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Interactive Audio Lesson
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Understanding Economic Life
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Today, we will discuss the economic life of a machine. Can anyone explain what economic life means?
Is it about how long the machine is useful for us without being too costly?
Exactly! Economic life refers to the period during which the costs of operating the machine are minimized. Beyond this time, costs generally increase.
So, what happens if we keep the machine too long?
Great question! Keeping the machine longer can lead to increased maintenance costs, downtime, and obsolescence. Remember the acronym MOD: Maintenance, Operating cost, Downtime.
Got it! MOD helps me remember the costs to consider.
Exactly! So, why is it important to understand economic life?
To decide when to replace it and avoid unnecessary costs!
Right! Let’s move on to see how we calculate depreciation using the double declining balance method.
Depreciation Calculation
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Now we will tackle depreciation. Can anyone tell me what depreciation is?
Is it how much value the machine loses each year?
Exactly! We use the double declining balance method, which accelerates the depreciation in the early years. The formula is 2/n × Book Value of the previous year. Can anyone apply this to our case?
So in the first year, it would be 2/8 × 35,00,000 which equals ₹8,75,000!
Correct! What’s the new book value?
It would be ₹35,00,000 minus ₹8,75,000, which is ₹26,25,000!
Excellent! You would repeat this process each year. Let’s ensure we understand how this affects our overall costs with inflation and salvage value.
Costs Associated with Machine Operation
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We must also consider other costs like maintenance, repair, downtime, and obsolescence. Can anyone explain downtime?
That’s when the machine isn’t available for use, right?
Exactly! Downtime can lead to additional costs. How do we measure the impact of downtime on our operation?
By calculating the downtime costs based on our equipment cost!
Right! And as machinery ages, costs like maintenance and obsolescence will increase. Remember, maintenance affects CAPEX — Capital Expenditure.
Can we calculate how much extra we lose in productivity if downtime increases?
Yes! Always try to connect the dots between maintenance, downtime, and productivity. Let's ensure we apply this understanding when we finalize replacement strategies.
Introduction & Overview
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Quick Overview
Standard
The section delves into depreciation calculation and how it influences the decision-making process for replacing machinery. It covers the economic life definition, the model for calculating depreciation using the double declining balance method, and the factors contributing to costs associated with machinery over time.
Detailed
Detailed Summary of Depreciation Calculation
This section discusses the economic life of machinery — defined as the period in which the cost of ownership is minimized. Beyond this economic life, costs typically arise in the form of increased maintenance, repair, and obsolescence. It emphasizes the necessity of timely replacement to avoid losses.
Key calculations are presented through a practical example — estimating the economic life of a machine, specifically a track-mounted front shovel purchased for ₹35,00,000 and expected to last 8 years with a salvage value of ₹7,00,000. The section illustrates how to employ the double declining balance method for depreciation, detailing the calculations year by year.
Additionally, factors such as inflation, operational costs, and maintenance costs are outlined. The relationship between downtime and increased costs is analyzed, noting how obsolescence due to technological advancements impacts financial planning for equipment replacement. Through cumulative calculations and practical exercises, students learn to assess total cost implications annually for decision-making. This thorough exploration of depreciation calculation serves as a critical foundation for understanding machinery cost analysis and investment strategies.
Audio Book
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Understanding Economic Life
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So, basically that is what is this economic life. Economic life means it is a time during which the cost of holding the machine will be minimum. So, beyond the economic life you can see that there will be increasing costs associated with the machine, either due to increase in the operating cost that is repair and the maintenance costs or increase in downtime costs or increasing obsolescence cost.
Detailed Explanation
Economic life refers to the period during which a machine operates at its most cost-effective capacity. After this period, costs begin to increase significantly due to repairs, maintenance, potential downtime (when the machine is not operational), and obsolescence (the machine becoming outdated). Therefore, a business should consider replacing machinery before these costs outweigh the benefits of keeping the old machine.
Examples & Analogies
Think of economic life like a car. A car that is well-maintained can be cost-efficient for many years. However, as it ages, maintenance fees rise, it may require more repairs, and it may lack modern features, making it less desirable. Once the costs of keeping the car exceed the costs of getting a new one, it's time to consider a replacement.
Estimating Economic Life Example
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In this example, we are going to see how to estimate the economic life of the machine. So, basically, so, here we are going to estimate economic life for a track mounted front shovel. The purchase price is 35,00,000. So, the machine is expected to last for 8 useful years and the depreciation is assumed to follow double declining balance method.
Detailed Explanation
In this example, a track-mounted front shovel is purchased for 35,00,000. It is anticipated that the machine will be effectively used for 8 years. The double declining balance method of depreciation will be employed to calculate how the machine's value decreases over that period. This means the machine will lose value faster in the earlier years.
