $1,000 925,758 87.2 3,865 107,004 17.9 3,175 Germany Total value Unit value DM 1,000 DM 1,000 831,518 215.1 250,068 78.8 19,208 4,508 499,455 21,437 575,459 927,364 70,920 5,640 339,069 55,375 7,190,962 5,513,526 977,472 699,964 76.7 246.0 12.4

NC horizontal lathes Non NC horizontal lathes NC milling machines, knee-type 1,871 163,756 87.5 non NC milling machines, knee-type 8,372 69,587 8.3 Other NC milling machines 2,674 Other non NC milling machines 2,802 Machining centres 12,525 1,446,580 115.5 2,632 Multi-station transfer lines 599 402,767 672.4 591 Unit construction machines 174 230,404 1,324.2 NC sharpening machines 605 non NC sharpening 13,356 NC grinding machines other than flat-surface 1,556 non NC grinding machines other than flat-surface 2,775 Total metalworking machine tools 6,989,569 of which : NC machines 35,057 4,504,426 128.5 22,411 non-NC 1,368,713 2,485,143 1.8 79,084 other not specified Percentage NC machines 64.4 Source: International Statistics of Machine Tools 1996, CECIMO 1998.

Number of units 10,615 5,991

186.8 7.7 218.6 1,569.1 117.2 0.4

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3.7
1. 2. 3.

Implications for measuring the value of capital stock

Assuming we have three categories of machines: Advanced machining systems with a high degree of utilization (some 80% of total output) Stand alone machines for odd jobs or tasks Idle old machines, which are practically never used.

In calculating the net stock from the present value of future income streams it would be logical to attach a value close to zero to (3) and a very low value to (2).

INVESTMENT BEHAVIOUR AND ASSUMPTIONS ON DECAY, SERVICE LIVES AND MODE OF RETIREMENT A criterion for investment decision - internal rate of return2

4.1

Text books in investment calculus usually tell us that companies decide to invest in a certain object if the internal rate of return i exceeds a cut-off rate r, usually the long term interest rate. The internal rate of return i is calculated according to formula (1) below in which Yt denotes the value of the flow of income, Ut cost for repair and maintenance, T the estimated length of service life which is determined according to experience or from specifications given by the equipment suppliers, the remaining value S at the end of the service life and K total investment cost. (1)

(1 + i )
t =1

Yt U t
t

(1 + i )T

K=0

The profitability of an investment calculated according to the internal rate of return method is of course an important criterion but it is far from being the only one. Certain investments are strategic with implications for the companies long term direction.3 Such investment as well as those which are strongly dependent on other complementary investments are determined partly on other criteria than the internal rate of return.

Asztly [4].

Investment can be classified according to the following breakdown: pilot investment, show room investment, strategic investment, replacement investment, rationalization investment and expansion investment.

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4.2

Flows of income and costs for maintenance and repair

The following five patterns will be discussed:

(1) Constant income flows (Y t) and constant repair and maintenance costs (U t) in the period T, where T is the estimated techno/economic primary service life. Based on assumptions about operating efficiency vis--vis future replacement investments and on how the particular investment object fits into the overall investment schemes, T is estimated or defined by the user company. It can also be estimated by the equipment/system suppliers, which guarantee certain operating efficiency, mean-timebetween failures etc. for a given time period, provided regular maintenance is carried out. (2) During an initial period t of running-in, trouble shooting and adjustment income flows are raising. As from t = 0, income flows and repair and maintenance cost are constant until T (see figure 2. The concepts in figure 2 are also discussed in section 4.9 below).

Figure 2. Generalised illustration of income flows and service lives for key manufacturing systems

Output

T T

T1

T2 Time

Source: UN/ECE. (3) Based on either (1) or (2) above, it is assumed that there is a flexibility component in the investment (which is understood to comprise of a major manufacturing system; assembly lines for cars, car components, household equipment etc.) which allow the system to increase its degree of utilization from two 8-hour shifts to three shifts, resulting in an increase in income flows to k*Yt as from t = T and maintenance and repair costs h*Ut , where k >1 and h > 1. Usually T is then reduced to T.

