Engineering Economics – The principles

Introduction
Every business enterprise must make profit in order to survive
Therefore, they need to make economy studies before taking
decisions. Economy studies are concerned with making
comparisons between alternative way of investing resources in
order to select the one , which will give the optimal future return
for the investment. Everybody do some simple form of such
comparisons in his personal life. An example of that is the choice
between different grades of carpet, taking into account quality
and cost. The principles entailed are similar. When the evaluation
demands knowledge of technology, Then the study must apply the
principles of engineering economics.
It is important that an engineer should be able to appreciate
money and to interpret its use in a way similar to that in which he
deals with all other resources by which he tries to design
economically. In this sense, the construction engineer must have a
sound knowledge of engineering economics because he is
concerned with the assessment and creation of works that have a
considerable life and a need for high capital investment. Even
with small tasks, he might also need such knowledge. An example
of that is the arrangement of various components of a structure
together with their design size in the most economical form.
The questioning approach can offer a useful aid in this . It is to
find the answers to Why ? When ?Where ? Who ? and How ? an
objective can be achieved . The alternatives are thus set up.
Another question ( Is it necessary to do it at all ?) is probably the
most important question.
In comparing alternatives for an engineering scheme, it is not
always possible to convert all the factors into terms of money.
There are some irreducible or intangible factors. The human
factor for example, must be evaluated to establish its influence.
Such as the case of shifting from labor-intensive scheme to
automation which may harm the enterprise reputation. Another
example is the judgment factor. Such as seeking reliability and
safety in service by keeping on buying equipments from the same
manufacturer in order to rationalize its problems concerning spare
parts and maintenance. A goodwill, which may have been
established by previous transactions, is another example.
Decisions in such cases are considered as decisions of policy.

Present Economy Studies

During the process of designing any project, it is necessary to
undergo through an economic selection of alternative materials,
labor, plant, construction methods that can be employed. Keeping
into consideration the ways in which the combinations of these
resources can be made and the cost of each alternative. If time
effect is neglected, it is called a present economy study. This
means that alternatives are equivalent in every way as much as
time effect is concerned .
Example
Three designs of a beam are available. Which is the economic
design? If it is known that :
 Beam Dimensions** Reinforcement* Concrete Grade
in mm Kg/m3 concrete and cost
I 300*600 69 A@$10.00per m3
II 375*600 72 B@$10.50 per m3
III 300*450 112 C@$11.00 per m3
*Reinforcement @$4.60 per 100Kg
** Formwork to beam sides @$3.76 per m2
Formwork to beam soffits @$4.90 per m2

Solution :
Consider 10 m run of each beam.
0.3*0.6*10=1.8m3 0.375*0.6*10=2.25m 0.3*0.45*10=1.35m3
3
1.8*96=172.8kg 1.35*112=151.2kg
0.6*2*10=12m2 2.25*72=162kg 0.45*2*10=9m2
0.3*10=3 m2 0.6*2*10=12m2 0.3*10=3m2
1.8*10=18$ 0.375*10=3.75m2 1.35*11=14.85$
172.8*4.6/100=7.95 2.25*10.5=23.63$ 151.2+4.6/100=6.95
$ 162*4.6/100=7.45$ $
12*3.76=45.12$ 12*3.76=45.12$ 9*3.76=33.84$
3*4.9=14.7$ 3.75*4.9=18.375$ 3*4.9=14.7$
45.12+14.7=59.28$ 45.12+18.375=63.5$ 33.84+14.7=48.54$
 Beam Beam Beam
I II III
Volume of concrete in m3 1.80 2.25 1.35
Weight of reinforcement in kg 172.80 162.00 151.20
Area of formwork to sides in m2 12.00 12.00 9.00
Area of formwork soffits in m2 3.00 3.75 3.00
Cost of concrete in $ 18.00 23.63 14.85
Cost of reinforcement in $ 7.95 7.45 6.95
Cost of formwork in $ 59.82 63.5 48.54
Total cost in $ 85.77 94.58 70.34

This indicates that beam III is the cheapest alternative.

