Unit-of-Production Depreciation
We have so far dealt with a variety of economic analysis problems and many techniques
for their solution. In the process we have avoided income taxes, which are an imponant
element of many private-sector economic analyses. Now, we can move to more realistic_
and,unfonunately,morecomplex-situations..
Our governmenttaxes individuals and businessesto support its processes-lawmaking,
domestic and foreign economic policymaking, even the making and issuing of money it-
self. The omnipresence of taxes requires that they be included in economic analyses, which
means that we must understand something about thewaytaxes are imposed. For capital
equipment, depreciation is required to compute income taxes. Chapter 11 examines depre-
ciation, and Chapter 12 illustrates how depreciation is used in income tax computations.
The goal is to support decision making on engineering projects, not to support final tax
calculations.
BASIC ASPECTS OF DEPRECIATION
The word depreciation is defined as a "decreasein value."This is not an entirely satisfactory
definition,forvaluehas several meanings. In the context of economic analysis, value may
refer either tomarket value-that is, the monetary value others place on property--orvalue
to the owner.For example, an assembly line is far more valuable to the manufacturing
firm that it was designed for, than it is to a used equipment market. Thus, we now have
two definitions of depreciation: a decrease in value to the market or a decrease to the
owner..
Deterioration and Obsolescence
A machine may depreciate because it is deteriorating or wearing out and no longer per-
forming its function as well as when it was new.Many kinds of machineryrequire increased
maintenanceas they age, reflectinga slowbut continuing failure of individualparts. In other
types of equipment, the quality of output may decline owing to wear on components and
resulting poorer mating of parts. Anyone who hasworked to maintain artauto has observed
deterioration due to failure of individual parts (such as fan belts, mufflers, and batteries)
and the wear on components (such as bearings, piston rings, and alternator brushes).
Depreciation is also caused by obsolescence. A mach~neis described as obsolete when
it is no longer needed or usefuL A machine that is in excellent working condition may still
be obsolete.In the 1970s,mechanical business calculatorswith hundreds of gears and levers
became obsolete. The advance of integrated circuits resulted in a completely different and
far superior approach to calculator design. Thus, mechanical calculators rapidly declined
or depreciatedin value.
If your auto depreciated in the last year, that means it has declined in market value. It
has less value to potential buyers. On the other hand, a manager who indicates {;hata piece
of machineryhas depreciated may be describing a machine that has deterioratedbecause of
use and/or because it has become obsolete compared with newer machinery.Both situations
indicate a decline in value to the owner.
The accounting profession defines depreciation in yet another way. Although in every-
day conversation we are likely to use "depreciation" to mean a decline in market valueor
