ENGINEERING ECONOMICS 2020

CHAPTER 03: ECONOMIC STUDY METHODS

LESSON 01: DEPRECIATION

DEPRECIATION

Depreciation is the decrease in value of physical property with the passage of

time. Depreciation is a way of accounting for the cost of an asset when income is
determined for tax purposes. The cost, including any delivery or installation charges,
is treated as a prepayment for future services; and depreciation consists in amortizing
this prepayment over the period of use of the asset.

Definitions of Value

Value, in commercia sense, is the present worth of all future profits that are to
be received through ownership of a particular property.

The market value of a property is the amount which a willing buyer will pay to
a willing seller for the property where each has equal advantage and is under no
compulsion to buy or sell.

The utility or use value of a property is what the property is worth to the owner
as an operating unit

Fair value is the value which is usually determined by a disinterested third party
in order to establish a price that is fair to both seller and buyer.

Book value, sometimes called depreciated book value, is the worth of a

property as shown on the accounting records of an enterprise.

Salvage value (or resale value) is the price that can be obtained from the sale
of the property after it has been used.

Scrap value is the amount the property would sell for if disposed off as junk.

Purposes of Depreciation

1. To provide for the recovery of capital which has been invested in physical
property.
2. To enable the cost of depreciation to be charged to the cost of producing
products or services that results from the use of the property

Types of Depreciation

1. Normal depreciation
a. Physical
b. Functional

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2. Depreciation due to changes in price levels

3. Depletion

Physical depreciation is due to the lessening of the physical ability of a property to

produce results. Its common causes are wear and deterioration. Functional
depreciation is due to the lessening in the demand for both the function which the
property was designed to render. Its common causes are inadequacy, changes in
styles, population centers shift, saturation of markets or more efficient machines are
produced.

Depreciation due to changes in price levels is almost impossible to predict and

therefore is not considered in economy studies.

Depletion refers to the decrease in the value of a property due to the gradual
extraction of its contents.

Physical and Economic Life

Physical life of a property is the length of time during which it is capable of

performing the function for which it was designed and manufactured.

Economic life is the length of time during which the property may be operated at
a profit.

Requirements of a Depreciation Method

1. It should be simple
2. It should recover capital
3. The book value will be reasonably close to the market value at any time.
4. The method should be accepted by the Bureau of Internal Revenue.

Depreciation Methods

We shall use the following symbols for the different depreciation methods.

L = useful life of the property in years

Co = the original cost
CL = the value at the end of the life, the scrap value (including gain or loss due to
removal)
d = the annual cost of depreciation
Cn = the book value at the end of n years
Dn = depreciation up to age n years

The Straight-Line Method

This method assumes that the loss in value is directly proportional to the age of
the property.

𝐶 −𝐶
𝑑=
𝐿

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𝑛(𝐶 − 𝐶 )
𝐷 = = 𝑛𝑑
𝐿

𝐶 = 𝐶 −𝐷

ILLUSTRATIVE PROBLEM

A new machine costs Php 8, 000, 000, has a useful life of 10 years. And can be
sold for Php 750, 000 at the end of its useful life. It is expected that Php 250, 000 will be
spent to dismantle and remove the machine at the end of its useful life. Compute the
book value after 3 years. Construct also a straight-line depreciation schedule for this
machine.

Compute for the value at the end of the life (salvage value), C L

𝐶 = 750, 000 − 250, 000

𝐶 = 𝑃ℎ𝑝 500, 000

𝐶 −𝐶
𝑑=
𝐿

8, 000, 000 − 500, 000

𝑑=
10

𝑑 = 750, 000

𝐷 = 𝑛𝑑

𝐷 = (3)(725, 000)

𝐷 = 2, 225, 000

𝐶 = 8, 000, 000 − 2, 225, 000

𝑪𝟑 = 𝑷𝒉𝒑 𝟓, 𝟕𝟓𝟎, 𝟎𝟎𝟎

Year Depreciation Charge Accumulated Book Value at the End of

(Php) Depreciation (Php) Year (Php)
1 750, 000 750, 000 7, 250, 000
2 750, 000 1, 500, 000 6, 500, 000
3 750, 000 2, 250, 000 5, 750, 000
4 750, 000 3, 000, 000 5, 000, 000
5 750, 000 3, 750, 000 4, 250, 000
6 750, 000 4, 500, 000 3, 500, 000
7 750, 000 5, 250, 000 2, 570, 000
8 750, 000 6, 000, 000 2, 000, 000
9 750, 000 6, 750, 000 1, 250, 000
10 750, 000 7, 500, 000 500, 000

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Sinking-Fund Method

This method depreciates an asset as if the firm were to make a series of equal
annual deposits (a sinking fund) whose value at the end of the asset’s useful life
just equaled the cost of replacing the asset. The total depreciation that has taken
place up to any given time is assumed to be equal to the accumulated amount
in the sinking fund at that time.

