There are several methods advocated, and in use, for fixing the rate at which the asset shall be depre ciated front the original cost to "scrap value." This is necessarily so, since conditions vary and personal opinions govern these matters to a large de gree. The three most important of these methods to be discussed at this point are percentage on original cost, percentage on diminishing value, and sinking fund.
11. Percentage on original cost.—Under the plan known as percentage on original cost, the total depre ciation, or the difference between the original cost and the "scrap value," is divided by the estimated pro ducing life, and the dividend is the amount set aside annually for depreciation. Thus, in the preceding example the annual depreciation would be $225. Since the same amount is deducted annually from the value of the asset the decline in value is uniform and, hence, follows a straight line. For this reason this method is sometimes designated "straight line" de preciation.
This method of depreciation has been much used because of its simplicity and because it does not make such a heavy reduction in inventory values in the be ginning of the life of the asset as does the method of percentage on diminishing value. This is an un doubted advantage for a new enterprise that has a scanty income during the early years of its existence. On the other hand, it is undoubtedly true that, with many assets, the depreciation is much greater during the early years of use than during the later years.
12. Percentage on g value.—It is also argued against the straight-line depreciation method that it is more desirable to depreciate heavily during the early years, when repairs and renew als are not costly, and to depreciate less heavily during the later years, when repairs begin to become more burdensome. For this reason, and others, some managers prefer the method of percentage on dimin ishing value. Under this system a definite percent age is taken each year from the depreciated value of the preceding year. Thus, in the case already men tioned, if the rate of depreciation be taken at ten per cent, and this percentage be taken annually from the depreciated value of the year before, the same results will be obtained as with the other method. It will be clear that under this last method the depreciation will be much heavier during the early years and much lighter during the later years, for the same producing life and "residual" value than under the straight-line method. The computation of depreciation by per centage on diminishing value will be facilitated by the use of Table 1, which follows.
13. Sinking fund.—Some accountants use the sinking-fund method in caring for depreciation.
Under this scheme such an annual sum is set aside as, at compound interest, will amount by the end of the producing life to the original cost of the asset, minus the "scrap value." There are several objections to this method. First, it is unnecessarily cumbersome, mathematically; and second, as it is usually applied to ordinary depreciation, it is faulty in theory. Depreciation is an allowance for losses that have already occurred. If this loss is $200, yearly, that amount should be set aside, and not the amount which will accumulate to that value in a period of years. It will be noted, furthermore, that
this method actually withdraws capital from the en terprise, and it does not seem to be a good financial policy to set aside earnings to draw interest at bank rates when, by retaining them in the business, a higher rate of interest could, presumably, be obtained. If the enterprise cannot produce earnings higher than bank interest it might as well go out of business and place all of its capital in the banks, thus avoiding, to some extent at least, the risks incident to a business venture.
14. Typical rates of depreciation.—The rates of de preciation will, as before noted, vary widely with the asset and the service. A single flat rate applied to all assets is unintelligent and misleading. Careful classification should, therefore, be made of all assets, and proper rates should be assigned; at the same time, the controlling factors----original cost, estimated life and "scrap value"—should be constantly borne in mind. The rate that should be assigned to any class of asset will depend largely upon circumstances, and nothing more than suggestions can be offered here. Judgment and expediency are always important fac tors in the fixing of these rates. The following table, taken from the author's "Principles of Industrial Organization," gives average rates for buildings and machinery kept in a good state of repair. These rates also include allowance for obsolescence. Cone sponding rates are given for the methods of depre ciation which have been discussed.
15. Depreciation a manufacturing expense.—It should be specially noted that depreciation is a manu facturing expense and not a general expense, as it is so often considered. There is no logical justification for distributing depreciation as an even layer over the total shop costs, since the rate of depreciation varies so greatly with various assets. At the least, it should be allocated by departments in common with all manufacturing expenses, and all the arguments pre sented later on, looking to a still more accurate dis tribution of all costs, are applicable, also, to depre ciation.
The amounts set aside for depreciation should, then, be distributed against production, credited in some manner to the equipment accounts and debited to the depreciation accounts. The exact method of hand ling depreciation reserve is a problem for the ac countant and the financier. Sometimes, as has been noted, it is actually put at interest outside the busi ness; on the other hand, it is often retained as working capital.
In conclusion, it should be remembered that mathe matical methods of depreciation cannot always be rigidly adhered to. Conditions change from year to year, and the state of trade may make it desirable to modify what may have previously been an excellent practice. The all-important fact to remember is, that depreciation is a very definite expense which must be met, and any well-defined method of deter mining this depreciation, even tho it cannot be abso lutely adhered to, is a safeguard against a day of reck oning that might prove fatal to the enterprise.