Engineering Economics

Module -4
Depreciation and Breakeven Analysis
Depreciation - Causes of depreciation, Basic methods of computing Depreciation charges:
Straight line method of depreciation--numerical exercises. Declining balance method of
depreciation--numerical exercises, Sum of year’s digits method of depreciation-numerical
exercises, Sinking fund method of depreciation -numerical exercises
Breakeven Analysis - Introduction to breakeven analysis, methods for lowering the break-
even point , Break-even chart, Break-even point, margin of safety ,Numerical exercises on
breakeven analysis
Introduction
Any equipment which is purchased today will not work for ever. This may be due to
wear and tear of the equipment or obsolescence of technology. Hence, it is to be replaced at
the proper time for continuance of any business. The replacement of the equipment at the
end of its life involves money. This must be internally generated from the earnings of the
equipment. The recovery of money from the earnings of an equipment for its replacement
purpose is called depreciation fund since we make an assumption that the value of the
equipment decreases with the passage of time. Thus, the word “depreciation” means
decrease in value of any physical asset with the passage of time.

Definition of Depreciation
Depreciation is the decrease in the value of fixed asset due to use/lapse of time.

Reduction in value.

Causes of Depreciation
1. Usage
2. Physical causes
3. Abnormal occurrences
4. Technological development and changes
5. Sudden failure
6. Depletion
Basic methods of Computing Depreciation Charges
Depreciation is a function of time , use , time & use, time & maintenance , time & interest.

1. Straight line method

2. Reducing balance or diminishing balance method
3. Production based methods – per unit , per hour
4. Repair provision method
5. Annuity method
6. Sinking fund method
7. Endowment policy method
8. Re-evaluation method
9. Sum of digits method.

Method 1 : Straight line method or Fixed Instalment

method or Proportional method
In this method of depreciation, a fixed sum is charged as the depreciation amount
throughout the lifetime of an asset such that the accumulated sum at the end of the life of the
asset is exactly equal to the salvage value of the asset. Here, we make an important
assumption that inflation(increase in price/fall in the purchasing value of money) is absent.

Let,

Por I or C = first cost of the asset/equipment,

For S or R = salvage/residual value of the asset(scrap value),

N = life of the asset/machine,

Bt = book value of the asset at the end of the period t,

Dt = depreciation amount for the period t.

The formulae for depreciation and book value are as

follows:
Dt = (P – F)/n or (I-S)/n or (C-R)/n
Bt = Bt–1 – Dt
Bt= P – t × [(P – F)/n] ( for particular value(period) t )
Problems
1. A melting unit for a steel foundry was purchased for Rs. 40,000 . Rs. 10,000 more
were spent in its errection and commissioning. The estimated residual value after 10
yrs was Rs.12,000.
(a) Calculate the annual rate of depreciation.
(b) Calculate the book value of the m/c at the end of each year using the straight
line depreciation and plot the graph of no. of yrs. v/s the depreciation fund.
(c) Calculate the depreciation fund collected at the end of 8th year.

Solution : P=40,000

Money spent on errection and maintenance =10,000

Total cost of capital(P) = 40,000 + 10,000=50,000

S=12,000 N=10 yrs

NOTE: Book value after the estimated life should be equal to the salvage value.

(a) Depreciation / year = (P-S)/n

= (50,000 – 12,000)/12 = 3800
(b) To calculate book value after each year
No. of Cost and Depreciation/yr Book value after
years balance depreciation each
year
1 50,000 3800 46,200
2 46200 3800 42400
3 42400 3800 38600
4 38600 3800 34800
5 34800 3800 31000
6 31000 3800 27200
7 27200 3800 23400
8 23400 3800 19600
9 19600 3800 15800
10 15800 3800 12000
(c) Depreciation fund collected at the end of 8th year
= 3800 * 8 = 30,400
2. An investment of Rs. 5000 in a new equipment is expected to have a salvage value
of Rs.1000 after a 4yrs life.
(a) Find a straight line depreciation expense.
(b) Plot the graph, the depreciation fund v/s the no. of years.

