Understanding the concept of equipment depreciation is important for any business dependent on heavy equipment, machinery, or vehicles. At its essence, depreciation reflects the loss in an asset’s value over its useful life, impacting a company’s financial health and strategic decision-making.
It provides an accurate picture of an asset’s value over time, which is critical for making informed, strategic decisions in areas such as finance, investments, and operations.
By thoroughly comprehending equipment depreciation, you can make informed decisions about equipment replacement, appropriate insurance coverage, and optimizing tax deductions.
Equipment maintenance and depreciation are closely related, playing a vital role in asset management. Regular upkeep of an asset can increase its lifespan, impacting its depreciation rate by spreading the cost over a long period and maintaining its value.
This relationship helps organizations in the strategic decision-making process, especially when deciding whether to repair or replace aging equipment.
This blog post explores the definition of equipment depreciation, how to calculate it, the importance of its calculations, and the benefits it offers to businesses.
What is equipment depreciation?
Equipment depreciation is the gradual decrease in the asset’s value over the time it is used. It is important to understand that depreciation is an accounting concept that reflects the estimated value of the asset rather than its market value.
Initially, when you purchase an asset, it holds a certain value. However, as you use it over time, it loses its value due to factors such as wear and tear and obsolescence. This loss of value over time is referred to as depreciation, and it can be calculated in several ways.
An example of depreciation on IT equipment
Here’s an example of depreciation on IT equipment. Suppose you bought a piece of IT equipment for $10,000 with an expected lifespan of five years. After using the straight-line depreciation method (one of the methods to calculate depreciation), the value of the asset might decrease to $5000 by the start of the fourth year. If it experiences a major breakdown, requiring $5000 for repairing, one must evaluate whether such investment in repairs is worth it.
Factors determining equipment depreciation life
Calculating equipment depreciation life involves three primary factors that are explained below:
Initial asset value
This refers to the original cost of the asset or the purchase price.
Useful life
This refers to the estimated time over which the asset will be used before it fully loses its value. It also reflects the timeframe over which the asset is expected to remain operational.
Salvage value
This refers to the estimated residual value of the asset at the end of its useful life. As soon as an asset depreciates to this value, you can sell or dispose of it.
Essentially, an asset will continue to depreciate until it reaches its salvage value. At this point, you can decide whether you want to sell it or scrap it altogether. The useful life of an asset could be based on several factors; for example, a piece of medical equipment could be based on the manufacturer’s specifications, user estimates, or standard values assigned by tax authorities such as the Internal Revenue Service.
What is an equipment depreciation schedule?
An equipment depreciation schedule is essentially a table that is used to document the loss in value of a certain asset throughout its estimated useful life. The purpose of an equipment depreciation schedule is to keep track of the depreciation values you’ve already deducted.
While there are slight variations based on the chosen depreciation method, most equipment depreciation schedules include common elements, such as:
- Each row in the schedule represents a year.
- Book Value at the Start represents the book value of the asset at the beginning of each year before deductions.
- Depreciation notes the amount dedicated for depreciation during that year, and it is often referred to as the ‘depreciation expense’.
- Book Value at the End signifies the book value of the asset at the end of that year after the depreciation expense has been deducted from it.
How to calculate equipment depreciation
The simplest method to calculate equipment depreciation is the straight-line method.
Here’s the formula:
(Initial Value – Salvage Value) ÷ Useful Life = Annual Equipment Depreciation
Subtract the salvage value from the initial value of the asset and then divide this amount by the asset’s useful life. Using this formula, you can derive the annual depreciation amount for the equipment.
For example, if you purchase an asset that costs $10,000 at the beginning of the year, has a salvage value of $3000, and has a useful life of five years, its depreciation amount would be:
($10,000 – $3,000) ÷ 5 years = $1,400/year
This result indicates that the value of your equipment decreases by $1,400 each year. In simpler words, each year, your equipment loses a consistent amount of its value due to depreciation until it reaches its estimated salvage value at the end of its useful life.
Why is it important to calculate equipment depreciation?
Businesses must calculate equipment depreciation as it helps them evaluate the current value of their equipment. On the other hand, it also helps business owners determine how much they should charge for its use and how much money they need to set aside for repairs and replacements.
Let’s discuss a manufacturing business as an example. As discussed earlier, calculating depreciation helps the business owner decide whether to buy new heavy equipment or continue leasing from another company.
Suppose a piece of office equipment costs $10,000 to buy brand new or $800 to rent for the year (this makes $9,600 over 12 months), has an expected lifespan of five years, and generates $10,000 in revenue each year during its useful life.
In this scenario, it would be a good decision for a business owner to purchase the equipment in a brand new condition, not only because it will cover the initial cost but also because it will yield profit over time, making the investment worthwhile.
What are the benefits of calculating equipment depreciation?
Calculating equipment depreciation and understanding its benefits helps you plan for the future, supports informed decisions, and enables you to make better choices about equipment purchases.
When you’re considering buying new equipment, calculating depreciation can help you evaluate whether the investment is financially viable. It can also serve as a basis for calculating your taxes in case you plan to claim any depreciation in your company’s financial statements.
A few tips to remember when calculating equipment depreciation
When calculating equipment depreciation, keep these key helpful tips in mind:
- Always remember to deduct the depreciation from your gross income. This will enable you to accurately determine your business’s profit or loss for a specific period.
- Deducting the depreciation from your gross income provides you with an accurate picture of the actual revenue generated from selling goods and services in a particular quarter or year.
Final thoughts
CMMS software can help maintain your equipment in excellent condition and ensure accurate depreciation calculations.
For instance, EZO CMMS, an advanced CMMS solution, can help in several ways; it can help track equipment usage and provide accurate data that helps you evaluate how much of the equipment’s useful life has been utilized, enabling you to calculate depreciation correctly.
On the other hand, it also streamlines and automates the scheduling and monitoring of maintenance tasks to ensure your equipment remains in optimal condition throughout its lifecycle. This results in preventing early breakdowns or replacements.
Frequently asked questions
What is the formula for the depreciation of equipment?
The formula for calculating the depreciation of equipment is as follows:
Annual depreciation = (acquisition cost – residual value) / years of useful life
Why is depreciation calculated?
Depreciation allows organizations to gradually recover the cost of equipment when it was purchased, enabling them to cover the total cost over its complete lifespan instead of immediately recovering the purchase price.
Is depreciation an expense?
Depreciation is listed as an expense on the income statement for almost every business, making it a crucial factor in year-end tax calculations and determining the validity of the item for liquidation purposes.
