Is depreciation expenses an overhead cost?

Depreciation

IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. The depreciable amount equals the purchase cost of the asset less the salvage value or other amount like revaluation amount of the asset. Depreciation amounts to distributing the cost of assets to the income statement over the useful life of the asset.

Depreciation expense is a non-cash operating activity which is the result of qualitative wear and tear in the use of asset but it has been quantified by the use of accounting principles and assumptions in line with the enterprise’s own accounting policies.

Depreciation is computed using various methods. Popular methods include the straight-line method and accelerated depreciation methods. The amount of depreciation needs to be calculated each year and is debited to Income statement like any other operating expenses.

Depreciation cumulatively rises over time and hits the cost less salvage value in the final year of useful life. The historical value of the asset is reduced by this accumulated depreciation so as to arrive at the written down value of the asset.

Written down value is computed after charging depreciation accumulated over the years to the initial cost i.e. historical cost.

Overhead costs

Overhead costs are residual costs after direct labor, direct expenses, and direct materials. Overhead costs are basically indirect costs. These cannot be directly traced back to the product and indirectly contributes to the value-added to the product. There are two types of overhead.

  1. Manufacturing overhead termed as factory overhead: These costs relate to the factory where production is taking place. Manufacturing overhead includes expenses as the electricity used to operate the factory equipment, depreciation on the factory equipment and building, cost of security guard personnel.
  2. Non-manufacturing overhead termed as administrative overhead: This overhead relates to administration cost of running a factory. These are basically office expenses that get added to the product in the cost sheet. Non-manufacturing costs include expenses related to maintenance, printing and stationery, depreciation of non-manufacturing equipment like vehicles to sell and distribute the products.

Direct costs vs overheads

Direct costs are easily traceable to the product. For example, a factory worker makes the product, so, direct labor is labor costs. Wood in the making of furniture attributes to direct material costs.

As can be seen, direct costs can be easily identified to product but not overheads. Overheads are indirectly related to the production and manufacturing of products.

Conclusion

Although depreciation has to be seen on case to case basis to decide whether it is direct cost or overhead, but a general parlance has been formed to classify it as overhead being part of factory overhead generally.

A Contrarian example would be turbine depreciation in the generation of electricity. This is the case of being directly related but is limited to only electricity or fewer industries.

Hence, depreciation expense is considered an indirect cost, since it is included in factory overhead and then allocated to the units manufactured during a reporting period. This is as per general parlance in businesses around globally.

Is depreciation expense an operating expense?

Depreciation

IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. The depreciable amount equals the purchase cost of the asset less the salvage value or other amount like revaluation amount of the asset. Depreciation amounts to distributing the cost of assets to the income statement over the useful life of the asset.

Depreciation is a non-cash operating activity which is the result of qualitative wear and tear in the use of asset but it has been quantified by the use of accounting principles and assumptions in line with the enterprise’s own accounting policies.

The amount of depreciation needs to be calculated each year and is debited to Income Statement like any other operating expenses. Depreciation cumulatively rises over the time and hits the cost less salvage value in the final year of useful life.

The historical value of the asset is reduced by this accumulated depreciation so as to arrive at the written down value of the asset.  Written down value is computed after charging depreciation accumulated over the years to the initial cost i.e. historical cost.

Depreciation is computed using various methods as straight-line method, double declining method, units of production and sum of years digits method.

Operating expense

Operating expenses are normal business expenditures incurred daily. The operating expenses are incurred during the daily works of business operations. These expenses are however not directly associated with the production of goods or services. Examples of operating expenses include the following:

  1. Insurance costs
  2. Legal fees
  3. Office supplies
  4. Compensation and related payroll tax expenses
  5. Advertising costs
  6. Entertainment costs
  7. Rent of production facilities
  8. Depreciation.

Basically, there are two types of operating expenses viz administrative operating expenses and sales and marketing related operating expenses.

The administrative expenses relate to office-related expenses like legal fees and printing and stationery. Sales and marketing related operating expenses include advertising costs, travel costs, amongst others.