Solution: P=5000 , S=1000 , N=4

Depreciation / year = (P-S)/n = (5000 – 1000)/4 = 1000

 To calculate book value after each year
No. of Cost and Depreciation/yr Book value after
years balance depreciation each
year
1 5,000 1000 4000
2 4000 1000 3000
3 3000 1000 2000
4 2000 1000 1000

3. A company has purchased an equipment whose first cost is Rs. 1,00,000 with
an estimated life of eight years. The estimated salvage value of the equipment at
the end of its lifetime is Rs. 20,000. Determine the depreciation charge and book
value at the end of various years using the straight line method of depreciation.
Solution : P=1,00,000 N=8yrs S=20,000
Depreciation / yr = (P-S) / n = (1,00,000 – 20,000)/ 8 = 10,000

No. of Cost and Depreciation/yr Book value after

years balance depreciation each
year
1 1,00,000 10,000 90,000
2 90000 10000 80000
3 80000 10000 70000
4 70000 10000 60000
5 60000 10000 50000
6 50000 10000 40000
7 40000 10000 30000
8 30000 10000 20000

4. Consider problem 3 and compute the depreciation and the book value for
period 5.
Solution : D5 = (P-F)/n = (100000-20000)/8 = 10,000
Bt= P – t × [(P – F)/n]
=1,00,000 – 5 * [(10,000)]
B5 = 50,000

Advantages

1. Easy to understand and simple to operate

2. Frequently used in practice
3. Uniform annual charge offers better comparative costs
4. This method requires little work for calculating depreciation amounts.
 Disadvantages

1. The fixed assets do not wear out exactly at the same rate during their life.
2. A straight line method in many cases becomes unrealistic.

Method 2 : Reducing Balance Method or Diminishing

Balance Method or Percentage on Book value Method
In this method of depreciation, a constant percentage of the book value of the previous
period of the asset will be charged as the depreciation amount for the current period. This
approach is a more realistic approach, since the depreciation charge decreases with the life
of the asset which matches with the earning potential of the asset.

The book value at the end of the life of the asset may not be exactly equal to the salvage
value of the asset. This is a major limitation of this approach.

𝑅 1/𝑛
Depreciation Percentage ‘P’ = 1 – (𝐶 )
The formulae for depreciation and book value are as follows:
Dt = K × Bt-1

Bt = Bt–1 – Dt

= Bt–1 – K × Bt–1

= (1 – K) × Bt–1

The formulae for depreciation and book value in terms of P are as follows:
Dt = K(1 – K)t–1 × P

Bt = (1 – K)t × P
P = first cost of the asset,
F = salvage value of the asset,
n = life of the asset,
Bt = book value of the asset at the end of the
period t, K = a fixed percentage, and
Dt = depreciation amount at the end of the period t.
While availing income-tax exception for the depreciation amount paid in
each year, the rate K is limited to at the most 2/n. If this rate is used, then the
corresponding approach is called the double declining balance method of
depreciation.

Note: If R is not given or no salvage value, consider it as

1 (not zero).
Problems
1. A machine costs Rs. 10,000 has a scrap value of Rs.400 at the end of 4yrs of its
serviceable life. Using Reducing balance:
(a) Determine the depreciation and book value in each year
(b) Plot the graph, no. of yrs v/s depreciation fund.
(c) What is the amount of depreciation collected at the end of 2 nd year or after
2yrs.

400 1/4
Solution : (a) Percentage depreciation = 1- (10000)

=0.552 or 55.2% of amount/year

No. of Cost of capital Depreciation/yr Book value after

(b) years at beginning of depreciation each
each year year
1 10,000 10000*0.552=5520 4480
2 4480 4480*0.552=2472.96 2007.04
3 2007.04 2007.04*0.552=1107.88 899.153
4 899.153 899.153*0.552=496.332 402.82

(c)Amount of depreciation fund collected at the end of 2nd year = 1st year + 2nd year

=5520 + 2472.96 = 7992.96 Rs.