Simple and compound interest
Interest may be defined as the time value of money. It is the
amount of money that is paid by the borrower to the lender for the
use of money. In wider terms, it is the return that may be obtained
when capital is invested. The effect of interest is that it increases
the amount of invested capital over time. Interest rate are
normally quoted as a percentage for a period of one year . The
following symbols and definitions are usually used :
n= time or number of periods over which the investment is paid.
i= the interest rate per period or unit of time.
I= total sum paid at end of period for use of money at simple
interest.
P=the principal which is a present or initial sum of money.
F=the future or compound amount of money at the end
of(n)periods at interest(i), made up from the principal +the
interest payable.
R=the uniform series of end-of-period payments or receipts which
extends to (n) periods.
Simple interest:
I=Pin
e.g if the amount to be deposited in the bank is 1000$ and the
bank is offering a 10% per year simple the interest , then and of
the first year the interest pay able the bank will be :
I=1000$*0.1=100$
Compound interest:
If the above amount of 1000$ (p) is deposited against a
compound interest of the same percentage per year for five years.
The amount at the end of the first year will be p(1+i)=110$ , then
at the end of the second year it will be P(1+i)2= 1210$ , and at the
of the third year it will be P(1+i)3=1331$ , then at the end of the
forth year it will be P(1+i)4 =1464.1$ , and finally at the end of
the fifth year it will be P(1+i)5=1610.51$ . It is the concept of the
paying interest on interest .i.e .
F=P(I+i)n
The term (1+i)n is called the compound amount factor. This can
be presented graphically like this :
 0 F

P 1 2 3 4 n=5

Present worth :
If the above formula is rearranged to express (p) in terms of(F,I,
and n ) then the formula will establish the initial. It can be said
that the sum (F) is being discounted to an equivalent value at a
previous date.
P=F/(1+i)n or , P=F{1/(1+i)n}
The term {1/(1+i)n} is called the present worth factor .
Uniform series of payments :
Any series of equal payments (R) , which are made at the end of
equal periods, is known as annuity There are four ways in which
(p)or (F) and (n) can be linked together with (R) for any given (i) .
These are :
Using the uniform series compound amount factor :
F=R[{(1+i)n -1}/i]
Using the sinking fund deposit factor :

0 1 2 3 4 F
R = F [i/{(1+i)n-1}]
N=5

R R R R R

Using the uniform series present worth factor:

P=R [{(1+i)n -1}/i(1+i)n]
 Using the uniform series capital recovery factor :
R=P [ i(1+i)n /{(1+i)n -1}]
P 1 2 3 4 n=5
Example :
Given an interest rate of 5 per cent
0 R R R R R
per year , what sum would be
accumulated after 6 years if 200 $ were invested at the end of
each year?
F=200[{(1+0.05)6 -1}/0.05 ] =200(6.8) = 1360$
P=200[{(1+0.05)6 -1}/ 0.05(1+0.05)6 ]=200(5.075)=1015$
Equivalence:
It is often desirable to compare payments or receipts of different
sums of money due at different dates , with each . To do so, it is
necessary to convert all sums into their equivalent sums at a
definite date, taking into account the effect of interest on time .
This can be done by finding the present worth of each sum in
order to be able to compare between them on equal bases.

Nominal and Effective Interest Rate :