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(4) Income flows, either immediately after the investment becomes operational or after an initial adjustment period, are constant but repair and maintenance costs are raising. (5) Income flows declines [(a) constant amount, (b) constant rate, (c) hyperbolic, or (d) decreasing rate] while repair and maintenance costs are raising (see Blades in [5]). In text books and articles about capital stock measurements references are often made to the case of the one hoss shay and light bulbs. These references might be inappropriate because there are now, in reality, no substantial investments, which can be characterised in that way. Besides, light bulbs are rather intermediate consumption than capital goods.

4.3

Decay and ageing

Decay is a result of usage. It results in declining output compared with an identical new machine. Ageing, whether a machine has ever been in operation or not, results in increasing operating inferiority compared with the best available new machine. The combination of decay and ageing of a particular asset of a certain vintage is its operating inferiority. While the operating inferiority of an asset, e.g. a machine system, increases by time the average yearly capital cost (annuity) decreases as the cost is distributed on a longer time period (see figure 3 and the MAPI method in annex 1). In [6] Triplett says: Most capital goods, however, lose productiveness as they age, and so exhibit some form of decay . This statement seems valid only for some capital goods. In the manufacturing industry, however, there are reasons to reject this hypothesis as concerns key capital goods used in the manufacturing process. A paper making machine, for instance, tends to increase its output during the first years due to adjustment and fine tuning, after which output remains constant. A general statement that replacement investment should take place only to maintain output that is lost through output decay and retirement , as is cited by Triplett [6], is probably valid only for certain type of assets, e.g. hand held tools and such simpler equipment. Instead, replacement investment it is more likely to occur at the so called adverse minimum, that is where in time the sum of capital cost plus operating inferiority reaches its minimum (see figure 3).

4.4

Input decay

In many articles and text books about capital stock measurement in the context of national accounts it is often assumed there is an input decay. Undoubtedly there are capital goods with input decay but several investigations point to the contrary. Present-day practises in industry also speak against such an assumption. Figure 3. Average capital costs and operating losses of equipment

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as a function of the number of years in operation

Costs

Minimum

Average capital costs plus operating losses Operating losses

Average capital costs Adverse minimum Year

Source: UN/ECE: Recent Trends in Flexible Manufacturing , New York 1996.

In a study on the machines in the Swedish engineering industries, Wallander [7] concluded that no significant increase or decrease in maintenance and repair costs with age could be determined. A previous study concerning cars had given the same result [8]. In a study by the Gothenburg School of Economics [9] concerning the use of 128 boring machines and 213 turning machines at the ABB plant in Vsters, Sweden, it was concluded that the repair and maintenance costs only increased by a few tenths of a percentage per year against an assumption of 2% per year. It should also be remembered that this study was made in the early 1960's when machines were mostly operated on a stand alone basis - a breakdown would thus not have the catastrophic effect as when they are integrated into systems and for this reason regular maintenance and overhaul was not as urgent as now. In a study on construction machinery (60 objects) in 1963, Nordgren [10] found that repair and maintenance costs seemed to be constant in relation to time of usage. He also concluded, that there is a functional degradation in the sense that after a certain time of usage they are assigned easier tasks. In modern day manufacturing this would imply that when a production system has been phased out for a more efficient new system the individual machines in the old system can be assigned as back-up capacity in stand alone mode, used for small batch production (e.g. for prototypes). Against these results can me mentioned the pioneering work carried out by Terborgh for the Machinery & Allied Products Institute (MAPI). In [11] Terborgh assumed an average yearly increase in maintenance and repair costs of 5 to 10% during the first 8-11 years for textile machinery, buses, cars and trucks and for the first 20 years for machine tools, agricultural machinery and locomotives. It should

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remembered, however, that these results refer to the period just after the war and practices have changed radically since then. When a company invests in a major manufacturing system, e.g. a computer controlled assembly line for a certain range of computers, stoves, cars etc., then that line is likely to operate in the range of 12-24 hours per day for, say 5 years, after which it is scrapped, sold or the individual components reused in other parts of the company. Maintenance and overhaul is made at regular intervals in order to ensure that the system as a whole and none of its components break down, which would result in an enormous expense to the enterprise.

4.5

Output decay

It was argued above that for key manufacturing systems it is realistic to assume that they, after an initial period of adaptation and running-in operations, provide more or less constant output during their primary service life. For other types of equipment, often stand-alone or simple type of equipment for which the economic life time is more uncertain, it might be realistic to assume some output decay through wear and tear, lack of maintenance etc.