𝑪𝒐 − 𝑪𝑳 𝑪𝒐 − 𝑪𝑳
𝒅= =
𝑭 (𝟏 + 𝒊)𝒏 − 𝟏
𝑨 , 𝒊%, 𝑳 𝒊

𝒊
𝒅 = (𝑪𝒐 − 𝑪𝑳 )
(𝟏 + 𝒊)𝒏 − 𝟏

𝑭 (𝟏 + 𝒊)𝒏 − 𝟏
𝑫𝒏 = 𝒅 , 𝒊%, 𝒏 = 𝒅
𝑨 𝒊

𝑪𝒏 = 𝑪𝒐 − 𝑫𝒏

ILLUSTRATIVE PROBLEM

A new machine costs Php 8, 000, 000, has a useful life of 10 years. And can be
sold for Php 750, 000 at the end of its useful life. It is expected that Php 250, 000 will be
spent to dismantle and remove the machine at the end of its useful life. Compute the
book value after 3 years. Construct also a depreciation schedule for this machine
using sinking-fund method. Interest rate, i = 15%.

𝐶 = 750, 000 − 250, 000

𝐶 = 𝑃ℎ𝑝 500, 000

𝑖
𝑑 = (𝐶 − 𝐶 )
(1 + 𝑖) − 1

0.15
𝑑 = (8, 000, 000 − 500, 000)
(1 + 0.15) −1

𝒅 = 𝑷𝒉𝒑 𝟑𝟔𝟗, 𝟑𝟗𝟎. 𝟒𝟔𝟖𝟗

(1 + 𝑖) − 1
𝐷 =𝑑
𝑖

(1 + 0.15) − 1
𝐷 = 369, 390.4689
0.15

𝑫𝟑 = 𝑷𝒉𝒑 𝟏, 𝟐𝟖𝟐, 𝟕𝟎𝟖. 𝟒𝟎𝟑

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Year Depreciation Charge Accumulated Book Value at the End of

(Php) Depreciation (Php) Year (Php)
1 369, 390.4689 369, 390.4689 7, 630, 609.531
2 424, 799.039 794, 189.5081 7, 205, 810.492
3 488, 518.895 1, 282, 708.403 6, 717, 291.597
4 561, 796.73 1, 844, 505.133 6, 155, 494.867
5 646, 066.238 2, 490, 571.371 5, 509, 428.629
6 742, 976.175 3, 233, 547.546 4, 766, 452.545
7 854, 422.601 4, 087, 970.147 3, 912, 029.853
8 982, 585.991 5, 070, 556.138 2, 929, 443.862
9 1, 129, 973.89 6, 200, 530.027 1, 799, 469.973
10 1, 299, 469.97 7, 500, 000.00 500, 000.00

Declining Balance Method

In this method, sometimes called the constant percentage method or the

Matheson Formula. It 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
𝒏
𝒏
𝑪𝑳 𝑳
𝑪𝒏 = 𝑪𝒐 (𝟏 − 𝒌) = 𝑪𝒐
𝑪𝒐

𝑪𝑳 = 𝑪𝒐 (𝟏 − 𝒌)𝑳

𝒏 𝑪𝒏 𝑳 𝑪
𝑳
𝒌= 𝟏− =𝟏−
𝑪𝒐 𝑪𝒐

The method does not apply if the salvage value is zero, because k will be equal
to one and d1 will be equal to Co.

Double Declining Balance Method (DDB)

This method is very similar to the declining balance method except that the
rate of depreciation k is replaced by 2/L.

𝒏 𝟏
𝟐 𝟐
𝒅𝒏 = 𝑪𝒐 𝟏 −
𝑳 𝑳
𝒏
𝟐
𝑪𝒏 = 𝑪𝒐 𝟏−
𝑳
𝑳
𝟐
𝑪𝑳 = 𝑪𝒐 𝟏 −
𝑳

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When the DDB method is used, the salvage value should not be subtracted
from the first cost when calculating the depreciation charge.

ILLUSTRATIVE PROBLEMS

1. Determine the rate of depreciation, the total depreciation up to the end of the
8th year and book value at the end of 8 years for an asset that costs Php 15,
000 new and has an estimated scrap value of Php 2, 000 at the end of 10 years
by (a) the declining balance method and (b) the double declining balance
method.

