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Depreciation

Depreciation

Depreciation is a procedure to allocate or assign a portion of the cost of an asset to each production period during which the asset is used.

Related link: "The Cost of Owning and Operating Farm Machinery -- Utah 1997", pp. 6 and 7 of the pdf file. 

 

Profit is defined as "the difference between the revenue generated during a period to time and the costs incurred to generate that revenue during that period of time."  Some assets or inputs, however, will be used during more than one production period; an easy example is equipment.  Accordingly, a procedure is necessary to allocate an appropriate portion of the cost of the input among the several time periods during which it will be used in the production process. This procedure of allocating cost is generally referred to as calculating depreciation; that is, assigning a portion of the cost of an asset to each production period during which the asset is used.

To simplify the procedure, the calculations are often based on time; for example, some methods of depreciation allocate a portion of the cost of the machine to each production period during which the machine will be used.  An alternative to allocating cost on the basis of time is to allocate the cost on the basis of use; thus, if the machine is used more heavily during one production period than during another, more of the cost of the machine will be assigned to the period of heavy use than to the period of light use.  This alternative should provide the business manager with better information, that is, a more accurate measure of the cost to operate the business, and thus the profit generated by the business during each production period.

Land is not considered a depreciable asset; presumably, land will not wear out or become obsolete.  However, improvements to land are considered depreciable assets; for example, a well, dam, building, fence, irrigation system, or drainage system will wear out.

A depreciable asset is an item that is used in more than one production period but will not last forever.

Depreciation is a procedure for allocating the cost of a depreciable asset among the production periods (and enterprises?) in which the asset is used.

 

Depreciation for income tax purposes

Perhaps the most frequent application of depreciation is in calculating the business net income (profit?) for purposes of determining the amount of income tax owed by the business or its owners.  However, the depreciation allowance for income tax purposes is not likely to reflect the actual use of the machine.  Accordingly, it is a common recommendation that businesses maintain two depreciation schedules -- one that complies with income tax law and one that more accurately allocates the cost of the machine over its useful life.  This page focuses on the second objective.

 

Depreciation for management purposes

Perhaps the simplest procedure for calculating depreciation is a straight line method; that is, assign an equal portion of the cost of the machine to each production period during which it will be used.  For example, a machine that cost $75,000 and will be used for 6 production periods, would have a straight line annual depreciation of $12,500 (75,000/6).

This simple approach, however, may not provide the best information for the manager.  For example, a new machine may be used more intensely immediately after it is acquired than it may be used in later years.  Accordingly, depreciation procedures have been devised that allocate a greater portion of the cost to the first years of the machine's useful life.  Another justification for this practice is that the market value drops most significantly during the early years even if the machine is not being heavily used.  Likewise, there is an income tax benefit to depreciate the machine "as quickly as possible,"  but this page does not focus on this last justification.

 

Depreciation Based on Use
Instead, this page suggests another way to consider depreciation for management purposes (as opposed to depreciation for income tax purposes).  Rather than measure the machine's useful life in terms of time, how about measuring it in terms of possible production?  For example, a tractor may have a projected useful life of 15,000 hours (even if the original buyer does not intend to own it that long; presumably someone else will purchase the used tractor and continue to operate it until it is "fully consumed" at 15,000 hours).  If the tractor costs $135,000, the hourly depreciation over its useful life would be $9 per hour (135,000/15,000).

Using an hourly rate to calculate depreciate now allows the manager to assign an appropriate portion of the cost of the tractor to each activity.  For example, if the tractor is used 1,000 hours one year and 2,500 hours another year, the first year would have to bear $9,000 of the tractor's original cost (1,000 x 9) whereas the second year would have to bear $22,500 of the tractor's original cost (2,500 x 9).

Using an hourly rate for depreciation also simplifies the question of allocating cost among enterprise.  For example, if the tractor was used 700 hours in the production of wheat one year and 300 hours in the production of soybeans (for a total of 1,000 hours as in the previous example), the wheat enterprise would have to bear $6,300 of the tractor's original cost (700 x 9) whereas the soybean enterprise would have to cover $2,700 of the cost (300 x 9).

This method assumes a form of straight line depreciation, but it allows the manager to more accurately assign the cost of the tractor to its actual use.

