DEPRECIATION

Engineering Economy
Definition

Depreciation is the decrease in value of physical

properties with the passage of time and use.
More specifically, depreciation is an accounting
concept that establishes an annual deduction
against before-tax income such that the effect of
time and use on an assets value can be reflected
in a firms financial statement.
Definition

Depreciable property is property for which

depreciation is allowed under federal, state, or
municipal income tax laws and regulations. To
determine if depreciation deductions can be
taken, the classification of various types of
property must be understood. In general,
property is depreciable if it meets the following
basic requirements.
Definition

It must be used in business or held to produce

income.
It must have a determinable useful life, and the
life must be longer than one year.
It must be something that wears out, decays,
gets used up, becomes obsolete, or loses value
from natural causes.
It is not inventory, stock in trade, or investment
property.
Types of Depreciation

Physical Depreciation caused by the following:

Deterioration due to the effects on the materials

composing the property
Wear and tear due to abrasion, friction between
moving parts of equipment, impact vibration, or
fatigue of materials of the property.
Types of Depreciation

Functional Depreciation which is due to a decrease in the

demand for the function of the equipment for which it was
designed.

Inadequacy of the equipment

Obsolescence caused by the invention of more efficient
equipment and machines to perform the same task.
Changes in methods of production
Changes in style and designs of the goods produced
Transfer of population due to various causes.
Types of Depreciation

Changes in the price levels of similar property. If

price levels rise during the life of a property,
even if the original investment has been
recovered through proper depreciation
procedures, the recovered capital will be
insufficient to provide an identical replacement.
Determination of Depreciation
Cost

Straight-Line Formula
Sinking Fund Formula
Matheson Formula
Sum of the Years Digits Method (SYD)
Straight Line Formula

It is simple and is more widely used than any

other method.
It gives a uniform annual charge.
It does not need annuity tables nor computing
machines for using it.
 Straight Line Formula

In this method the loss of values is considered to be directly proportional to

the age of the property. No interest is assumed to be paid on the amounts set
aside in the depreciation fund.
We shall adopt the following symbols:
n = useful life of the property in years
m= age of the property at any time less than or equal to n (m < or = n)
d = annual cost of depreciation
Dm= accrued or total depreciation up to m years
Co = original or first cost of the property
Cm = book value of the property at the end of m years
Cn = book value at the end of life, n years,
(salvage or scrap value, as the case may be)
 Straight Line Formula

Then,

Straight Line Method

A new electric saw for cutting small pieces of lumber in a

furniture manufacturing plant has a cost basis of $4,000
and a 10-year depreciation life. The estimated SV of the
saw is zero at the end of 10 years. Determine the annual
depreciation amounts and the book value of the saw at the
end of each year.
Straight Line Method

Solution:
The depreciation amount, cumulative depreciation, and
book value for each year are obtained by applying the
equations.

D5 = ($4,000 0)/10 = $400

D5* = [5($4,000 0)]/10 = $2,000
BV5 = $4,000 - [5($4,000 0)]/10 = $2,000
Straight Line Method

EOY, K Dk BV k
0 - 4,000
1 400 3,600
2 400 3,200
3 400 2,800
4 400 2,400
5 400 2,000
6 400 1,600
7 400 1,200
8 400 800
9 400 400
10 400 0
Matheson Formula

This method assumes that the annual cost of depreciation is a

fixed percentage of the book value at the beginning of the
year. In addition to the previous symbols for SL formula, let

K =ratio of the depreciation in any one year to the book value

at the beginning of that year. This is constant throughout the
life of a property.
R (0<= R<=1)
Matheson Formula

dm = kCm-1
Cm = Co (1 k)m
Cn = Co(1 k)n
Matheson Formula

Rework the problem with R or K = 2/N (200% DB Method).

