Brief note on the concept of depreciation

During a year, the value of fixed assets (such as machines, buildings, equipments, etc.) declines due to wear and tear and obsolescence. This decline in the value of fixed assets is known as consumption of fixed capital or depreciation. This decline in value is not made good by current repair or maintenance. By subtracting depreciation from gross fixed capital formation, net capital formation is obtained.

There are two following important forms of consumption of fixed capital:

(i) Wear and tear of fixed capital:

This signifies general wear and tear of machinery in the production process during a year which cannot be made up by current repair or maintenance.

(ii) Obsolescence:

Loss in value of fixed asset either due to change in demand for goods and services it produces or due to change in the technique of production (technology) is known as obsolescence. Due to research and development there is improvement in the technology in every productive activity.

As a result of this, old types of machines are being replaced by new machines which are more efficient, such as automatic and computerised machines. This improvement in technology has led to a reduction in the demand for old machines, with the result their value has gone down. This decline in the value of machines due to improvement in technology is known as technological obsolescence.

Thus, when machinery goes out of use due to technological improvement, it is known as technological obsolescence such as steam engines gradually being replaced by diesel engines.

Demand for a commodity also changes due to change in fashion such as declining demand for nylon cloth. Due to such changes machines used for manufacturing nylon cloth are being replaced. This is another aspect of obsolescence.

According to prevailing conditions, manufacturing firms estimate the extent of obsolescence caused due to change in fashion and technology. This is known as expected obsolescence. Expected obsolescence is included in consumption of fixed capital.

At times, obsolescence is unexpected such as less use of machines or decline in their value due to floods, fire, earthquakes, etc. Such kind of obsolescence is known as capital loss. In short, decline in the value of fixed asset due to unexpected obsolescence is known as capital loss. Capital loss is not included in consumption of fixed capital.

Net Money Value = Gross Money Value – Depreciation

Keeping this basic thing in mind we should know the following also:

1. Net Value Added: Gross Value Added – Depreciation

2. Net Domestic Product: Gross Domestic Production – Depreciation

3. Net National Product: Gross Domestic Product – Depreciation

4. Net Domestic Capital Formation: Gross Domestic Capital Formation – Depreciation