It has been mentioned that interest rate are normally quoted as
a percentage for a period of one year. Such an interest rate is
known as a nominal rate. However, if it is stated that the interest
rate is a percentage per year compounded quarterly or monthly,
then the real interest rate is higher than the nominal rate, and it is
called the effective rate. If interest is compounded (t) times per
year and the nominal interest rate per year is (i), then the effective
interest rate is =(1+0.1/4)4 -1000=1104-1000=104$
Uniform gradient Series :
When considering annuity, it was stated that (R) represent
equal basic annual payments. Now payments, which are
increasing each year by uniform amount (g), are considered.
These (g) increments can be converted to uniform annual
equivalent of increments (Rg) as follows :
Fg1 =g1[{1+i)n-1 – 1}/i] and Fg2=g2[{(1+i)n-2 -1] and so forth.
Fg=(g/i) [{(1+i)n -1}/i] -(ng/i)
Rg=(g/i)-(ng/i) [i/{(1+i)n -1}]
Example: If(basic R=200$),(g=50$),(n=5years) ,(i=0.05)
.Find(total R):
Rg=(500/0.05)-(5*50/0.05)[0.05/{(1+0.05)5-1}]=95$
R=200+95=295$
Economic Comparisons
Financing Projects:
If enough money is not available in order to finance a
construction project, it must be borrowed. A capital can be
borrowed on the basis that the project itself is regarded as a
security by virtue of its net revenue earnings. In such a case, it
must be understood that repayment of the loan is to redeem the
loan itself in addition to payoff interest of the loan. The ultimate
redemption of the loan is met by making an annual investment
into a sinking fund. In the case of replacement of an asset at the
end of its useful life, the absolute total of the sinking fund is often
determined by taking into account inflation rate and thus the
increased replacement cost of the asset in the future. In addition,
the interest on the loan itself is something else than the interest of
the sinking fund because of the different nature of the transaction
according to circumstances of the national economy and the risk
being undertaken by the lender.

Methods of Economic Appraisal:

The choice between various alternatives for investment is rarely
affected whether the required finance is already in reserve or there
is a need to borrow it. Therefore, no account will be taken of the
effect of borrowing the capital. Interest payable on any loan can
be treated separately. Economy comparisons are made with a
view to decide as to which alternative should be chosen or
whether investment should be made at all. This might need a
knowledge of the rate of return of investing the capital elsewhere.
In addition to that, something extra should be returned for any
risk undertaken or profit foregone.
Rule – of – Thumb Methods:
These methods are considered as an approximation to more
refined methods because they neither take into account the time
effect on money nor the timing of the capital recovery. One such
method is the rate of return on capital method. This can easily
be calculated as follows:
Rate of return on capital=Annual net profit/Capital investment
There are many variants depending on the interpretation of the net
annual profit in the sense of what is deducted from the gross
profit and whether it is treated as an average sum over period of
year or not.
Another method is the payback or payout method. The principle
of this method is to determine how quickly the gross capital can
be recovered by the net cash inflow. This can easily be calculated
as follows:
 Payback period= Capital investment /Annual net profit
No account is taken of the potential profitability the payback
period.

The Equivalent Annual Cost Method:

In this method, account is taken of both the capital and the
recurrent investments made over the full period of assessment.
Payments and receipts are charged on annual basis. While they
are charged in fact on daily basis, an end-of-year convention is
used in order to set an equivalent uniform annual series .
Example : It is proposed to maintain a temporary road that is
expected to last six years, by one of three alternatives. Either by
laborers only, with annual cost of 18000$ or by buying a grader
for18000$, with annual maintenance cost 300$ and labor cost of
10000$ per year. The salvage value of the grader after six years
is estimated to be 750$. The third alternative is to divide the job
into three stages every two years. The initial costs of these stages
are 12000$, 7000$, and 6500$ concurrently. The total labor cost
of this scheme amount to 8000$ per year. If a return of at least
10% is desired, which is the economic scheme?
 Scheme I $ $
Annual labor cost 18000 18000
Scheme II $ $
Annual capital recovery of grader
=(P-S)[{i(1+i)n}/{(1+i)n-1}]+Si
=(18000-750)[{0.1(1.1)6}/{(1.1)6-1}+750(0.1)] 4036
Annual maintenance cost 300
Annual labor cost 10000
Total equivalent annual cost 14336

