CHAPTER VII

DEPRECIATION AND DEPLETION

DEPRECIATION
Depreciation is defined as the decrease in the value of a property, such as
machinery, equipment, building or other structure, due to the passage of time.
Excluded from this definition are properties whose values increase with time,
such as antiques, paintings of the masters. Rare
stamps, rare coins, and in most cases, lands.
Depreciation must always be included in the cost of production of any product or
the rendering of any service where equipment is used for the following reasons:
(1) To provide for the replacement of the equipment either at the end of its physical or
economic life or at the time when its operation no longer results in a satisfactory
profit.
(2) To provide for the maintenance of capital to replace the decrease in the value of
equipment caused by physical or functional causes.

TYPES OF DEPRECIATION
Decreases in the value of property with the passage of time are due mainly to the
following:
(1) Physical depreciation caused by the following:
(a) Deterioration due to the effects of various chemical and mechanical factors on
the materials composes the property.
(b) Wear and tear due to abrasion, friction between moving parts
of equipment, impact, vibration, or fatigue of the materials in the property. It is
determined by use rather than by age. Sudden physical damage to a property
due to accidents and disasters, such as fire, flood, earthquake, tidal waves
and other unforeseen acts of nature are excluded from the determination of
decrease in value.
(2) Functional depreciation which is due to a decrease in the demand for the function
of the equipment for which it was designed. Such depreciation is caused by the
following:
(a) Inadequacy of the equipment.
(b) Obsolescence caused by the invention of more efficient equipment and
machines to perform the same task.
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 (c) Changes in methods of production.
(d) Changes in styles and designs of the goods produced on the equipment.
(e) Transfer of population due to various causes.
(3) Changes in the price levels of similar property. If price levels rise during the life of
a property, even if the original investment has been recovered capital will be
insufficient to provide an identical replacement. Thus, it is the capital that has
depreciated, and not the property.
DEPRECIATION COST
The depreciation cost depends upon the physical or economic life of the
equipment and its first cost.
The physical life of equipment is the length of time during
which it will operate at a satisfactory profit.
The life of any property is usually difficult to determine accurately. In many cases,
the determination of life is dependent to a great extent upon the experience of the
men managing the enterprise in the use of similar equipment. The first cost of any
property
includes the original purchase prices, freight and transportation
charges to the site, installation expenses needed to put the equipment into operation.
The amount to be recovered, equal to the depreciation cost, is the difference
between the first cost and the salvage or scrap value of the equipment.
Salvage value, sometimes called second-hand value, is defined to be the
amount for which the equipment or machine can be sold as second hand. It implies
that the machine can still perform its function.
Scrap or junk value is the amount the equipment can be sold for, when
disposed off as junk. This implies that the equipment cannot be used anymore for the
function for which it was designed.
DETERMINATION OF DEPRECIATION COST
The methods often used to determine annual depreciation cost are the following:
(1) Straight-Line Formula
(2) Sinking Fund Formula
(3) Matheson Formula. This is also known by other names like: Constant
Percentage Method, Fixed Percentage Method,
Declining Balance Method, or Diminishing Balance Method
(4) Sum of the Years-Digits Method (SYD Method)
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 (5) Service-Output or Production-Units Method
Other Methods formulated in recent years are:
(6) Straight-Line Plus Average Interest Formula
(7) Double-Rate Declining-Balance Method
(8) Operating Day Method
(9) Retirement Method
(10) Annual Inventory Method
THE STRAIGHT-LINE FORMULA
In this method the loss in value is considered to be directly proportional to the age
of the property. No interest is assumed to be paid on the amounts set aside in the
depreciation fund.
We shall adopt the following symbols:
L = useful life of the property in years
d = annual cost of depreciation
Dn = accrued or total depreciation after n years
Co = original or first cost of the property
Cn = book value of the property after n years
CL = Salvage value
Then d = Co – CL
L
Dn = nd = (Co – CL) n/L
Cn = Co – Dn
THE SINKING FUND FORMULA
In this method it is assumed that a sinking fund is established in which funds will
accumulate for replacement purposes and will bear interest. The total depreciation,
which has occurred up to any given
time, is assumed to equal the amount in the sinking fund at that time.
Using the same symbols as those for the straight-line formula, the formulas for
this method are:
(Co – CL) i
d = ------------------------
( 1+i)L – 1

