There is,
however, another element in the cost of manufacture closely
associated with expense (so closely that I have not hereto-
fore referred to it) and yet characterized by qualities quite
distinctively its own qualities which differentiate it from
expense and suggest the need of a different mode of treat-
ment. This last element of cost is depreciation. Deprecia-
tion is the decrease in value of our property, that is, espe-
cially our buildings, machinery, and equipment, by the fact
that it is growing older and is drawing nearer the time when
it will be worn out, or when through some change of condi-
tions, processes or methods it will become obsolete, and will
have to be discarded, scrapped and replaced by something
new. We must therefore anticipate this inevitable depreci-
ation by estimating in our costs, and recovering from our
sales, a reserve fund, thus accumulating in advance a fund
from which the depreciated equipment may be replaced.
Our cost must include not only the material and the labor
that have actually gone into the product, plus a share of the
expense burden actually incurred. It must include further
a factor for something that has not yet happened, or at least
has not yet materialized in the form of an expenditure in-
curred and recorded on our books. We must provide for
the depreciation which is going on day by day, even though
it may not make itself evident for a long time to come, or
until the wear and tear have grown serious enough to re-
quire overhauling or replacing of the depreciated item.
In reckoning the allowance to be made for depreciation,
we have not only the same difficulties that we have in the case
of expense,- that is, the difficulty of apportioning an indi-
rect account to direct classes or items of product but we
have the additional problem of determining what amount we
must thus apportion.
We have seen that authorities differ in their treatment of
the expense account. They differ more widely and aggres-
sively yet over depreciation. Some treat it rather curtly, al-
most with indifference, maintaining that where repairs and
renewals are consistently kept up, depreciation need be rec-
ognized only by comparison of annual inventories and the
use of such averaged figures as may be thus disclosed. At
the other extreme, some accountants argue fiercely that de-
preciation should be assumed at an arbitrary percentage of
the value of our equipment, and they split hairs in the debate
whether this percentage should be taken always on the orig-
inal investment, or each succeeding year on the investment
as reduced by preceding deductions. 1
It is a proposition upon which it is perhaps impossible to
generalize except perhaps to this extent:
First, that it is very dangerous to regard investment in
short-lived equipment (such as small tools, for example) as
a plant account a part of our fixed capital at all; it
should be considered an expense and so charged at once, or
if carried as an asset should be given only a nominal value.
Second, that items of intermediate permanency such as
drawings, patterns, should be credited as an asset only at a
fraction of the cost and a very high factor of depreciation
should be applied to them year by year until they are
charged off and disappear.
Third, that as to the permanent items such as machinery,
apparatus, power-plant, heavy tools, structures, etc., the
chief danger to the continuance of their value is not so much
that they may be destroyed by wear and tear as that they
may be superseded by some new and radical development.
Suppose we are building large reciprocating steam engines:
Our costly drawings, patterns, templates and equipment for
a great horizontal and vertical compound type may be made
obsolete in a year or two by the introduction of the steam
turbine. Suppose we are operating a cable-road: our
power-plant may have to be scrapped to put in electric trac-
tion. Suppose we own a bicycle factory: it may be thrown
into idleness because the popular whim turns to tennis and
golf. Suppose we are prosperous manufacturers of tin-
plates in Wales: our mills may be closed by the Dingley
tariff in the United States. Suppose we are proprietors of
a machine-shop : it may have to be remodelled throughout
and largely re-equipped for electric driving and the use of
high-speed steel. In some of these cases, even, it might be
1 A standard work on depreciation is " The Depreciation of Factories,
and their Valuation," by Ewing Matheson; E. & F. N. Spon.
argued that the renewal expense should not be charged
against the profits of the past as a depreciation, but rather
as a new investment justified by the larger profits obtain-
able in the future through the improvement. Others might
be held to be " risks of the business " rather than cases of
depreciation. If we are to provide for such contingencies
by a factor of depreciation, depreciation becomes to a cer-
tain extent a sort of insurance against an indeterminable
risk. It is prudent to provide for it; to consider that cer-
tain future expense not yet visible is yet inevitable; to assess
a provision for it as a part of our calculated costs, and to
set aside a corresponding share of our current receipts as a
reserve fund to meet the contingency. But what the factor
should be in any given case I think can be determined only
by the method of inspection and the exercise of deliberate
and intelligent common-sense.