Scheme III $ $
Annual capital recovery of initial cost
=(12000)[{0.1(1.1)6}/{(1.1)6-1}] 2755
=(7000){1/(1.1)2}[{0.1(1.1)6}/{(1.1)6-1}] 1327
=(6500){1/(1.1)4}[{0.1(1.1)6}/{(1.1) 6-1}]
1020
Annual labor cost
8000
Total equivalent annual cost 13102
Scheme III is therefore the economic one.
Length of Asset Life :
When the alternatives have equal lives, the equivalent annual
costs are comparable. Nevertheless, it is seldom the case in
reality. Alternatives may have different lives therefore; they must
be repeated to reach the lowest common multiplier taking into
account future rising costs.
Example: A warehouse can be built using either a concrete or a
steel structure. The initial cost of concrete is 160000$ , which
may last for 60 years without maintenance for the first 10 years,
 thereafter there will be an annual maintenance cost of 1000$ and
a salvage value of 40000$. While the initial cost of steel is
60000$, which may last for 20 years annual maintenance cost
form the beginning of 1150$ and a salvage value of 6000$. An
acceptable rate of return is assessed at 10%. Which is the
economic proposition ?

For the concrete structure

Capital recovery=(160000-40000)[{0.1(1.1)60}/{(1.1)60-1}
+4000(0.1)] = 16049$

Present worth of annual costs=(1000)[{(1.1)50-1}-1} /{0.1(1.1)50}]

{1(1.1)10}=3822$

Equivalent uniform series=(3822)[{0.1(1.1)60}/{(1.1)60-1}=384$

Total equivalent annual cost= 16049+384=16433$

For the steel structure

Capital recovery= (60000-60000)[{0.1(1.1)20}/{(1.1)20-1}
+6000(0.1)]=6943$
Total equivalent annual cost= 6943+1150=8093$
If the replacement cost of steel increases by 50% each twenty
years, it will become 90000$ at the end of the 20 th year and
135000$ at the end of the 40th year. This means that the present
worth of this increase in the cost may amount to 4458$ and
1657$ concurrently. These two sums together produces an
equivalent uniform annual cost of 613$ over the total life of 60
years which, makes the total equivalent annual cost equal to
8706$.
 Perpetual Life of Assets :
The life f assets created by construction works may be difficult
to be assessed because they stretch far into future and some
works last forever. Such as railways, dames and sewers. In such
cases, the computation of capital recovery takes a similar form to
the computation of simple interest. Since the computation of
capital recovery is calculated by:
R=P[i/{(1+i)n-1}+i]
It can be noticed that as much as (n) increases, the term [i/{(1+i)n-
1}] decreases approaching to zero. So that the formula become
[R=P i] which is similar to the expression of simple interest.
The Present worth Method :
It also called the present Value or Net Present Value
method(NPV). This method is long establish and well tried. The
base of this method is that all future receipts and payment are
converted to present worth. The acceptable interest rate is the
same as in the aforementioned method Nevertheless, it is easier
especially when widely varying sums of money are paid out or
received over time.
Example: The same example of road maintenance can solved as
follows :
Scheme I $ $
Present worth of annual labor cost
=(18000)[{(1.1)6-1}/{0.1(1.1)6}] 78390 78390
Scheme II $ $
Initial cost of grader 18000
Present worth of annual labor and maintenance cost 44857
=(10300)[{(1.1)6-1}/{0.1(1.1)6}]
Less Present worth of salvage value
=(750){1/(1.1)6} -423
Present worth of total cost 62434

Scheme III $ $
Initial cost of first section of road 12000
Present worth of second section of road
=(7000){1/(1.1)2} 5785
Present worth of third section of road
=(6500){1/(1.1)4} 4440
Present worth of annual labor cost
=(8000)[{(1.1)6-1}/{0.1(1.1)6}] 34840
Present worth of total cost 57065

Scheme III is still the economic one.

Length of Asset Life:
As before, when the alternative have equal lives, the present
value are comparable. Otherwise, they must be repeated to reach
the lowest common multiplier taking into account future rising
cost.

Example: The same example of concrete and steel structures.