Dn = (Co – CL) (1+i)n -1

( 1+i)L -1
Cn = Co – Dn
3
Declining Balance Method
Sometimes called Matheson Formula, is assumed that the annual cost of
depreciation is a fixed percentage of the salvage value at the beginning of the year.
The ratio of the depreciation in any year to the book value at the beginning of that
year is constant throughout the life of the property and is designated by k, the rate of
depreciation.
dn = Co ( 1-k ) n-1 k
Cn = Co ( 1- k ) n
Cl = Co ( 1-K ) L
n L
k=1- Cn/Co = 1- CL/Co

Example:
A certain type of machine loses 10% of its value each year. The machine costs
P2,000 originally. Make out a schedule showing the yearly depreciation , the total
depreciation and the book value at end of each year for 5 years.

Solution:
Year Book value at the Depreciation Total Book Value at
beginning of the during the year Depreciation at the end of year
period 10% the end of the
year
1 P2,000.00 200.00 200.00 1800.00
2 1800.00 180.00 380.00 1620.00
3 1620.00 162.00 542.00 1458.00
4 1458.00 145.80 687.80 1312.20
5 1312.20 131.22 819.12 1180.98

Double Declining Balance

This method is very similar to declining balance except that the rate of
depreciation k is replaced by 2/L
dn = CO ( 1-2/L ) n-1 2/L
Cn = CO ( 1-2/L)n
CL = CO ( 1-2/L )L
Example:
Determine the rate of depreciation, the total depreciation up to the end of the
8th year and the book value at the end of 8 years for an asset that costs P15,000 new
and has an estimated scrap value of P2,000 at the end of 10 years by: a) declining
balance method and
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 b) the double declining balance method.
Solution:
CO = P15,000 CL = P2,000 L = 10 n= 8
a) for the declining balance method
L 10
k = 1- CL/CO =1 – P2,000/P15,000
= 0.1825 or 18.25%
b) Double declining balance
Rate of depreciation = 2/L = 2/20 = 0. 20 or 20%
C8 = CO ( 1-2/L ) 8 = P15,000 ( 1 – 2/10 ) 8 = P2,517
Sum- of – the- Years’ Digits method ( SYD )
Let dn = depreciation charge during the nth year
dn = ( depreciation factor ) (total depreciation)
reverse digit
dn = (CO - CL )
sum of digits
Example:

\For a property whose life is 5 years

year Year in Depreciation Depreciation during the

reverse order factor year
1 5 5/15 (5/15)(CO –CL)

2 4 4/15 (4/15)(CO –CL)

3 3 3/15 (3/15)(CO –CL)

4 2 2/15 (2/15)(CO –CL)

5 1 1/15 (1/15)(CO –CL)

The Service – Output Method

Let T = total units up to the end of life
Q = total number of units of output during the nth year
Depreciation per unit output = CO – CL/ T
d n = ( C O - C L / T ) / ( Q n)
GROUP AND COMPOSITE METHODS OF DEPRECIATION
The methods explained in previous topics are called unit or item depreciation
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because they consider the write-off on only one asset at a time. However, in large
companies, assets are usually grouped into classes and the depreciation charge is
computed for the entire class, not for each individual asset. An advantage in grouping
assets together and depreciating them as a unit is that no capital gain or loss is
computed at the time a single asset is retired. The cost of a single asset is removed
from the group account and the gain or loss is determined only at the time when the
last asset is retired.
The group depreciation method consists of the computation of a single annual
depreciation charge for a group of similar assets using their average life. When an
asset in the group is retired, the method requires the calculation of a new value of the
depreciation charge for the remaining assets. Any of the previous methods for
computing the depreciation charge can be used.
The appropriate group depreciation rate is determined by the equation:
1
Group depreciation rate =
Estimated average life of group and is applied to the total
first cost of the assets.
If the class consists of dissimilar assets, the depreciation computed is termed
composite depreciation. For this method, annual
depreciation is computed for each asset on a straight-line basis, and the total annual
depreciation for the group is related to the total first cost to give the depreciation rate.
The formulas for this method are:

Composite depreciation rate = Total annual depreciation

Total first cost
Composite life = Total depreciable value
Total annual depreciation
DEPLETION
Certain natural resources such as mines, quarries, oil and gas wells, and
timberlands are called ‘wasting’ or ‘depleting’ assets due to the gradual extraction of
the contents of such properties. To provide for the recovery of capital invested in
such assets, a depletion fund is provided. The annual charge set aside in the fund is
called depletion cost rather than depreciation cost.
It is usual practice to return annually a part of the investment of each investor
instead of accumulating a depletion fund. The yearly amount paid to an investor
consists of two parts: part of the capital invested and the dividends or profit of the
6
investor.
The theoretical depletion charge for a year is usually determined by two methods:
(1) The Unit or Factor Method. The depletion charge depends upon the initial cost
of the property and number of units in the property.
The depletion cost during any year is calculated from the following formula.
Depletion cost during any year
= Initial cost of property Units sold during year
Total units in property

This depletion cost, of course, varies each year depending upon the production
during the year.
(2) The Percentage or Depletion Allowance Method. This allows a fixed
percentage of the gross income received during a year to be the depletion charge.
Consequently, the total depletion charges may exceed the initial cost of the
property. However, it is required that for any year the depletion charge should not
exceed 50% of the net taxable income for that year obtained by deducting all
expenses excluding depletion from the gross income. Some of the fixed
percentages allowed for certain natural resources are:

Exercises:
1. The cost of equipment is P500,000 and the cost of installation is P30,000. If
the salvage value is 10% of the cost of equipment at the end of 5 years,
determine the book value at the end of the fourth year. Use straight line
method.
( P146,000)
2. An asset is purchased for 500,000.The salvage value in 25 years is P100,000.
What are the depreciations in the first three years using straight line method?
(P48,000 )
3. An engineering firm purchased 12 years ago a heavy planner for P50,000. As
the life of the planner was 20 years, a straight line depreciation reserve has
been provided on that basis. Now the firm wishes to replace the old planner
possessing several advantages. It can sell the old planner for P10,000. The
new machine will cost P70,000. How much new capital will be required to
make the purchase? 9 P30,000 )
4. An engineer bought an equipment for P500,000. He spent an additional
amount of P30,000 for installation and other expenses. The salvage value is
10% of the
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5. first cost. If the book value at the end of 5 years will be P291,500 using straight
line method of depreciation, compute the useful life of the equipment in years.
( 10 years )
6. An equipment which cost P200,000 has a useful life of 8 years with a salvage
value of P25,000 at the end of its useful life. If the depreciation at the first year
is P21,875, what method is used in the calculation of depreciation ? ( straight
line method)
7. An equipment costs P10,000 with a salvage value of P500 at the end of 10
years. Calculate the annual depreciation by sinking fund method of 40%
interest. P13,608 )
8. A broadcasting corporation purchased equipment for P53,000 and paid P1,500
for freight and delivery charges to the job site. The equipment has a normal life
of 10 years with a trade in value of P5,000 against the purchase of a new
equipment at the end of the life. Determine the annual depreciation cost by
sinking fund method. ( P3,755.46 )
9. An asset is purchased for P20,000. Its estimated life is 10 years after which it
will be sold for P12,000. Find the depreciation for the first year using the sum
of the years digit method.
10. A telephone company purchased a microwave radio equipment for P6M.
Freight and installment charges amounted to 3% of the purchased price. If the
equipment shall be depreciated over a period of 8 years with a salvage value
of 5% , determine the depreciation charge during the 5 th year using the sum of
the years digit method. ( P652,333.33 )
11. A machine costing P45,000 is estimated to have a salvage value of P4,350
when retired at the end of 6 years. Depreciation cost is computed using a
constant percentage of the declining book value. What is the annual rate of
depreciation in % ? ( 32.25% )
12. A radio service panel truck initially cost P56,000. Its resale value at the end of
the 5th year of useful life is estimated at P15,000. By means of the declining
balance method, determine the depreciation charge for the 2 nd year.
( P9,977.86 )
 13. A certain office equipment has a first cost of P20,000 and a salvage value of
P1,000 at the end of 10 years. Determine its book value at the end of 6 years
using declining balance method. ( P3,311 )
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Chapter VIII . PRESENT ECONOMY STUDIES
A. Selections
There are many cases in engineering economy studies where interest is not a
factor. Those studies are called present economy problems. Present economy
studies usually involve selection between alternative designs, materials or methods.
Selection of materials
In manufacturing a product it usually happens that two or more materials are
available and such materials will be equally satisfactory. The problem therefore
reduces to which among the materials will result in the most economical product and
at the same time give the best results.
Example:
An electrical contractor has a job which should be completed in 100 days. At
present, he has 80 men on the job and it is estimated that they will finish the work in
130 days. If out of the 80 men, 50 are paid P190 a day 25 at P220 a day and 5 at 300
a day and if for each day beyond the original 100, the contractor has to pay P2,000
liquidated damages.
a. How many more men should the contractor add so he can complete the work
on time?
b. If the additional men of 5 are paid P220 a day and the rest at P190 a day,
would the contractor save money by employing more men and not paying the
fine?
Solution:
a. Let X = number of men to be added to complete the job on time
Equating man-days we have
( x + 80 )( 100 ) = ( 80 ) ( 130 )
X = 24 men
b. 80 men on the job
Wages: ( 50 ) ( P 190 ) ( 130 ) = P 1, 235, 000
( 25) ( 220 ) ( 130 ) = 715, 000
( 5 ) ( 300 ) ( 130 ) = 195, 000
Damages: ( 2000 ) ( 30 ) = 60,000
 _______________
Total expenses P 2, 205 , 000
104 men on the job :
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Wages: ( 50 + 19 ) ( P 190 ) ( 100 ) = P 1, 311, 000
( 25+ 5 ) ( 220 ) ( 100 ) = 660, 000
( 5 ) ( 300 ) ( 100 ) = 150, 000
_______________
Total expenses P 2, 121, 000
Saving by employing more men = P 2, 205 , 000 – P 2121, 000
= P 84, 000
B. Methods for making economy studies
Basic methods or patterns for making economy studies:
1. The Rate of return ( ROR ) method
Rate of return is a measure of the effectiveness of an investment of capital.
It is a financial efficiency. When this method is used, it is necessary to
decide whether the computed rate of return is sufficient to justify the
investment. The advantage of this method is that it is easily understood by
management and investors. The application of the rate of return method is
controlled by the following conditions. A single investment of capital at the
beginning of the first year of the project life and identical revenue and cost
data for each year. The capital invested is the total amount of capital
investment required to finance the project, whether equity or borrowed.
The rate of return on the capital invested is given by the formula:
net annual profit
Rate of return =
additional investment