4.6

A process of continuous replacement investment, often according to plan

An individual investment (if it concerns a major investment object) can be analysed in isolation only if it can be assumed that the company will never again undertake that kind of activity for which the investment was made. The normal case, however, is that the company wants to continue this particular activity. This implies that some times before (often years) the optimal or, which is often the case, the predetermined time of usage has been reached, a decision has to be taken to replace the first investment object. This second set of investments determines another replacement investment and so on. If the company intends to continue its activity indefinitely we could talk about an indefinite chain of replacement investments. If they had the same length of service life and operating performance (which they of course do not have but assumed here in order to simply the formula) then the present value of capital would be
T S T Yt U t (1 + r ) + K t T T 1 1 + r + r = 1 ( ) ( ) t (1 + r ) 1

(2)

(The variables in (2) are defined in section 4.1). A common method for calculating when replacement investment should be done is the MAPI method (see annex 1).

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4.7

Desired capital stock

Fixed capital formation by firms is determined by expectations or assumptions of certain levels of output and profit. These expectations change continuously which implies that in each period in time there is a desired level of capital stock, denoted Kt*, which is normally different from the actual capital stock, denoted Kt . When Kt * Kt firms either invest or disinvest. As investment takes time this difference can usually not be eliminated in the same time period. The actual capital stock can therefore be seen as an adjustment process of previous desired levels of capital stocks. This process of adjustment is conceptually elaborated in annex 2. It is also shown how investment can be expressed as a function of the desired capital stock.

4.8

Most investment projects are interdependent

An investment in a particular machine system, for instance, is usually dependent on existing stock of machines and layouts as well as on planned future installations. When various investment projects are closely interactive then it is of course difficult to estimate the income flows from individual investments. In such situations cost minimisation becomes the criteria for decisions.

4.9

Service lives for assets: primary and secondary service lives

For investment calculations as well as when estimating capital stocks, the value of T is of critical importance. The service life of an investment T is not only dependent on input or output decay, when such are present, but also, and in particular, on the increasing operating inferiority, compared to new and more efficient equipment. The service life of a particular asset is also heavily dependent on the difference in time when it was acquired, irrespectively if it was put into operation or not, and when a new improved model was released. (A new 386 computer had a much shorter service life if it was bought 2 months before the release of 486 computers, compared to the same computer acquired 2 years earlier.) It has been argued in this article that for many types of equipment, the economic service life is predetermined. After the period T, the user company and/or the equipment/system supplier cannot assure constant output and mean-time-between failure without refurbishing the equipment or the whole system. T is also determined by model changes, e.g. for cars, and/or estimated time for the so called adverse minimum when competing investment objects become more profitable (see figure 3). What happens then after T (which will be called primary service life)? There are three alternatives: (a) The equipment is scrapped or sold. In other words, it is permanently removed from the company;

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(b) It is refurbished (e.g. change of drives, pumps etc.) and integrated into a new manufacturing system with constant output. The primary service life is extended to 1 T (see figure 2). (c) The equipment is taken out of the manufacturing system and assigned completely new tasks, often carried out in stand alone mode for small batch production, e.g. prototype production, or as reserve capacity, training or just standing idle waiting to be scrapped. The equipment enters a secondary service life T2 - T during which the output is only a fraction of what is used to be. In all the examples mentioned, it can no longer be seen as continuing its service life, in terms of the function for which it was bought.

A SUMMARY OF PRACTICES IN BUSINESS ACCOUNTING

A survey of the practices in the valuation of gross and net capital stock was carried out for some 20 large multinational corporations. The main conclusions of the survey of are summarised below:

Property, plant and equipment:

Property, plant and equipment is carried at acquisition or production cost, except for revaluation adjustments, less scheduled depreciation over their estimated useful lives, taking into account any expected residual values. Revaluation adjustments are allowed under certain circumstances in accordance with accounting principles generally accepted. Periodically, companies evaluate the carrying value of long-lived assets to be held and used, including goodwill and other intangible assets, when events and circumstances warrant such a review. The carrying value of a long-lived asset is considered impaired when the anticipated undiscounted cash flow from such asset is separately identifiable and is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair market value of the long-lived asset. Fair market value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that fair market values are reduced for the cost to dispose.

