Chapter: Which method of estimating depreciation involves identifying all instances of physical deterioration, functional obsolescence, and external obsolescence, then summing their individual depreciation amounts? (EN)

Chapter: Which method of estimating depreciation involves identifying all instances of physical deterioration, functional obsolescence, and external obsolescence, then summing their individual depreciation amounts? (EN)

The Breakdown Method of Depreciation Estimation

The method of estimating depreciation that involves identifying and quantifying physical deterioration, functional obsolescence, and external obsolescence individually, then summing their individual amounts, is known as the Breakdown Method, also sometimes referred to as the Observed Condition Method or the Engineering Method. This method adopts a bottom-up approach, meticulously analyzing all depreciation factors to arrive at a comprehensive depreciation estimate.

Components of Depreciation

The Breakdown Method necessitates a thorough understanding of the three primary categories of depreciation:

• Physical Deterioration: The loss in value due to the physical wear and tear of an asset resulting from age, use, and exposure to environmental factors.
• Functional Obsolescence: The loss in value caused by inadequacies of the asset itself compared to newer, more efficient, or more desirable assets. This can be due to design flaws, inefficient operational characteristics, or technological advancements that render the asset outdated.
• External Obsolescence: The loss in value caused by factors external to the asset itself, such as changes in market demand, economic conditions, government regulations, or environmental influences.

Scientific Principles and Theories Underlying the Breakdown Method

The Breakdown Method is rooted in several scientific and engineering principles:

1. Material Science and Engineering: Understanding the material properties of the asset and how they degrade over time is critical for estimating physical deterioration. Factors like corrosion rates, fatigue limits, and wear resistance are considered. For example, the corrosion rate ( r ) of a metal in a specific environment can be modeled using Faraday’s Law of Electrolysis:

   • r = ( M I ) / ( n F A )

     where:

     • M is the molar mass of the metal.
     • I is the corrosion current.
     • n is the number of electrons transferred in the corrosion reaction.
     • F is Faraday’s constant.
     • A is the area exposed to corrosion.

2. Reliability Engineering: This field provides tools for predicting the lifespan and failure rates of components. Concepts like Mean Time Between Failures (MTBF) and Weibull distribution are used to model the probability of physical deterioration leading to failure. The Weibull distribution, for instance, can be expressed as:

   • f(t) = (β/η) * (t/η)^(β-1) * exp(-(t/η)^β)

     where:

     • t is time
     • β is the shape parameter
     • η is the scale parameter

3. Economics and Market Analysis: Assessing functional and external obsolescence requires understanding market dynamics, technological trends, and economic indicators. Economic principles like supply and demand, and concepts like Net Present Value (NPV) are used to quantify the impact of these factors on the asset’s value.

   • NPV = Σ (CFt / (1+r)^t) - Initial Investment

     where:

     • CFt is the cash flow in period t
     • r is the discount rate

Practical Applications and Related Experiments

1. Physical Deterioration Assessment:

   • Visual Inspection: A thorough visual examination of the asset to identify signs of wear, corrosion, cracking, or other physical damage.
   • Non-Destructive Testing (NDT): Techniques like ultrasonic testing, radiographic testing, and magnetic particle testing can be used to assess the internal condition of the asset without causing damage. Experiments can be conducted to correlate NDT results with the remaining useful life of the asset.
   • Material Testing: Taking samples of materials from the asset and subjecting them to laboratory tests to determine their strength, hardness, and other relevant properties. Tensile testing, for example, can determine the yield strength and ultimate tensile strength of a material, providing insight into its remaining load-bearing capacity.

2. Functional Obsolescence Assessment:

   • Performance Comparison: Comparing the asset’s performance (e.g., output, efficiency, operating costs) to that of newer, more advanced assets. Conducting controlled experiments to measure these parameters is crucial. For example, the energy consumption of an older machine can be compared to a newer, energy-efficient model under the same operating conditions.
   • Cost Analysis: Analyzing the operating and maintenance costs of the asset compared to the costs associated with newer alternatives. A life cycle cost analysis can be performed to compare the total cost of ownership over the asset’s entire life.

3. External Obsolescence Assessment:

   • Market Research: Analyzing market trends, supply and demand, and competitive pressures to determine the impact on the asset’s value.
   • Economic Analysis: Evaluating the impact of economic factors such as inflation, interest rates, and government regulations.
   • Expert Opinion: Consulting with industry experts to obtain insights into the potential impact of external factors on the asset’s value.

Calculation of Depreciation using the Breakdown Method

The total depreciation is calculated by summing the depreciation amounts for each category:

• Total Depreciation = Physical Deterioration Depreciation + Functional Obsolescence Depreciation + External Obsolescence Depreciation

Each component is calculated separately, often using a combination of quantitative and qualitative assessments. For example:

1. Physical Deterioration Depreciation:

   • Estimating the cost to repair or replace damaged components.
   • Calculating the percentage of physical deterioration based on age, condition, and remaining useful life.

2. Functional Obsolescence Depreciation:

   • Calculating the cost savings that could be achieved by replacing the asset with a more efficient alternative.
   • Determining the loss in value due to design flaws or operational inefficiencies.

3. External Obsolescence Depreciation:

   • Estimating the reduction in market value due to external factors.
   • Determining the impact of regulations or economic changes on the asset’s earning potential.

Important Discoveries and Breakthroughs

The evolution of NDT methods, advancements in material science, and the development of sophisticated economic modeling techniques have significantly enhanced the accuracy and reliability of the Breakdown Method. For instance, the development of phased array ultrasonic testing (PAUT) has allowed for more detailed and accurate inspection of internal defects, leading to more precise estimations of physical deterioration. Similarly, advancements in computational economics have improved the ability to quantify the impact of external obsolescence on asset values.

Limitations

Despite its comprehensiveness, the Breakdown Method has limitations:

• Subjectivity: Estimating depreciation amounts for functional and external obsolescence can be subjective and requires expert judgment.
• Complexity: The method can be time-consuming and require significant expertise.
• Cost: The detailed inspections and analyses required can be expensive.

Conclusion

The Breakdown Method provides a detailed and comprehensive approach to estimating depreciation by considering all relevant factors. While it can be complex and time-consuming, it offers the most accurate and reliable depreciation estimate when properly applied. Its scientific foundation in material science, engineering, and economics makes it a valuable tool for asset valuation and management.