2. A car was purchased for Rs.32,000 and salvage value was established Rs.8000 after
7yrs. Using the reducing balance method.
(a) Calculate the percentage of depreciation
(b) Calculate the book value and depreciation in each year
(c) Plot a graph, no. of yrs v/s depreciation fund

8000 1/7
Solution : (a) Percentage depreciation = 1- (32000)

= 0.1796 or 17.96% per year

 No. Cost of capital Depreciation/yr Book value
of at beginning after
years of each year depreciation
each year
1 32000 32000*0.1796=5747.2 26252.8
2 26252.8 26252.8 * 0.1796 = 4715.0028 21537.7971
3 21537.7971 21537.7971*0.1796=3838.1883 17669.6087
4 17669.6087 17669.6087*0.179=3173.4617 14496.14697
5 14496.14697 14496.14697*0.179=2603.5079 11892.638
6 11892.638 11892.638*0.179=2135.91796 9756.7200
7 9756.7200 9756.7200*0.179=1752.306 8004.41308

3. Two machines are purchased each for Rs.12,000. The estimated useful life of m/c is
5yrs. The estimated scrap value is Rs.2000. For machine A, the straight line method
and for B the reducing balance method are used to calculate the depreciation every
year. Compare the depreciations charged in each year of both i.e, A and B and plot
the graph, the no. of yrs v/s the depreciation fund for both.
Solution :
Depreciation /year for machine A = (C-R)/n
= (12,000-2000)/5 =2000
2000 1/5
Percentage depreciation for m/c B = 1- (12000)
=0.3011=30.11%

No. of Cost of capital at Depreciation/yr Book value after

years beginning of each year depreciation each
year
m/c A m/c B St.line m/c R.Bal. m/c A m/c B
A m/c B
1 12,000 12000 2000 3613.2 10000 8386.8
2 10000 8386.8 2000 2525.26 8000 5861.53
3 8000 5861.53 2000 1764.90 6000 4096.62
4 6000 4096.62 2000 1233.49 4000 2863.12
5 4000 2863.12 2000 862.08 2000 2001.04

4. A company has purchased an equipment whose first cost is Rs. 1,00,000

with an estimated life of eight years. The estimated salvage value of the
equipment at the end of its lifetime is Rs. 20,000. and demonstrate the
calculations of the declining balance method of depreciation by
assuming 0.2 for K.
Solution : Depreciation percentage(k) = 0.2
 No. of Cost of Depreciation/yr Book value after
years capital at depreciation
beginning of each year
each year
1 1,00,000 1,00000*0.2=20000 80000
2 80000 80000*0.2=16,000 64000
3 64000 64000*0.2=12800 51200
4 51200 51200*0.2=10240 40960
5 40960 40960*0.2=8192 32768
6 32768 32768*0.2=6553.6 26214.4
7 26214.4 26214.4*0.2=5242.88 20971.52
8 20971.52 20971.52*0.2=4194.3 16777.22

5. Consider problem 4 and calculate the depreciation and the book value for
period 5 using the declining balance method of depreciation by assuming
0.2 for K.
Solution : Dt = K(1 – K)t–1 × P

D5 = 0.2 (1-0.2) 4 * 1,00,000 = 8192

Bt = (1 – K)t × P

B5=(1-0.2) 5 * 1,00,000 = 32,768

Advantages
1. Simple to understand and calculate
2. Mathematical relationship can be employed to arrive at the appropriate
percentage
3. This method is more logical as the largest annual amount of depreciation is
charged in the first year where repair and maintenance charges are almost
negligible.

Disadvantages

1. It is not simple to fix percentage P accurately.

2. A standard percentage P for all conditions may produce misleading results.

Method 3 : Sum of Digits Method

In this method of depreciation, it is assumed that the book value of the
asset decreases at a decreasing rate. If the asset has a life of eight years, first the
sum of the years is computed as,

Sum of the years = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8

 = 36 = n(n + 1)/2
If ‘n’ is the estimated life of the m/c the rate is calculated for each
period as a fraction in which the denominator is always the sum of the series
1,2,3,….n and the numerator for the first period is n , for the second period is
n-1 and so on.
The rate of depreciation charge for the first year is assumed as the highest
and then it decreases. The rates of depreciation for the years 1–8, respectively
are as follows: 8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36, and 1/36.
For any year, the depreciation is calculated by multiplying the corresponding
rate of depreciation with (P – F).
Dt = Rate × (P – F)