There is, however, a certain ethical consideration, as
pointed out by Prof. L. S. Randolph, 1 which should not be
overlooked when a rate of allowance for depreciation is de-
termined. It is this: In industrial and corporate undertak-
ings generally there are usually at least two classes of owner-
ship interests, typically represented by the bondholder and
the stockholder. The bondholder lends capital on the se-
curity of the actual physical property. In view of this
security he lends the money at a comparatively low rate of
interest, looking to this physical property for the ultimate
return of his principal. The stockholder seeks his return
from the profits of the business and generally expects to re-
ceive a higher rate of interest. He owns the business, sub-
ject only to the lien given to the bondholders for the bor-
rowed capital. He manages the business. Its success is
proportionate to his skill and ability and all surplus earn-
ings accrue to him.
Now if in calculating and distributing his profits the
1 The Engineering Magazine, August, 1910.
stockholder does not make proper provision for restoring
wear and tear, replacing worn-out equipment, and main-
taining the value of the plant, which is the bondholder's se-
curity, he is not keeping up the value that he has pledged
against the money borrowed from the bondholders. He is
not dealing fairly with his creditors.
If, on the other hand, the stockholder set aside an un-
necessarily large proportion of his gross earnings for a de-
preciation fund, thereby diminishing his apparent net profits
or his surplus available for dividends, this fund nevertheless
remains in his hands for administration and need be drawn
upon only so far as actual depreciation occurs, the remain-
der reverting to the stockholder, so that he does himself no
wrong. This is, in other words, an argument for a high
rather than a low depreciation allowance.
Clearly, the distribution we have been talking of is all
retrospective. It shows us the dollars and cents of what we
have done. This is very important, but it is even more im-
portant to know what we can do in the future. In other
words, the gift of prophecy is often more valuable
than the knowledge of history. Therefore the chief
object of putting history into this form is to make
it effective for prophecy that is, for determining the
cost of new product, estimating the cost of new work,
and directing the expansion of business along the most
profitable channels. And beyond that, figures of cost in-
telligently prepared and analyzed serve as true guides show-
ing exactly where our losses, wastes, and inefficiencies occur,
revealing changes or irregularities requiring investigation,
and calling as loudly as figures can call for the reforms and
economies that will make our output larger, better, or lower
in cost of production. The real purpose of cost finding is
cost reduction.
however, another element in the cost of manufacture closely
associated with expense (so closely that I have not hereto-
fore referred to it) and yet characterized by qualities quite
distinctively its own qualities which differentiate it from
expense and suggest the need of a different mode of treat-
ment. This last element of cost is depreciation. Deprecia-
tion is the decrease in value of our property, that is, espe-
cially our buildings, machinery, and equipment, by the fact
that it is growing older and is drawing nearer the time when
it will be worn out, or when through some change of condi-
tions, processes or methods it will become obsolete, and will
have to be discarded, scrapped and replaced by something
new. We must therefore anticipate this inevitable depreci-
ation by estimating in our costs, and recovering from our
sales, a reserve fund, thus accumulating in advance a fund
from which the depreciated equipment may be replaced.
Our cost must include not only the material and the labor
that have actually gone into the product, plus a share of the
expense burden actually incurred. It must include further
a factor for something that has not yet happened, or at least
has not yet materialized in the form of an expenditure in-
curred and recorded on our books. We must provide for
the depreciation which is going on day by day, even though
it may not make itself evident for a long time to come, or
until the wear and tear have grown serious enough to re-
quire overhauling or replacing of the depreciated item.
In reckoning the allowance to be made for depreciation,
we have not only the same difficulties that we have in the case
of expense,- that is, the difficulty of apportioning an indi-
rect account to direct classes or items of product but we
have the additional problem of determining what amount we
must thus apportion.
We have seen that authorities differ in their treatment of
the expense account. They differ more widely and aggres-
sively yet over depreciation. Some treat it rather curtly, al-
most with indifference, maintaining that where repairs and
renewals are consistently kept up, depreciation need be rec-
ognized only by comparison of annual inventories and the
use of such averaged figures as may be thus disclosed. At
the other extreme, some accountants argue fiercely that de-
preciation should be assumed at an arbitrary percentage of
the value of our equipment, and they split hairs in the debate
whether this percentage should be taken always on the orig-
inal investment, or each succeeding year on the investment
as reduced by preceding deductions. 1
It is a proposition upon which it is perhaps impossible to
generalize except perhaps to this extent:
First, that it is very dangerous to regard investment in
short-lived equipment (such as small tools, for example) as
a plant account a part of our fixed capital at all; it
should be considered an expense and so charged at once, or
if carried as an asset should be given only a nominal value.