Depreciation:
Basically there are three types of depreciation methods: straight-line, declining balance (normally accumulated depreciation of approximately two-thirds of the depreciable cost during the first half of the estimated useful lives) and a combination of the two (starting with the of use declining balance method of depreciation, switching to the straight-line method as soon as the latter results in higher depreciation). Depreciation is computed based on estimated useful lives of the assets.

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Nonscheduled depreciation is provided when an impairment of the value of assets occurs or is anticipated. In order to increase the informative value of financial statements, accelerated depreciation recorded in some companies financial statements to increase tax-deductions has not been recognized in the consolidated financial statements. Depreciation can be done according to plan and for tax purposes. Companies normally claim the maximum depreciation deduction allowable for tax purposes. The differences between depreciation for tax purposes and planned depreciation is noted as depreciation in excess of plan. Depreciation in excess of plan is reported as appropriations, accumulated extra depreciation, which is included in untaxed reserves.

Intangible assets:
Research and development costs are normally expended in the financial period during which they are incurred, except that some companies for certain development costs which are capitalized when it is probable that a development project will be a success, and certain criteria, including commercial and technological feasibility, have been met (here business accounting has gone one step further than SNA 93). Capitalized development costs are amortized on a systematic basis over their expected useful lives. Software: Costs related to the conceptual formulation and design of licensed programs are normally expended as research and development. Costs incurred subsequent to establishment of technological feasibility to produce the finished product are capitalized. The annual amortization of the capitalized amounts is the greater of the amount computed based on the estimated revenue distribution over the products revenue-producing lives, or the straight-line method. Periodic reviews are performed to ensure that unamortized program costs remain recoverable from future revenue. Costs to support or service licensed programs are charged against income as incurred, or when related revenue is recognized, whichever occurs first. Goodwill, representing the excess of purchase price over the fair value of net tangible assets at the date of acquisition of businesses purchased, is normally amortised on a straight-line basis.

Is capital stock estimated on the basis of business accounting arbitrary because depreciation is done for tax purposes?
This was certainly valid some years ago and might still be valid for small enterprises and for the low-end of medium-sized enterprises. For most medium-sized and large companies the depreciation of capital today, at least as concerns depreciation according to plan, seems to follow closely the true economic life length of assets. It can be argued that as assets which are already fully depreciated and not yet scrapped are not included the valuation the stock, it will in fact be underestimated. If the degree of utilization pattern for assets of different vintages follow what was described in previous sections of this paper, then it is likely that this underestimation is negligible.

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Given that the allowed depreciation schemes are much more flexible today then before, it would be worth investigate if the net value of the assets of a company is not more correctly set by internal financial experts than that by using PIM and general assumptions about asset lives. Theoretically, financial experts in companies are continuously involved in the following decision process: (a) If the market value of a piece of equipment, or rather a system or a plant, is higher than the present value of the net income of future revenues and cost streams of the system then the system or the plant is sold. The company would then go into a new business area. (b) If the present value of the net income of future revenues and cost streams of the present system is lower than that of a new system then the former is sold, scrapped or retired. Normally this process of phasing in and phasing out new and old systems are, as was described in previous sections of this paper, planned years ahead. Almost at the time as when a system is installed, it is decided how long it will be in use. The net value of assets in business accounting should be close to what the assets would be worth on the market.

What capital stock measure should be used?

From whatever analytical point of view, the gross capital stock measure, regardless if it is measured at constant replacement cost, current replacement cost or historical cost, is from analytical point of view rather meaningless. If a large share of equipment do not provide declining services due to deterioration (but rather providing constant output for the planned service life) or if it is not a one-hoss shay, then the productive capital stock measure is also rather meaningless. This leaves us with the net capital stock. Here analytical reasons can be found. Companies need to know the net value of assets in order to calculate profitability. In fact the whole business planning is based on detailed analysis of the profitability of various combinations of capital assets and labour (there is not one given production organization but an infinite number each having a certain capital structure, combined with a certain labour structure). Also from macro economic point of view, i.e. concerning estimates of production functions, factor productivities etc., it is the net capital stock that makes sense. In this note, a hypothesis is put forward that the net stock as calculated from business accounting gives a more accurate estimate of the true market value than that calculated by using PIM and general assumptions about asset lives and mode of depreciation.

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6.

