lowest taxable income in times of rising prices, but also because
it assigns the most recent prices to cost of goods sold.
The Agile Managerâ€™s Checklist
The method a company uses to value its ending inven-
tory will affect its assets, cost of goods sold, gross profit,
net income, and retained earnings.
An inventory may be valued using four methods: specific
invoice prices, FIFO, LIFO, and weighted average.
Companies must use the same inventory valuation
method each year if they want the information on their
financial statements to be comparable from one year to
the next. Also, the IRS requires it.
â€śItâ€™s better to wear out than rust out.â€ť
â€śDepreciation is one of those things, Steve, that shows why cash
flow is so important,â€ť said the Agile Manager.
This was the final training session for Steve. Good thing, too,
thought the Agile Manager before the meeting. Iâ€™ve been neglect-
ing some important things. But thisâ€™ll pay off in the long run. Steve
can start doing ratios for meâ€”and Iâ€™ll get him working on cost
estimates and figuring price points.
â€śThe money you spent on the car or computer or whatever is
long gone,â€ť he continued, â€śbut you might take deductions for five,
seven, or ten years. Thatâ€™s why your profits may be down while
cash is actually up.â€ť
Steve seemed to drink it in. â€śHmm. But if you took the big hit all
at onceâ€”like you deducted $800,000 for a machine in one yearâ€”
then your profits would sink to the floor of the Grand Canyon.â€ť
â€śDarn tootinâ€™. But the idea is that the machine goes on making
78 THE AGILE MANAGERâ€™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS
you money for many years, so you should deduct a little bit as long
as itâ€™s in use.â€ť
â€śI get it,â€ť Steve said. â€śYou know, this isnâ€™t so bad. I donâ€™t know
what I was afraid of.â€ť
â€śAll you were afraid of, dear boy, was the unknown.â€ť
The philosophy embodied in the quote leading off this chap-
ter applies just as well to a companyâ€™s machinery and equipment
as it does to your body. Companies, however, can deduct the
annual wear-out (or depreciation) on equipment, buildings, and
other expensive assets as a business expense each year. That de-
creases their taxable income. (Unfortunately, the IRS refuses to
let us taxpayers do that with our bodies, darn it. How about
some real tax reform?)
Depreciation is how a company recovers the high cost of its
costly assets gradually, over the course of the years theyâ€™ll be
used in the business.
BT This makes sense.To record the
ip entire $2 million cost of a new
machine as an expense in the year
Depreciation is an estimate.
it was bought would really clob-
Technology, routine mainte-
ber net income that year, plus it
nance, and other factors
wouldnâ€™t be fair. That one par-
affect how long a machine
ticular year would take a nuclear
will actually run before it has
hit in expenses for a machine that
to be replaced. might actually run for ten or fif-
Each yearâ€™s depreciation throughout the machineâ€™s life is
matched, therefore, against the net sales that the machine helped
the company make that year. (Thatâ€™s called â€śthe matching prin-
ciple of accounting,â€ť by the way.)
Types of Depreciation
Depreciation can be either physical or technological. Both
types reduce an assetâ€™s value.
Physical depreciation is simply wear and tear. Example? Check
out how rough a companyâ€™s delivery trucks look after theyâ€™ve
been driven on salted roads up
north for several winters.
happens to ever ything from Depreciation can be physical,
mainframe computers to photo- technological, or both.
copying machines and laser sur-
gery equipment, because high-
tech will eventually be replaced by higher-tech. When that hap-
pens, the equipment ends up being sold or used for a doorstop
or a planter.
Some Preliminary Details
Before we go charging off in all directions, letâ€™s look at a few
ideas about an assetâ€™s true cost for depreciation purposes.
Depreciation starts with the assetâ€™s cost, but â€ścostâ€ť includes
both actual cost plus everything the company paid to get the
machine delivered, installed, shined, sheened, polished and glossed,
and up and running. That would include, for example, freight
charges, unpacking, changes to existing facilities (such as pour-
ing a concrete-reinforced base or installing customized wiring),
and other relevant items.
Keep in mind, too, that depreciation is an estimate. Equip-
ment thatâ€™s well maintained may last many years past its esti-
mated life, while machines that are run half to deathâ€”and only
noticed when they break downâ€”die before their time.
Responsible managers naturally treat the companyâ€™s equip-
ment as they would their best friends (witness the recently cel-
ebrated â€śTake a Drill Press to Lunchâ€ť week), because equip-
ment tends to treat you as well as you treat it. The â€™78 Ford
LTD II that I bought new has got more than 194,000 miles on
it with nary a major breakdown or wreck. Everything works.
(No, itâ€™s not for sale.)
You can calculate depreciation using one of a few methods.