Second, that items of intermediate permanency such as
drawings, patterns, should be credited as an asset only at a
fraction of the cost and a very high factor of depreciation
should be applied to them year by year until they are
charged off and disappear.
Third, that as to the permanent items such as machinery,
apparatus, power-plant, heavy tools, structures, etc., the
chief danger to the continuance of their value is not so much
that they may be destroyed by wear and tear as that they
may be superseded by some new and radical development.
Suppose we are building large reciprocating steam engines:
Our costly drawings, patterns, templates and equipment for
a great horizontal and vertical compound type may be made
obsolete in a year or two by the introduction of the steam
turbine. Suppose we are operating a cable-road: our
power-plant may have to be scrapped to put in electric trac-
tion. Suppose we own a bicycle factory: it may be thrown
into idleness because the popular whim turns to tennis and
golf. Suppose we are prosperous manufacturers of tin-
plates in Wales: our mills may be closed by the Dingley
tariff in the United States. Suppose we are proprietors of
a machine-shop : it may have to be remodelled throughout
and largely re-equipped for electric driving and the use of
high-speed steel. In some of these cases, even, it might be
1 A standard work on depreciation is " The Depreciation of Factories,
and their Valuation," by Ewing Matheson; E. & F. N. Spon.
argued that the renewal expense should not be charged
against the profits of the past as a depreciation, but rather
as a new investment justified by the larger profits obtain-
able in the future through the improvement. Others might
be held to be " risks of the business " rather than cases of
depreciation. If we are to provide for such contingencies
by a factor of depreciation, depreciation becomes to a cer-
tain extent a sort of insurance against an indeterminable
risk. It is prudent to provide for it; to consider that cer-
tain future expense not yet visible is yet inevitable; to assess
a provision for it as a part of our calculated costs, and to
set aside a corresponding share of our current receipts as a
reserve fund to meet the contingency. But what the factor
should be in any given case I think can be determined only
by the method of inspection and the exercise of deliberate
and intelligent common-sense.
There is, however, a certain ethical consideration, as
pointed out by Prof. L. S. Randolph, 1 which should not be
overlooked when a rate of allowance for depreciation is de-
termined. It is this: In industrial and corporate undertak-
ings generally there are usually at least two classes of owner-
ship interests, typically represented by the bondholder and
the stockholder. The bondholder lends capital on the se-
curity of the actual physical property. In view of this
security he lends the money at a comparatively low rate of
interest, looking to this physical property for the ultimate
return of his principal. The stockholder seeks his return
from the profits of the business and generally expects to re-
ceive a higher rate of interest. He owns the business, sub-
ject only to the lien given to the bondholders for the bor-
rowed capital. He manages the business. Its success is
proportionate to his skill and ability and all surplus earn-
ings accrue to him.
Now if in calculating and distributing his profits the
1 The Engineering Magazine, August, 1910.
stockholder does not make proper provision for restoring
wear and tear, replacing worn-out equipment, and main-
taining the value of the plant, which is the bondholder's se-
curity, he is not keeping up the value that he has pledged
against the money borrowed from the bondholders. He is
not dealing fairly with his creditors.
If, on the other hand, the stockholder set aside an un-
necessarily large proportion of his gross earnings for a de-
preciation fund, thereby diminishing his apparent net profits
or his surplus available for dividends, this fund nevertheless
remains in his hands for administration and need be drawn
upon only so far as actual depreciation occurs, the remain-
der reverting to the stockholder, so that he does himself no
wrong. This is, in other words, an argument for a high
rather than a low depreciation allowance.
Clearly, the distribution we have been talking of is all
retrospective. It shows us the dollars and cents of what we
have done. This is very important, but it is even more im-
portant to know what we can do in the future. In other
words, the gift of prophecy is often more valuable
than the knowledge of history. Therefore the chief
object of putting history into this form is to make
it effective for prophecy that is, for determining the
cost of new product, estimating the cost of new work,
and directing the expansion of business along the most
profitable channels. And beyond that, figures of cost in-
telligently prepared and analyzed serve as true guides show-
ing exactly where our losses, wastes, and inefficiencies occur,
revealing changes or irregularities requiring investigation,
and calling as loudly as figures can call for the reforms and
economies that will make our output larger, better, or lower
in cost of production. The real purpose of cost finding is
cost reduction.
No comments:
Post a Comment