CONCLUSIONS

From both the theoretical and the empirical point of view, PIM seems to be a very uncertain method for measuring the capital stock. The main causes of uncertainty are the doubt about total length of service life and relative utility over the period. The only way forward therefore is to increasingly supplement PIM by (a) regular direct observations of asset lives and asset utility, and (b) much more research on how equipment is actually used in industry. The focus on equipment in this paper is, as was shown above, motivated by the fact that they account for the order of 90% of total investment in industry. Within the category "equipment" there is much heterogeneity. Machines from one and the same machine category can have completely different service lives and degree of utilization, depending how they are integrated into the production process. It is necessary to have much better understanding of functional breakdown of equipment and their mode of utilization. Such understanding should be captured in conjunction with direct observations based on sampling techniques. A wealth of information as concerns service lives is also available in annual reports of the big international corporations.

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References: [1] [2] [3] [4] [5] [6] [7] [8] [9] Australian Bureau of Statistics: Direct Measurement of Capital Stock, OECD 1998 (Second Meeting of the Canberra Group on Capital Stock Statistics). Diewert, W.E.: Productivity Measurement Problems , OECD 1998 (Second Meeting of the Canberra Group on Capital Stock Statistics). ECE: Recent Trends in Flexible Manufacturing, New York, 1986. Asztly, S.: Investeringsplanering, Uddevalla, 1968 {Investment planning - in Swedish}. Blades, D.: Measuring depreciation, OECD 1998 (Second Meeting of the Canberra Group on Capital Stock Statistics). Triplett; J.: Dictionary of Usage on Capital Measurement, OECD 1998 (Second Meeting of the Canberra Group on Capital Stock Statistics). Wallander, J.: Verkstadsindustrins maskinkapital, Stockholm 1962{ The machine capital in the engineering industries - in Swedish}. Wallander, J.: Studier i bilismens ekonomi, Stockholm 1958 {Studies in the economy of motoring - in Swedish}. Kiviaed, J.: Maskinlderns inverkan p reparationskostanderna, 1960 {The influence of the age of machines on the cost of repair and maintenance - in Swedish}. Nordgren, S.: Ngra faktorer av betydelse fr en maskinparks ldrande och dd, 1963 {Some factors of importance for the ageing and death of a machine stock - In Swedish}. Terborgh, G.: Dynamic Economic Policy, New York 1949.

[10]

[11]

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ANNEX 1 Traditional methods for investment calculations

There are many methods which may be used in investment appraisals and the selection of the one applied depends on the size and type of investment object, as well as on that aspect - e.g. profitability versus cash flow - to which the enterprise gives preference. This section will discuss the methods most commonly used. These methods, which are well-established in industry, will be presented in their basic forms, from which it is possible to derive several variants depending on the factors, which are included in the analysis. (a) The pay-back method is defined as the time period needed in order to recover the original investment cost through the net profit generated by the investment. This method, which is simple to use, is mainly applied to make a preliminary financial assessment of investment proposals and to rank them. It also serves as a criterion for deciding on smaller inexpensive investments. Many enterprises specify that investment for which the capital outlay is less than a certain amount need only be appraised with the pay-back method. The major shortcomings of the pay-back method are, first, that it does not consider income generated after the pay-back period and, secondly, that it does not measure the profitability of an investment but only its liquidity 4 implications . After installation, a computer-controlled manufacturing system frequently requires up to six months or even longer before the full planned operation rate is reached. Furthermore, the net profit resulting from the system often increases continuously over the years owing to successive adjustments of the system, thus permitting the realization of the full advantages of its flexibility. In this context, the pay-back method would not be a suitable approach in attempting to justify the investment. It would only reveal that there might be liquidity problems, which, as may be deduced from the above discussion, are inherent in the method.

If the cash budget of an enterprise shows the onset of liquidity problems in the near future, then only projects with a rapid capital return will be considered, while more profitable - but long-term - projects might be rejected. In this situation, the payback method is a very useful tool.

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(b)

The return-on-investment (ROI) method is defined as the ratio of net profit during a "normal" year of full production to the total capital outlay of the investment. It is usually expressed in percentage terms. The ROI method is mainly applied for calculating the profitability of smaller investment objects having more or less equal yearly returns over their entire economic life. Just as the pay-back method, it is a useful tool for making a preliminary evaluation of competing projects.

