W12.0_HN_Depreciation Analysis

1. Problem Definition

One of the compressors on the offshore platform is suddenly broken and Project Engineering Team was requested to investigate and find a solution whether to replace it with the new one or re-engineer it with another existing compressor. The new compressor price is about $2.50M and the compressor will be running for the next 10 years. The salvage value of the compressor at the end of it life time is estimated about $100K. If we want to buy the new one then we need to calculate the depreciation of the equipment.

2. Development of the Feasible Alternatives

There are several methods to calculate depreciation as below:

1. Straight-Line (SL) Method
   
2. Declining-Balance (DB) Method
   
3. DB with Switchover to SL
   
4. Units of Production Method
   
5. Modified Accelerated Cost Recovery System (MACRS):
   

   (a) General Depreciation System (GDS)
   

   (b) Alternated Depreciation System (ADS)

3. Development of the Outcomes for Each Alternative

3.1. Straight-Line (SL) Method

SL depreciation is the simplest depreciation method. It assumes that a constant amount is depreciated each year over the useful life of the asset.

dk = (B – SVN) / N

dk* = k. dk for 1≤ k ≤ N

BVk = B – dk*

where,

N = depreciable life (recovery period) of the asset in years.

B = cost basis, including allowable adjustments.

dk = annual depreciation deduction in year k (1≤ k ≤ N);

BVk = book value at end of year k.

SVN = estimated salvage value at the end of year N; and

dk* = cumulative depreciation through year k,

3.2. Declining-Balance (DB) Method

DB method is assumed that the annual cost of depreciation is a fixed percentage of the BV at the beginning of the year. The ratio of the depreciation in any one year to the BV at the beginning of the year is constant throughout the life of the asset and is designated by R (0 ≤ R ≤ 1). The following relationship hold true for the DB method:

d1 = B(R),

dk = B(1-R)k-1 (R),

dk* = B(1 – (1-R)k0,

BVk = B(1-R)k

3.3. DB with Switchover to SL

Because the DB method never reaches a BV of zero, it is permissible to switch from this method to the SL method so that an asset’s BVN will be zero.

3.4. Unit of Production Method

Sometimes the depreciation value is a function of use, thus depreciation may be based on a method not expressed in terms of years. This method is cost basis (minus final SV) being allocated equally over the estimated number of units produced during the useful life of the asset. The depreciation rate is calculated as follow.

3.5. Modified Accelerated Cost Recovery System (MACRS) GDS

The MACRS was created by TRA 86 and is now the principal method for computing depreciation deduction for property in engineering projects. Under MARCS, the Salvage Value (SV) is defined to be zero, and useful life estimates are not directly used in the calculation. One of the systems from MARCS method is the GDS. The GDS uses the DB with switchover to SL to calculate the depreciation. GDS uses table which contains both the recovery period and recovery rates for the property.

3.6. Modified Accelerated Cost Recovery System (MACRS) ADS

Another method is the MARCS ADS. Unlike GDS, the GDS use the SL method to calculate the depreciation. The depreciation deduction in year k (dk) is using this formula:

d1 = 0.5 (SL amount)

d2 thru dN = SL amount

dn+1 = 0.5 (SL amount)

A flow diagram for computing depreciation deductions under MACRS is shown in the Figure below:

Figure 1. Flow Diagram for Computing Depreciation Deductions under MACRS

4. Selection of Criteria

The depreciation analysis of the equipment will use the 6 methods above and then the depreciation and the book value results will be tabulated and compared the result of each method.

For DB switchover to SL, depreciation method is using 5-year, 200% DB then switchover to SL for next 5-year.

For the MACRS GDS method, since the useful life of 10 years is used, then the GDS asset class and depreciation method is using 7-year, 200% DB with a switchover to SL for the remaining.

For the MACRS ADS, Compressor is considered as 13.3 Petroleum Refining asset class which has a class life of 16 years.

5. Analysis and Comparison of the Alternatives

Based on the data and formula above, the calculation has been carried out using all six methods:

Table 1. Depreciation Calculation for all six methods

6. Selection of the Preferred Alternative

The comparison graphic of the calculation using six methods is shown in the figure below:

Figure 2. Graphic Depreciation Calculation for all six methods

Based on the data calculation and graphic above, we select the MACRS (GDS) method since this depreciation method charged more in the early years of the asset and the depreciation amount reduces in each accounting period over time.

7. Performance Monitoring and Post Evaluation of Result

The decisions what depreciation method needs to be chosen begin when the company places asset in service; and depend on asset type and the total amount of asset. The depreciation is important to take the right decision on what action should be taken to the equipment after its useful life is over. All support data for determining the depreciation should be clear. The depreciation stops when the cost of placing an asset in service has been recovered or when the asset is sold, whichever occurs first.

References:

1. PTMC & Giammalvo, P. D. (2021). 1.4.1.7 unit 7– Managing Resources. Retrieved from: https://build-project-management-competency.com/1-4-1-7-unit-7/
   
2. Sullivan, William G., Wicks, Elin M. &Koelling, C. Patrick (1942), Engineering Economy, 16th Edition, Chapter 7. Singapore: Prentice Hall, Inc.
   
3. Ramila, Rachmad. (2022). Retrieved from: https://theexcellentaace2022.wordpress.com/2022/09/09/w5-0_rml_asset-depreciation-analysis/
   
4. Which method of deprecation should we adopt? Retrieved from: https://www.wikiaccounting.com/how-determine-right-depreciation-method-fixed-assets/
   
5. The Best Method of Calculating Depreciation for Tax Reporting Purposes. Retrieved from: https://www.investopedia.com/ask/answers/013015/what-best-method-calculating-depreciation-tax-reporting-purposes.asp