For the concrete structure
Initial cost of building =$160000
Less present worth of salvage value = (40000){1/(1.1)60}=132$
Present worth of annual costs
=(1000)[{(1.1)50-1}/{0.1(1.1)50}]{1/(1.1)10}=3822$
Present worth of total cost over 60 years=163690$
For the steel structure
Initial cost of building =$60000
present worth of annual costs
=(1150)[{(1.1)60-1}/{0.1(1.1)60}]=11462$
present worth of renewal cost less salvage value at the end of 40
years=(60000-6000){1/(1.1)20}=8024$
present worth of renewal cost less salvage value at the end of 60
years=(60000-6000){1/(1.1)40}=1193$
Less present worth of salvage value at the end of 60 years =
(6000){1/(1.1)60}=-20$
present worth of total cost over 60 years = 80659$
Capitalized costs:
This term is use in case where comparisons of costs are
assumed to be incurred on a perpetual basis. The cost of the
renewal of long life assets can be converted into a uniform
perpetual series of payment as between renewals using the
aforementioned expression [ P=R/i]. The capitalized cost is the
present sum, which will finance an annual cost at a fixed rate of
interest in perpetuity.
The Yield Method :
In both of the present worth and the equivalent annual cost
methods, the calculation are based on the selection of an
appropriate interest rate. The interest rate selected must indicate
the required rate of return. Both methods may yield some reverse
result for different interest rates. While, it is difficult to select a
rate that can fairly reflect the cost of capital. Therefore, it is
advisable to calculate the prospective rate itself. A method that
employs discounted cash flow techniques ( DCF) called the yield
method or the investors' method is widely use to calculate the rate
of return that equates the estimated set of cashflows of each
alternative and compare them with each other. Such a rate is
called the internal rate of return(IRR), the profitability index or
the marginal efficiency of capital .

Example: A firm has purchased a power shovel for the sum of

15000$. The payments and receipts due to operating this
equipment for five years, are shown in the table below. At the
end of that period the firm has reconditioned the equipment at
accost of 500$ and sell it for the sum of 2000$. It is required to
establish the rate of return of this investment. The italic numbers
represent the sums that are mentioned in the text.

year Receipts $ Payments $ Net cashflow$

0 0 -15000 -15000
1 6000 -2000 4000
2 7500 -3500 4000
3 6500 -2500 4000
4 8000 -3000 5000
5 5000+2000 -2500-500 4000
 35000 -29000 6000

Such problems are solved by trial and error. Tow likely

interest rates is to be assumed. One being greater and one
smaller, then the IRR can be interpolated.
 year Net PWF @ PW of PWF @ PW of
11% NCF $ 13% NCF $
Cash flow $
0 -15000 1.000 -15000 1.0000 -15000

1 4000 0.9009 3604 0.8850 3540

2 4000 0.8116 3246 0.7831 3132

3 4000 0.7312 2925 0.6931 2772

4 5000 0.6587 2394 0.6133 3067

5 4000 0.5935 2374 0.5428 2171

 21000 - 15443 - 14682

11+ 0 x=1.17 2

IRR %=11+2[(2)(15443-15000)/(15443-14682)] 443

=11+(2)(443)/(761)=11+1.7=12.17% 761
Selection from alternatives :
Example: The table below list the profits for three alternative
investments over a period of six years with the same capital
outlay.
Year Project NCF in $
  
0 -20000 -20000 -20000
1 3000 6500 7000
2 4000 6500 6000
3 6000 6500 7000
4 8000 6500 5000
5 8000 - 3000
6 8000 - 1000
 37000$ 26000$ 29000$
Average annual 6170$ 6500$ 4833$
profits
IRR 17.5% 11.67% 14%

It is required to make a choice between each of them in order to

select the economic one. If these three projects are now
considered in the light of the return on capital method, it would
appear that project () is the most favorable having return on
capital of 36.7% Should the payback method is use, then project
() clearly become the obvious selection with the repayment of
the initial investment carried out in the first three years. If the
rate of return is calculated by the DCF method, project () would
be selected for having the higher IRR. Therefore it is very
essential to take into account the effect of time on money .