This method could also be applied in terms of acreage; for example, a machine that has an expected life of 16,000 acres and cost $240,000 would have an depreciation expense of $15 per acre of use (240,000/16,000).  This depreciation cost per acre can then be used to allocate cost of the machine among enterprises and production periods.

 

Depreciation and Relationship to Cash Flow

The concept of depreciation has some unique characteristics relative to other operating cost.  The primary difference is that when the cost of depreciation will be accounted for by the business in computing its profit will not align with when the business has to pay for the machine.  For example, purchasing the $135,000 tractor will require that the dealer be paid immediately even though the 15,000 hours of useful life may be spread over 5 to 20 years.  Thus the cash outflow to purchase the tractor does not align with when the depreciation will be recognized and subtracted as a cost.

Likewise, if the producer borrowed the $135,000 to purchase the tractor and will repay the debt to the bank over the next 4 years; the cash outflow will most likely not align with when the tractor is being used; that is, the tractor will likely be used for more than 4 years.

It is critical that managers understand the distinction between cost (as reported on an income statement) and cash outflow (as reported on a cash flow statement).  The two concepts are not the same.  Certainly, principal payments on a loan to buy a tractor and depreciation allowance to account for the cost of the tractor is one such example.  Also see Cost v. Cash Outflow.

 

Depreciation Schedule (example)

  • Initial data

Information to record might include the item; a unit of measure; the item’s useful life (in units of measure), cost and salvage value (if any); and the calculated deprecation per unit of measure.

Item

Unit of measure

Useful life

(in units of measure)

Cost of Item

Salvage value

Calculated
Deprecation

per unit of measure

X

Acre

12,000

$180,000

$0

$15/acre

Y

Hour

20,000

$240,000

$20,000

$11/hour

Z

Acre

35,000

$87,500

$0

$2.50/acre

.

.

.

.

.

.

.

.

.

.

.

.

  • Record of Use

Information to record could include item, depreciation per unit of use, enterprise in which the activity occurs, the quantity of use, and the calculated depreciation cost for the activity.

Item

Deprecation per unit of measure

Enterprise

Quantity of Use

Calculated
Depreciation

for the Activity

X

$15/acre

Wheat

400 acres

$6,000

X

$15/acre

Corn

500 acres

$7,500

Y

$11/hour

Wheat

28 hours

$308

Z

$2.50/acre

Wheat

400 acres

$1,000

 

Review

A common business goal is to earn a profit, that is, produce and sell a product from more revenue than it costs to produce the product. In order to accurately calculate the profit earned during a production period, the manager must have an accurate measure of the value of the product produced during that time and the cost of the inputs used to produce the product during that time.

Some inputs used to produce the product are fully consumed during the production period (e.g., fuel or labor); some inputs are used in several production periods (e.g., a truck or building).  For those input items that are used in several production periods, the cost of the input must be allocated among the production periods during which the input is used.  The analytical method of allocating the cost of an input among several production periods is referred to as depreciation.

Depreciation reflects the idea that an input that is used to produce a product will decline in value as it is being used to produce the product.  This reduction in value is a cost that needs to be associated with or “charged against” the value of the product being produced. 

  • Depreciation is used to allocate the cost of an input that is purchased in one time period but is used and consumed by the business over several time periods.
  • Depreciation applies only to those inputs used in several time periods that actually wear out, such as a machine or a building. The understanding is that some inputs used in several time periods will not wear out, such as land, and therefore are not depreciable.

An analytical method that calculates depreciation on the basis of use of the input or asset (e.g., hours of useful life and hours of use), rather than time (i.e., years of useful life), also could be used to allocate the cost of an asset among several enterprises in which the input is used.  For example, allocate the cost of a tractor among the several crop enterprises and production periods in which the tractor is used on the basis of hours of use.

 

Summary

  • Depreciation is a procedure by which the cost of a long-term asset is allocated among the time periods during which the asset is used.
  • Although depreciation is often calculated on the basis of time, managers may want to consider allocating the cost on the basis of use.
  • Likewise, managers may find it more logical to analyze some business decisions using a depreciation method other than the method specified by federal income tax law.
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