Whenever any machine or equipment performs useful work, its wear and tear is bound to occur. This can be minimised up to some extent by proper care and maintenance but cannot be totally prevented. Its efficiency also reduces with the lapse of time and at one time it becomes uneconomical to be used further and needs replacement by another new unit.
Therefore, we can say efficiency and value of machine or asset constantly reduces with the lapse of time during use, which is known as “Depreciation”.
So some money must be set aside yearly from the profits, so that when that equipment becomes uneconomical, it can be replaced by the new one. Therefore, the initial cost of machine plus installation charges + repair chargesâ€” scrap value is charged against overheads and spread over the machine’s useful life.
For this purpose, depreciation account for the complete plant or individual equipment is opened in the Company’s Books and is known as Depreciation Fund or “Sinking Fund”. This amount is deducted yearly from the profits and kept separate to have sufficient money for replacement at the end of useful life.
Types of Depreciation:
For further understanding depreciation can be classified as under:
Now, each type of depreciation is explained in short below:
(a) Depreciation due to Wear and Tear:
Everybody knows that when any machinery performs work, wear and tear of certain components takes place, although sufficient precautions are taken, e.g. proper lubricating and cooling is done, which minimise wear and tear but it cannot be totally prevented. Hence the cost of replacement because of this cause, is the value of depreciation due to wear and tear.
(b) Depreciation due to “Physical decay”:
There are certain items in a factory, such as insulation of materials, furnitures, electric cables, buildings, chemicals, vessels etc., which get decay, because of climatic and atmospheric effect, with the result the value of these articles goes on reducing with the lapse of time.
Although every effort is made by the owner to keep them in serviceable condition even then because of climatic and atmospheric effect, there will be reduction in their costs. This reduction in cost is depreciation due to physical decay.
(c) “Accidental” Depreciation:
Although, the machine might have installed even few days back and sufficient care is taken to prevent accident, even then, accident may occur due to some wrong operation, or some loose component or some other cause which may result in a heavy damages. The depreciation in a machine caused due to this reason is called accidental depreciation.
Now-a-days, to cover this risk most of the owners get their equipment insured with the insurance companies. For this, owners have to pay certain premium yearly. The amount of premium depends upon the estimated cost and life of equipment.
(d) Depreciation due to “Deferred Maintenance and Neglect”:
Every manufacturer supplies certain instructions for the smooth and efficient running of an equipment.
For example, in the case of a vehicle, a manufacturer gave the following instructions:
(i) Lubricating oil of particular grade should be used in engine.
(ii) Oil should be drained and new oil should be refilled after first 1000 km running, and then every 5000 km.
(iii) All the bolts and nuts should be re-tightened after 5000 km running.
(iv) Decarbonising after 30000 km running and so on.
If these instructions are not followed because of neglect, and proper maintenance is not done as recommended by manufacturer, then the life of the vehicle may be reduced and depreciation in value because of this, is called depreciation due to deferred maintenance and neglect.
This is the form of functional depreciation. Inadequacy means reduction in efficiency of an asset. This may result even if any equipment is servicing under proper precautions and sufficient maintenance is provided, there is fall in efficiency with the lapse of time.
Secondly, suppose after 2-3 years of running, the demand of products manufactured by certain plant is increased. But the plant cannot cope with the increased demand. This needs additional money either to replace with the bigger size machinery or installation of more similar size plants. This is, what is called depreciation due to inadequacy.
(f) Depreciation by Obsolescence:
Now-a-days because of rapid scientific advancement, there are frequent changes. If a new machine comes in the market which is more efficient because of new invention or better design than the existing one, manufacturing same type of products by the new one are much cheaper and better than the existing one, then the existing machinery has to be replaced to withstand market competition. This is called depreciation by obsolescence.