Depreciation and amortization
Expensing a truck leads to inconsistent performance
You buy a truck for $60,000 to start a shipping business. The truck has a useful life of 3 years. You then have to buy another truck. What I've done here is, I've drawn our actual ... a series of income statements for our shipping business. This is year 1, year 2, year 3, year 4. This is the revenue that we make in each of those years. It's kind of a business that right from the get go we start making $100,000 a year. This is all in thousands. Let me it write that. This is all in thousands. This is 100,000. It kind of just stays steady there. We just keep making $100,000 a year in revenue, for the first 10 years. Then, we have to pay a driver. Let's say the cost of the labor is $50,000 a year. Once again, this is in thousands. What I want to address in this video … This would be a cost. When you just subtract out the labor cost, you have $50,000 left. Then, your other cost is going to be the truck itself. What I want to think about in this video is how should we account for the cost of the truck. You might just say, "Hey look, to start off" "I spent $60,000." In year 1 we'll actually go out to the truck store and buy the truck. Why don't I just call it an expense of $60,000? One reality is, you can just say, "Hey look, in year 1 my truck cost $60,000." Then, in year 2 I don't have to spend any money on a truck, because I have one. In year 3 I don't have to do it, but then in year 4 my first truck now has to be scrapped, because I used it so much. In year 4 I have to buy another truck for $60,000. Then, again in year 5, year 6 I don't have to do anything. Then, in year 7 I have to buy another truck for $60,000. 8, 9, I don't have to do anything. Then, in year 10 I have to buy another truck for $60,000. If you've counted for the purchase of your truck every 3 years this way, your profit would look like this. In year 1, 100 - … This is revenue and these 2 lines are expenses. 100 - 50 - 60, this is -10,000 in profit in that first year. The second year you make 50,000. The third year you make $50,000. Just 100 - 50. Then, fourth year, again, -10,000. Then, you make 50,000 and 50,000. Then, again -10,000. Then 50,000. Then 50,000. To someone who looked at this series of income statements, they'd say, "This is some type of bizarre business." "In the first year …" "Every 3 years you lose a tone of money." "I don't know why." "Maybe it's being mismanaged," "maybe something strange is happening," maybe it's because of bad weather." "Who knows?" "Then, you make a ton of money." "Then, you lose some money." "Then, you make a ton of money." It seems like some type of very bizarre business when you look at it from the operating ... when you look at it from the profit line. Just when you just expense the truck every 3 years. An operating profit is the profit from the operation. Before you think about how you're paying for the operations, how you're financing them or taxes, or any of that type of thing. This is strange, because this is a very stable business. It's very strange for it's operating profit to kind of jump around like this. The way that we kind of reconcile this is by doing something called capitalizing the expense of the truck and then depreciating it over the course of it's life. I'll cover that in the next video.