2. The annual Worth ( AW ) Method

In this method, interest on the original investment is included as a cost. If
the excess of annual cash inflows over annual cash outflows is not less
than zero the proposed investment is justified – is valid. This method is
covered by the same limitations as the rate of return pattern a single initial
investment of capital and uniform revenue and cost throughout the life of
the investment.
3. The Present Worth ( PW ) Method
 This pattern for economy studies is based on the concept of present worth.
If the present worth of the net cash flows is equal to, or greater than zero,
the project is justified economically. The present worth method is flexible
and can be used for any type of economy study. It is used extensively in
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making economy studies in the public works field, where long-lived
structures are involved.
4. The Future Worth ( FW ) Method
The future worth method for economy studies is exactly comparable to the
present worth method except that all cash inflows and outflows are
compounded forward a reference point in time called the future. If the
future worth of the net cash flows is equal to, or greater than zero, the
project is justified economically.
5. The Payback ( Payout ) Period Method
The payback period is commonly defined as the length of time required to
recover the first cost of an investment from the net cash flow produced by
that investment for an interest rate of zero.
investment−salvage value
Payout period ( years ) =
net annualcas h flow
Example: An investment of P 200,000 can be made in a project that will
produce a uniform annual revenue of
P180,000 for 5 years and have a salvage value of 10% of the investment.
Out – of – pocket costs for operation and maintenance will be P80,000 per
year. Taxes and insurance will be 4% of the first cost per year. The
company expects capital to earn not less than 25% before income taxes. Is
this a desirable investment? What is the payback period of the investment?
Solution:
By the rate of return
Annual Revenue -------------------------180,000
200,000−20,000
Depreciation =
SCAF −i−n

180000
= = 21,932
8.2070
Operation and maintenance = 80,000
Taxes and insurance = 8,000
 Total annual cost = 109932
Net annual profit = 70068

11
70068
Rate of return =
200,000
X 100 = 35%
Since the rate of return is more than 25% the investment is justified.
By the annual worth method
Annual revenue P180,000
Annual costs

200,000−20,000
Depreciation =
SCAF −i−n

180000
= = 21,932
8.2070
Operation and maintenance = 80,000
Taxes and insurance = 8,000
Interest on capital (200,000X 25% ) = 50,000

Total annual cost = 159932 Net annual profit =

20068
The investment is justified

By the present worth method

P20,000

P180,000 P180,000 P180,000 P180,000 P180,000

0 1 2 3 4 5
Cash Flow Diagram of Cash Inflows
PW of cash inflows = 180,000 ( P/A, 25%, 5) + P20,000 ( P/F, 25%,5)
= 180,000 ( 2.693 ) + 20,000 ( 0.3277 )
 = 484074 + 6554 = 490,628

12

0 1 2 3 4 5

88,000 88,000 88,000 88,000 80,000

200,000
Cash flow diagram of cash outflows
PW of cash outflows = P200, 000 + 88,000 ( P/A, 25%, 5 )
= 436,658.4
Since the PW of the net cash flows is more than zero (P 53,969 ) the
investment is justified.

By the future worth method

FW of cash inflows = P 200,000 + P180,000( F/A, 25%, 5 )
= P 1497260
FW of cashoutflows =P88,000 (F/A,25%,5) + P200,000( F/P, 25%, 5 )
= P 1,332,576

Since the FW of the net cash flows is more than zero the investment is justified.

By the payback period

Total annual cost = 88,000
Net annual cash flows = 180,000 – 88,000 = 92,000

investment−salvage value
Payback period =
net annualcas h flows

20 0,000−20000
Payback period =
92,000

= 1.9565 years

C. Comparing Alternatives
 Most engineering and business projects can be accomplished by more than
one method or alternative. The alternative that requires the minimum
investment of capital and will produce satisfactory functional result will always
be used unless there are definite reasons why an alternative requiring a larger
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investment should be adopted.
Methods or patterns in Comparing Alternatives
There are several methods for comparing alternatives but only six patterns will be
discussed.
a. The rate of return on additional investment

net annual profit

Rate of return =
additional investment

If the rate of return on additional investment is satisfactory, then, the alternative

