If the instrument was purchased for $3,352.15 it might be said that its prospective service was bought on a 15 per cent basis; if bought at a lower price the basis would be higher. Its service for the first year, therefore, would cost $869.56 and that amount is assignable for depreciation for the year. In like manner depreciation charges for successive years would be respectively: $756.14, $657.52, $571.75 and $497.18.
The foregoing example illustrates the principle known as allocated cost. In accordance with this prin ciple, to find the depreciation of an instrument dur ing any given period we ascertain that part of the instrument's cost that was the cost of the service it renders during the period.
The following conclusions may be drawn from the principle of allocated costs : (1) provision for depre ciation is not a provision for the replacement of one in strument by another when the former shall be dis carded ; (2) depreciation is not synonymous with de crease in operating efficiency. It was assumed, in the illustration, that the operating efficiency of an in strument remained at a uniform level, giving the same amount of service each year until the end of the fifth year. Yet, over this period, a large amount of de preciation is found assignable to each year; (3) the immediate cause of depreciation is the fact that a part of the total service which the instrument was capable of rendering either has already been given or has been wasted thru idleness or thru some other cause. If a year's service is obtained from an instru ment, part of the cost is assignable to the service ren tiered. Whether or not the machine has been used to maximum efficiency is not a pertinent question in com puting depreciation. As great an amount of depre ciation is assignable to the period as if the instrument had been operated at maximum efficiency; (4) de preciation does not consist of a decrease in salable value, either of the instrument in question or of an other of like design. It will be remembered that in the illustration used to explain the principle of al located costs nothing was said about salable value. Yet, allowance had to be made for the depreciation of the instrument. Instruments of production are not purchased to be sold but to be installed as integral parts of a going concern. (5) Finally, it should be
borne in mind that depreciation is a matter of cost distribution and not a value shrinkage.
4. Depreciation confused with value shrinkage.— The idea of depreciation in the minds of many is quite frequently confused with that of value shrinkage, as is evidenced by such statements as the following: "Frequently an asset depreciates more during the first month of its life than in a year thereafter; a machine that had been used a few days could not be sold for anything like its cost." The value shrinkage referred to, however, may be either of two kinds, namely : (1) the decrease in selling value of the instrument; (2) the decrease in present worth taken on the same basis as that on which the original value was determined.
5. Illustration of value shrinkage thru decrease in selling value. When an instrument is bought with the deliberate intention of using it for two years and then selling it at a reduced price, already determined, which it is judged can be obtained, the estimated shrinkage in selling value may be an acceptable quantity in calculating the whole depreciation to be apportioned. Moreover, the scrap value is always to be taken into consideration. But as has already been pointed out, productive instruments, as a rule, are not purchased for resale but for the service which they are capable of rendering.
6. Value shrinkage thru decrease in present worth. —The second kind of shrinkage represents another theory of depreciation that is closely related to the al located cost theory but contains an added idea. To illustrate, reverting to the case previously cited, a new calculation of the present worth of the instrument at the end of each year of its life will be made and its remaining future services discounted on the same basis as originally, namely, 15 per cent per annum. During the first year, returning to the original sup position that each year's service would be received at the end of the year, the present worth of this service computed by the value shrinkage method of deprecia tion would rise from $869.56 to $1,000. The second year's service being now one year nearer realization, would have a present worth of $869.56 instead of $756.14, as formerly.