Bt = Bt–1 – Dt

The formulae for Dt and Bt for a specific year t are as follows:

n−t+ 1
Dt =
n(n + 1)/2 (P – F)

(n − t) (n − t + 1)
B = (P – F) +F
(n + 1)
n
T
Problems
1. The cost of the vehicle is Rs. 19,000 , the scrap value after 5yrs is estimated at
Rs.4000. Using the sum of digits method, calculate the depreciation at the end of
each year. Plot a graph, the no. of yrs v/s the depreciation fund.
Solution: No. of years , n= 1,2,3,4,5
Denominator = 1+2+3+4+5=15
Depreciation for the 1st year = Rate * (P-F)
=5/15 * (19000-4000)
=5000
nd
Depreciation for 2 year = 4/15 * 15000
=4000
rd
Depreciation for 3 year = 3/15 * 15000=3000
Depreciation for 4th year =2/15 * 15000 =2000
Depreciation for 5th year =1/15 * 15000=1000

2. An investment of Rs. 5900 in new equipment is expected to have a salvage value of

Rs.1000 after 4yrs. Using the sum-of-digits method , find out the depreciation for
each year and what is the depreciation amount to be collected after 2yrs.

Solution: No.of years = 1,2,3,4

Denominator = 1+2+3+4=10
(a) Depreciation for 1st year=4/10 * (5900-1000) = 1960

Depreciation for 2nd year=3/10 * 4900=1470

Depreciation for 3rd year=2/10 * 4900 =980

Depreciation for 4th year=1/10 * 4900=490

(b) Depreciation amount after 2 years = 1 st yr + 2nd year = 1960+1470= Rs. 3430

3. A company has purchased an equipment whose first cost is Rs. 1,00,000 with an
estimated life of eight years. The estimated salvage value of the equipment at the
end of its lifetime is Rs. 20,000. Demonstrate the calculations of the sum-of-the-
years-digits method of depreciation.
Solution : P=1,00,000 F=20,000 n=8 yrs
Denominator = n(n+1) / 2 = 8(8+1) / 2 =8 * 9/2 =36
 No. of Cost of Depreciation/yr Book value
years capital at after
beginning depreciation
of each each year
year
1 1,00,000 8/36 * 82222.23
(80,000)=17777.77
2 82,222.22 7/36 * 80,000=15,555.55 66,666.68
3 66,666.68 6/36*80,000=13,333.33 53333.35
4 53333.35 5/36*80,000=11,111.11 42,222.24
5 42,222.24 4/36*80000=8,888.88 33,333.36
6 33,333.36 3/36*80000=6,666.66 26,666.7
7 26,666.7 2/36*80000=4,444.44 22,222.26
8 22,222.26 1/36*80000=2,222.22 20,000.04
4. Consider above problem 3 and find the depreciation and book value for the 5th year
using sum-of-years-digits method of depreciation.

Method 4 : Sinking Fund Factor

This method is based on the assumption of setting up a sinking fund in which
money accumulates to replace the existing asset at the proper time. At the end
of the useful life of the asset, the total amount in depreciation + compound
interest should become equal to original cost of the fixed asset.
In this method of depreciation, the book value decreases at increasing rates
with respect to the life of the asset
i(C−R)
Rate of depreciation = (1+i)n −1
Where, ‘i’ is the rate of interest
‘n’ is the expected life
‘C’ is the investment
‘R’ is the salvage value of the equipment
The loss in value of the asset (P – F) is made available an the
 form of cumulative depreciation amount at the end of the life of the
asset by setting up an equal depreciation amount (A) at the end of
each period during the life time of the asset.
A = (P – F) × [A/F, i, n]
The fixed sum depreciated at the end of every time period earns
an interest at the rate of i% compounded annually, and hence the
actual depreciation amount will be in the increasing manner with
respect to the time period.
A generalized formula for Dt is
Dt = (P – F) × (A/F, i, n) × (F/P, i, t – 1)
The formula to calculate the book value at the end of period ‘t’ is
Bt = P – (P – F) (A/F, i, n) (F/A, i, t)
The above two formulae are very useful if we have to calculate
Dt and Bt for any specific period. If we calculate Dt and Bt for all
the periods, then the tabular approach would be better.

