Plant Design and Economics Course
Chapter 3- Depreciation
Dr. Walaa Shehata
Faculty of Petroleum and Mining Engineering
Suez University
CONTENT
1-Depreciation definition
2-Types of Depreciation
3-Methods applied for determining Depreciation
4-Examples
Adel Elfanagily
DEPRECIATION DEFINITION
Physical assets decrease in value with age, this decrease in
value may be due to:
1) Physical deterioration
2) Technological advances
3) Economic changes
4) Any other factors which ultimately will cause retirement of
the property
The reduction in value due to any of these causes is a
measure of the depreciation?
Example: a piece of equipment had been put into use 10 years ago at a
total cost of $31,000. the equipment is now worn out and is worth only
$1000 as scrap material.
The decrease in value during the 10-year period is $30,000
the engineer recognizes that this $30,000 is in reality a cost incurred for
the use of the equipment. this depreciation cost was spread over a period
of 10 years, and sound economic procedure would require part of this
cost to be charged during each of the years
Depreciation :Distributing the original expense for a physical asset over
the period during which the asset is in use.
TYPES OF DEPRECIATION
Physical Depreciation
Measure of the decrease in value due to changes in the physical aspects of
the property such as wear and tear, corrosion, accidents, and deterioration
due to age
Functional Depreciation:
Measure of the decrease in value due to:
(1) Changes in technological advances or developments which make an
existing property obsolete
(2) Change in demand, such as a decrease in the demand for the product
involved because of saturation of the market
(3) Shift of population center
(4) Changes in requirements of public authority
(5) Insufficient capacity for the service required
(6) Termination of the need for the type of service rendered
DEFINITIONS:
Original value (V):
Total cost of the property at the time it is ready for initial use
Ser vice life (useful life ) (n) :
The period during which the a property is used
Scrap or salvage value (V s ) :
The net amount of money obtainable from the sale of used property.
• If a property is capable of further service, its salvage value may be high.
Book Value ( V a )
The difference between the original value of a property, and all the depreciation
charges made to date
From “Depreciation-Guidelines and Rules” issued by the Internal Revenue Service of the U.S. Treasury
Department as Publication No. 456 (7-62) in July, 1962
METHODS APPLIED FOR DETERMINING DEPRECIATION
1- Straight-Line Method
2- Declining-Balance (Fixed Percentage) Method
3- Double declining -balance (200 percent) method
4- Sum-of-the-Years-Digits Method
5- Sinking-Fund Method
STRAIGHT-LINE METHOD
In the straight-line method for determining depreciation, it is assumed that
the value of the property decreases linearly with time. Equal amounts are
charged for depreciation each year throughout the entire service life of the
property. The annual depreciation cost may be expressed in equation
form as follows:
𝑉− 𝑉𝑠
d=
𝑛
The asset value or book value of the equipment at any time during the
service life is:
𝑉𝑎 = 𝑉 − 𝑎𝑑
24000
Va - Asset value, dollars
18000
Where: 𝑉𝑎 = asset or book value, dollars, 12000
a = the number of years in actual use 6000
Book value at a= 5 year 0
0 5 10 15 20
n, service life, years
𝑉5 = 𝑉 − 5𝑑
• Because its simplicity. The straight -line method is widely used for
determining depreciation costs
• Because it is impossible to estimate exact service lives and salvage values
when a property is first in use, it is sometimes desirable to re-estimate
these factors from time to time during the life period of the property.
EXAMPLE 1:
The original value of a piece of equipment is $22,000, completely installed and
ready for use. Its salvage value is estimated to be $2000 at the end of a service
life estimated to be 10 years. Determine the asset (or book) value of the
equipment at the end of 5 years using straight-line method
Solution
Original value V=$22000
(𝑉−𝑉𝑠 ) (22000−2000)
Salvage value Vs = $2000 𝑑= 𝑛
= 10
= $2000
Service life N=10 years
The asset (or book) value of the equipment at the end of 5 years
𝑉5 = V- 5*d = 22000-(5*2000)= $12000
2- Declining-Balance (Fixed Percentage) Method
When the declining-balance method is used, the annual depreciation cost
is a fixed percentage of the property value at the beginning of the particular
year.
