Depreciation

Definition

Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. It represents the gradual decrease in the value of an asset due to wear and tear, age, or obsolescence. Depreciation is a crucial concept in both the topics of conversion costs and capital investment decisions.

5 Must Know Facts For Your Next Test

1. Depreciation expense is a non-cash expense that reduces the net income of a business, but does not affect the company's cash flow.
2. The choice of depreciation method (straight-line, accelerated, etc.) can significantly impact a company's reported profits and taxes.
3. Depreciation is a key component of conversion costs, as it represents the cost of using fixed assets in the production process.
4. Accurate depreciation estimates are crucial for making informed capital investment decisions, as they affect the projected cash flows and profitability of a project.
5. Depreciation is an important consideration in the make-or-buy decision, as it impacts the relative costs of in-house production versus outsourcing.

Review Questions

• Explain how depreciation is related to conversion costs and how it affects the reporting of production costs.
  • Depreciation is a key component of conversion costs, which represent the costs incurred in the manufacturing process to convert raw materials into finished goods. Depreciation expense reflects the gradual decline in the value of the company's production equipment and facilities over time. This non-cash expense is included in the calculation of conversion costs, which are then used to determine the total cost of production and the cost per unit. The choice of depreciation method can significantly impact the reported conversion costs and, consequently, the company's profitability and pricing decisions.
• Describe how depreciation is considered in capital investment decisions and how it affects the evaluation of potential projects.
  • Depreciation is a crucial factor in capital investment decisions, as it directly impacts the projected cash flows and profitability of a potential project. The depreciation expense associated with the new asset being considered is included in the project's operating costs, reducing the net income and cash flows generated by the investment. Additionally, the choice of depreciation method can affect the project's tax liability, which is another important consideration in the capital budgeting process. Accurate depreciation estimates are essential for conducting a thorough cost-benefit analysis and determining the true economic viability of a capital investment project.
• Evaluate the role of depreciation in the make-or-buy decision and how it influences the comparison of in-house production versus outsourcing.
  • When making a make-or-buy decision, the depreciation expense associated with the company's production equipment and facilities is a key factor to consider. If the company chooses to produce the item in-house, the depreciation of its own assets must be accounted for in the production costs. However, if the company decides to outsource the production, it would not incur this depreciation expense, potentially making the outsourcing option more cost-effective. The impact of depreciation on the relative costs of in-house production versus outsourcing is an important consideration in the make-or-buy analysis, as it can significantly influence the final decision and the company's overall profitability.

Related terms

Straight-Line Depreciation: A method of depreciation where the asset's cost is divided equally over its useful life, resulting in the same depreciation expense each period.

Accelerated Depreciation: Depreciation methods that allocate a larger portion of the asset's cost to the earlier years of its useful life, such as the Double-Declining Balance method.

Salvage Value: The estimated value of an asset at the end of its useful life, which is subtracted from the asset's original cost to determine the depreciable amount.