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What is Depreciation

Depreciation (depn) is used to measure the reduction in the useful life of the asset in terms of dollars. Measurement is an estimate because an asset may have a longer useful life than the estimated useful life or vice versa. Its purpose is to help a business better reflect the cost of using capital (excluding maintenance cost) over its useful life. Without this measure, the profitability of a business decreases or even suffers a loss for the period an asset is acquired and shows a higher profit in subsequent periods when the asset is still used for business.

Accumulated depreciation is the total decrease in the asset’s value since the asset’s purchase. Assume that you have an asset that you purchased for $9,000 and that it has an estimated useful life of 3 years. Two years passed. So the accumulated depth is two-thirds of the purchase price or $6,000. Using this, you will be able to calculate the book value or residual value of the asset. Continuing with our example, the book value would be $3,000 because the asset is estimated to have a useful life of one year.

After 3 years, you can use your presence for “zero cost”. You can continue to use the capital and your net profit (which is the amount after deducting expenses and operating cost) will increase by the amount of the deposit. Although this is not ideal, we are better off knowing the total cost of the purchase in one year.

The most common method of depn is real. First an estimate is made on the useful life of the asset. The value of the asset is then divided equally (usually per month) over the useful life of the project and that will be the principal value. For most assets, there are already legal standards or recommendations on their useful life. Most businesses only accept these legal standards. For example, it is a common practice to depreciate computers and computer peripherals over a period of 3 years. Other methods of depn are year-round numbers and double-declining balances. The depn method adopted for a particular asset is usually determined by how its value changes over time.

Depreciation can be a major contributor to a company’s profit and loss, especially for businesses that require heavy capital investments. For example, in a telephone company (telco), a large investment in its telephone network is required before the telco can offer its service to customers. This network, once invested, could be used by the telephone for its services for several years. It is therefore important that the telephone minimizes this cost over its useful life so that the company can reflect the true cost of providing the service to its customers. In this case, it is important for a telecommunications business analyst when setting up a business model to make sure that the depn is calculated correctly or it may ruin the overall profitability of the business.

Calculating the depn in an Excel based business model is fairly easy if you understand the Excel worksheet functions well. You will only need to use some formula and a row to calculate the depn instead of using a 36 column 36 row table to calculate the depn for an asset with a useful life of 3 years. Click on this download link to learn how!

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