Depreciation & Obsolescences of Plants & Machines
Depreciation: It is the usual wear and tear caused by the
normal working of any asset, its use is liable to a certain amount of
deterioration despite the care and attention bestowed on its maintenance and
preservation.
Physical depreciation can be broken down into curable and
incurable depreciation;
Curable depreciation being fixable by refurbishing, rebuilding
of the equipment
Physical Incurable Depreciation
Physical depreciation is caused from age, wear and tear,
fatigue, exposure to the elements or lack of maintenance. Overall physical
depreciation is caused more by use rather than age.
A visual inspection can help to assess present condition of
the machine
General Upkeep:
If an equipment is well-maintained during its service life
and is expected to operate longer with lower costs, its value may be higher
than expected for a machine of its age.
Dirt, dust, and other contaminants can interfere with
lubrication and cause abrasive wear on the surfaces of the rotating equipment.
This can also lead to increased friction, leading to increased heat, and damage
to seals, bearings, and other components. Contamination can also lead to
corrosion and oxidation, which can cause parts to degrade and fail prematurely.
Additionally, contaminants can interfere with the flow of fluids, cause bearing
failure, cause pressure spikes, block lubricant pathways, and reduce equipment
efficiency.
If upkeep and maintenance are high, then the effective age
will be lower than the actual age and conversely if upkeep and maintenance have
been low then the effective age will be greater than the actual age.
Observed deterioration (also known as the 0 – 100%
method)
Lump sum figure of
depreciation can be adopted as given below:
Condition Depreciation
%
New (N)
0 - 5
Excellent (E) 6
- 10
Very Good (VG) 11
- 20
Good (G) 21
- 50
Fair (F) 51
- 70
Poor (P) 71
- 90
Scrap (S)
91 - 100
As one of the important obsolescence factors considered by
the cost approach, physical deterioration influences the conclusion of value.
: Determining the loss of asset value from functional
obsolescence
The determination of fair value of machinery and equipment assets for financial reporting purposes should include the consideration of three forms of depreciation: physical, economic and functional.
Physical depreciation is the normal wear and tear that
diminishes the value of assets over time. Let’s
consider in more detail the third form of depreciation, functional
obsolescence.
The American Society of Appraisers, defines functional obsolescence as:
“…a form of depreciation in which the loss in value or
usefulness of a property is caused by inefficiencies or inadequacies inherent
in the property itself, when compared to a more efficient or less costly
replacement property that new technology and changes in design, materials, or
process that result in inadequacy, overcapacity, excess construction, lack of
functional utility, or excess operating costs in the property. Symptoms
suggesting the presence of functional obsolescence are excess operating cost, excess
capital cost, over-capacity, inadequacy, and lack of utility.”
A few examples will help illustrate the elements of this
definition.
Curable functional obsolescence: This form of FO
is present in an asset when, with the expense of replacing necessary
components, the asset can be brought up to current operating standards. For
example, a milling machine may have its capacity limited by out-of-date
computer numeric controls, or CNC. By upgrading the CNC, the machine’s capacity
is increased. This is the easiest form of FO to quantify if the cost of the
necessary upgrade can be identified.
Functional obsolescence from excess capital cost: Equipment
appraisers differentiate between reproduction cost (the cost to reproduce the
exact same asset) and replacement cost (the cost to replace an asset with an
asset providing the same utility). When the replacement cost for an asset is
less than the reproduction cost, the difference is an indication of FO. For
example, not too long ago, surveying equipment cost thousands of dollars.
Today one can find laser-based equipment offering the same
(or better) utility in a big box hardware store for several hundred dollars.
The value of the older equipment has suffered a loss in value due to FO from
excess capital cost.
Functional obsolescence from excess operating cost: As
a result of new technology or superior design, it may not only be cheaper to
acquire a modern asset, it may also be cheaper to operate it. In one
engagement, we valued a number of paper mills. Some of the mills were 100 years
old. The inefficient design (the older mills had been reconfigured and added on
to over the decades) and technological deficiencies of the older mills were
indicators of FO. A comparison of production cost per ton for the older mills
with that of newer mills producing similar products confirmed this assumption.
The calculation of the amount of FO was based on the amount of the increased
operating expenses.
Functional obsolescence from excess capacity: The
loss in value due to excess capacity of a product plant as a whole is most
often due to economic obsolescence—factors external to the assets such as
changing demand or industry economics.
However, excess capacity of a single asset within a
production plant is an indicator of FO resulting in the loss in value of that
particular asset. For example, a brewery production line might have a filling
machine with the capacity to fill 1000 bottles per minute.
If that same line should have a bottle-capping machine with
a capacity to cap 2,000 bottles per minute, the capping machine suffers from a
loss in value due to FO. This component of the production line is not used to
its full capacity, and therefore no prudent investor would pay for its rated
capacity.
Functional obsolescence and economic obsolescence
interrelationship: In a recent engagement, we had to deal with both FO and EO.
(The calculations below are simplified for the sake of
clarity. The actual analysis included exponential adjustments and annual
inflation adjustments.)
The chemical plant, built at a cost of $200 million, was
designed to produce 100,000 metric tons (MT) of product per year (MT/Y).
Because of changing environmental regulations, the facility has never produced
more than 50,000MT/Y (50 percent of rated capacity), resulting in an EO penalty
caused by external factors.
The company decided to replace certain components of the
plant at a cost of $20 million to raise permitted production capacity to
80,000MT/Y. After the new equipment is installed, the facility will have an FO
penalty.
The FO on the upgraded plant is measured by the reduction in
utilization of most of the plant equipment from its rated 100,000MT/Y to
80,000MT/Y. (This is properly regarded as FO because utilization is limited by
the new components installed.)
There are at least two reasons why the consideration of
functional obsolescence is important. First, it ensures that the valuation is
correct. A prudent investor will either implicitly or explicitly consider FO in
the determination of a purchase price for the entire business.
The valuation of the individual assets should correlate with
these considerations. Second, a failure to consider all forms of depreciation
in an initial valuation may result in an impairment charge to the value of the
asset or asset group later.
Economic depreciation (or obsolescence) is the loss in value resulting from factors external to the asset (or group of assets) such as changes in supply of raw materials or demand for products.
Economic obsolescence can be properly measured with a
“Business Enterprise Equation” as stated below :
Assets = Liabilities + Stockholders Equity
or CA + FA + IA = CL
+ LTD + SE
where CA = Current assets
FA = Fixed assets
IA = Intangible assets
CL = Current liabilities
LTD = Long-term debt
SE = Stockholders’ equity
(CA - CL) is net working capital (NWC)
and (LTD + SE) is defined as the value of the business
enterprise (BE),
Business enterprise value less net working capital represents the economic support for fixed and intangible assets.
BE - NWC = FA + IA
Economic obsolescence exists, if the economic support for
fixed and intangible assets is less than the fractional values of the
underlying identified assets, as individually estimated by the depreciated
replacement cost or sales comparison methods, as the case may be.
Economic obsolescence is thus expressed as:
BE - NWC < (FA + IA)
Whenever economic obsolescence is established to exist, it
is necessary to reduce the individual asset values to the level of indicated
economic support as contributing to the operation. This adjustment is called an
economic penalty.
If there is excess economic support for the underlying
identified assets, it is concluded that unidentified intangible value exists,
which is generally considered to be goodwill or going concern value.
The above formula can be used as a quick valuation tool by the Companies.
The above interpretation is absolutely personal in nature
and is not binding on any individual or organization in particular.
Publisher: Centre for Valuation Studies, Research &
Training Association, India
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