Is depreciation operating expense?

Depreciation replicates the period and scheduled conversion for a fixed asset into an expense as the asset is used during normal business operations. As the assets are used to generate operating income in the normal course of business, depreciation expense is considered as operating expense.

Depreciation depicts the scheduled conversion of the purchase cost and other associated costs into the expense during its useful life during the normal course of business operations.

Depreciation is however one of those operating expenses where cash movement is lacking. This is because the cash was already incurred for acquiring the asset and hence there is no requirement of spending the cash unless up-gradation of asset is required.

Therefore, depreciation is a non-cash component of operating expenses. The same treatment goes with the amortization of intangible assets.

Another way to look at it is to assume that all the fixed assets of business will ultimately be replaced in which case large cash outflow would be required for replacement asset. From this angle, there is better view to identify relationship between cash flow and amount of depreciation.

Hence. Depreciation will not be considered as part of operating expenses in the short term, but it should be considered as operating expense in the long term to provide for replacement cycles.

Is depreciation expenses a direct or indirect cost

Depreciation

Depreciation is a non-cash operating activity which is the result of wear and tear in the use of asset but it has been quantified by the use of accounting principles and assumptions in line with the enterprise’s own accounting policies.

The amount of depreciation needs to be calculated each year and is debited to Income statement like any other operating expenses. Depreciation expenses cumulatively rise over time and hit the cost less salvage value in the final year of useful life.

Indirect costs

Overhead costs are residual costs after direct labor, direct expenses, and direct materials. Overhead costs are basically indirect costs. These cannot be directly traced back to the product and indirectly contributes to the value-added to the product. There are two types of overhead.

  1. Manufacturing overhead termed as factory overhead: These costs relate to the factory where production is taking place. Manufacturing overhead includes expenses as the electricity used to operate the factory equipment, depreciation on the factory equipment and building, cost of security guard personnel.
  2. Non-manufacturing overhead termed as administrative overhead: These overheads relates to administration cost of the running factory. These are basically office expenses that get added to the product in the cost sheet. Non-manufacturing costs include expenses related to maintenance, printing and stationery, depreciation of non-manufacturing equipment like vehicles to sell and distribute the products.

Direct costs

Direct costs are easily traceable to a product and be connected to a specific cost object, which may be a product, department or project.

Direct costs can include materials of production as raw materials, paint for finishing product, and cost of labor skill in finishing the product. Labor and direct materials, which are used in creating a specific product, constitute the majority of direct costs.

For example, to make furniture, the direct costs are the cost of wood, the labor skill to make furniture and the paint works to complete it.

Direct costs vs indirect costs

Direct costs are easily traceable to the product. For example, a factory worker makes the product, so, direct labor is labor costs. Wood in the making of furniture attributes to direct material costs.

As can be seen, direct costs can be easily identified to product but not overheads. Overheads are indirectly related to the production and manufacturing of products.

Conclusion

Depreciation has to be decided on one to one basis as the use can differ and can link sometimes to units of production. Take an example of a logging machine where depreciation is computed according to the number of plants it cuts in the financial year.

This is however not a general case in business. Most of the business’ assets are not linked to units of production. For example, the milk tarnishing machines are just assets not linked to the production of milk. There is a rigid depreciation method here which is fixed.

The important thing is that in both the case, the input of assets cannot be visibly seen in the feature of the product.

Hence, depreciation expense is considered an indirect cost, since it is included in factory overhead and then allocated to the units manufactured during a reporting period

Is depreciation expenses a fixed or variable cost?

Depreciation

IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. The depreciable amount equals the purchase cost of the asset less the salvage value or other amount like revaluation amount of the asset. Depreciation amounts to distributing the cost of assets to the income statement over the useful life of the asset.

Depreciation is a non-cash operating activity which is the result of qualitative wear and tear in the use of asset but it has been quantified by the use of accounting principles and assumptions in line with the enterprise’s own accounting policies.

Depreciation is computed using various methods. Popular methods include the straight-line method and accelerated depreciation methods.

