Depreciation

So we have a company here. Let's just say it's a widget factory again or a widget company. And what I'm going to do is I'm going to actually write out its income statement over a given number of years. What we did in the first video on this series is we just did one snapshot of the income statement. I think it was 2008. But here we're looking at the income statement over a bunch of years, and in this case, I'm just assuming that they have a very stable revenue base, that they bring in a very stable amount of revenue every year. Now, their cost of goods, I'm going to split up this time, because there's two components of cost of goods, so I'll just make a cost of goods category right here. COGS, but that just stands for Cost of Goods Sold, but sometimes you'll hear someone say our COGS were this or our COGS were that. Cost of Goods Sold. So they're the variable costs. And this video isn't a video on variable versus fixed costs, but you might learn a little bit about it. So they're the variable costs, and that's literally the actual costs of making those widgets. So if the widgets are made out stainless steel, it's the cost of buying the stainless steel and maybe the electricity bill of melting it and reforming it or however you have to work with stainless steel. So let's say the variable costs each of these years-- and I'm assuming stainless steel prices don't change-- is $100,000. Minus $100,000 every year. And actually, let's just say that also includes employee costs. They have people on hourly wages that are forming these stainless steel widgets, so that incorporates everything. And then the fixed costs will essentially be the cost of the factory. And let's say that they essentially have to build a new factory every two years, or let's say they have to do major repairs to the factory every two years. So let's say repairs on factory. Because that's part of the cost of building the widgets, because if you continue to make widgets at this kind of $1 million a year pace, your factory has to be retooled or revamped every two years. So let's put this fixed cost. So the factory retooling. And most times, and we'll see this when you look at an actual company's income statement, they're not going to break up the variable and fixed costs within their cost of goods sold like this, because really, they actually want to hide it from a lot of their competitors. They don't want their competitors to have too much intelligence on what their cost structure is like. It could be used against them potentially, or maybe they don't want their customers to know. Anyway, factory tooling. So the way I just described it, one way to account for it is when you do the factory retooling, you essentially just mark it as an expense. So let's say a factory retooling costs $500,000. So let's say it's minus $500,000. But they do it every two years. So you did it in 2005. They didn't have to do it in 2006, then they can do it in 2007. They don't have to do it in 2008. Fair enough. And then we have their gross profit. Here it's $1 million minus $600,000. It's $400,000, then it's $900,000, then it is $400,000, then it's $900,000. And let's say that their SG&A-- SG&A is Selling, General and Administrative expenses. I'll leave out marketing for now. They're SG&A, let's say it's another $500,000 every year. So minus $500,000. And that never changes. $500,000 every year. Minus $500,000. And so their operating profit, the amount of pre-tax income, but you know, we're not considering financing either, so this is their operating profit or their EBIT. So operating profit. And this year, it's minus $100,000. Here it's also minus $100,000. But then in these years, they make money. It's $400,000 and $400,000. And then we could take this down. Let's say they have no interest expense. They have no interest expense, because that's not the point of this video. And then their pre-tax profit is going to be the same thing as the operating profit, so minus $100,000, minus $100,000, $400,000-- I'll make the good years in green-- $400,000. And then, let's just say they're in the Caribbean and they don't have to pay taxes. Because that's not the point of this, but you can apply some tax rate to this and figure out what their net income is. But the point of this is, even though their business is ultra stable, they do the exact same thing every year, when we look at the pre-tax or the operating income, or if we tax it, or even at the net income, we see a super lumpy business, because in one year they lost $100,000. If you're looking at the business, you're like, oh, what a horrible business. But then the next year they make $400,000, and then they lose $100,000. And you're like, gee, how is that possible? That you have such a sleepy, stable business that's just making COGS year in year out, and they have the exact same amount of revenue? How is it possible that their actual income is so lumpy? And I think you know, because you have this every other year factory retooling, where they have to spend $500,000 to essentially rebuild their factory because of all of the wear and tear that happened over the last two years. So the question is, is this a good way to account for it, where when you have to-- I guess you could say-- buy new equipment. Let's say this $500,000 is to buy actual new stainless steel shaping tools, so is it a good idea to account for it only in the period that you