 # Depreciation

Over the course of a company utilizing equipment, it is bound to take on some wear-and-tear.

However, this wear-and-tear can be difficult to calculate exact amounts for.

For example...

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

There's a couple critical things to understand here, first being...

The wear-and-tear on our equipment resulting in reduction of its value is referred to as depreciation.

Now, with this wear-and-tear, it'd be impossible to calculate the exact depreciation incurred with each lemon squeezed. However, utilizing our equipment (and the resulting wear-and-tear) is a cost of business, therefore it must be accounted for!

Rather than calculate the exact depreciation with each lemon squeezed, we can use the following two depreciation methods to estimate depreciation over a span of time.

• Straight-line method
• Activity-based method

We cannot calculate the exact depreciation on equipment, so we utilize the straight-line and / or activity-based methods to estimate depreciation on equipment over a span of time.

Let's dig into how we could apply each of these methods in this scenario!

If we were to use the straight-line depreciation method for our lemonade stand's lemon squeezer, we might formalize our scenario with a question like so:

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

Question: Using the straight-line depreciation method, calculate the annual depreciation on our lemon squeezer.

To utilize the straight-line method, we need to know 3 things about our equipment...

• Original Cost
• Residual Value
• Service Life

...to apply the straight-line depreciation method formula like so!

Depreciation Expense (per year) = (Original Cost - Residual Value) / (Service Life)

In the case of our lemon squeezer, it originally cost \$200...

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

Question: Using the straight-line depreciation method, calculate the annual depreciation on our lemon squeezer.

Depreciation Expense (per year) = (Original Cost - Residual Value) / (Service Life)
Depreciation Expense (per year) = (\$200 - Residual Value) / (Service Life)

...and at the end of its 3 year life...

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

Question: Using the straight-line depreciation method, calculate the annual depreciation on our lemon squeezer.

Depreciation Expense (per year) = (Original Cost - Residual Value) / (Service Life)
Depreciation Expense (per year) = (\$200 - Residual Value) / (3)

...has a value of \$20 (a.k.a. residual value)!

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

Question: Using the straight-line depreciation method, calculate the annual depreciation on our lemon squeezer.

Depreciation Expense (per year) = (Original Cost - Residual Value) / (Service Life)
Depreciation Expense (per year) = (\$200 - \$20) / (3)

This means that each year, we estimate our lemon squeezer to depreciate by \$60!

Depreciation Expense (per year) = (Original Cost - Residual Value) / (Service Life)
Depreciation Expense (per year) = (\$200 - \$20) / (3)
Depreciation Expense (per year) = (\$180) / (3)
Depreciation Expense (per year) = \$60

If this is confusing to you, think of it this way:

• We bought the lemon squeezer for \$200.
• We're able to sell it (once we're done with it) for \$20.
• In total, we lose \$200 - \$20 = \$180 by utilizing the lemon squeezer over 3 years.
• This means that each, we lose \$180 / 3 years = \$60

The term "lose" in this case can be interpreted as depreciation!

To formally answer our question, we'd write the following:

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks

If our lemonade stand utilized the activity-based method to depreciate the lemon squeezer, we'd need the following added-context...

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

The lemon squeezer is estimated to be able to squeeze 18,000 lemons. The actual number of lemons squeezed per year are:

• Year 1: 7,500
• Year 2: 2,500
• Year 3: 5,000

Question: Using the activity-based depreciation method, calculate the annual depreciation on our lemon squeezer.

...because the activity-based method requires the following factors...

• Original Cost
• Residual Value
• # of Units Expected to be Produced

...to apply the activity-based method formula like so!

Depreciation Expense (per unit) = (Original Cost - Residual Value) / (# of Units Expected to be Produced)

In the case of our lemon squeezer, it originally cost \$200...

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

The lemon squeezer is estimated to be able to squeeze 18,000 lemons. The actual number of lemons squeezed per year are:

• Year 1: 7,500
• Year 2: 2,500
• Year 3: 5,000

Question: Using the activity-based depreciation method, calculate the annual depreciation on our lemon squeezer.

Depreciation Expense (per unit) = (Original Cost - Residual Value) / (# of Units Expected to be Produced)
Depreciation Expense (per unit) = (\$200 - Residual Value) / (# of Units Expected to be Produced)

...and at the end of its life, is expected to have a value of \$20 (a.k.a. residual value)...

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

The lemon squeezer is estimated to be able to squeeze 18,000 lemons. The actual number of lemons squeezed per year are:

• Year 1: 7,500
• Year 2: 2,500
• Year 3: 5,000

Question: Using the activity-based depreciation method, calculate the annual depreciation on our lemon squeezer.