A new electric saw for cutting small pieces of lumber in a furniture

manufacturing plant has a cost basis of $4,000 and a 10-year
depreciation life. The estimated SV of the saw is zero at the end of 10
years. Determine the annual depreciation amounts and the book value
of the saw at the end of each year.
Matheson Formula

Solution:

R = 2/10 = 0.2
D6 = 4,000 (1- 0.2)^5 (0.2) = $262.14
D6* = 4,000 [1 (1- 0.2)^6] = $2,951.42
BV6 = 4,000 (1 0.2)^6 = $1,048.58
Matheson Formula

EOY Dk BVk
0 - 4,000.00
1 800.00 3,200.00
2 640.00 2,560.00
3 512.00 2,048.00
4 409.60 1,638.40
5 327.68 1,310.72
6 262.14 1,048.58
7 209.72 838.86
8 167.77 671.09
9 134.22 536.87
10 107.37 429.50
The Sum of the Years-Digits (SYD)
Method

It provides very rapid depreciation during the

early years of life of the property, and therefore
enables faster recovery of the capital.
It is easier to use than the Matheson Formula
Properties can be depreciated to zero value.
The basic assumption for the method is that the
value of the property decreases at a decreasing
rate.
The Sum of the Years-Digits (SYD)
Method

The
steps are:
Determine the sum of the years of the life of the
property. If n is the life of the property in years,
and noting that the digits 1,2,3, (n-1) n form
an arithmetic progression, then:
 The Sum of the Years-Digits (SYD)
Method
Determine the loss in value due to depreciation, Co- Cn.
The respective annual depreciation charges are:

For first year, (Co- Cn) * [n/Summation of Years]

For the second year, (Co- Cn) * [(n-1)/Summation of Years]
For the nth year, (Co- Cn) * [ 1/Summation of Years]
For any year m, m<=n, the annual depreciation charge is

Dm = (Co Cn)[2(n-m+1)/n(n+1)]
Note that the annual depreciation charge gradually decreases as the
property gets older. The depreciation for the first year is n times the
The Sum of the Years-Digits (SYD)
Method

Example:
A contractor imported a bulldozer for his job, paying
P250,000 to the manufacturer. Freight and insurance
charges amounted to P18,000; customs, brokers fees and
arrastre services, P8,500; taxes, permits, and other
expenses, P25,000. If the contractor estimates the life of
the bulldozer to be 10 years with a salvage value of
P20,000, determine the formula using the SYD method.
The Sum of the Years-Digits (SYD)
Method

Solution:
E of Years: 1+2+3 10 = (10/2)(1+10) = 55
Co Cn = 281,500
D6 = [(10+9+8+7+6+5)/55]*(281,500) = 230,318.18
C6 = Co D6 = 301,500 230,318.18 = P71,181.82
Sinking Fund Formula

In this method it is assumed that a sinking fund is

established in which funds will accumulate for
replacement purposes and will bear interest. The total
depreciation which has occurred up to any given time is
assumed to equal the amount in the sinking fund at that
time.
Using the same symbols as those for the straight line
formula, the formulas for this method are:
d = (Co Cn) [1/(F/A, i%, n)]
dm = (Co Cn) [(F/A, i%, m)/(F/A, i%, n)]
Cm = Co - dm
Depreciation Problem

A civil engineer bought a gantry crane for erecting tall buildings.

It was invoiced from Japan CIF (cost, insurance, freight) Manila at
250,000. Brokerage, bank arrastre fees, customs duties, permits,
etc. total 120,000. At the end of 10 years, he expects to sell it for
P50,000. Prepare a depreciation schedule for each of the
following methods: (a) straight-line, (b) sinking formula at 12%,
(c) Matheson, and (d) SYD Method
Depreciation Problem

