3.1.1. Depreciation Calculation

So under the ownership cost we are going to estimate the depreciation first. So under the ownership cost we are going to estimate the depreciation first. So we are going to adopt these straight line methods for estimation and depreciation.

In this section, we start by discussing how to calculate depreciation as part of the ownership cost of equipment. Depreciation is an important concept in accounting that reflects the decrease in value of an asset over time. Here, we are adopting the straight-line method for calculating depreciation, which means that the cost of the equipment will be spread evenly over its useful life. This allows for a predictable and consistent approach to accounting for the loss of value of the equipment.

Think of it like a new smartphone that you buy for $800. If you expect to use it for 4 years, under the straight-line method, you might consider that it loses$200 in value each year. At the end of four years, it would be worth $0 in accounting terms, just as you would calculate its depreciation.

So, how to estimate the depreciation using straight line method? It is nothing but the difference between your initial price minus a salvage value.

To calculate depreciation using the straight-line method, you need to know the initial purchase price of the equipment, its estimated salvage value (the amount it could be sold for at the end of its useful life), and the depreciation period, which is often measured in hours of operation for machinery. The formula used is:

This formula emphasizes that depreciation is directly related to both the total cost and how long you expect to use the equipment.

Imagine you buy a lawnmower for $300, and you believe it can be sold for$50 after 5 years. Here, the depreciation would be calculated by taking $300 (initial price) -$50 (salvage value) = $250. If you use the lawnmower for 100 hours each year over those 5 years, that's 500 hours total, leading to an annual depreciation cost of$0.50 per hour.

Now let us calculate the other components of the ownership cost. It is nothing but the cost of investment, taxes, insurance. So everything will be calculated as a percentage of the average value of equipment.

After calculating the depreciation, the next step is to determine the remaining components of ownership cost, which include investment costs, taxes, and insurance. Instead of considering the entire initial purchase cost, these costs are typically calculated as a percentage of the average value of the equipment throughout its useful life. This approach captures the ongoing operational costs linked to owning the equipment, allowing for better financial planning.

Think of a car. The car's insurance and taxes might be based on its market value, which decreases over time. In the first year, the insurance cost might be based on a market value of $20,000. In the next year, it might drop to$18,000. Treat the car similarly to equipment, where each year's cost reflects its average value.

Hope you remember so how to estimate the average value of the machine using straight line depreciation method we have derived this formula in the earlier lecture.

To find the average value of a machine over its useful life, you can use the formula:

Where P is the initial purchase price and S is the salvage value. This formula takes into account the depreciation of the machine over time and helps in calculating other ownership cost factors as a percentage of this average value.

Imagine you have a bike worth $500, which you estimate to sell for$100 at the end of its 5-year life. The average value over five years would use the same formula, providing a more realistic view of how much it is worth annually.

Now the ownership cost is done it is more to the operating cost. So under operating cost we are going to discuss cost of consumable.

Once we have covered the ownership costs, we move on to operating costs. Operating costs are the expenses incurred during the operation of the equipment. This includes fuel, routine maintenance, and any consumable items needed for the equipment's operation. It's essential to estimate these costs accurately since they directly impact the overall cost of operating the machinery.

Consider cooking a meal. The ingredients (like meat, vegetables, and spices) represent the consumables needed to operate. The costs for these supplies, much like fuel and parts for machinery, forms a significant part of the operating costs in keeping your kitchen functional.

--