Depreciation: An Insidious Distortion

June 12, 2018
Depreciation is a backward-looking convention. Manufacturers instead need to incorporate a forward-looking, continuous evaluation of capital replacement costs into their strategic, market and risk analyses.

Most manufacturers have seen the impact of the insidious distortions associated with depreciation. In one common version, a manufacturer lines up standard orders for production on an older, fully depreciated line that has lower-quality and higher personnel and maintenance costs; meanwhile, all rush orders go to the new, higher quality, completely automated line because it carries a hefty depreciation charge.

What’s going on? Salespeople are being compensated on gross margin of orders calculated with a financial accounting cost of goods sold that is specific to the production equipment used. If a company uses accelerated depreciation for cost of goods sold, the depreciation expense for new equipment can be massive in the first years of operation. A similar issue can occur with return on asset analytics. It can be difficult to maintain the same return when fully depreciated equipment is replaced with expensive new equipment that carries a high depreciation expense. Investments are often deferred even when the delay can damage a company’s competitiveness.

The fundamental problem is that depreciation—like many financial accounting and reporting rules—is a made up, backward-looking convention. The historical cost convention is used because it can be easily audited and is somewhat comparable across companies, but historical cost is completely distorted for use as a forward-looking decision-making tool. Furthermore, the tax code uses depreciation as a policy tool to encourage new investment, and these fictions often leach into financial accounting, further distorting the information used for decisions.

Manufacturers need to incorporate the replacement of capital equipment into their margins in a manner that is value added, not value destroying. Depreciation was intended for that purpose. But in today’s rapidly developing economy, it is rare that the present or future looks much like the past. The critical improvement is to make capital replacement costs a forward-looking, continuous evaluation incorporated into your strategic, market and risk analyses.

When examining the economic impact on decisions, good managerial costing first examines causality. Replacing existing capital is necessary for two reasons – deterioration and obsolescence. Deterioration occurs through the use of equipment to create products. Its impact is higher maintenance costs, more breakdowns and diminishing product quality. Obsolescence is based on time, to some extent; but the real factor is the pace of technological improvement. Today, depreciation expense is typically assigned to product cost, just the way it was 100+ years ago when the technology life cycle was 20 years or more. Is this appropriate?

Clearly, production is the causal factor for deterioration, but production is not the causal factor for obsolescence. Obsolescence occurs because business is competitive and dynamic. It may occur more quickly if you serve the most demanding, leading-edge customers in the market. But even if only some of your customers’ demands drive you to make technological improvements, the cost of serving those particular customers may be the causal factor for frequent capital investments and higher depreciation expense than your competitors. This merits serious evaluation, since obsolescence has probably overtaken deterioration as a factor in capital replacement.

Capital investments need to result in a profit for a manufacturer to stay in business. The traditional approach is to include a capital replacement charge in the form of depreciation expense in product cost. That’s what accounting rules require. It’s simple. But it’s also flawed logic in today’s technologically driven economy. A similar example of irrelevance is using direct labor to allocate overhead in a highly automated production environment. Allocating all depreciation to product cost may be giving your technologically advanced customers a bargain, and your average customers an incentive to look elsewhere for a supplier. Traditional financial information should always be subjected to a logical cause and effect analysis before it is used for decision making.

>>Larry White, CMA, CFM, CPA, CGFM, [email protected], is executive director of the Resource Consumption Accounting Institute, which trains and advocates for improved cost information connecting operations to business performance.

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