Depreciation Expense (per unit) = (Original Cost - Residual Value) / (# of Units Expected to be Produced)
Depreciation Expense (per unit) = (\$200 - \$20) / (# of Units Expected to be Produced)

...and is expected to produce a total of 18,000 units!

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

The lemon squeezer is estimated to be able to squeeze 18,000 lemons. The actual number of lemons squeezed per year are:

• Year 1: 7,500
• Year 2: 2,500
• Year 3: 5,000

Question: Using the activity-based depreciation method, calculate the annual depreciation on our lemon squeezer.

Depreciation Expense (per unit) = (Original Cost - Residual Value) / (# of Units Expected to be Produced)
Depreciation Expense (per unit) = (\$200 - \$20) / (18,000)

This means that each unit is estimated to depreciate our lemon squeezer by \$0.01!

Depreciation Expense (per unit) = (Original Cost - Residual Value) / (# of Units Expected to be Produced)
Depreciation Expense (per unit) = (\$200 - \$20) / (18,000)
Depreciation Expense (per unit) = (\$180) / (18,000)
Depreciation Expense (per unit) = \$0.01

From here, we can multiply each year's lemon count by \$0.01...

• Year 1: 7,500 x \$0.01 = ???
• Year 2: 2,500 x \$0.01 = ???
• Year 3: 5,000 x \$0.01 = ???

...to compute each year's depreciation expense!

• Year 1: 7,500 x \$0.01 = \$75
• Year 2: 2,500 x \$0.01 = \$25
• Year 3: 5,000 x \$0.01 = \$50

To formally answer our question, we'd write the following:

Scenario: Imagine we run a lemonade stand and bought a lemon squeezer for \$200. Each year as we use the lemon squeezer, it takes on wear-and-tear. After 3 years utilizing the lemon squeezer, it breaks and we sell the salvaged parts for \$20.

The lemon squeezer is estimated to be able to squeeze 18,000 lemons. The actual number of lemons squeezed per year are:

• Year 1: 7,500
• Year 2: 2,500
• Year 3: 5,000

Question: Using the activity-based depreciation method, calculate the annual depreciation on our lemon squeezer.

• Year 1: \$75 in depreciation
• Year 2: \$25 in depreciation
• Year 3: \$50 in depreciation

## Practice!

Want some more practice with depreciation? Check out the practice problems below included in Practice Problems (Exam 3)!

Consider the following - Steez Inc. has a printing press they purchased for \$10,000. At the end of its 4 year life, Steez Inc. estimates it will be worth \$2,000. During the course of its life, Steez Inc. expects it to produce 8,000 shirts. The actual number of shirts it produced are:

• Year 1: 2,500
• Year 2: 1,500
• Year 3: 1,000
• Year 4: 2,000

Question #1 - Calculate the annual depreciation on the printing press over the 4 years with the straight-line depreciation method.

Using the straight-line depreciation method, we need to determine the amount of depreciation incurred with each year of operation.

To find this value, we need to find the difference between the cost of our printing press and the residual value of it at the end of its life, and then divide by the years of operation.

Yearly Depreciation = (Cost - Residual Value) / Life (in years)

The cost of the printing press was \$10,000...

Consider the following - Steez Inc. has a printing press they purchased for \$10,000. At the end of its 4 year life, Steez Inc. estimates it will be worth \$2,000. During the course of its life, Steez Inc. expects it to produce 8,000 shirts. The actual number of shirts it produced are:

Yearly Depreciation = (Cost - Residual Value) / Life (in years)
Yearly Depreciation = (\$10,000 - Residual Value) / Life (in years)

...and at the end of its 4 year life...

Consider the following - Steez Inc. has a printing press they purchased for \$10,000. At the end of its 4 year life, Steez Inc. estimates it will be worth \$2,000. During the course of its life, Steez Inc. expects it to produce 8,000 shirts. The actual number of shirts it produced are:

Yearly Depreciation = (Cost - Residual Value) / Life (in years)
Yearly Depreciation = (\$10,000 - Residual Value) / 4

...it's estimated to have a value of \$2,000...

Consider the following - Steez Inc. has a printing press they purchased for \$10,000. At the end of its 4 year life, Steez Inc. estimates it will be worth \$2,000. During the course of its life, Steez Inc. expects it to produce 8,000 shirts. The actual number of shirts it produced are:

Yearly Depreciation = (Cost - Residual Value) / Life (in years)
Yearly Depreciation = (\$10,000 - \$2,000) / 4

...therefore, our printing press depreciates by \$2,000 per year (via straight-line depreciation method)!

Yearly Depreciation = (Cost - Residual Value) / Life (in years)
Yearly Depreciation = (\$10,000 - \$2,000) / 4
Yearly Depreciation = (\$8,000) / 4
Yearly Depreciation = \$2,000

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