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

Lecture No. 30Chapter 9

Contemporary Engineering EconomicsCopyright © 2010

Contemporary Engineering Economics, 5th 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


Depreciation Definition: Loss of value for a fixed asset Example: You purchased a vehicle worth $25,000 at the beginning of year 2010.

Changes in Market Value


Depreciatio

n

End of Year

Market

Value

Loss of

Value

0

1

2

3

4

5

$25,00019,00016,00014,00012,00010,000

$6,0003,0002,0002,0002,000

Classification of Types of DepreciationEconomic

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



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.


Depreciable life (how long?)

Salvage value (disposal value)

Cost basis (depreciation basis)

Method of depreciation (how?)


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 BasisWithout Trade-In Allowance With Trade-In Allowance


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.



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


Component of Depreciation Book Depreciation Tax depreciation (MACRS)

Cost basisBased 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


Component of Depreciation

Book Depreciation Tax 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-lineAccelerated 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.


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.


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.

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