Engineering Economic Analysis

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Basic Aspects of Depreciation 339

value to the owner, accountants define depreciation as allocating an asset's cost over its

useful or depreciable life. Thus, we now havethree distinct definitions of depreciation:

1. Decline in market value of an asset.


2. Decline in value of an asset to its owner.


3. Systematic allocation of an asset's cost over its depreciablelife.

Depreciation and Expenses

It is this third (accountant's) definition that is used to compute depreciation for business

assets. Business costs are generally either expensed or depreciated. Expensed items, such

as labor, utilities, materials, and insurance, are part of regular business operations and are

"consumed" over short periods of time (sometimesrecurring).These costs do not lose value

gradually over time. For tax purposes they are subtracted from business revenues when they

occur. Expensed costs reduce income taxes because businesses are able towrite off~eir

full amount when they occur.

In contrast, business costs due to depreciated assets are not fully written off when

they occur. A depreciated asset does lose value gradually and must be written off over

an extended period. For instance, consider a plastic injection-molding machine used to

produce the beverage cups found at sporting events. The plastic pellets melted into the

cup shape lose their value as raw material directly after manufacturing. The raw material

cost for production material (plastic pellets) is written off, or expensed, immediately. On

the other hand, the plastic injection mold machine itself will lose value over time, and

thus its cost (purchase price and installation expenses) are written off (or depreciated)

over a period of years. The number of years over which the machine is depreciated is

called its depreciable life or recovery period, which is often different from the asset's

useful or most economic life. Depreciable life is determined by the depreciation method

used to spread out the cost-depreciated assets of many types operate well beyond their

depreciable life.

Depreciation is a noncash cost that requires no exchange of dollars. Companies do

not writea checkto someoneto pay theirdepreciationexpenses.Rather,thesearebusiness.

expenses that are allowed by the government to offset the loss in value of business assets.

Remember, the company has already paid for assets up front; depreciation is simply a way

to claim these "business expenses" over time. Depreciation is important to the engineering

economist on anafter-tax basisbecause, even though it is a noncash cost, it does change the

cash flows due to taxes. Depreciation deductions reduce the taxable income of husine"sses

and thus reduce the amount of taxes paid.

In general business assets can be depreciated only if they meet the following basic

requirements:

1. The property must be used for business purposes to produce income.


2. The property must have a useful life that can be determined, and this life must be
   longer than one year. II


3. The propertymust be an asset that decays, getsused up, wears out,becomes obsolete,
   or loses value to the owner from natural causes.

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