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.
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 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.
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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Because yes, they are different. Let’s dive in!
1. The Dates are Different
Project accounting has start and end dates. Your project budget starts when the project starts. The accounting work ends when your project moves through closure and ties up all the contracts and you’re done.
Financial accounting is different. It is based on periods in a financial year. Your financial year will be different in different businesses. Mine starts in May, because that’s when my company was created. For ease, some businesses align their financial years to the tax year (that’s April to April in the UK) or the calendar year (January to December). Whatever works best for you and your team of accountants is OK.
Unfortunately this means that project accounting timetables and financial accounting timetables – what the rest of the business is doing beyond your project – rarely, if ever, align.
2. Reporting Is Based on Different Elements
Reporting in project accounting is based on deliverables. This won’t be news to you. In your project reports you’ll be tracking spend against a certain milestone or a product that you had to buy.
You could also track in a cost breakdown structure against the various deliverables or products that you are creating. Your costs are tied back to the things you are doing, the work you are producing and the output you are creating. It’s very easy to see that buying software licences is linked to the delivery of a new piece of software for the business.
In financial accounting reports, they don’t relate to deliverables. Financial accounting looks at other aspects of running a business, like profit and loss, something that projects don’t much have to worry about.
There’s another difference in the reporting and that’s depreciation. If you are installing assets over a long period of time, as I did on a 18-month software rollout project, your financial accountants will be depreciating the assets behind the scenes. You probably never have to know that this is happening, but it is, based on your company’s defined policy.
On a project, the costs are calculated when invoices are received. If you should be depreciating those assets to spread the cost, it’s done by financial accountants afterwards. I have never met anyone or come across any policy that says this is an expected part of project accounting, so you shouldn’t have to deal with it in your project reports.
3. The Cost Hierarchies are Different
Project accounting hierarchies are based on tasks and projects. Your project costs relate to costs generated by deliverables and project activities.
Rolled up, you can see the costs per project.
Rolled up even further, your programme office can see costs for the programme.
Rolled up even further, your portfolio office can see costs for the business projects overall. They can see which departments have the most project-related spend and cut the project cost data in any way they like.
Financial accounting hierarchies are based on departments and cost centres. You might need to know the cost centres for your work so that you can bill your project costs to the right place. I have worked on a big project with its own cost centre.
But generally the approach financial accounting takes to drilling down or rolling up is different to how you would look at project-related spend.
4. Comparative Analysis Is Different
Comparing project costs across projects is hard. How is it possible to compare the relative costs of a multi-million pound project with huge benefits to the relatively small costs of upgrading a server for one of your offices? And what would the value in that comparison even be?
It’s possible to compare costs against projects in a meaningful way only if the projects are similar. There needs to be a consistent structure for coding the costs on the project, for example, standard cost codes for expense items.
And it’s important to look at why you would want to do that. It can be interesting to do a comparison across projects if you think you’ll be able to find out more about the financial exposure for the business. It might help you understand what is going on across the business at portfolio level if you are able to split and compare costs like this. And it’s helpful for comparing benefits, where it makes sense for projects to compare their benefits.
Comparative analysis in financial accounting is comparatively easy (see what I did there?). You look back at costs for the previous period or the same period in the previous year. Then spot the differences. Simple, and a lot more meaningful.
5. Level of Understanding is Different
Stakeholders don’t always understand project accounting. Your project sponsor probably has some idea of the fact that you shouldn’t be spending it all in one go, but they probably don’t understand the way that you have to process invoices or the quirks of assigning money to capital. Or perhaps they do. You are bound, however, to come across some project stakeholders who don’t get how to spend money on a project in a way that fits with the rules. These ar the people who want changes done but don’t want to pay for them!
On the other hand, most leaders understand financial accounting principles. These are the things taught on MBAs and on the Finance for Non-Financial Managers courses.
In this video I share 5 differences between what it means to do accounting on your project (and manage the financials/budget) and how financial accounting can work. Understanding these differences makes it easier for you to work with your Finance teams and run your project budgeting processes.
In this video I talk about 4 pitfalls of project estimating.