(c)

The net-present-value method takes into account the cash flows generated over the whole economic life of a project as well as the timing of these cash flows. The net present value (NPV) is calculated as the sum of the discounted yearly differences between cash inflows and cash outflows generated during the economic life of the project. The discount rate (r) is usually set to be equal to the actual rate of interest on long-term capital. If the NPV is equal or larger than zero, the profitability of the investment is equal to or higher than the target rate of return (r). In that case the investment proposal has passed the profitability test.

(d)

The internal-rate-of-return (IRR) method resembles the NPV method. In the IRR method a calculation is made of that internal rate of return - denoted (i) - at which the net present value is zero. The IRR method gives a measure of the profitability of the investment. If it is equal to or higher than (r), the profitability is higher than or equal to the cutoff value set up by the enterprise.

(e)

The net-present-value method adjusted for capital utilization . See ECE [3] for presentation and explanation of the formula. This method of investment calculation is used in connection with large projects, e.g. new plants, large machine investments for expanding capacity and when new products are to be launched and new machines installed for that purpose.

(f)

The MAPI method was developed in the beginning of the 1950s by the Machinery and Allied Products Institute in the United States. The MAPI method, which is used mainly for replacement investments, is based on the same principle as the net-present-value method adjusted for capital utilization. According to the MAPI method, decisions regarding the replacement of existing machines and equipment should be based on their age. The basic questions to be answered are: When should existing equipment be replaced? What will it cost to use the existing equipment another year?

The MAPI method assumes that existing equipment has an "operating inferiority" vis--vis new equipment (e.g. because of technological progress),

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which results in continuously increasing operating losses of the existing equipment. These losses are, however, compensated partly by the fact that the average capital cost (calculated as the net present value and amortized over a given number of years) of existing equipment decreases with age. That number of years of operation where the sum of operating loss and capital cost is at the minimum is called "adverse minimum" (see figure 3). This is the optimum time of usage. In order to gauge whether or not an existing piece of equipment should be replaced, the following steps are prescribed by the MAPI method: 1. Identify all those pieces of equipment which could replace the existing one (in the MAPI terminology the latter is called "the defender"). Select the one which at present is the best (referred to as "the challenger"). Decide whether or not the challenger should replace the defender. Calculate the present average capital cost and operating loss of the defender. Calculate, by use of specially developed MAPI-nomograms, the adverse minimum of the challenger. Replace the defender if its adverse minimum is higher than that of the defender.

2. 3.

4.

5.

The MAPI method has been further developed in order to deal with situations when completely new investments are to be appraised. This extended variant of MAPI makes it possible to appraise not only profitability but also the ranking of individual projects, which is accomplished by calculating an "urgency rating".

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ANNEX 2 Notes on the theory for investment behaviour

In each point in time it is assumed that there is a desired level of capital stock K t . This is often different from the actual capital stock Kt. If K*t >Kt then a decision might be taken to add to the existing stock of capital.5 Investment takes time and the difference can usually not be eliminated in the same time period. The actual capital stock is therefore an adjustment process of previous desired levels of capital:
*

(1)

Kt = w0 K*t + w1 K*t-1 + w2 K*t-2 + ............ = w(L) K *t

where L is a lag operator. There is also a desired composition of capital stock (2) K*t = pi k*i,j where k*i,j is the desired amount of capital of type i with the vintage j (or estimated remaining usage, recommended or planned).

Net investment can be defined as (3) IN t = It - I Rt = Kt - Kt-1

where INt is net investment, IRt is replacement investment and It is gross investment. Equations (1) and (3) give (4) It = w(L)(K *t - K*t-1 ) + I Rt

The desired level of capital stock and the adjustment to that level is derived from the assumptions that entrepreneurs are maximising the present value of future profits. Assume that the desired level of capital stock (optimal from point of view of profit maximizing) is a given level of output (5) K*t = Xt Then (4) can written as (6) It = w(L) (Xt - Xt-1 ) + I Rt

If w(L) is a Koyck-type of distributed lag, which implies that wi = (1-)i for i=0,1,2,... and 0 <<1, then w(L) = (1- )/(1-L) and then (7) It = (It-1 - I Rt-1 ) + (1 - )(K*t - K*t-1 ) + I Rt

R.F. Wynn & K.Holden: An introduction to Applied Econometric Analysis, London 1974.