Depreciation is one of the more poorly understood, yet commonly encountered terms in managerial accounting. In accounting lingo, depreciation is the systematic allocation of the cost of an asset across its useful life. That’s a mouthful. But breaking down the definition into simpler terms helps explain how its used and why it’s important when conducting Return on Investment Analysis.
Once a year, I pay my car insurance for the full next year. I make one payment, and I’m insured for the entire year. Let’s assume my policy costs $1,000. Therefore, my cost of insurance per day equals $1,000 / 365 days = $2.74 per day. Now it would be horribly inconvenient for me (and horribly unappreciated by my insurance agent) if I wrote a check every day to All-State for $2.74.
So instead, I write one check per year to purchase as an asset which we could call “Pre-Paid Insurance”. On the first day my policy is in effect, my “Pre-Paid Insurance” asset is worth $1,000. But at the start of day 2, I’ve consumed $2.74 of my asset as an expense and my “Pre-Paid Insurance” is now worth $997.26. This process continues every day until I’ve fully expensed my asset and its value goes to zero.
Back to accounting lingo, my “Pre-Paid Insurance” asset has a cost of $1,000, a useful life of 1 year, a residual value of $0, and a daily depreciation expense of $2.74.
The science of accounting leans heavily on an underlying principle called Matching. The Matching principle, which serves as the basis for so called accrual accounting, directs accountants to “match” an expense to the time period in which it was consumed regardless of the period in which it was paid for. Consider my car insurance example. If I were to track all my expenses for a given day, I would naturally include the food and gasoline I purchase. But I would also need to include the cost of my insurance coverage for that day, even though I may have paid for it months earlier. The accounting for large commercial assets like machinery and buildings work in a similar manner.
Let’s consider one of these long-term assets. When your organization purchases a large piece of production equipment, it’s recorded in your company’s books as an asset with a value equal to its purchase price. Often, accountants and engineers collaborate in estimating the useful life, typically 5 to 15 years. And unlike our insurance policy, major investments often have a residual value—the price it could be sold for at the end of its useful life.
Imagine then a scenario where we purchase a piece of equipment for $100,000 with an expected useful life of 10 years and a residual value of $10,000. What is our depreciation expense per year? Using the simplest and most common method of calculating the depreciation expense called Straight Line Depreciation,
Depreciation Expense = (Initial Cost – Residual Value) / Number of Time Periods
($100,000 – $10,000) / 10 years = $9,000 per year
Similarly,
($100,000 – $10,000) / 120 months = $750 per month
Once the formula is laid out, it’s easy to see that depreciation is the expense per accounting period of purchasing the capital equipment.
But why is this necessary … why not just account for the large purchase up front?
First, it’s a requirement of the major accounting systems used throughout the world to follow the matching principle, and as a result, employ the use of depreciation. Second, depreciation is considered a business expense that is deducted from your organization’s revenue when calculating income taxes owed. Without an accurate depreciation calculation, your organization will also miscalculate the taxes it owes. And lastly, it’s necessary to accurately calculate depreciation when estimating the Return on Investment (ROI) for a major project. Like the costs of maintenance, utilities and labor, depreciation is a legitimate cost of running a piece of equipment. By not including it in your ROI analysis, you will artificially inflate your projected returns.
To learn the ROI process for capital equipment purchases, sign up for the online short course titled, “Return on Investment Analysis for Manufacturing”. In it you will learn how to model the investment and payback of your major purchase in the language of executives. If you’re eager to add business finance and financial modeling to your skill set, this is the class for you!
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