spend it? Because it's not like you're only using these tools in this period and that period? You're using these tools throughout the period. So the answer is, well, no, it's not a good idea. Because the whole purpose of accounting is to give the person reading the income statement in this case as accurate a picture of the actual state of the business as possible. And this, in my opinion, isn't an accurate picture, where it creates this huge lumpiness and it creates the impression of a volatile business even though it's a super, super stable business. So what you do, instead of just saying, oh, I had to buy $500,000 worth of equipment in 2005, so I literally put a $500,000 expense there, and I didn't have to do that in 2006, so I have no expense. I had to do it in 2007, so I put the expense. Instead of doing that, what you do is-- I'll put the balance sheet down here-- so whatever the balance sheet was in-- so I'll draw both hand sides of the balance sheet. So this is the asset side of the balance sheet. And just so you don't get confused, there's always a liability side of the balance sheet as well. So in 2007, maybe before I spent the $500,000, right when I do it, I probably had $500,000 of cash sitting here. Let me write that down. So I have cash. I'll just put a C there. Cash, $500,000. And instead of just using this an expense, and we'll go in the future on kind of how you account for things in a little bit more detail and how you actually do the debits and credits, but a simple way to think about it, instead of using this $500,000 as an expense, we just transferred this $500,000 to buy an asset. So when you use cash to buy an asset, and that asset has a useful life that's more than just that period, you're essentially capitalizing the expense or you're essentially creating that asset on the balance sheet. So instead of this $500,000 just disappearing expense, you say, no, now I have-- let's call it F for factory tools. I have factory tools worth $500,000, and then that cash will go away. So your assets will not have really changed, the absolute value of the assets. You'll have just had $500,000 going from cash to new factory tools. And so this might be at the beginning of when you do it. Let's say this is 1/1/2007. And what you say is, I'm going to use these factory tools. They're usable over two years. So what you do is you depreciate the tools. So the way you'd think about this is instead of having factory retooling, you could say factory tool. Instead of retooling I'll call that depreciation. I don't know if you can read that. So it essentially spreads out the cost of that $500,000 a year. So you say, I had a $500,000 piece of capital equipment, and its useful life is two years. So I used half of it in year one. So instead of putting $500,000 there, the depreciation is minus $250,000. Likewise, in this year, no cash went out the door, but my equipment got a little bit older, so I used half more of it. So it's $250,000. And then my equipment is worthless. So this is in 1/1/2005. I have this tool that's worth $500,000. Then on 1/1/2006, I will have used half of the tool. So now this balance sheet-- I copied the numbers, too, but that's 2006. I'm going from 2005 to 2006. So now I will have used up half of it. So according to the accounting, this equipment is no longer worth $500,000. It's now worth $250,000. You know, that actually might make sense. Maybe if I were to sell it in the open market, someone might say, you know what? I'm only willing to pay $250,000, because you've already used it for a year and it only has one year of useful life left, so it's of $250,000 of value to me. And then the other $250,000 essentially went to an expense called depreciation, which is right there. So every year, you're going to have this asset go down on the balance sheets by $250,000. So here at the beginning of this year, the asset is worth $500,000. So I'll write that up here. So this is what the asset's valued. I'll do it in this orange color. So over here, let's say you did it right at the beginning of the year, the asset's worth $500,000. Now, it's worth $250,000. Now, the asset's worth zero, but at the beginning of this year, you buy a new asset worth $500,000. Then it's worth $250,000 again. And this is just an arguably long-winded way of saying that the way you account for this is you spread out the cost over time, over its useful life, and this spreading out is called the depreciation of an asset. And I'm running out of time in this video, and I'll cover it in the next, but you might have also heard of the word "amortization." Amortization is to spread out a non-tangible cost over a period of time. So for example, depreciation, this was factory equipment, and it gets old as I use it, so I spread out its cost. That's what depreciation does. And it accurately reflects what's actually happening in the business. It's not like I didn't have any cost here. I did have cost. I'm using an asset up. So therefore, I put it down there. Amortization is the exact same thing as depreciation, but it applies to things that aren't equipment. It applies to-- and I'll do it in the next video-- but let's say I had one big expense in terms of I had to pay a bunch of fees to the bank, but the benefit of those fees are going to be over time. Then I would amortize those fees. I'll do that in the next video. Anyway, hopefully, you found this vaguely useful.