3.2. Depreciation Calculation

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.

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repairs, maintenance, potential downtime (when the machine is not operational), and obsolescence (the machine becoming outdated).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.

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.

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.

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.

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 The first year, you might find many features outdated due to rapidly changing technology, causing its value to drop significantly.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.

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%.

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.

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.

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.

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.

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.

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.

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.

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.

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