Selection from alternative having one existing case among

them:

Example : The table below lists the annual expenses for a factory
that is currently running plus two development investments with
their initial costs. The estimated life of the mechanical equipment
is five years. The management requires a 5% minimum rate of
return.

Year Expenses in $
A-Existing Alternative B Alternative C
arrangement
0 - -20000 -12000
1 -10000 -5300 7000-
2 -10000 -5300 7000-
3 -10000 -5300 7000-
4 -10000 -5300 7000-
5 -10000 -5300 7000-

It can be noticed that all the sums have a negative sign due to
being expenses. Therefore we need to subtract each alternative
from the others to get negative and positive signs so that the yield
method can be applied. The table below shows that employing
alternative B will provide an acceptable rate of return of 5.75%,
while employing alternative C will provide an attractive rate of
return of 8%, which is higher than the one gained by employing
alternative B. In both words alternative C to B will yield a rate of
return of only 2% on the difference between the two initial sums.
This difference can be invested elsewhere for better rate of
return.

Year A-B A-C C-B

0 -20000 -12000 -8000
1 4700 3000 1700
2 4700 3000 1700
3 4700 3000 1700
4 4700 3000 1700
5 4700 3000 1700
IRR 5.75% 8% 2%

Postponement of investment :

This can be treated exactly like the aforementioned case except

the present worth is to be calculated instead of IRR.

Example : The table below lists the annual expenses for a

development investment to be employed now with its initial cost
plus the case if it is postponed for two years. It also shows the
benefit of postponement.
 Year Immediate Postponed NCF PWF PW of
investment investment @ 10% NCF
1 -20000 -2000 -18000 1.0000 -18000
2 -500 -2000 1500 0.9091 1365
3 -1000 -2000 19000 0.8264 15700
4 -1500 -500 -1000 0.7513 -751
5 -2000 -1000 -1000 0.6830 -683
6 -2000 -1500 -500 0.6209 -310
7 -2000 -2000 0 - -
n -2000 -2000 0 - -

The Principle of Valuation

The fact that people are ready to give different amount of thing
in order to satisfy their different needs means that different
things have different values for them. One way in which the
value of an object can be defined is by the number of hours
which a person is ready to work in order to obtain it. A general
statement may be deduced that the value of a good or a service
may be assessed by the extent to which it is exchangeable for
some other good or service. The exchange of goods and services
is carried out through the medium of money by interpreting the
value in terms of money. This means that values of goods and
services can be compared by comparing their price. But it must
be noted that price is not the same as value. The exchange rates
for money may vary on a daily bases, but this does not mean that
the value of goods and services varies in similar way. The value
of a piece of bread, for example, is the same as it was many years
ago. However, the price of it has changed considerably.
Therefore the price is considered as a market value. While the
use value, Which is the value to the owner may be something
else, and the value to non interested buyer may not exceed the
scrap value. In general, the value of an asset to its owner will not
exceed the replacement cost of that asset, making due
allowances for any variation there might be in the quality of
replacement. On the other hand, the value to the owner will not
be less than the market value, which is the resale value (or
salvage value) in the second hand market before its useful life is
completed. Replacement cost must also take into consideration
the revenue factor , which is the loss of revenue earning along
the time of replacement delay. On the other hand the ability of
the asset to earn money over its expected future life must also be
considered.

The valuation of an asset already in a company's possession

necessitates the establishment of the net cash flows which will
arise from it, taking into account that it will be maintained and
replaced at regular intervals. These net cash flows must then be
compared with those that would result from immediate
replacement.
 Example :
A company owns an equipment, which it has been using for the
past three years. The economic life of the equipment has been
calculated to be eight years, with an estimated resale value of
1000$. The capital cost of replacement by a similar one amounts
to 5000$. The operating costs for the existing one amount to
500$ per annum. If the cost of capital is 10% per annum, what is
the value of the existing equipment now ?

Year Existing Equipment New Equipment

0 - 5000
1 500 300
2 500 300
3 500 300
4 500 300
5 500+500-1000 300
6 300 300
7 300 300
8 300 300+500-1000
9 300 300
etc. etc. Etc.

