When Dr Baldeep Farmah set up his aesthetic and skincare clinic Dr Aesthetica in 2018, he needed to invest in a number of pieces of expensive equipment costing between £3,000 and over £85,000.
“It is a huge investment," says Dr Farmah, "but essential for us to offer the services that are expected in the industry.”
As with any investment for your business, it's important to understand how the value of that investment will change over time. In the case of equipment or other tangible (physical) assets, this requires an understanding of depreciation.
What is depreciation?
Depreciation is an accounting technique that tracks the value of tangible assets – like beauty machines – over time. In the case of Dr Aesthetica, the machines that the business buys have a value that reduces over a period of time.
“Not every business asset will have depreciation, it’s used to track the value of items that a business uses for more than one year,” explains Andy Smith, of Abbeygate Accounting. “Most businesses will use depreciation to write off the cost of things like vehicles, property and equipment." When a return on initial investment is impossible or unlikely, an asset can be written off using depreciation.
What is the importance of depreciation?
Understanding depreciation means that you have a clear picture of your company’s long-term expenses and the true value of its assets at any given time. “We look at depreciation at the end of the year, and it’s important to keep an eye on the value of those assets and ensure we aren’t over-extended,” says Dr Farmah.
Depreciation can also impact your company’s profit and loss. If you are spending on new assets and a high proportion of that money is written off by depreciation, this will reduce overall net income.
Types of depreciation
There are several types of depreciation, which depend on the nature of the asset and how its value changes over time. Your business should calculate it using one of several corresponding methods.
Straight line depreciation
This is the most simple and most common method of calculating depreciation. It assumes that an asset loses value at a steady rate over a specific period. For example, Dr Aesthetica writes off the value of a £3,000 micro-needling machine over five years, which is the useful life of the machine. This process can be automated in the company’s account system, making it easy for Dr Farmah to see the change in each set of accounts.
Example of straight-line depreciation
A business spends £50,000 on new laptops for remote workers. Assuming a typical rate of depreciation of 25%, the depreciation looks like this:
- Purchase price £50,000
- After 1 year £37,500
- After 2 years £25,000
- After 3 years £12,500
- After 4 years £0 (the asset has been fully written off)
Units of production depreciation
This type of depreciation assumes that an asset loses value for each item it produces, at a predictable rate. For example, a piece of machinery in a factory might be assumed to make 100,000 croissants over its lifetime. Depreciation could be calculated on how many croissants the machine produces during the accounting period.
The advantage of a unit of production depreciation is that it is relatively easy to calculate – however, businesses need to have an accurate record or estimate of production capacity to use this method. If production varies from month to month, this will need to be recorded in the accounting system.
Example of units of production depreciation
- A business spends £100,000 on a new industrial printer.
- Over its useful lifetime, the printer is expected to print 500,000 designs.
- The machine has a salvage value of £5,000.
- In this case, the amount to be depreciated is 1.99 per unit (£995,000 divided by 500,000).
- If the machine has printed 50,000 designs in the most recent year, then the depreciation would total 50,000 x 1.99, or £99,500.
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Double declining balance depreciation
The third common way to calculate depreciation is by using accelerated methods. This is likely to be useful when calculating depreciation on assets that are more valuable and productive when new, and then the value tails off quickly.
It is commonly used to account for the depreciation of vehicles, which lose value rapidly after one year. It is more complex to calculate than units of production, but more accurate.
Example of declining balance depreciation
A business spent £40,000 on a new delivery van that is expected to have a useful life of ten years. At the end of that period, the van will likely be sold for around £4,000.
Typical depreciation might be 10% for a van, but for declining balance depreciation the business applies 20% of the van’s value in each year, as shown below:
- Purchase value £36,000 (purchase price minus salvage value)
- After 1 year £28,000 (starting value minus 20%)
- After 2 years £23,040 (year one value minus 20%)
- After 3 years £18,432 (year two value minus 20%)
How to calculate depreciation
The good news is that calculating depreciation doesn’t have to take huge amounts of time. At Dr Aesthetica, the business works with an external accountant to agree on depreciation rates for specific asset categories. From there, Dr Farmah records purchases into accounting software, and this will calculate the annual depreciation expense and post it to the appropriate accounting records.
Dr Farmah keeps a close eye on the numbers throughout the year, including depreciation figures. “It helps to inform our cash flow, because I can see the value of each machine, and understand how we should be targeting and expanding different services to maximise the ROI from those machines',” he says.
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