One of the biggest challenges that construction projects face is the maintenance of equipment required for the job.
Like all assets, construction equipment loses value over time due to operations, wear and tear, the introduction of newer models, and other factors.
Construction equipment losing its value over time is called equipment depreciation in construction.
Project managers and contractors must understand how depreciation works and calculate it effectively.
In this blog, we will answer what depreciation means, how it is calculated, best practices for managing depreciation, and how asset management software can help streamline processes and reduce depreciation costs.
Construction equipment depreciation refers to the gradual decrease in the value of construction machinery and tools over time.
It is one of the more important financial aspects of construction as it allows contractors to allocate some equipment costs as a tax-deductible expense.
It is also important as it helps companies keep track of their asset's actual worth over time.
So, what does depreciation mean? In practical terms, depreciation reflects the reduction in the economic value of the equipment over its lifespan.
For example, A bulldozer that costs $100,000 when new may be worth only $70,000 after a few years. This results from:
This declining value helps businesses track the cost of owning and operating equipment.
Moving on to the next question that many may have, what does depreciable mean? In accounting, a depreciable asset refers to equipment subjected to wear and tear while operating.
Construction equipment fits the depreciable category due to its heavy machinery usage.
The depreciation expense for such assets accounts for the inevitable decline in their value.
Calculating depreciation may seem complex, especially with the different methods available.
Before giving up, why not take a deep look at these methods and how to calculate depreciation on equipment using them?
We promise to make things easier to understand.
One of the simplest and most extensively employed methods for estimating depreciation is the Straight-Line Method.
This approach shares equipment costs equally over its useful lifespan, providing a consistent annual expense.
A simple formula for annual straight-line depreciation is
Annual depreciation = Dn = (P - F) / N = 50,000 - 10,000 / 5 = LE8,000 per year
Some other ways to calculate this type of depreciation include:
The Sum-of-the-Years-Digits Method is an accelerated depreciation technique that will calculate a more significant expense in the early years of the life of the equipment, reflecting the greater use observed during that time.
Due to its simple calculations, the sum-of-the-years method is most commonly used to calculate construction machine operations. In this approach, new and old machines have the same annual depreciation.
Even though the depreciation is done annually, the depreciation amount varies yearly.
When calculating the sum-of-the-year, you can use the following formula:
R=N-m=1/SOY
Where
R= is the calculation of depreciation
N= Number of years
m= Particular year
SOY= Sum of Years
You can calculate SOY using the following formula
SOY = N+(N-1)+(N-2)+(N-3)+...+1
This method is closer to the realistic changes in the value of the equipment. Since the rate of depreciation changes annually, it is easier to determine which machines are old and which are newer.
Some other ways to calculate this type of depreciation are as follows
The Declining-Balance Method is a technique for accelerated depreciation in which a fixed percentage, instead of a set amount, is deducted from the asset’s book value annually.
An example is the Double-Declining Balance (DDB) Method, which increases the decline seen in straight-line depreciation by a factor of two.
The declining balance method is used by companies looking to calculate depreciation for accounting purposes.
In this method changes in the rate of depreciation of a machine are calculated on its whole usage period, right up to the end of its life.
According to this method, the annual depreciation rate depends upon the remaining value of the machine in the accounting books.
You can calculate the declining balance value by following this formula:
Declining Balance Depreciation=CBV×DR
Where:
CBV=current book value
DR=depreciation rate (%)
Accurately calculating construction equipment depreciation is vital for keeping a sound financial base for the company.
Here are some best practices that contractors and equipment managers can use:
Several types of businesses may use different approaches depending on their financial aspirations.
People may prefer to apply accelerated methods like SYD or DDB to retrieve more considerable expense recoveries sooner, compared to those who like the more straightforward, straight-line approach.
Equipment utilization and proper financial planning, instead of a set amount, are deducted from the asset’s book value today.
A critical element in determining depreciation is finding the correct life duration of construction equipment.
When you overestimate, you jeopardize your ability to judge expenses accurately, and underestimating can rapidly decrease your taxable income.
You should look into industry standards and work with equipment manufacturers for a practical estimate.
In equipment depreciation, construction equipment is affected by the progression of time and the level of care it receives.
You can easily manage equipment depreciation and significantly reduce depreciation expenses through regular inspections, repairs, and upgrades.
Creating a record of the condition of equipment offers a solution to incorrect depreciation schedules.
Increasing your equipment fleet without automation can make managing depreciation time-intensive and prone to mistakes.
Construction equipment management software aims to provide a single pane of glass solution for real-time monitoring of equipment and machinery.
These tools enable businesses to:
Using software can facilitate construction managers' achieving organization, reducing errors, and helping them select the best moment to perform preventive maintenance, upgrade, or retire assets.
Managing construction equipment requires depreciation as a vital component.
Recognizing the importance of depreciation and picking an appropriate method allows contractors and project managers to efficiently manage their finances and make informed decisions regarding equipment usage, maintenance, and repairs.
When you deploy depreciation methods like Straight-Line, Sum-of-the-Years, or declining balance, use asset management software solutions to monitor your assets.
To correctly depreciate construction equipment, follow these steps:
Asset depreciation is managed by regularly calculating the depreciation expense, tracking the condition of assets, and using asset management software to ensure all data is up to date.
The best depreciation method for equipment depends upon the financial goals of a construction company. Here is a brief look at the different deprecation methods and what they are best for.
Best For: Simplicity and consistency. It works successfully for equipment that wears out consistently over time.
Why Use It: This process of equal distribution of the cost of the equipment over its lifetime creates straightforward predictions and planning.
Best For: Equipment used a lot at the beginning, including machinery that could likely need maintenance or substitution shortly.
Why Use It: With SYD, you can claim a higher portion of the equipment's cost upfront, which is helpful considering the equipment's significant early usage.
Best For: Maximizing tax savings early. It is an excellent fit for equipment that decreases in value quickly or sees robust usage right after it's new.
Why Use It: This method initially results in faster asset depreciation, which allows for bigger tax deductions. Ideal for equipment subject to quick wear, such as cranes or loaders.
The general rule is to spread the cost of an asset over its useful life, allowing for a reduction in taxable income. Equipment that wears out quickly may benefit from accelerated depreciation methods, while longer-lasting assets can use the Straight-Line Method.