New Equipment :
Considering one set of eight years:

PRN=300[{(1.1)8-1}/{0.1(1.1)8}]=1600.5$

PSN=1000{1/(1.1)8}=466.5 $

Therefore, a perpetual series of payments each eight years will be:

PTN=5000+1600.5-466.5=6134$ each eight years

The present worth of net cash flows will be :

PN= [6134/{(1.1)8-1}]+6134=11484$

Existing Equipment:
Considering the first five years:
PRE=500[{(1.1)5-1}/{0.1(1.1)5}]=1895$
PSE= 1000{1/(1.1)5}=621$
The present worth of the perpetual series of payment will be:
PTE=11484/(1.1)5= 7130 $
The present worth of net cash flows will be :
PE=7130+1895-621=8404 $
Therefore, the value of the existing asset=11484-8404=3080$
Derivation:
If payment (A)is made at the end of every (t)years, then the present
worth of such a series in perpetuity amounts to :
P={A/(1+i)t}+{A/(1+i)2t}+{A/(1+i)3t}+…..+{A/(1+i)}
P(1+i)t=A+{A/(1+i)t}+{A/(1+i)2t}…..+{A/(1+i)}
P(1+i)t-P=A= P{(1+i)t-1}
P=A/{(1+i)t-1}

If the same payment is also made at the beginning of first year

then:

PO =A+P=A+[A/{(1+i)t-1}]
Note:
In the earlier work concerning the comparison of cash flows by
various methods, the end-of-year conversion has been used.
When considering operation costs, it may not be realistic to
assume that they all occur at the end of a particular year. It is a
better approximation to assume that the total operation costs arise
at the middle of the year and be multiplied by (1+i/2) in order to
convert it to the end of the year.

Depreciation

Depreciation is the decrease in the value of an asset that result

from deterioration of its condition and obsolescence, which make
it less able to perform efficiently. The depreciation of an asset is
charged against the revenues of the owner. The purposes of
taking depreciation into account are to recover the initial capital
investment, along the asset useful life, and to insure that the
initial capital investment is included in calculating production
costs. Depreciation allowances can be made by distributing the
initial cost of an asset, less any salvage value it may have, over
the period of its useful life. For simplicity, it is calculated as an
allocation process rather than valuation. For example, when you
purchase steel molds, made for casting concrete lintels, at a cost
of 2600$, having a useful life of two years, with a production rate
of 1000 lintels per year, and each lintel can be sold for 10$. If the
cost of producing each lintel is 7$, it is quite wrong to imagine
that the profit will be 3000$ per year, because the molds will be
out of order after two years and their initial cost is not recovered.
Therefore you must divide the 2600$ by 2000 lintels that you can
produce within two years period, which leads to a 1.3$ annual
depreciation allowance for each lintel (neglecting interest).
Doing so, your true profit will be only 1700$ . Depreciation
allowances are either equally made or by a decreasing or
increasing order, depending upon the type of the asset. Some
assets deteriorate faster at the beginning of their useful lives,
while others deteriorate faster at the end of it.

Methods of Depreciation Accounting

Straight Line Method :

It is also known as the Fixed Installment Method, in which, the

difference between the initial cost and the salvage value(if any),
is divided by the useful life (in years), in order to get a uniform
yearly installment of depreciation, i,e. [Dr=(P-S)/n], and the
Book Value at each year can be calculated from

[Br=P-(r*Dr)].Book value is an expression, which is commonly

used to represent the current amount of the initial cast that
remains after deducting the total sum of depreciation allowances
for previous years, it is some time called unamortized cost being
the complement of amortized cost. The latter is the expression
that describes the part of the initial cost, which has already been
allocated by depreciation methods during the past life of the
asset. The advantages of this method are ; its simplicity, and that
it completely write off the initial cost at the end of the useful life.
 While the disadvantage are; that it make no account for the time-
value of money, and it dose not allow for leveling-up the
increased maintenance cost.

