5.2. Minimum Cost Method Overview

So, depreciation for the first year is nothing but 0.4 into book value. D = 0.4 × 28,00,000 = 11,20,000 rupees So, now you calculate the book value at the end of the first year, so what is the book value at the beginning of the 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.

In this chunk, we learn how to calculate depreciation for the first year using the method given. Depreciation is calculated as a percentage (in this case, 40%) of the book value of the asset, which is the initial purchase price of the machine. The formula D = 0.4 × Book Value shows how to derive the first year's depreciation. The book value at the end of the first year is then calculated by subtracting this depreciation from the purchase price, resulting in a new book value.

Think of buying a car worth 28 lakh rupees. If the car loses 40% of its value in the first year, that's 11.20 lakh rupees. Thus, at the end of the first year, your car's value is now 16.80 lakh rupees. This is similar to how businesses calculate the depreciation of machines to understand how much value they lose over time.

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

Here, we see the same principle applied to the second year. Depreciation for this year is again calculated at 40%, but this time it's based on the new book value (16.80 lakh rupees) from the previous year. After calculating the depreciation (6.72 lakh rupees), we again subtract this amount from the prior book value to find the new book value at the end of the second year.

Imagine after your car's first year, it has a new value of 16.80 lakh rupees. If it loses another 40% this year, that amounts to 6.72 lakh rupees. So, at the end of the second year, your car is now valued at 10.08 lakh rupees. This stepwise calculation helps keep track of the asset's value over the years.

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

After calculating depreciation, it's essential to look at the total annual costs. This includes all expenses such as operating costs, maintenance costs, and depreciation, giving a complete picture of the expense incurred for the machine each year. By summing these costs, businesses can assess the financial implications of using the equipment.

Consider you spent 12 lakh rupees on operating and maintaining your car in the first year, in addition to the 11.20 lakh depreciation. Your total car expenses that year would amount to 23.20 lakh rupees. Understanding these total annual costs is vital for making informed financial decisions regarding the asset.

Then you can calculate the cumulative cost, then find the average annual cumulative cost. Average annual cumulative cost, first year = 23,20,000 rupees. Average annual cumulative cost, second year = 21,26,000 rupees.

Cumulative costs represent the total expense over the years up to a certain point. To get the average annual cumulative cost, you divide the cumulative cost by the number of years of usage. This gives businesses a clear idea of how their investment is performing over time and helps in planning future expenditures.

If you initially spent 23.20 lakh in the first year and, over the second year, your total cumulative cost becomes 42.52 lakh, then your average cost is simply that total divided by 2 years. It's akin to averaging your spending to understand how much, on average, you spend each year on your car.

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.

Businesses use this guideline to decide whether to continue using current machinery or invest in new equipment. If the predicted costs of operating the current machine for the next year are higher than the average cost of a new machine, it justifies replacing the old with new. This decision keeps operational costs in check and ensures efficiency.

If next year's operating cost for your old car is predicted to be more than what you'd expect to pay to operate a new car, it might be a wise decision to sell the old car and buy the new one. Just like in business, it's about making the financially sound choice to minimize costs.

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