Solution:

Co = 15, 000
CL = 2, 000
L = 10
n=8

a. Declining balance method

𝐶
𝑘 = 1−
𝐶

2, 000
𝑘 = 1−
15, 000
𝑘 = 0.1825 𝑜𝑟 18.25%

𝐶 = 𝐶 (1 − 𝑘)

𝐶 = 15, 000(1 − 0.1825)

𝑪𝟖 = 𝑷𝒉𝒑 𝟐, 𝟗𝟗𝟐. 𝟐𝟏𝟗

𝐷 = 𝐶 −𝐶

𝐷 = 𝐶 −𝐶

𝐷 = 15, 000 − 2, 992.219

𝑫𝟖 = 𝑷𝒉𝒑 𝟏𝟐, 𝟎𝟎𝟕. 𝟕𝟖𝟏

b. Double declining balance method

2 2
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = 0.2 𝑜𝑟 20%
𝐿 10

𝐶 = 15, 000(1 − 0.2)

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𝑪𝟖 = 𝑷𝒉𝒑 𝟐, 𝟓𝟏𝟔. 𝟓𝟖𝟐𝟒

𝐷 = 𝐶 −𝐶

𝐷 = 15, 000 − 2, 516.5824

𝑫𝟖 = 𝑷𝒉𝒑 𝟏𝟐, 𝟒𝟖𝟑. 𝟒𝟏𝟕𝟔

2. A plant bought a calciner for Php 220, 000 and used it for 10 years, the life span
of the equipment. What is the book value of the calciner after 5 years of use?
Assume a scrap value of Php 20, 000 for straight line method; Php 22, 000 scrap
value for declining balance method and Php 20, 000 for the double declining
balance method.

Solution:

a. Straight-line method

Co = 220, 000
CL = 20, 000
L = 10
n=5

𝑛(𝐶 − 𝐶 )
𝐷 =
𝐿
5(220, 000 − 20, 000)
𝐷 =
10

𝑫𝟓 = 𝑷𝒉𝒑 𝟏𝟎𝟎, 𝟎𝟎𝟎

𝐶 = 𝐶 −𝐷

𝐶 = 220, 000 − 100, 000

𝑪𝟓 = 𝑷𝒉𝒑 𝟏𝟐𝟎, 𝟎𝟎𝟎

b. Declining balance method

Co = 220, 000
CL = 22, 000
L = 10
n=5

𝐶
𝐶 =𝐶
𝐶

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22, 000
𝐶 = 220, 000
220, 000

𝑪𝟓 = 𝑷𝒉𝒑 𝟔𝟗, 𝟓𝟕𝟎. 𝟏𝟎𝟗

c. Double Declining balance method

Co = 220, 000
CL = 20, 000
L = 10
n=5

2
𝐶 =𝐶 1−
𝐿

2
𝐶 = 220, 000 1 −
10

𝑪𝟓 = 𝑷𝒉𝒑 𝟕𝟐, 𝟎𝟖𝟗. 𝟔

Sum-of-the-Years’-Digits (SYD) Method

𝑛(𝑛 + 1)
𝑆𝑢𝑚 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 =
2

𝐿𝑒𝑡 𝑑 = 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑐ℎ𝑎𝑟𝑔𝑒 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑛𝑡ℎ 𝑦𝑒𝑎𝑟

𝑑 = (𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟)(𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)

𝒓𝒆𝒗𝒆𝒓𝒔𝒆 𝒅𝒊𝒈𝒊𝒕
𝒅𝒏 = (𝑪 − 𝑪𝑳 )
𝒔𝒖𝒎 𝒐𝒇 𝒅𝒊𝒈𝒊𝒕𝒔 𝒐

For example, for a property whose life is 5 years.

Year Year in Reverse Depreciation Depreciation

Order Factor during the year
1 5 5/15 (5/15)(C0 - CL)
2 4 4/15 (4/15)(C0 - CL)
3 3 3/15 (3/15)(C0 - CL)
4 2 2/15 (2/15)(C0 - CL)
5 1 1/15 (1/15)(C0 - CL)
Σ of digits=15

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ILLUSTRATIVE PROBLEMS

1. A structure costs P12,000 new. It is estimated to have a life of 5 years

with a salvage value at the end of life of P1,000. Determine the book
value at the end of each year of life.

Solution:
C0 – CL = P12,000 –P1,000 = P11,000

Year Year in Depreciation during Accumulated Book value at

reverse order the year (Php) Depreciation end of year
(Php) (Php)
1 5 (5/15)(P11,000)= 3,667 3, 667 P8,333
2 4 (4/15)(P11,000)= 2,933 6, 600 P5,400
3 3 (3/15)(P11,000)= 2,200 8, 800 P3,200
4 2 (2/15)(P11,000)= 1,467 10, 267 P1,733
5 1 (1/15)(P11,000)= 733 11, 000 P1,000
Σ of digits = 15

2. A new machine costs Php 8, 000, 000, has a useful life of 10 years. And
can be sold for Php 750, 000 at the end of its useful life. It is expected that
Php 250, 000 will be spent to dismantle and remove the machine at the
end of its useful life. Construct a depreciation schedule using the sum-of-
the-years’-digits method for this machine.