Solution:
Co = 250,000 + 120,000 = 370,000
Cn = 50,000
n = 10
Depreciation Problem: Straight Line

d = (Co Cn)/n = 320,000/10 = 32,000

Year BV at BOY Depreciation BV at EOY

1 370,000 32,000 338,000
2 338,000 32,000 306,000
3 306,000 32,000 274,000
4 274,000 32,000 242,000
5 242,000 32,000 210,000
6 210,000 32,000 178,000
7 178,000 32,000 146,000
8 146,000 32,000 114,000
9 114,000 32,000 82,000
10 82,000 32,000 50,000
Depreciation Problem: Sinking Fund

d = (Co Cn)(A/F, 12%, 10) = 320,000 (0.05698416) = 18,234.93

Dm = d(F/A, 12%, m) = 18,234.93 [(1.12)^m -1/0.12]

D1 = 18,234.93 (1) 18,234.93

D2 = 18,234.93 (2.12) 38,658.06
D3 = 18,234.93 (3.37) 61,531.96
D4 = 18,234.93 (4.77) 87,150.72
D5 = 18,234.93 (6.35) 115,843.74
D6 = 18,234.93 (8.11) 147,979.92
D7 = 18,234.93 (10.08) 183,972.45
D8 = 18,234.93 (12.29) 224,282.07
D9 = 18,234.93 (14.77) 269,433.10
D10 = 18,234.93 (17.54) 320,000.00
Depreciation Problem: Sinking Fund

Depreciation Schedule for Sinking Fund Formula (i=12%)

Year BV at BOY Accrued BV at EOY
m Co Depreciation (Co-Dm)
(Dm)
1 370,000 18,234.93 351,765.07
2 370,000 38,658.06 331,341.94
3 370,000 61,531.96 308,468.04
4 370,000 87,150.72 282,849.28
5 370,000 115,843.74 254,156.26
6 370,000 147,979.92 222,020.08
7 370,000 183,972.45 186,027.55
8 370,000 224,282.07 145,715.93
9 370,000 269,433.10 100,566.90
10 370,000 320,000.00 50,000
Depreciation Problem: Matheson

Co = 370,000; Cn = 50,000; n=10

Depreciation Problem: Matheson

Depreciation Table for Matheson Formula

Year BV at BOY Depreciation BV at EOY
m Cm during year (Cm-kCm)
(kCm)
1 370,000.00 67,114.45 302.885.55
2 302,885.55 54,940.53 247.945.02
3 247,945.02 44,974.85 202,970.17
4 202,970.17 36,816.84 166,153.33
5 166,153.33 30,138.62 136,014.71
6 136,014.71 24,671.76 111,342.95
7 111,342.95 20,196.54 91,146.41
8 91,146.41 16,533.08 74,613.33
9 74,613.33 13,534.14 61,079.19
10 61,079.19 11,079.18 50,000
Depreciation Problem: SYD

Summation of Years: 1+2+3 .. +10 = 55

Co Cn = 320,000
Depreciation Problem: SYD

Depreciation Table for SYD Method

Year BV at BOY Factor Depreciation BV at EOY
during year
[Factor*(Co-Cn)]

1 370,000.00 10/55 58,181.82 311,818.18

2 311,818.18 9/55 52,363.64 259,454.54
3 259,454.54 8/55 46,545.45 212,909.09
4 212,909.09 7/55 40,727.27 172,181.82
5 172,181.82 6/55 34,909.09 137,272.73
6 137,272.73 5/55 29,090.91 108,181.82
7 108,181.82 4/55 23,272.73 84,909.09
8 84,909.09 3/55 17,454.55 67,454.54
9 67,454.54 2/55 11,636.36 55,818.18
10 55,818.18 1/55 5,818.18 50,000
Exercise:

A contractor imported a bulldozer for his job,

paying P250,000 to the manufacturer. Freight and
insurance charges amounted to P18,000; customs,
brokers fees and arrastre services, P8,500; taxes,
permits, and other expenses, P25,000. If the
contractor estimates the life of the bulldozer to be
10 years with a salvage value of P20,000, determine
the formula using Straight-Line, Sinking Fund at 8%,
Matheson Formula and SYD method. Create a
depreciation table.