Depreciation sounds like a complicated business term, but once you understand how important it is for your company, it will get a lot more interesting.
Whenever you purchase a piece of equipment, your company spends money. As you use the item, the amount of money you would be able to get for it if you sold it to someone else diminishes.
This reduction of value is deducted from the tax costs over the equipment’s life span instead of all at once.
How can you calculate that on your own?
This article will explain the key components of depreciation and four main methods of calculating depreciation.
Once you read it, you’ll be ready to depreciate assets and save money in the long run.
In this post, we’ll cover:
- What equipment depreciation is
- What you need to know to calculate equipment depreciation
- How to calculate different types of equipment depreciation
What Is Equipment Depreciation
Equipment depreciation is a metric that shows how much value your equipment is losing yearly through regular use.
Of course, your assets are worth less now than they were when you first bought them due to frequent use, no matter how good your maintenance is.
Depreciation shows you precisely how much value an asset loses over time.
Think of depreciation when planning maintenance as well—it might not be financially viable to invest in the care of items that have already lost a lot of their value.
When an older asset breaks down, it could be wiser to buy a new one instead of spending more money on repairs than the asset itself is worth. After all, you’ll have to get a new one eventually.
On top of that, depreciation helps you with taxes as you can write it off as a company expense, which saves you money.
You can choose your deduction plan to spread these expenses over several years instead of spending more at once.
Whatever deduction option you choose, depreciation gives you the exact value of your equipment and lets you figure out how much more you want to spend on it.
The Information You Need to Calculate Equipment Depreciation
Calculating depreciation is straightforward if you understand all the values used in the process.
You can depreciate assets expected to last more than a year, the assets you own and use in your business to earn revenue, and those whose useful life can be determined.
If an item doesn’t meet all four criteria, you cannot depreciate it.
Several methods of determining depreciation that your company can use will be explained in the next section, after the four values related to depreciation.
To start getting to the worth of your equipment, think of its purchasing price.
The cost value of an item is the amount you paid when purchasing it, including taxes, transportation, and set-up fees.
If your company uses something that it spent money on, it’s an asset to the company.
Consider that equipment can be either physical or non-physical, like intellectual property.
However, the depreciation for non-physical assets is called amortization. You should focus on physical equipment when working out depreciation.
Before calculating it, you need to know how much you paid for the equipment itself, which is where receipts and proofs of purchase come in handy.
Supposing an asset’s purchase price is $5,000, but you’re required to pay $400 in taxes and another $400 for transport and installment.
Then, the asset’s total cost value is $5,800, which is the value you should use for depreciation instead of the original price.
The item cost your company $5,800, which is its total cost value.
Salvage or residual value is the estimated amount you could get for your asset if you were to sell it at the end of its useful life, i.e., once you can’t use it for its original purpose anymore.
In accounting, it’s the amount the company can receive after the useful life period.
You can calculate this value using the asset and depreciation costs and its useful life. A formula you can use to get salvage value is:
salvage value = cost value – (annual depreciation x useful life)
Let’s say you have an asset you paid $200,000. You choose to depreciate it with $18,000 each year over the ten years of its useful life, adding up to $180,000.
The residual value is $20,000 in that case, according to the formula, meaning that after ten years, you should be able to sell the item for $20,000.
If the amount is negligible or too complicated to work out, you can skip this step and replace it with the cost of the item through its useful life.
After all, residual value is simply an estimate as it’s not possible to be sure about the value of equipment five or ten years from now.
Companies usually think that there will be no salvage value, i.e., that it will be zero, and they calculate depreciation using that value instead.
The book value of a piece of equipment is not the amount you can get for it if you decide to sell it, but its estimate in your financial books.
This value is used for tax purposes and various calculations, mainly when accountants have to determine how much they will write off on depreciation.
Therefore, you can’t calculate book value on assets that can’t be depreciated, such as money.
Book value is basically the cost value of the item minus the amount of annual depreciation multiplied by the age of the asset.
book value = cost value – (annual depreciation x age)
For example, if your item cost you $20,000 five years ago and you depreciate $2,000 for it every year, its book value would be $10,000, meaning that in your financial books, the item is worth $10,000 after five years of use.
When you buy the item, its book value is its cost value.
With time, accumulated depreciation cost is higher, so the book value of an asset is automatically lower, as per the formula.
At a certain point, after you’ve had equipment for a long time, the book value might only stand for the salvage value, and it’s considered “off the books.”
Equipment lifetime is an estimate of how long you can use an asset for its original purpose before it depreciates fully.
It doesn’t stand for the number of years the equipment will exist, but for the years during which you can use it to produce income.
After the useful life period, the item is the same worth as the salvage value, which, in most cases, is zero by that point.
This value is practical for calculating depreciation and your finances in general—it lets you know how long an asset will be functional, which helps you decide whether to invest in it or replace it.
It’s difficult to estimate an asset’s useful life without any help, which is why most companies opt for using the professional industry guidelines or online databases, such as the NIES one.