80 THE AGILE MANAGERâ€™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS
Most of these acknowledge an assetâ€™s salvage value, which is how
much management figures itâ€™ll be worth at the end of its useful
life.That value might be how much management thinks it would
get on a trade-in or if the machine were sold for scrap.
As an example, letâ€™s set up a hypothetical machine. Weâ€™ll call it
a nit-picker; no doubt youâ€™ve run into several of them in the
accounting department. Hereâ€™s the lowdown:
Our model, the 386-PA (Partially Awesome), came with a
200 MHz Pentium chip, built-in compass, neat secret com-
partment, and fat-gram counter. It cost $16,000, including
all that installation stuff that was mentioned above.
s Management estimates that the 386-PA will run faithfully
for five years and be worth $2,000 when itâ€™s finally put out
to pasture.That means itâ€™ll be de-
BT est preciated a total of $14,000
s The 386-PA is a piece of pro-
Straight-line depreciation is
duction equipment (batteries not
the easiest to figure and is
included) that the manufacturer
often used for reporting to
claims will pick 80,000 nits dur-
ing its lifetime.
Letâ€™s crank up our calculators
and depreciate this beast four different ways.
This method depreciates an asset the same amount each year
for its estimated life. The formula is:
Costâ€“Salvage value $14,000
= = $2,800 per year
Estimated years of service 5
On its income statement, A.I. would record a depreciation
expense of $2,800 on the nit-picker each year. Then it would
add that to the running total in an account called â€śaccumulated
depreciation.â€ť The total in that account is subtracted from the
machineâ€™s original cost on the est
balance sheet (see page 30) to
come up with its book value on
Units of production deprecia-
the balance sheet date.
tion closely matches a ma-
At the end of its five-year life,
chineâ€™s depreciation to how
the machine would be fully de-
much it produces each year.
preciated.The company wouldnâ€™t
record any more depreciation af-
ter five years even if the nit-picker is still going like the Ener-
gizer Rabbit. The companyâ€™s books for this machine (in case
youâ€™re interested) would look like this under straight-line:
Year Expense Depreciation Book Value
1 $2,800 $2,800 $13,200
2 $2,800 $5,600 $10,400
3 $2,800 $8,400 $ 7,600
4 $2,800 $11,200 $ 4,800
5 $2,800 $14,000 $ 2,000
Units of Production
The units of production technique relates a machineâ€™s depre-
ciation to the number of units it makes each accounting period.
The only catch is, the operator (or somebodyâ€”probably a com-
puter) has to keep track of the machineâ€™s output each year. What
The formula for depreciation per unit under this approach is:
Estimated units of production (over its life)
= $.175 depreciation per unit
If the machine made the following number of nits each year,
its depreciation would be:
82 THE AGILE MANAGERâ€™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS
Nits Depreciation Yearly
Year Produced Per Nit Depreciation
1 11,250 X .175 $ 1,968.75
2 15,580 X .175 $ 2,726.50
3 18,390 X .175 $ 3,218.25
4 19,470 X .175 $ 3,407.25
5 15,100 X .175 $ 2,642.50
Note: The company could depreciate the machine $36.75 in
its sixth year (210 nitsâ€™ worth), because it only made 79,790
during its first five years and this method depreciates by units,
not by years. But then, this is really nit-picking.
The declining balance method figures depreciation each ac-
counting period by applying a fixed rate to the assetâ€™s book value.
Thatâ€™s its value when you subtract accumulated depreciation from
BT The declining balance method
ip doesnâ€™t take the assetâ€™s salvage
value off the front end, as the
Both declining balance and
other two did. Instead, it stops
sum-of-the-yearsâ€™ digits are ac- when the assetâ€™s book value hits
celerated methods that depre- its salvage value.
ciate equipment heavily in its The â€śfixed rateâ€ť mentioned
newer years. above is usually twice the straight-
line rate, which is why this
method is often called the â€śdouble declining balance method.â€ť
Itâ€™s an accelerated method that increases depreciation in a
machineâ€™s newer years and decreases it as it gets older.
In this case, the machine has five years of expected life. That
means the depreciation rate would be (1/5 X 2) or 40 percent
each year on the nit-pickerâ€™s value. Each yearâ€™s depreciation would
Year 1 ($16,000 - $0) X .40 = $6,400
Year 2 ($16,000-$6,400) X .40 = $3,840
Year 3 ($16,000-$6,400-$3,840) X .40 = $2,304
Year 4 ($16,000-$6,400-$3,840-$2,304) X .40 = $1,382 $13,926
Year 5($16,000-$6,400-$3,840-$2,304-$1,382) X .40 = $ 829 74
See how the depreciation in year five was cut back? Since this
is the declining balance method, accumulated depreciation must
stop at $14,000. Anything more would cut into the machineâ€™s
$2,000 salvage value. Thatâ€™s why the machine can be depreci-
ated only $74 in year five.