Categories: accounting
Depreciation. It’s something that you have probably heard about but might not be using day-to-day in your work as a project manager. However, if you are working towards the Project Management Professional (PMP)® exam, then you might already know you have to understand the basic concepts of depreciation. You might get asked a question about it.
Depreciation explained
So what is depreciation? I write a lot about different financial aspects of project cost management on this blog but I don’t think I’ve ever covered depreciation before!
Depreciation is a way to split the cost of an item over the life of the item. It is why some insurance companies will only offer you a like-for-like replacement after a loss. If your television is 10 years old, they will pay out on the value of the 10 year old set, not the cost of a new one (which is silly, as you are most likely going to buy a new one, not seek out one that is 10 years old – but that’s a different conversation!).
Depreciation is an accounting treatment that allocates the capital cost of a purchase over the life of the item purchased. If your goods have a finite lifespan – let’s say that TV was going to last you 12 years – then each year a bit of the cost gets accounted for. You are ‘spending’ the cost of the item over multiple years.
Straight-Line Depreciation
Straight-line depreciation has this name because if you draw the cost of the asset on a graph, you get a straight line. You depreciate the overall cost by the same amount every year, based on how long you say the asset will last (this part is accounting magic – your Finance team may have guidelines on how long an asset will last in the world of finance.)
Here’s an example.
Let’s say the lifespan of a computer is 5 years. You buy the computer at the cost of £5,000. First we need to workout the rate of depreciation. £5,000 divided by 5 years is £1,000 a year. That’s 20% of the total cost. So the value of the computer depreciates by 20% each year.
You can see how the straight line appears on the graph below.
Double-Declining Depreciation
There’s another type of depreciation to learn about too.
Double-declining depreciation works on the same principle, but the value declines doubly fast (as you can tell from the name). So in our computer example, the rate of depreciation isn’t 20% per year, it’s 40%.
But – you don’t take the flat 40% off each time. Instead, you take the 40% off the new asset value.
In the first year, you take 40% off the price paid, leaving us with £3,000. This becomes the new asset value. In the following year, you take 40% off again – but off the £3,000. That brings our asset value down to £1,800.
And so on.
When you get to year 5 in this example, you actually have £388.80 left. That’s the value of the asset at the end of its lifespan, and what you would want to try to recover if you sold it as scrap (note: don’t try to sell company computers as scrap, that’s now how to dispose of them!).
The graph of depreciation for our laptop now looks like this.
That’s quite a drop off in year one, and then it levels out a bit as it gets more and more worthless – you know what I mean.
Why you need to know about depreciation
Depreciation is a useful concept to understand when talking to finance people about the assets your project is buying or creating. It’s not something I use day to day, but you might come across it in financial projections for your projects, for example in the business case or forecasts.
Understanding the concepts will help you better understand the way your project is being costed and budgeted.
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