Intermediate Equipment Handbook
Intech Associates
Figure 1.3 Case Study - Effect of Inflation
A piece of equipment cost 150,000 Local Currency Units (LCU) when
purchased new 5 years ago. However, with inflation a replacement of the same
model would now cost 250,000 LCU. The current scrap value for a similar
machine is 25,000 LCU.
Assuming the machine will have a working life of 10,000 hours, the current
depreciation charge should be:-
(250,000 - 25,000) / 10,000 = 22.5 LCU/hour
IF THE OWNER MAKES INSUFFICIENT CHARGES FOR DEPRECIATION/
REPLACEMENT THEN HE/SHE IS EFFECTIVELY WASTING THE ASSET.
A contractor risks bankruptcy and a public fleet manager risks ending up with a
fleet of scrap with insufficient funds to replace it. Unfortunately it can take many
years for this to become apparent when equipment life cycles are typically 10 -
20 years.
For normal accounting purposes a writing-down or depreciation allowance is
usually made for equipment investments. This is for accounting or taxation
purposes and should not be confused with the economic management of the
equipment asset and charge rates to be recovered from the user or client.
Finance or Opportunity Cost
This is a more difficult concept to explain. This is the cost of the capital tied up in
the piece of equipment. There are two ways of looking at this cost.
Firstly, if an individual, contractor or organisation procures a piece of equipment
and needs to borrow the money to buy it, he/she will be charged interest on the
capital amount (as well as having to repay the total capital amount borrowed -
the principal). The cost of this interest should be recovered from the use of the
equipment. Sometimes this charge is actually included in the overall operational
overhead, however it is likely to be a substantial component and should certainly
be part of the charge rate.
Alternatively, if the owner already has the financial resources to buy the
equipment for cash, he/she could choose to invest it elsewhere, e.g. deposit at a
bank, purchase government securities bearing interest, loan it to another
business or friend. In every case the owner could expect a return or interest on
the capital deployed, as well as getting the capital back after a period of time.
Whichever view is taken there is a cost or value on the availability of the capital
or opportunity cost - the interest charged for or foregone by investing in the
equipment.
The problem is to determine what value should be used for costing this
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