1.3. Annual Cost Calculation

So, depreciation for the first year is nothing but 0.4 into book value. D = 0.4 × 28,00,000 = 11,20,000 rupees.

This chunk describes how to calculate the depreciation for the first year of the machine. The method used is a straightforward multiplication of the book value by the depreciation rate, which is 40% in this case. The book value at the start is given as 28,00,000 rupees. By multiplying 0.4 by 28,00,000, we find that the depreciation for the first year is 11,20,000 rupees.

Think of depreciation like the value you lose on a new car every year. If you buy a car for 28 lakhs and it loses 40% of its value in the first year, it means that by the end of that year, you’ve lost about 11.2 lakhs in value.

So, now you calculate the book value at the end of first year, so what is the book value at the beginning of year that is nothing but your purchase price of the machine 28 lakh minus the depreciation for the first year.

To find the book value at the end of the first year, you subtract the calculated depreciation from the initial cost of the machine. Here, the book value at the start of the year is 28,00,000 rupees, and after subtracting the depreciation of 11,20,000, we arrive at a book value of 16,80,000 rupees at the end of the first year.

Using the car analogy again, if your car's initial value was 28 lakhs and it depreciated by 11.2 lakhs in the first year, its value at the end of that year would be 16.8 lakhs. This is like checking how much your car is worth after a year of use.

So, for the second year the depreciation is nothing but D2 is 0.4 into book value the end of first year, D = 0.4 × 16,80,000 = 6,72,000 rupees.

In the second year, the depreciation is calculated again using the book value at the end of the first year which is now 16,80,000 rupees. Multiplying this by the depreciation rate of 40% results in 6,72,000 rupees of depreciation for the second year.

Continuing with our car example, if your car is now valued at 16.8 lakhs at the beginning of the second year, then by the end of that year, it may depreciate by 6.72 lakhs, showing that the loss in value continues albeit at a different amount.

Now calculate the book value at the end of second year, it is nothing but book value at the end of the first year minus the depreciation for the second year.

To determine the book value at the end of the second year, subtract the second year's depreciation from the end of the first year's book value. The equation is 16,80,000 minus 6,72,000, which leads to a new book value of 10,80,000 rupees at year-end two.

If your car was worth 16.8 lakhs after the first year and it loses another 6.72 lakhs in value during the second year, its new worth would be 10.8 lakhs at the end of the second year. This shows how depreciation leads to reduced machine value over time.

Now you can estimate the annual cost by adding the operating and maintenance cost as the depreciation. When you add column 2 and the column 3 you will get the annual costs for every year.

The annual cost calculation involves summing the depreciation and maintenance costs every year. For example, for the first year, you combine the depreciation of 11,20,000 with the operating and maintenance costs of 12,00,000 to find a total annual cost of 23,20,000 rupees.

Imagine you have a monthly budget for your car. You spend on oil changes and maintenance, which is like operating costs, along with accounting for the depreciation loss in value. If you know both your expenses for repairs and how much value you’re losing, you can fully understand the annual cost of owning the car.

Then you can calculate the cumulative cost, then find the average annual cumulative cost.

Cumulative cost is the total cost accumulated over the years, and average annual cumulative cost is calculated by dividing the cumulative cost by the total number of years the machine has been in use. For example, after the first year, the average cost equals the total incurred costs divided by one year, resulting in the annual cost of 23,20,000. After the second year, it's averaged by two, reflecting the trend of cost changes over time.

Think of saving money in a piggy bank; if the piggy bank has 1000 rupees after the first year, your average savings per year is 1000. After the second year, if you have 2000 rupees total, your average savings per year becomes 1000 too. This helps you see how quickly your savings grow over time.

If the estimated annual cost of the current machine for the next year exceeds the minimum average annual cumulative cost of the proposed machine...

This section discusses how to decide when to replace machinery. The guideline suggests that when the estimated annual cost for the current machine surpasses the average annual cumulative cost of a new machine, it's time to consider a replacement. For instance, when the cost of maintaining an older piece of equipment outweighs the benefits compared to a new one, replacement is justified.

Imagine you have an old phone that costs a lot to repair every year, while a new model would cost less in maintenance and offers better features. The decision to upgrade would be based on whether the repair costs exceed what you would spend on a new phone.

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