3.2. Cumulative Profit 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

Depreciation is an accounting method to allocate the cost of a tangible asset over its useful life. In this case, we calculate the depreciation for the first year of a machine that was purchased for 28,00,000 rupees. To find the depreciation, we multiply the book value by the depreciation rate of 40% (0.4). Therefore, the depreciation for the first year is calculated as 0.4 multiplied by 28,00,000, which equals 11,20,000 rupees.

Imagine you bought a car for 28 lakhs, and every year it loses 40% of its value due to usage. At the end of the first year, your car is worth approximately 11.2 lakhs less, showing the car's depreciation 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. That is nothing but 11,20,000, that gives you the book value at the end of the first year as 16,80,000.

To determine the book value at the end of the first year, you start with the initial purchase price of the machine (28 lakh) and subtract the first-year depreciation (11.2 lakh). Therefore, the calculation will be: 28,00,000 - 11,20,000 = 16,80,000 rupees. This book value reflects the machine's worth after accounting for its depreciation.

Think of a piece of machinery as a phone you purchased for 28,000 rupees. If it loses 11,200 rupees in value due to depreciation, its current worth is 16,800 rupees after one year.

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.

The second-year depreciation is calculated using the new book value at the end of the first year (16,80,000). Again, we apply the same 40% depreciation rate. By multiplying 0.4 by the new book value, the depreciation for the second year becomes 6,72,000 rupees.

Imagine if your phone lost not just its initial value, but it also depreciates more quickly each year. In the second year, it might lose 6,720 rupees due to wear and tear based on how much it’s currently worth (16,800 rupees).

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. So, what is the book value at the end of first year? It is nothing but 16,80,000 minus your depreciation for the second year is 6,72,000 that gives me the book value at the end of second year as 10,08,000.

To find the book value at the end of the second year, take the book value at the end of the first year (16,80,000) and subtract the second-year depreciation (6,72,000). Thus, the calculation is: 16,80,000 - 6,72,000 = 10,08,000 rupees.

If your phone was valued at 16,800 rupees and lost another 6,720 rupees in the second year, its worth would be down to 10,080 rupees. This ongoing depreciation reflects how quickly the value drops with age and usage.

Now you can estimate the annual cost by adding the operating and the maintenance cost as the depreciation. When you add column 2 and the column 3 you will get the annual costs for every year. So, what is the annual cost for the first year? Your operating in the maintenance cost for the first year is 12 lakh and your depreciation for the first year is 11,20,000, so your annual cost will be Annual cost of first year = 11,20,000+12,00,000 = 23,20,000 rupees.

To find the annual costs of operating the machine, you add the operating and maintenance costs to the depreciation. For the first year, if the operating and maintenance costs total 12,00,000 rupees, then the annual cost is the sum of depreciation (11,20,000) and these costs, resulting in an annual cost of 23,20,000 rupees.

Consider owning a car where you must account for fuel, maintenance, and depreciation. If it costs you 12,000 rupees for maintenance and your car lost 11,200 rupees in value, your total yearly expenditure for the car is 23,200 rupees.

Then you can calculate the cumulative cost, then find the average annual cumulative cost. So, like we did for the earlier old loader or the current loader or the defender. So, now, how will you calculate the average annual cumulative cost? It is nothing but your the cumulative cost divided by the cumulative usage of the machine.

Cumulative cost entails all costs gathered over the years, while average annual cumulative cost is derived by dividing this total by the total usage of the machine. This gives insights into the cost-efficiency based on usage.

If you've owned a bike for 5 years, and it has cost you a total of 1 lakh rupees, the average annual cost would be 20,000 rupees per year as it factors in both the overall cost and how much you used it.

So, the decision to replace the equipment is made when the estimated annual cost of the current machine for the next year exceeds the minimum average annual cumulative cost of the proposed machine.

The principle behind replacement decisions is to monitor costs. If the annual costs of maintaining an old machine rise above the average costs of a newer, more efficient machine, it might be beneficial to replace the old machine to lower overall expenses.

Imagine considering whether to keep an older car. If the maintenance and operating expenses rise above those of a newer model that performs better and costs less to maintain, then replacing it makes sense financially.

So, basically here the economic life of the machine is 9th year for the proposed loader, because the cost is minimum 9th year.

Economic life refers to the period during which an asset is most beneficial. In this case, the optimal time to utilize the machine noted is the 9th year when accumulated costs are lowest.

Think of a rental apartment that offers great deals for the first few years. If you live there for 9 years, that period represents the most economical choice before you might need to move to save costs.

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