If you’re calculating the equipment lifetime duration on your own, consider the quality of the asset, its use and environment.
Higher-quality products tend to last longer than lower-quality ones.
An asset’s longevity also depends on how often and where it’s used—a piece of equipment used less frequently and indoors will last longer than the one used daily in rough terrain or strictly outdoors.
You should also review all the maintenance and repairs done on the equipment since they prolong its expected lifetime.
Since there is no formula to help you with the equipment lifetime, you should turn to guidelines and consult professionals.
How to Calculate Equipment Depreciation
Now that you are familiar with the four values used in cost allocation, it’s time to get to know the different methods of calculating depreciation.
There are numerous equipment depreciation methods, and we will focus on the four most commonly used ones.
Even though you can do these calculations independently, it’s good to know that specific software can help you by providing you with automatic depreciation reports if you have too many assets to count.
Straight Line Depreciation
This technique includes the depreciation of an item’s value by using the same amount yearly until reaching salvage value.
It’s commonly used due to its simplicity—you need to know an item’s useful life and the cost and salvage value.
While this method is easy to use and practically eliminates errors, there is a slight chance that your calculations will be off because some items lose value quickly, and for others, it happens over time.
Still, this method is preferred over others because it’s so straightforward and simple. It’s popular among smaller businesses that might not have an accountant but do this work independently.
The formula that can help you calculate is
straight line method = (cost value – salvage value) / useful life
For an item that costs you $5,000 in total with a salvage value of $1,000 and useful life of four years, depreciation is $1,000 a year.
To put it in simpler terms, you will pay $5,000 up-front but will spread the cost over those four years, depreciating $1,000 annually and having an item of the total worth of $1,000 in the end.
Written Down Value
The written-down value or book value method adds a depreciation rate to the book value when calculating depreciation, thus registering more costs in the earlier stages than later on.
It’s also called the diminishing balance method, as the expenses diminish over time, as opposed to the straight line where the spendings stay the same throughout the item’s useful life.
Companies most commonly use this method for items that lose value quickly as they depreciate less over time, causing a reduction in taxes.
The formula you can use if you opt for this method is
depreciation = (cost value – salvage value) x depreciation rate in %
You can calculate the depreciation rate by dividing one by the number of years of useful life—an item with a useful life of five years has a 20% depreciation rate.
depreciation rate = 1 / useful life
If an asset with a useful life of five years and a salvage value of $1,000 costs you $10,000, the total depreciation in the first year is $1,800. Next year’s item value will be $1,800 cheaper, meaning that depreciation will amount to $1,440.
The figure will go down annually, allowing you to pay less each year.
Units of Production Depreciation
The units of production method lets you depreciate an asset, based on how much work it does for you, hence the “units” part of its name.
Units don’t necessarily have to be finished products—they can refer to the number of hours the asset has spent working.
Smaller businesses opt for this method if they are interested in increasing the depreciation levels when they use the asset more while doing the opposite when they use it less. The equipment in question is of higher value because it includes constant tracking throughout the year.
While this method is helpful for internal bookkeeping, you can’t use it for tax purposes.
The recommended formula for calculating depreciation using the units of production method is
depreciation = [(cost value – salvage value) / units produced in useful life] x number of units
Let’s practice on an item you paid $5,000 with a salvage value of $250 that is supposed to provide 70,000 hours of work during its lifetime.
Each unit’s depreciation (in square brackets) would be $0,068. If the asset spent 15,000 hours working, your depreciation for that year would be $1,020.
If the math seems too complicated, you can use a unit depreciation calculator.
Sum of the Years’ Digits Depreciation
The sum of the years’ digits (SYD) depreciation is an accelerated depreciation method that allows you to depreciate less as time goes on, much like the written-down value method.
It presumes that the asset is less productive as time goes on, which is why you pay off more during the earlier years and proportionally less each year.
To calculate the SYD, use the following formula:
depreciation = (remaining asset lifetime/ SYD) x (cost value – salvage value)
Bear in mind that the SYD value is the sum of all useful life years’ digits. If an item’s useful life is five years, its SYD would be 15 (1+2+3+4+5). If it’s ten years, its SYD is 55.
Let’s say you paid $10,000 for an asset with a salvage value of $1,000 and an SYD of 15, meaning that you need to depreciate the cost of $9,000 over five years.
Your first-year depreciation value would be $3,000, while your last depreciation amount would be only $600.
If you opted for the written-down value method, your first-year depreciation would be $1,800.
When using this method, keep in mind that the remaining asset lifetime value diminishes each year.
Equipment depreciation lets you write off item costs over time in your books instead of all at once, supposing that an asset loses its value with use.
Different methods let you depreciate at different rates, but all of them include the same values: cost, salvage, book, and useful life.
No matter the method, you will depreciate the same amount over the useful life. The only difference is the timing.
Some let you depreciate more initially and less towards the end, while others do it proportionately.
All you have to do is decide which option suits your company best and start calculating!