Presentation in Financial Statement:

Income Statement: The asset cost less salvage value is spread over the useful life of the asset. The amount of depreciation needs to be calculated each year and is debited to Income Statement like any other operating expenses. All the fixed and variable expenses are shown in the income statement.

Balance Sheet: Depreciation reduces the value of assets over time. Depreciation cumulatively rises over time and hits the cost less salvage value in the final year of useful life. The Balance sheet balances assets with liabilities and capital.

Variable cost

The variable cost is closely associated with the number of units of production or services given. The variable cost increases and decreases with production volume.

That means if the production volume goes up, the variable cost will also rise while on the other hand, if the production volume goes down, the variable costs would also go down.

Variable costs differ among industries. Hence, it’s not useful to compare the variable costs between metal companies and manufacturing companies as they are not comparable. However, variable costs can be easily compared among the same industry like a metal company with another metal company.

Fixed cost

Fixed costs are the level of costs that are not associated with level of production. Unlike the variable cost, a company’s fixed cost does not vary with the volume of production.

The fixed cost remains the same even if no goods or services are produced, and hence, these cannot be avoided. The higher the company has fixed costs, the higher would be the breakeven target the company needs to achieve. The fixed costs occur regularly and rarely change.

Depreciation is fixed cost

Depreciation is fixed cost as it incurs in the same amount per period throughout the useful life of asset. Depreciation cannot be considered a variable cost, since it does not vary with activity volume.  However, there is an exception.

However, there is a notable exception when the company employs units of production method to depreciate fixed assets. In this case, depreciation would be variable costs as it is closely linked with the number of units of production. The nature of this method is more consistent with variable cost. Take an example of

For example, invertor machine or power generators in factories can be used on the number of hours being used, so that depreciation expense will vary the number of products used. This can be easily done by maintaining the log.

However, usage-based depreciation systems are not commonly used, so in most cases, depreciation cannot be considered a variable cost.

Depreciation is fixed cost and used to compute breakeven cost of the company.

What is the acquisition cost?

Meaning

The cost of acquisition is the amount that is needed to acquire a firm or unit from a company. It can reflect the amount paid for fixed assets. It also reflects the cost incurred by the business for getting a customer.

Beyond the payment for the asset, there are further costs associated with the acquisition cost. For example, if the company buys land for manufacturing, the company has to incur legal fees, registration fees, and so on.

We will discuss acquisition costs in relation to acquiring business or part of it.

Potential business acquisition

The computation of potential business is based on estimate valuation. The evaluator looks at all facts and financial data and concludes the valuation taking into the consequences of future events as well.

Further down the road is about succession planning, preliminary negotiations, and situations involving important issues that are subject to financial constraints. The computation of these aspects is more complicated than mere estimation.

Then, comprehensive analysis of valuation is made for companies tussling with legal cases. The valuator analyzed the case one by one and also values the patent, trademark, market conditions, forecasting of data along with appropriate discount rates.

The basic acquisition cost is dependent on the following:

  • Future outlook
  • Future cash flow
  • Capital assets
  • Business Value Determination
  • Asset-based which is the book value

Liquidation value of the company depicts that if the company liquidates the assets and pays off all liabilities, what will be apportioned to stockholders.

Acquisition cost on grounds of future cash flows or earnings.

This is very apt concept than mere basic acquisition cost. This takes into account the potential cash flow of the business.

There are many techniques to compute value of business as:

  1. Capitalization of average net earnings: This is value connected to future earnings resulting from the business acquisition. The assumption is that there will be synergy benefits resulting in higher earnings in the future.
  2. Discounting of anticipated future cash flows: Businesses now days instead prefer using average cash flows instead of earnings. This is computed by computing most likely potential inflows and reducing them on the date of valuation.
  3. Determination of net assets: This is basically the computation of net worth with some modifications. This is mainly for sectors that are related to assets instead of operations.

The other computations also include calculation of customer acquisition costs when new franchise is bought or news business is entered upon.  

