Depreciation refers to wear and tear on valuable assets and is calculated in a number of different ways. An accurate estimation of depreciation is critical for calculating the true profitability of the firm. The depreciation expense will also impact the firm's tax liability.
Depreciation refers to the loss of asset values as a result of wear and tear. Such value erosion can occur merely due to the passage of time or as a result of active use of an asset. In most instances, both factors contribute to depreciation. A brand new vehicle, for instance, will lose some of its value even if it is not driven at all. Putting miles on the car will, of course, accelerate the rate of depreciation.
Straight Line Method
The most common method for calculating depreciation expense is to assume a linear decline in value over the lifetime of an asset. If a brand new vehicle cost $20,000 to acquire and the firm expects to sell it for $10,000 after five years, the loss of value can be estimated at $2,000 per year. The advantage of this method, also known as "straight line," is the ease of calculation and objectivity. When using the straight line method, it is hard for an accountant to twist the system to achieve the figures he is looking for. The shortcoming of this methodology, however, is that it may not always produce very realistic figures. Most importantly, the asset may not necessarily depreciate by the same amount every year.
Units of Production Method
The units of production method aims to overcome the limitations of the straight line method by linking the actual use of an asset to the estimated loss in value. Assume that a bottling machine cost $120,000 to build and is deemed capable of manufacturing 20 million bottles of soft drink before it will be salvaged for $20,000. The total depreciation is $100,000 over the course of 20 million units. Hence, the machine can be assumed to lose half a cent in value per bottle manufactured. The advantage is a far more accurate estimate of depreciation cost, which will not only provide a far better picture of the true costs but also help assess the true state of each asset owned by the firm.
The major shortcoming of the units of production method is that it is hard to apply to real-life situations. While a bottling machine's useful life may be directly related to the number of bottles manufactured in the factory, a truck will lose value based on the number of years in service, miles driven as well as the type of product carried and the kind of road traveled. Most assets depreciate based on multiple factors, and assigning depreciation based on production levels alone will lead to inaccuracies. Even when an asset depreciates only with use, it is often not easy to estimate how many units can be manufactured with a particular piece of machinery before it will have to be salvaged.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.