The fixed-percentage (or declining-balance) factor remains constant
throughout the entire service life of the property, while the annual cost for
depreciation is different each year.
𝑑1 = 𝑉 ∗ 𝑓 𝑉1 = V- 𝑑1 = V- (V*f) = V(1-f)
𝑑2 = 𝑉1 ∗ 𝑓 𝑉2 = 𝑉1 − 𝑑2 = 𝑉1 − 𝑉1 ∗ 𝑓 = 𝑉1 (1-f) = V(1 − 𝑓)2
𝑑3 = 𝑉2 ∗ 𝑓 𝑉3 = 𝑉2 − 𝑑3 = 𝑉2 - 𝑉2 ∗ 𝑓 = 𝑉2 1 − f = V(1 − 𝑓)3
𝒅𝒂 =V *(𝟏 − 𝒇)𝒂−𝟏 * f 𝑽𝒂 =V *(𝟏 − 𝒇)𝒂
Calculating 𝒇 factor:
At the end of service life years, the scrape value is
𝑽𝒂 =V *(𝟏 − 𝒇)𝒂
𝑽𝒔 =V *(𝟏 − 𝒇)𝒏
𝑽𝒔
= (𝟏 − 𝒇)𝒏
𝑽
𝟏
𝑽𝒔 𝒏
𝒇=𝟏−
𝑽
It should be noted that the value of the asset cannot decrease to zero at
the end of the service life and may possibly be greater than the salvage or
scrap value
3- Double declining -balance method
• Combination between straight line and declining method when the
salvage value is considered to be zero, the fixed-percentage factor is
based on the straight-line rate of depreciation during the first year.
𝟐𝒅 Depreciation by straight line method
𝒇=
𝑽
Book value at a year 𝑽𝒂 =V *(𝟏 − 𝒇)𝒂
Depreciation at a year 𝒅𝒂 =V *(𝟏 − 𝒇)𝒂−𝟏 * f
EXAMPLE 2:
The original value of a piece of equipment is $22,000, completely installed
and ready for use. Its salvage value is estimated to be $2000 at the end of a
service life estimated to be 10 years. Determine the asset (or book) value of
the equipment at the end of 5 years using
a) Straight-line method b) declining balance method c) Double declining
method
Solution
a) From example 1- by straight line method
𝑑 = $2000 𝑉5 = $12000
𝟏 𝟏
𝑽𝒔 𝒏 𝟐𝟎𝟎𝟎 𝟏𝟎
b) Declining balance method 𝒇= 𝟏− =𝟏− = 0.2131
𝑽 𝟐𝟐𝟎𝟎𝟎
𝒂𝒇𝒕𝒆𝒓 𝟓 𝒚𝒆𝒓𝒂𝒔 ∶ 𝑽𝒂 =V *(𝟏 − 𝒇)𝒂 = 𝟐𝟐𝟎𝟎𝟎 ∗ (𝟏 − 𝟎. 𝟐𝟏𝟑𝟏)𝟓= $6650 𝑑5 = $ 1798
𝟐𝒅 𝟐∗𝟐𝟎𝟎𝟎
c) Double-declining method 𝒇= = = 0.1818
𝑽 𝟐𝟐𝟎𝟎𝟎
𝒂𝒇𝒕𝒆𝒓 𝟓 𝒚𝒆𝒓𝒂𝒔 ∶ 𝑽𝒂 =V *(𝟏 − 𝒇)𝒂 = 𝟐𝟐𝟎𝟎𝟎 ∗ (𝟏 − 𝟎. 𝟏𝟖𝟏𝟖)𝟓= $8060 𝑑5 = $ 1792