IFRS on acquisition costs

IAS 32 on Financial instruments and presentation and IAS 39 on financial instruments deal with the issue of debt issuing costs and equity instruments. The costs that are associated with acquisition costs must be expensed.

It may include reimbursements to acquiree for incurring some of the acquisition costs. The costs which need to be expensed include advisory fees, legal fees, accounting fees, similar consulting fees, cost of maintaining the acquisition department, and so on.

What is the difference between fixed asset write off and disposal?

Write off Fixed Assets

A fixed asset is written off when it is decided that there is no further use of the asset. It means that assets would not be able to generate any value be it continuing or any salvage or scrap value.

A write off of fixed assets includes removing the traces of fixed assets from the balance sheet. This is done to reduce the related fixed assets’ account and accumulated fixed assets’ account.

Write off specifically refers to the removal or derecognition of the asset from the Fixed Assets register and Statement of Financial Position at Zero value. Some experts or authors believe that this writing off of assets is a form of disposal of the asset.

For instance, the business eliminates fixed assets without receiving any payment in return.

This is a general scenario where the fixed asset is scrapped because it is obsolete or no longer in use. Further, there is no resale value to it. Let us take an example for accounting purpose:

Sinra Inc buys a machine for $200,000 and recognizes $20,000 of depreciation each year for the next 10 years. At the end of 10 years, the machine is fully depreciated and ready for scrappage.

Sinra Inc gives away the asset free of cost and should record the following journal entry:

DateDescriptionDebitCredit
xxAccumulated Depreciation (Machinery)$ 200,000
xx Machinery $ 200,000

Another way to write-off the asset is providing for a reduction in carrying value of the asset.

This amount is usually charged to expense as it is considered as the cost of doing business. The term writes off refers to the value of the asset, the amount is written off and not the asset itself.

Disposal of the fixed asset

Generally, discarding involves writing off assets too. However, when we study the meaning deeply, these are two different terms and having different accounting implications.

Disposal of fixed means discarding the fixed asset from the performance to create any value. Further, disposal has a bit more complicated procedure than purchases.

A form for disposal shall be filled while disposing of the assets. It shall contain details such as:

  • Description of the asset disposed of
  • Reason for disposal
  • Financial year originally acquired
  • Method of disposal i.e. sale/scrap/part exchange/other
  • Value received for a disposed asset
  • Sales invoice number and asset id
  • Sale of an asset at again

There are three scenarios where assets are disposed of

A) Sale of Assets at Gain/Loss:

Let’s say Sinra Inc sells machinery of $200,000 for $70,000 cash after having completed $140,000 of accumulated depreciation. The requisite journal entry would be:

B) Part exchange of asset:

Sinra Inc replaces asset A that has an original cost of $80,000 and accumulated depreciation of $40,000 with another asset B that has a fair market value of $50,000.

In such scenario, the accounting standards come into place which says the asset which has more evident value shall be recorded at its value. The journal entry would be:

Controls and Processes:

Even though fixed assets is not consider as the sensitive assets that could easily convert into cash.

And the fraud risks of losing fixed assets is low in general compare to cash, but entity should have proper control and process to make sure that the assets are correctly written off or dispose at the company benefit.

Management or staff should not gain the benefit from this write-off or disposal at the company’s costs.

There are number of controls that generally apply to prevent such a risks. Those control include:

  • Set authorization matrix or approval matrix to make sure that only authorized persons could approve to write off or dispose of.
  • Physical inspection should be performed to confirm the condition of assets.
  • A regular physical count of assets belong to the entity should be performed to ensure that assets are not loss at any reason include abuse power by management on assets write off or disposal. Sometime management might write off assets that have value more than the right that board was given to them. And sometimes the disposal process is not at the company benefit. For example, assets are disposal to staff or relative at the price that should be. Or the income from sales of fixed assets is not recorded or reported to the company.
  • Maintain assists listing and regularly update.
  • Ensure that assets that written off or disposed of are reflected accounting records.
  • Having an internal audit to regularly review the execution of write off or disposal and report the result to the board.