𝑛(𝑛 + 1)
𝑆𝑢𝑚 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 =
2

10(10 + 1)
𝑆𝑢𝑚 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 =
2

𝑆𝑢𝑚 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 = 55

𝐶 − 𝐶 = 8, 000, 000 − (750, 000 − 250, 000) = 7, 500, 000

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Year Year in Depreciation during Accumulated Book value at

reverse the year (Php) Depreciation (Php) end of year
order (Php)
1 10 (10/55) (7, 500, 000) 1, 363, 636.364 6, 636, 363.636
= 1, 363, 636.364
2 9 (9/55) (7, 500, 000) 2, 590, 909.091 5, 409, 090.909
= 1, 227, 272.727
3 8 (8/55) (7, 500, 000) 3, 681, 818.182 4, 318, 181.818
= 1, 090, 909.091
4 7 (7/55) (7, 500, 000) 4, 636, 363.637 3, 363, 636.363
= 954, 545.4545
5 6 (6/55) (7, 500, 000) 5, 454, 545.455 2, 545, 454.545
= 818, 181.8182
6 5 (5/55) (7, 500, 000) 6, 136, 363.637 1, 863, 636.363
= 681, 818.1818
7 4 (4/55) (7, 500, 000) 6, 681, 818.182 1, 318, 181.818
= 545, 454.5455
8 3 (3/55) (7, 500, 000) 7, 090, 909.091 909, 090.909
= 409, 090.9091
9 2 (2/55) (7, 500, 000) 7, 363, 636.364 636, 363.636
= 272, 727.2727
10 1 (1/55) (7, 500, 000) 7, 500, 000 500, 000
= 136, 363.6364

The Service-Output Method

This method assumes that the total depreciation that has taken place is directly
proportional to the quantity of output of the property up to that time. This method has
the advantage of making the unit cost of depreciation constant and giving low
depreciation expense during periods of low production.

Let T = total units of output up to the end of life

Qn= total number of units of product during the nth year

𝐶 −𝐶
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 =
𝑇

𝑪𝒐 − 𝑪𝑳
𝒅𝒏 = 𝑸𝒏
𝑻
In terms of working hours

𝑪𝒐 − 𝑪𝑳
𝒅𝒏 = 𝑯𝒏
𝑯

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ILLUSTRATIVE PROBLEM

A television Company purchased machinery for P100,000 on July 1,1979. It is

estimated that it will have a useful life of 10years; scrap value of P4,000, production of
400,000 hours and working hours of 120,000.

The company uses the machinery for 14,000 hours in 1979 and 18,000 hours
in1980. The machinery produces 36,000 units in 1979 and 44,000 units in 1980. Compute
the depreciation for 1980 using each method given below:

a. Straight line
b. Working hours
c. Output method

CO = Php 100, 000

CL = Php 4, 000
L = 10 years
T = 400, 000 units
H = 120, 000 hours

a. Straight line

(𝐶 − 𝐶 )
𝑑 =
𝐿
(100, 000 − 4, 000)
𝑑 =
10

𝒅𝟏𝟗𝟖𝟎 = 𝑷𝒉𝒑 𝟗, 𝟔𝟎𝟎

b. Working hours
𝐶 −𝐶
𝑑 = 𝐻
𝐻

100, 000 − 4, 000

𝑑 = (18, 000)
120, 000

𝒅𝟏𝟗𝟖𝟎 = 𝑷𝒉𝒑 𝟏𝟒, 𝟒𝟎𝟎

c. Output method
𝐶𝑜 − 𝐶𝐿
𝑑𝑛 = 𝑄𝑛
𝑇

100, 000 − 4, 000

𝑑 = (44, 000)
400, 000

𝒅𝟏𝟗𝟖𝟎 = 𝑷𝒉𝒑 𝟏𝟎, 𝟓𝟔𝟎

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EXERCISES 07
Direction: Solve the following problems. Show complete and neat solution. Show
illustrations if necessary.

1. Underwater electroacoustic transducers were purchased for use in SONAR

applications. The equipment will be Double Declining Balance (DDB)
depreciated over an expected life of 12 years. There is a first cost of Php 1,
250, 000 and an estimated salvage of Php 125, 000. Calculate the
depreciation and book value for years 1 and 4. (Ans.: C1 = Php 1, 041, 66.67,
D1 = Php 208, 333.33, C4 = Php 602, 816.36, D4 = Php 647, 183.642)

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2. If an asset has a first cost of Php 2, 500, 000 with a Php 500,000
estimated salvage value after 5 years, (a) calculate the annual
depreciation and (b) calculate and tabulate the book value of the
asset after each year, using straight line depreciation. (Ans. (a) Php
400, 000)

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