Example : Find the book values and the depreciation allowances

at each year, for an equipment that have an initial cost of 10000$
and an estimated salvage value of 2000$ at the end of a useful
life of eight years?

Dr=(10000-2000)/8=1000$ per annum.

End of year Depreciation Dr in $ Book value Br in $

0 0 10000
1 1000 9000
2 1000 8000
etc. etc. etc.
7 1000 3000
8 1000 2000

Straight line depreciation may also be calculated in terms other

than the useful life, such as machine hours, and in this case it is
called the working-hours method. It can also be calculated
against production capacity where [D=(P-S)/Q].

The Declining Balance method:

It is a method that are used to write off the initial cost rate in the
early years of the useful life, than the later years. Therefore, it
overcomes one of the deficiencies of the straight line method. In
the declining or diminishing balance method, also known as the
Matheson Formula or Constant Percentage method, a fixed
percentage of the book value of an asset is written off annually.
For an asset with a known initial cost, an estimated salvage value,
and an expected service life, it is possible to calculate the
declining balance percentage of depreciation (d), which is
necessary to write off the capital completely by [d=1-n√(S/P)].
Therefore, this method can not be used with an asset having zero
salvage value. But such calculations might not be needed, for it is
common to use well known percentages for different types of
equipment that range from (22%) for construction equipment to
(35%) for having ones.
Example : The same aforementioned example can be resolved
using a (20%) declining balance percentage in steel of (18.22%)
as calculated from the above formula.
End of year Declining balance Dr in $ Br in $
0 0 0 10000
1 0.2 2000 8000
2 0.2 1600 6400
etc. etc. etc. etc.
7 0.2 524 2097
8 0.2 420 1677

Sum of the Integers Method :

This is another method that enables a greater proportion of the
initial cost to be depreciated in the early years, also called Sum of
the Years' Digits. Each year's depreciation is calculated as a
fraction of the initial cost less the salvage value (if any). The
denominator of the fraction is the sum of all the digits
corresponding to the number of each year in the life of the asset,
then the year's numbers are used in a reverse order for the
numerators of the fractions. The following expression can also be
useful [D=(P-S){2(n-r+1)/n(n+1)} ].
 Example : The same aforementioned example can be
resolved as follows:
End of year Fraction Depreciation Dr in $ Book value Br in $
0 0 0 10000
1 8/36 1778 8222
2 7/36 1555 6667
etc. etc. etc. etc.
7 2/36 444 2222
8 1/36 222 2000

Sinking Fund Method :

As its name implies, this method involves the assumed deposit
of a uniform series of end-of-year payments into an imaginary
sinking fund at a give rate of interest, it is also called the Present
worth method. Therefore, it takes the time- value of money into
account. The amount of the annual deposits is so calculated that
the accumulated sum at the end of the estimated life of the asset
will just equal the value of the asset which is being depreciated,
therefore :

R = (P-S) {i/(1+i)n-1}

1∑
r
Dj = R{(1+i)r -1}/i
Br = P-1∑r Dj
Example : The same aforementioned can be resolved using a
(10%) interest rate as follows :
R= (10000-2000) {0.1/(1.1)8-1} =699.55≈ 700$
 1∑
r
End of year Annual deposit R Dj = R{(1+i)r -1}/i Br in $

0 0 0 10000
1 700 700 9300
2 700 1470 8530
etc. etc. etc. etc.
7 700 6640 3360
8 700 8000 2000

Graphical Comparison of Depreciation Method :

10 Initial Cost
Book Valuue in $000s

9
8 S.F.
7
6
5 S.L.
4 D.B.
3
2 S.I. Salvage Value
1
0
1 2 3 4 5 6 7 8
Age of Asset in Year
Annul Depreciation in $000S

1.5 S.I. S.F.

S.L.
1

0.5 D.B.

0
1 2 3 4 5 6 7 8
Age of Asset in Year
What is the probability that program will be completed in 33
weeks ?