Week 8_LanreGiwa_Depreciation of Computers

Problem Recognition / Identification

In an engineering company, computers used are procured specifically for projects and charged to the project account. The costs of the computers are depreciated over the duration of four years based on the experience of the company and the cost is usually deducted /charged to the project on a pro rata basis. The challenge of the cost engineer is to determine an appropriate method of calculating the depreciation of the computers used in the company.

Development of Feasible Alternatives/Solutions

There are four possible alternatives that can be explored in calculating the depreciation:

Alternative 1 – Single Line Depreciation Method is a way to depreciate an item by deducting an equal amount over the duration or lifespan of the item while considering the scrap value of the item. Mathematically, D= (C-S) / N

Where

D = Amount to be deducted annually

C = Original cost of the item

S = Scrap or salvage value

N = Depreciable lifespan or duration of item.

Alternative 2 – Double-Declining Balance Method is applied by deducting a constant depreciation rate to the assets value. Mathematically, D = (2/N) (C-BV_t-1)

Where

D = Amount to be deducted,

C = Original cost of item,

BV = Book value at given year, and

N = Depreciable lifespan of item (years).

Alternative 3 – Sum of years Digit Method considers depreciation annually as the product of a fractional value multiplied by the total original depreciable value. Mathematically,

Dr = (C – S)*[(2(N-r+1))/ (N(N + 1)]

Where:

Dr = depreciation charge for the rth year

C = asset original cost

S = scrap or salvage value

N = depreciable lifespan of item (years)

r = rth year

Alternative 4 – Units of Production Method is utilized when the depreciation is based on number of times the item is used as against the depreciable lifespan of the item.

Possible Outcomes of Alternatives / Solutions

Alternative 1: This method is straight forward and will be implemented easily by engineers that do not have an accounting or finance background.

Alternative 2: A fast method of retrieving the original cost of the item considering the time value of money.

Alternative 3: This method is a faster way of retrieving the original cost of the item considering the time value of money

Alternative 4: This alternative will not be the best approach in this case since the company will be charging per annum not on variable demand. If the company intended to charge on every use, then this may possibly be the best approach to depreciation.

Selection Criteria of best solution

• Calculate the depreciation on a yearly basis
• Easy to use, understand and implement by the engineering company

Analysis and comparison of the Alternatives/Solutions

Alternatives 2 and 3 allow a faster write-off of the value of the computers. This will be good for a company that has little cash flow and want to quickly recover cost of investment from the client. This methods wont be ideal in this case because the company has a robust cash flow and do not want to over burden the client with high bills at the inception of the project. The company is also considering maintaining a stable cash inflow.

Alternative 4 would not readily apply in this situation because that option will work if the company was to charge the client on a per use basis. However, for simplicity and avoidance of conflict, the company intends to charge on a yearly or monthly basis.

Alternative 1 is quite straight forward and easy to apply for the depreciation of the computers. The method will also avoid conflict between the company and the clients.

Best Alternative to be Selected

Based on the above analysis and criteria of the alternative selection, it is recommended that company should select ALTERNATIVE-1 as the best option to calculate the depreciation of the value of computers used on projects in order to recover the cost and dispose of the computer at a book value of zero.

Based on this method, if a personal computer costs the company NGN200, 000. 00, with a 4-year depreciable lifespan and a scrap value of NGN10, 000.00, then the amount that a client will pay assuming that the project will run for a period of four years will be:

D= NGN (200,000 – 10,000) /4 =NGN47, 500 per annum.

Performance Monitoring / Post evaluation

The method of calculating depreciation can be evaluated over time by analyzing the amount spend of computers within the company to determine

• The rate of return on investment
• The salvage or scrap value
• When to replace the computers
• If the option adopted is good for the company regarding the cash flow.

References:

1. AACE International. Skills & Knowledge of Cost Engineering, 5^th Edition Revised.Chapter-7, P.7.4-7.7 Edited by Dr. Scott J. Amos, PE. 2010. AACE International. Morgantown, WV, USA.

2. Sulliven, W. G., Wicks, E.M., Koelling, C. P., et al. (2009). Engineering Economy (14^th ed.), P.27 table 1.1. New Jersey: Pearson Education