What are the advantages and disadvantages of using different depreciation methods in industrial engineering?

1 Straight-line method

The straight-line method is the simplest and most widely used depreciation method, as it assumes that the asset loses the same amount of value every year until it reaches its salvage value or zero. To calculate the annual depreciation expense using this method, you need to subtract the salvage value from the initial cost of the asset and divide it by the number of years of its useful life. For example, if you buy a machine for $10,000 and expect it to last for 10 years and have a salvage value of $2,000, the annual depreciation expense would be ($10,000 - $2,000) / 10 = $800. The advantages of this method are that it is easy to apply, consistent, and matches the revenue and expense principle. The disadvantages are that it does not reflect the actual pattern of asset usage, ignores the time value of money, and may overstate the net income in the early years of the asset's life.

2 Declining-balance method

The declining-balance method is an accelerated depreciation method, as it assumes that the asset loses more value in the early years of its life and less in the later years. To calculate the annual depreciation expense using this method, you need to multiply the book value of the asset at the beginning of the year by a constant depreciation rate that is higher than the straight-line rate. For example, if you use the double-declining balance method, which is a common variant of this method, the depreciation rate would be 2 / 10 = 0.2 or 20%. Therefore, the annual depreciation expense for the first year would be $10,000 x 0.2 = $2,000, and for the second year it would be ($10,000 - $2,000) x 0.2 = $1,600, and so on. The advantages of this method are that it reflects the actual pattern of asset usage, considers the time value of money, and reduces the taxable income in the early years of the asset's life. The disadvantages are that it is more complex to apply, inconsistent, and may understate the net income in the later years of the asset's life.

3 Units-of-production method

The units-of-production method is a variable depreciation method, as it assumes that the asset loses value based on its actual output or usage rather than its age. To calculate the annual depreciation expense using this method, you need to divide the initial cost of the asset minus the salvage value by the total estimated output or usage of the asset over its useful life, and then multiply it by the actual output or usage in that year. For example, if you buy a machine for $10,000 and expect it to produce 100,000 units over 10 years and have a salvage value of $2,000, the depreciation rate per unit would be ($10,000 - $2,000) / 100,000 = $0.08. Therefore, if the machine produces 12,000 units in the first year, the annual depreciation expense would be $0.08 x 12,000 = $960. The advantages of this method are that it reflects the actual pattern of asset usage, matches the revenue and expense principle, and adjusts for fluctuations in demand or efficiency. The disadvantages are that it requires accurate estimates of output or usage, ignores the time value of money, and may vary significantly from year to year.

4 Sum-of-the-years'-digits method

The sum-of-the-years'-digits method is another accelerated depreciation method, as it assumes that the asset loses more value in the early years of its life and less in the later years. To calculate the annual depreciation expense using this method, you need to multiply the initial cost of the asset minus the salvage value by a fraction that has the remaining useful life of the asset as the numerator and the sum of the years' digits as the denominator. For example, if you buy a machine for $10,000 and expect it to last for 10 years and have a salvage value of $2,000, the sum of the years' digits would be 1 + 2 + ... + 10 = 55. Therefore, the annual depreciation expense for the first year would be ($10,000 - $2,000) x (10 / 55) = $1,455, and for the second year it would be ($10,000 - $2,000) x (9 / 55) = $1,309, and so on. The advantages of this method are that it reflects the actual pattern of asset usage, considers the time value of money, and reduces the taxable income in the early years of the asset's life. The disadvantages are that it is more complex to apply, inconsistent, and may understate the net income in the later years of the asset's life.