Examples & Analogies
Imagine you bought a new smartphone for 35,00,000. The first year, you might find many features outdated due to rapidly changing technology, causing its value to drop significantly. In contrast, as years go by, the depreciation slows down until you're left with a very low resale price.
Inflation and Additional Costs
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At the end of the 8 years, you will be able to sell the machine at the cost of rupees 7,00,000. That means the salvage value of the machine is 7,00,000. So, due to inflation, you can see that annual increase of the average cost of the equipment is approximately 6%.
Detailed Explanation
After 8 years, the machine can be sold for a salvage value of 7,00,000. Additionally, inflation affects the pricing of machinery, leading to an annual increase of about 6% in the average cost. This needs to be factored into any cost analysis regarding replacement.
Examples & Analogies
Like buying a house, its value can appreciate over time. Inflation increases property prices, requiring homeowners to take into account both the price they paid initially and the potential selling price many years later. Similarly, when considering machinery, it’s crucial to account for its expected selling price after many years, alongside how inflation might increase the costs of similar machines.
Understanding Depreciation Calculation
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Now, let us calculate the depreciation using double declining balance method. The formula used is D_n = (2/n) * BV_n-1, where D_n represents depreciation for year n, n is the useful life in years, and BV_n-1 is the book value at the end of the previous year.
Detailed Explanation
The double declining balance method calculates depreciation by applying a fixed percentage (2/n in this case) to the previous year's book value. This results in higher depreciation expenses in the early years of the asset's life, which gradually decline as the asset ages. This method allows businesses to recover their investment costs more quickly during the asset’s most productive years.
Examples & Analogies
Consider a personal laptop. The first couple of years, it may be worth a lot due to its cutting-edge specifications. As technology evolves, its value drops rapidly. Double declining balance depreciation reflects this idea, dropping the value quicker early on when it's most influential for business use.
Calculating Loss on Replacement
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Now let’s say what is the loss associated with the replacement? The new cost is 37,10,000 due to inflation, but at the end of the first year, the book value has depreciated to 26,25,000. Loss for year 1 = 37,10,000 – 26,25,000 = 10,85,000 rupees.
Detailed Explanation
When considering replacing the machine, you calculate the potential loss. If in year one, the replacement cost rises to 37,10,000 while the machine's book value is merely 26,25,000, replacing it would result in a loss of 10,85,000. Understanding this loss becomes crucial for making informed financial decisions.
Examples & Analogies
It's similar to considering whether to sell a used car. If the market price rises significantly but your car's depreciation leaves you with little to sell, you might be losing money by trying to sell it. Buyers only pay market value, not the increased price, thus understanding how much you are not recovering helps in making a better decision.
Definitions & Key Concepts
Learn essential terms and foundational ideas that form the basis of the topic.
Key Concepts
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Economic Life: The time frame in which equipment holds the least cost of ownership and operation.
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Depreciation Method: Double declining balance is an acceleration method leading to more rapid depreciation upfront compared to the straight-line method.
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Downtime Costs: Costs incurred due to non-operational periods, impacting productivity and revenue.
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Obsolescence: The process of becoming outdated, which can increase replacement costs over time.
Examples & Real-Life Applications
See how the concepts apply in real-world scenarios to understand their practical implications.
Examples
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If a machine costs ₹35,00,000 and depreciates ₹8,75,000 in the first year, its book value at the end of the first year is ₹26,25,000.
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As inflation increases the initial price by ₹2,10,000 per year, replacement costs need to be recalculated yearly.
Memory Aids
Use mnemonics, acronyms, or visual cues to help remember key information more easily.
🎵 Rhymes Time
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To save your cash, replace don't wait, keep your machines in their prime state.
📖 Fascinating Stories
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A carpenter clings to his old, rusty saw, believing it still cuts as well. As it dulls, he can't finish jobs on time. Needing new tools, he learns to replace them before they become obsolete.
🧠 Other Memory Gems
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Remember the costs with the phrase MOD: Maintenance, Operating costs, Downtime.
🎯 Super Acronyms
DDB - Double Declining Balance
- the method for calculating accelerated depreciation.
Flash Cards
Review key concepts with flashcards.
Glossary of Terms
Review the Definitions for terms.
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Term: Economic Life
Definition:
The period during which a machine operates with minimal costs.
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Term: Depreciation
Definition:
The reduction in value of an asset over time, used for accounting purposes.
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Term: Double Declining Balance
Definition:
An accelerated depreciation method that doubles the straight-line rate.
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Term: Downtime
Definition:
The period during which a machine is not operational and cannot perform productive work.
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Term: Obsolescence
Definition:
The process of becoming outdated, particularly due to advances in technology.