TARLAC STATE UNIVERSITY

COLLEGE OF ENGINEERING
DEPARTMENT OF CIVIL ENGINEERING

B313: ENGINEERING ECONOMICS

MODULE 5: METHODS OF DEPRECIATION
Prepared By: Engr. Karl Angelo G. Clarete

5.1 DEFINITIONS OF VALUE the asset's useful life, depreciation helps in

Value, in a commercial sense, is the present determining the true economic value of an asset and
worth of all future profits that are to be received facilitates better decision-making regarding
through ownership of a particular property. The replacement, repair, or continued use. Different
market value of a property is the amount at which a methods, such as straight-line depreciation, declining
willing buyer will pay to a willing seller for the balance depreciation, and sum-of-the-years-digits
property, where each has equal advantage and is depreciation, are employed to calculate and allocate
under no compulsion to buy or sell. depreciation based on the specific characteristics and
The utility or use value of a property is what the requirements of the asset and the organization's
property is worth to the owner as an operating unit. financial strategy.
Fair value is the value which is usually determined
by a disinterested third party to establish a price that Summarily, here are two key points:
is fair to both seller and buyer.
Book value, sometimes called depreciated book 1. To provide for the recovery of capital which
value, is the worth of a property as shown on the has been invested in physical property.
accounting records of an enterprise. Salvage or resale 2. To enable the cost of depreciation to be
value is the price that can be obtained from the sale charged to the cost of producing products or
of the property after it has been used. Scrap value is services that results from the use of the
the amount of property would sell for if disposed as property.
junk.
5.4 TYPES OF DEPRECIATION
5.2 INTRODUCTION TO DEPRECIATION 1. Normal Depreciation
Depreciation expense is used in accounting to a. Physical
allocate the cost of a tangible asset over its useful life. b. Functional
Depreciation in engineering economy refers to the 2. Depreciation due to changes in price levels
systematic allocation of the cost of a capital asset over 3. Depletion
its useful life. It reflects the decrease in the value of an
Physical depreciation is due to the lessening of
asset over time, considering factors such as wear and
the physical ability of a property to produce results.
tear, obsolescence, and deterioration. Depreciation is
Its common causes are periodic wear and
a fundamental concept in financial accounting and
deterioration. Functional depreciation is due to the
economic analysis, as it allows businesses and
lessening in the demand for function in which the
engineers to distribute the initial cost of an asset
property was designed to render. Its common causes
across the periods in which it contributes to revenue
are inadequacy, changes in trends/styles, population
generation.
centers shift, saturation of markets, or more efficient
5.3 PURPOSE OF DEPRECIATION production of machines.

The primary purpose of recognizing depreciation Depreciation due to changes in price levels is
is to accurately match the cost of using an asset with almost impossible to predict and therefore is not
the revenue it generates. By spreading the cost over considered in economic studies.

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 Depletion refers to the decrease in the value of a 𝒌 — rate of depreciation, maybe interchangeable
property due to the gradual extraction of its contents. with 𝒊 (depending on the method of depreciation)
Depletion is an accounting technique used to allocate
the cost of extracting natural resources such as 5.6 STRAIGHT LINE METHOD
timber, minerals, and oil from the earth. Straight-line depreciation spreads the cost of
an asset evenly over the time it will be used without
Like depreciation and amortization, depletion is due consideration for interest, also known as its
a non-cash expense that lowers the cost value of an "useful life." It requires only three inputs to calculate:
asset incrementally through scheduled charges to asset cost, useful life, and estimated salvage value —
income. meaning, how much the asset is likely to be worth at
the end of its useful life. Another important term to
5.5 METHODS OF DEPRECIATION
understand is "depreciable base," which is the
difference between the asset's cost and its salvage
Depreciation
value. The depreciable base is divided by the number
of years the asset is estimated to be useful, to calculate
Time Independent Time Dependent the annual depreciation expense. In each accounting
period, this depreciation amount is uniformly
Capacity charged, stepping down the asset's book value until
Uniform Non-Uniform
Methods Methods Methods it reaches its salvage value. This method neglects
interest.
Working Hours Straight Line Sum of the Years
Method or Method Digit Method Summarily, this method assumes that the
Machine Hour loss in value is directly proportional to the age of the
Rate Method
Sinking Fund Declining Balance property.
Method Method
Unit Production 𝑭𝑪 − 𝑺𝑽
𝒅=
Method or Double Declining 𝒏
Service Output
Balance Method
Method 𝑫𝒎 = 𝒅(𝒎)

𝑩𝑽𝒎 = 𝑭𝑪 − 𝑫𝒎

We shall use the following symbols for the different

depreciation methods:

𝒏 — useful life of the property in years

𝑭𝑪 — original cost of the property/item

𝑺𝑽 — value at the end of economic life, or scrap

value or salvage value

𝑩𝑽𝒎 — the book value at the end of m years

5.7 SINKING FUND METHOD
𝒅 or 𝒅𝒎 — annual / periodic cost of depreciation / The sinking fund method is a technique for
depreciation charge depreciating an asset while generating enough
money to replace it at the end of its useful life. As
𝑫𝒎 — total depreciation up to age n or m years depreciation charges are incurred to reflect the asset's
falling value, a matching amount of cash is invested.
Note: depreciation is different to total depreciation.
These funds sit in a sinking fund account and
m — any year in consideration within the economic generate interest. This method considers interest.
life n

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 (𝑭𝑪 − 𝑺𝑽)𝒊 The declining balance method, also known as
𝒅=
(𝟏 + 𝒊)𝒏 − 𝟏 the reducing balance method, is ideal for assets that
(𝟏 + 𝒊)𝒎 − 𝟏 quickly lose their values or inevitably become
𝑫𝒎 = 𝒅 obsolete. This is classically true with computer
𝒊
equipment, cell phones, and other high-tech items,
𝑩𝑽𝒎 = 𝑭𝑪 − 𝑫𝒎 which are generally useful earlier on but become less
so as newer models are brought to market. An
accelerated method of depreciation ultimately factors
in the phase-out of these assets.

The declining balance technique represents

the opposite of the straight-line depreciation method,
which is more suitable for assets whose book value
drops at a steady rate throughout their useful lives.

In this method, sometimes also called the

constant percentage method or the Matheson
5.8 SUM OF THE YEARS DIGIT METHOD
Formula, it is assumed that the annual cost of
(SOYD METHOD) depreciation is a fixed percentage of the salvage value
It is also called the sum of the years’ method at the beginning of the year. The ratio of the
which decreases the value of an asset at a rapid rate. depreciation in any year to the book value at the
This allows greater deductions at the beginning of the beginning of that year is constant throughout the life
useful life of the asset and lesser in the subsequent of the property. This method cannot be applied if the
years. It lays importance on the economic usefulness salvage value is zero.
of the asset instead of the time span for which the
𝑺𝑽 = 𝑭𝑪(𝟏 − 𝒌)𝒏 , 𝑘 → 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑
asset is used.
𝒏 Matheson’s Constant (k):
𝑺𝑶𝒀𝑫 = (𝒏 + 𝟏)
𝟐 𝒏 𝑺𝑽
(based on Arithmetic Progression) 𝒌= 𝟏−
𝑭𝑪

(𝒏 − 𝒎 + 𝟏)
𝒅𝒎 = (𝑭𝑪 − 𝑺𝑽) 𝑩𝑽𝒎 = 𝑭𝑪(𝟏 − 𝒌)𝒎
𝑺𝑶𝒀𝑫
From:
𝑫𝒎 = 𝒅 = 𝒅𝟏 + 𝒅𝟐 + ⋯ + 𝒅𝒎 𝑩𝑽𝒎 = 𝑭𝑪 − 𝑫𝒎

𝑫𝒎 = 𝑭𝑪 − 𝑩𝑽𝒎
𝒎(𝟐𝒏 − 𝒎 + 𝟏)
𝑫𝒎 = (𝑭𝑪 − 𝑺𝑽) 𝒅𝒎 = |𝑩𝑽𝒎 − 𝑩𝑽𝒎 𝟏 |
𝟐(𝑺𝑶𝒀𝑫)

𝑩𝑽𝒎 = 𝑭𝑪 − 𝑫𝒎 𝑫𝒎 = 𝒅 = 𝒅𝟏 + 𝒅𝟐 + ⋯ + 𝒅𝒎

5.9 DECLINING BALANCE METHOD 5.10 DOUBLE DECLINING BALANCE

The declining balance method is an METHOD
accelerated depreciation system of recording larger This method is very similar to the declining
depreciation expenses during the earlier years of an balance method except that the rate of depreciation
asset’s useful life and recording smaller depreciation k is replaced by 2/n.
expenses during the asset's later years. .

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 The double declining balance (DDB) 𝒅𝒎 = 𝒅𝑯𝒎
depreciation method is an approach to accounting
that involves depreciating certain assets at twice the 𝑫𝒎 = 𝒅 = 𝒅𝟏 + 𝒅𝟐 + ⋯ + 𝒅𝒎
rate outlined under straight-line depreciation. This 𝑩𝑽𝒎 = (𝑭𝑪 − 𝑺𝑽) − 𝑫𝒎
results in depreciation being the highest in the first
year of ownership and declining over time. where:

Given the nature of the DDB depreciation 𝑯𝒏 — total machine hours during economic life
method, it is best reserved for assets that depreciate 𝑯𝒎 — machine hours consumed at m years
rapidly in the first several years of ownership, such
as cars and heavy equipment. By applying the DDB 5.12 UNIT PRODUCTION METHOD OR
depreciation method, you can depreciate these assets
SERVICE OUTPUT METHOD
faster, capturing tax benefits more quickly and
reducing your tax liability in the first few years after The unit of production method is a method
purchasing them. of calculating the depreciation of the value of an asset
over time. It becomes useful when an asset's value is
𝟐 more closely related to the number of units it
𝒌=
𝒏 produces rather than the number of years it is in use.
This method often results in greater deductions being
𝑩𝑽𝒎 = 𝑭𝑪(𝟏 − 𝒌)𝒎
taken for depreciation in years when the asset is
𝑫𝒎 = 𝑭𝑪 − 𝑩𝑽𝒎 heavily used, which can then offset periods when the
equipment experiences less use.
𝒅𝒎 = |𝑩𝑽𝒎 − 𝑩𝑽𝒎 𝟏 |
This method can be contrasted with time-
𝑫𝒎 = 𝒅 = 𝒅𝟏 + 𝒅𝟐 + ⋯ + 𝒅𝒎
based measures of depreciation such as straight-line
or accelerated methods.
5.11 WORKING HOURS METHOD /
(𝑭𝑪 − 𝑺𝑽)
MACHINE HOUR RATE METHOD 𝒅=
𝑸𝒏
Machine hour rate is useful for calculating
the value of different overheads quickly. Because 𝒅𝒎 = 𝒅𝑸𝒎
depreciation is one of main overhead of the business,
so, we can use machine hour rate method for 𝑫𝒎 = 𝒅 = 𝒅𝟏 + 𝒅𝟐 + ⋯ + 𝒅𝒎
calculating the value of depreciation. 𝑩𝑽𝒎 = (𝑭𝑪 − 𝑺𝑽) − 𝑫𝒎

As per machine hour rate method of where:

depreciation, we calculate the total life of any fixed
𝑸𝒏 — total quantity produced during economic life
asset based on its working hours life. After this, we
divide actual cost of fixed assets with life of fixed 𝑸𝒎 — quantity produced up to m years
assets in hours. After dividing, we will obtain the
depreciation rate per hour. This method will apply 5.13 SAMPLE PROBLEMS
mostly on the machines. So, in following formula, we EXAMPLE #1: A machine is worth ₱1,800,000. It has
have used the word machine instead of fixed asset.
a salvage value of ₱300,000 at the end of 5 years. If
You can also find any other fixed asset's hourly
money is worth 6% annually; determine the total
depreciation rate with following formula by
depreciation at 3rd year and the book value after 3
changing the cost of machine, scrap value and
years? Use Straight Line Method of Depreciation.
estimated life in hours.
Solve in 2 ways
(𝑭𝑪 − 𝑺𝑽) EXAMPLE #2: A machine is worth ₱1,800,000. It has
𝒅=
𝑯𝒏 a salvage value of ₱300,000 at the end of 5 years. If
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money is worth 6% annually; determine the total “Life has two rules:
depreciation at 3rd year and the book value after 3 #1: Never quit
years? Use Sinking Fund Method of Depreciation. #2: Always remember rule #1”
Solve in 2 ways – Unknown
EXAMPLE #3: A machine is worth ₱1,800,000. It has
a salvage value of ₱300,000 at the end of 5 years. If
money is worth 6% annually; determine the total
depreciation at 3rd year and the book value after 3
years? Use Sum of the Years Digit (SOYD) Method
of Depreciation. Solve in 2 ways

EXAMPLE #4: A machine is worth ₱1,800,000. It has

a salvage value of ₱300,000 at the end of 5 years. If
money is worth 6% annually; determine the total
depreciation at 3rd year and the book value after 3
years? Use Declining Balance Method of
Depreciation. Solve in 2 ways

EXAMPLE #5: A machine is worth ₱1,800,000. It has

a salvage value of ₱300,000 at the end of 5 years. If
money is worth 6% annually; determine the total
depreciation at 3rd year and the book value after 3
years? Use Double Declining Balance Method of
Depreciation.

EXAMPLE #6: A television company purchased

machinery for ₱100,000 on July 1, 1979. It is estimated
that it will have a useful life of 10 years, scrap value
of ₱4,000, production of 400,000 units and working
hours of 120,000 hours. It was used for 15,000 hours
in 1979 and 18,000 hours in 1980. The machinery
produces 36,000 units in 1979 and 44,000 units in
1980. Compute the depreciation per hour and the
depreciation in July 1, 1980 using the Working Hours
Method or Machine Hour Rate Method of
Depreciation.

EXAMPLE #7: A television company purchased

machinery for ₱100,000 on July 1, 1979. It is estimated
that it will have a useful life of 10 years, scrap value
of ₱4,000, production of 400,000 units and working
hours of 120,000 hours. It was used for 15,000 hours
in 1979, and 18,000 hours in 1980. The machinery
produces 36,000 units in 1979 and 44,000 units in
1980. Compute the depreciation per unit and the
depreciation in July 1, 1980 using the Unit
Production Method or Service Output Method of
Depreciation.
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