When you purchase equipment for your business that is expected to last more than one year, it is considered a fixed asset. As such, its value decreases from year to year. This is called equipment depreciation. It is important to understand this process because the correct value must be used when you file taxes. There are several factors and methods used to calculate depreciation.
In order to figure a piece of equipment’s worth from year to year, you need to know a few basic things about it. First, you need its original cost. Second, you need to estimate its useful life, or how long such a piece of equipment tends to last before you must replace it. Third, it is helpful to know its salvage value, or how much money it will sell for when its useful life has come to an end.
The most common method for calculating equipment depreciation is straight line depreciation. It is also the easiest to calculate. You simply subtract the salvage value from the original cost. Then you divide 1 by the number of years of useful life. This gives you your depreciation rate. Every year, you subtract the same percentage off the worth of the equipment.
If, for example, you bought a piece of equipment worth $100,000 with a $20,000 salvage value and a useful life of eight years, you would start your depreciation calculation by subtracting $20,000 from $100,000, giving you $80,000. Your depreciation rate is going to equal 1/8, or 12.5%, of $80,000. Therefore, every year you must subtract $10,000 from the equipment’s worth, leaving you with only the salvage value at the end of its eight-year useful life.
Some equipment, however, loses productivity and thus generates less revenue as it gets older. For such equipment, you probably need to use the declining balance method. If its productivity decreases rapidly, you may even need to use the double declining balance method. Both methods involve a higher percentage of equipment depreciation the first year, with the percentage getting lower in subsequent years. With the declining balance method, a piece of equipment that costs $100,000 may depreciate $20,000 the first year but only $18,750 the second year.
Purchasing equipment inevitably means that it loses value as years go by. The only way to avoid equipment depreciation is to lease the machinery that you need for your business. This is especially helpful if your business uses equipment that needs to be upgraded frequently. It is a good idea to weigh the advantages of purchasing against the advantages of leasing when you are making your budgeting decisions.