Depreciation
is a part of the cost calculation with the engineering formula.
It considers the loss of value of a working system during its life span.
Imagine you plan
to buy a machine. It is very expensive, so the decision should be made
carefully. If you intend to get a loan from the
bank, you need a plan to pay the money back within a certain time. That means:
Hour by hour you must put aside a certain sum, which you will transfer to your
bank at the end of the month.We call this depreciation.
The lifetime of a
tool or machine is limited. There are several reasons for decay:
• Technical decay (obsolescence) depends
on technical progress: when new and better machines appear, your old machine
may be no longer competitive.
• Technical aging (wear) happens when
parts of the machine become thin, stiff, inflexible, and break, i.e.
• In some situations, we have only limited
use of a machine, afterwards we will not need it
any longer.
• Or the machine suffers from a “fashion
change”, when your technology will become unfashionable, and nobody will be
interested in this technology any longer.
Depreciation is
the response to the progressive loss of value of your machine. During this
time, we must pay back the initial investment.
If we did not
borrow the money from the bank, we have taken it from the “investment pool” of
our company. We have only changed money into a machine with the same value.
When the value of the machine decreases, we must pay back into this pool in
order to stay as “rich” as before.
A third argument
for depreciation deals with taxes:
Since the taxes
are based on the win, we should not forget the hidden costs by the daily
devaluation of our equipment.
How do we
calculate depreciation?
• First, we decide how many years the
machine will be used.
• Then we ask, whether it will be possible
to sell the old machine at the end of the utilization time. But be careful
there! Normally there is some residual value, but we may want to assume that it
is 0 and use it as a silent reserve to compensate the higher price for a new
machine – due to inflation and technical development.
• The annual depreciation now is
calculated as the initial investment minus the assumed residual value divided
by the number of years.
This is called
linear depreciation. In fact, real devaluation is not linear (here implied with
red or green) but in practical term a linear solution is good enough and it is
easier to calculate.