Problems
1. A machine is purchased for Rs. 10,000 the estimated life of the m/c is 4yrs.
and the scrap value is Rs. 400 . The rate of interest on the depreciation fund is
4%. Calculate the book value of the machine at the end of each year using
sinking fund method.
Solution : C=10,000 F=400 n=4 i=4%
0.04(10,000−400)
Rate of depreciation = (1+0.04)4 −1
= 2,260.7118

Book value of each year = 10,000 – corresponding years balance

No. Balance Interest at Annual Annual Balance Book

of 4% provision Investment col 4 + col 5 Value
years col.2 + col.3 10,000 – col. 6
1 - - - 2260.71 2260.71 7739.29
2 2260.71 90.4 2351.13 2260.71 4611.8 5388.2
3 4611.8 184.47 4796.27 2260.71 7056.98 2943.01
4 7056.98 282.27 7339.25 2260.71 9599.96 400.03

2.A m/c is purchased for Rs. 40,000 . The estimated life of the m/c is 5yrs. The
scrap value is Rs. 15,000. The rate of interest on the depreciation is 10%.
Calculate the book value of the m/c at the end of each year using Sinking fund
method and plot a graph of the number of years v/s depreciation fund.

Solution : C=40,000 F=15,000 n=5 i=10%

 0.1(40,000−15,000)
Rate of depreciation = (1+0.1)5 −1
= 4094.93

Book value of each year = 40,000 – corresponding years balance

No. Balance Interest at Annual Annual Balance Book

of 10% provision Investment col 4 + col 5 Value
years col.2 + col.3 40,000 – col. 6
1 - - - 4094.93 4094.93 35905.06
2 4094.93 409.49 4504.42 4094.93 8599.35 31400.64
3 8599.35 859.93 9459.28 4094.93 13554.21 26445.78
4 13554.21 135.54 14909.63 4094.93 19004.56 20995.43
5 19004.56 190.04 19194.6 4094.93 23289.53 16710.47

3. A company has purchased an equipment whose first cost is Rs. 1,00,000

with an estimated life of eight years. The estimated salvage value of the
equipment at the end of its lifetime is Rs. 20,000. Use sinking fund method of
depreciation with an interest rate of 12%, compounded annually.

Solution: C=1,00,000 F=20,000 n=8 i=12%

0.12(1,00,000−20,000)
Rate of depreciation = (1+0.12)8 −1
= 6,504.22

Book value of each year = 1,00,000 – corresponding years balance

No. Balance Interest at Annual Annual Balance Book

of 10% provision Investment col 4 + col 5 Value
years col.2 + col.3 1,00,000 – col. 6
1 - - - 6504.22 6504.22 93,495.78
2 6504.22 650.422 7154.642 6504.22 13,658.862 86,341.138
3 13658.862 1365.8862 15,024.7482 6504.22 21,528.9682 78,471.0318
4 21,528.9682 2152.8968 23,681.865 6504.22 30,186.085 69,813.915
5 30,186.085 3018.6085 33,204.6935 6504.22 39,708.9135 60,291.0865
6 39,708.9135 3970.8913 43,679.8048 6504.22 50,184.0248 49,815.9752
7 50,184.0248 5018.4024 55,198.4272 6504.22 61,702.6472 38,297.3528
8 61,702.6472 6170.2647 67,872.9119 6504.22 74,377.1319 25,622.8681
4. Consider above problem 3 and compute D5 and B7 using the sinking fund
method of depreciation with an interest rate of 12%, compounded annually.

Solution:

Requirements of a Depreciation method

1.Provide for the recovery of inverted capital as rapidly as is consistent with
economic facts involved.
2.Not be too complex.
3. Ensure that the book value will be reasonably close to the market value at any
time.
4.Be accepted by the Internal Revenue Service(IRS), if the method is also to be
used for determining federal income tax.