requiring a bigger investment is more economical and should be chosen.
b. The annual cost ( AC ) method
To apply this method, the annual cost of the alternatives including interest on
investment is determined. The alternative with the least annual cost is chosen. This
pattern, like the rate of return on additional investment pattern, applies only to
alternatives which has a uniform cost data for each year and a single investment of
capital at the beginning of the first year of the project life.
c. The equivalent uniform annual cost ( EUAC ) method
In this method, all cash flows ( irregular or uniform ) must be converted to an
equivalent uniform annual cost, that is, a year-end amount which is the same
each year. The alternative with the least equivalent uniform annual cost is
preferred. When the EUAC method is used, the equivalent uniform annual cost
of the alternatives must be calculated for one life cycle only. This method is
flexible and can be used for any type of alternatives selection problems. The
method is a modification of the annual cost pattern.
d. The present worth cost (PWC ) method
In comparing alternatives by this method, determine the present worth of the
net cash outflows for each alternative for the same period of time. The
alternative with the least present worth of cost selected.
 e. The capitalized cost method is a variation of the present worth cost pattern.
This method is used for alternatives having long lives. To use this method,
determine the capitalized cost of all
f. the alternatives and choose that one with the least capitalized cost.
g. Payback ( Payout ) period method
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To use this method, the payback period of each alternative is computed. The
alternative with the shortest payback period is adopted. This method is seldom
used.
Example: . An industrial firm received an offer for the supply of two electric motors,
which are being considered to power an industrial hoist. Each motor is capable of
providing 100hp. Other pertinent data for each motor are as follows:

Motor A Motor B
Investment ------------ P25,000 P32,000
Efficiency ------------- 84% 88%
Maintenance/year --- P400 P600
Life, years 10 10
Money is worth 20%. If the expected users of the hoist is 700 hrs. annually and
power cost P3.50 per kW-hr, which motor should be recommended?

By AWCM = Depreciation + AAE + IOI

For Motor A
(Co-Cl )i ( 25,000 –0)(0.20)
Dep = --------------- = --------------------------
(1+i)L –1 (1.20)10 –1
= P963.4
100
Power cost = 3.50 (0.746)(700hrs/yr) = P217583.33
0.84
Maintenance =P400

AAE = 217583.33 +400 = 217983.33

96
IOI = 25,000(0.20) =P 5,000
AWCMA = P963.4 + 217983.33 + 5000 = P223,946.73
Motor B
(Co-Cl )i ( 32,000 –0)(0.20)
Dep = --------------- = --------------------------
(1+i)L –1 (1.20)10 –1
= P1,233.74

100
Power cost =3.50 ( 0.746)(700hrs/yr) = P207,693.18
0.88
 Maintenance =P600

AAE = P207,693.18+600 = P208,293.18

IOI = 32,000(0.20) =P 6,400
AWCMB = P1,233.74 + P207,693.18 + P 6,400 =P215,926. 92
Select Motor B

15
Exercises
1. Two different types of hydraulic equipment are being considered for a certain
power plant. Machine A has a first cost of P12,000, and a salvage value of
P1,500, life is 6 years and has an annual maintenance and operating cost of
P900. Machine B has a first cost of P13,600, life of 8 years with no salvage
value. Annual operating cost is P700. Which machine would be used to justify
the purchase of such machine if money is worth 7% and compute the
difference between its equivalent present worth.( P2,641)
2. For its proposed expansion, an ice plant company is selecting from 2 offers of
ice cans. The data on the offers are as follows.
Offer A Offer B
1.8mm thick 1.6 mm thick
Total cost P720,000 P640,000
Annual maintenance 60,000 90,000
Life in years 12 8
For their replacements, the company is putting up a sinking fund to
earn 16% interest compounded annually. If the money to purchase the ice cans is to
be borrowed at 20% annual interest and the tax on the first cost is 2%, which offer will
you recommend to be purchased?
( P241,738.61 ) Offer A
3. Choose from the two machines which is more economical.
Machine A Machine B
First Cost P8,000 P14,000
Salvage Value 0 2,000
Annual Operation 3,000 2,400
Annual Maintenance 1,200 1,000
Taxes and insurance 3% 3%
Life in years 10 15
Money is worth at least 16%.
Answer ( Machine A is more economical )

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