Accounting theory and practice, Volume 2 (of 3)

by Roy B. Kester

Unit Efficiency

The efficiency of the unit, however, has a somewhat different relation to depreciation. Units, i.e., individual assets comprising the plant, are constantly wearing out and being replaced. The plant, aside from exceptional cases, never reaches the point where it must be discarded in its entirety and replaced as a whole. The depreciation of each unit continues until the point of inefficiency is reached, when it is scrapped and replaced. The unit frequently is allowed to drop below its margin of efficient service before being scrapped, and it may be made to render service much longer than is customary, by means of heavy repairs and a relatively high up-keep expense. When to scrap a particular unit involves a nice calculation. The heavy cost of repairs necessary to secure good service from the old unit and the possible loss through failure to accumulate a sufficient reserve must be weighed against the cost of a new unit and its up-keep and running expense. Usually the efficiency of the individual unit is very like the parson’s one-hoss shay which “ran a hundred years to a day and then of a sudden it went to pieces all at once.”

The following chart illustrates accurately the relation of efficiency to uniform depreciation, the XCY line being the efficiency curve and XY the depreciation curve. Also curve 6 of the chart on page 105 gives a good illustration of the same point. Inasmuch as the depreciation reserve must provide for the loss of the entire asset by the time it goes out of service, it is readily seen that in judging an asset from its bookkeeping record of cost and reserve there is no measure of efficiency shown therein, since a normal efficiency must be maintained by repairs at all times. The record is, however, a good index of the time when the point of inefficiency will be reached.

From “Principles of Depreciation,” by Earl A. Saliers.

Chart Showing Progress of Uniform Depreciation
and of Diminishing Efficiency

Engineers hold the opinion that machinery as a rule cannot suffer more than 25% to 50% actual depreciation and give efficient service. A depreciation reserve of anything more than that does not mean that the point of inefficiency has been reached, for the reserve is usually estimated and applied on the basis of theoretical depreciation and so takes cognizance of all its factors. It has sometimes been stated that inefficiency is a factor of depreciation distinct from wear and tear, obsolescence, and supersession. It seems a better statement of the relation to say that the point of inefficient service is the limit beyond which the three factors named cannot be allowed to operate or have effect. The need of judging the efficiency of some kinds of assets is not so apparent as of others. Thus in the case of poles, wires, conduits, and the like, efficient service is secured until they are worn out, with very little expense for up-keep. That is, such assets are normally efficient throughout their whole term of life, and the application of repairs will not appreciably extend their life nor will it affect their efficiency. In the case of other assets, such as machinery, telephone switchboards, motors, etc., the item of up-keep is a very vital one in the determination of the point or margin between efficient and inefficient service, and that in turn is an important factor in the determination of the length of service life of the asset. Thus, although efficiency and depreciation are intimately related, the degree of depreciation at a given time is not by any means an inverse measure of the efficiency of the service being rendered by an asset.

Depreciation and Fluctuations in Market Value

The relation of depreciation to fluctuation in value, due to whatever causes affect the market, also deserves consideration. Depreciation primarily refers to a decrease in value from a definite cost figure, such decrease being due to certain well-recognized causes, of which change in market value is not one. Thus, while it may be correct, through a loose use of the term, to use the expressions, “depreciation of securities,” “depreciation of real estate,” and similar phrases, and there may be no likelihood of any misunderstanding, that is not the sense in which the term depreciation is used here. Unfortunately, market fluctuations are sometimes allowed to influence depreciation charges.

Such influence may come about in three ways: (1) In valuation proceedings for the determination of rates for a public utility company, a basis frequently used is that of the cost of reproduction or renewal less depreciation. The theory is that under existing views of private property such a company has the right to the enjoyment of all increments in its own properties and therefore has a right to such rates as will earn a fair income on the present value of those properties. Depreciation based on the present reproduction cost is in this way influenced by fluctuations in market value, and the oftener a physical appraisal is made and its determined values brought upon the books, the greater will be the disturbance of the basis for the depreciation charge. (2) Occasionally the practice is met with of basing the present depreciation charge upon the estimated cost to replace the old asset. This is discussed later and is mentioned here merely to show a possible relationship between fluctuations and depreciation. (3) Finally, in the periodic adjustment of depreciation rates and charges, the estimated scrap value of the asset does affect the amount of the periodic charge. Changes in market value of scrap, which may be considered as due to causes which will continue in force rather than to the ups and downs of the market, may legitimately be reflected in the depreciation charge for the remaining life-term of the asset and must be so reflected in the interests of accuracy in any statement of true values.