Thursday, November 13, 2014

Why You Should Ignore Depreciation When Modeling ROI

By Richard Hamje, Senior  Strategy Consultant, Mainstay

Does a purchase of a new widget pay for itself and if so, how quickly? Is money spent on widgets better spent elsewhere, for instance on an upgrade of a doodad or hiring more staff? These are the type of questions that a Return on Investment (ROI) analysis attempts to answer. Money spent long ago, depreciation in accounting lingo, is not relevant to the question and should be ignored.

What is depreciation?
Depreciation is an accounting method, used to represent the real-life expectation of an asset’s value over time. Things wear out or become obsolete as they get older.

Suppose we purchase a truck for $100,000 and drive it 200,000 miles per year. After five years, the truck will have one million miles on it. It will be worth very little on the resale market. Why? The truck will not be as reliable due to worn parts. It will have dents and faded paint and rust. Its warranty will have expired. It will require more maintenance and therefore spend more time in the shop and less time on the road. Parts will be harder to get. Anyone buying that truck will know they will get less use from it than from a new truck, so they will pay less. Let’s say that the million-mile truck is now worth $10,000.

From an accounting standpoint, we originally traded one asset ($100,000 in cash) for another (a new truck). On our balance sheet, nothing changed. However, five years later, our truck is now only worth $10,000 whereas if we’d kept the cash we’d still have $100,000. Now our balance sheet does not balance - $90,000 has disappeared. Enter depreciation. Each year, we charge ourselves $18,000 and place it into an asset account called accumulated depreciation. After five years, this has added up to $90,000 and everything balances.

Note that depreciation is not a cash expense; nobody writes a check for it. The actual money was spent when the truck was bought. Everything since then has been paper transactions intended to make our balance sheet reflect the real-world value of our asset.

How is depreciation related to ROI?
When we conduct an ROI analysis, we are looking at the value of a potential new purchase relative to other possible uses of the money. One of the options that should always be considered is doing nothing; business as usual.

Suppose that a new hybrid truck comes on the market three years after we bought the truck above. We first look at the cost of running the old truck; let’s suppose it’s costing us $160,000 per year in fuel compared to the hybrid truck with better fuel economy at $100,000 per year. The old truck will need $20,000 per year in repairs (its warranty just ran out); the new one has a three-year warranty. In five more years, the old truck will have cost another $100,000 in repair bills with the new one eventually needing maybe $40,000. So our five-year projected savings is $360,000. Even if the hybrid truck costs $150,000, this is clearly a great ROI. We would recommend buying the new truck assuming there was no other investment available to us that generated a better return.

However, there is the matter of accumulated depreciation. Our old truck is still on our balance sheet as being worth $46,000 since we’ve only taken three years of depreciation charges so far. Yet its actual value is only $10,000 partly because it’s old and partly because the new hybrid trucks have made it less desirable. After we sell it, we’re left with $36,000 unaccounted for that will be “written off” as an unexpected loss on the sale of an asset.

Should this change our decision about the new truck? No, it should not! We stand to save $360,000 in actual cash outlays over five years or $72,000 each year. The depreciation adjustment is not a cash item (recall that the actual cash outlay was three years ago) but the fuel budget is real money being spent right now.

Depreciation is simply not relevant to an ROI analysis. It represents historical outlays while ROI looks at current and future spending.

Then why is depreciation ever included in ROI modeling?
Depreciation write-offs do have an indirect cash impact. First, depreciation is tax-deductible to profitable businesses so reducing depreciation may increase taxes. Second, depreciation write-offs have to be taken against current year reported net income which can also affect taxes. Third, writing off depreciation requires extra accounting work which has a small cost. Governments or non-profit organizations don’t have any of these considerations.

Since there is potentially a small cash impact, some companies want to include depreciation in their ROI analysis. Also, some companies include a depreciation expense item in departmental budgets which causes managers to be concerned with it.

But these are not good reasons. There are many reasons to omit depreciation from ROI models:
  •         Depreciation expense is not necessarily reduced by adding a new asset. Sometimes the new asset is more expensive than the old (as with our hybrid truck) which will actually increase depreciation expense and potentially reduce taxes. Lowering depreciation expense is not the objective; saving or making more money is.
  •         With a solid ROI, any write-off taken this year will be quickly recovered in actual cash savings.
  •         Unless extremely large purchases are being modeled and relatively young assets being replaced, the depreciation impact should be immaterial to the company’s overall profitability. In the worst case, where a write-off would damage the company’s results in the current quarter or year, the purchase might be postponed into the next period.
  •         A departmental budget will include expenses that are being directly reduced by our purchase – these savings more than offset the potential increase in depreciation on the department’s budget. With our truck, $60,000 per year saved in our fuel budget easily covers the increased depreciation charge of $12,000. Even if the department budget is hit with the $36,000 one-time write-off they come out ahead.
  •         The decision on how to handle depreciation is made by the accounting or finance department based on variables that have nothing to do with the operational benefits of the purchase – things like tax liability and expected net profits.
  •         Obtaining fixed asset registers and tracking depreciation expense is difficult in many organizations, so building this into an ROI model is time-consuming and not necessarily accurate. It is a waste of time and money to enter details that do not affect the ultimate decision points.
  •         Depreciation is confusing to non-accountants. Since the numbers are shown as dollar costs it is very easy to begin thinking about them as if they are real money. They are not.


Suppose you had a skiing accident and broke your leg three years ago. Would that stop you from hurrying to the hospital if you fell down the stairs and broke the same leg today? In the same manner, don’t focus your ROI analysis on decisions made in the past or money spent long ago. Instead focus on the actual situation today and the potential to improve things tomorrow. Leave depreciation out of it.

38 comments:

  1. Those people who don't know about depreciation will find this post very effective indeed. I really like the educational information shared here. I agree depreciation in accounting lingo, is not relevant to the question and should be ignored. Income statement analysis is all about researching your business's revenue and expenses. Analytics tools are key for this (like PanXpan finance summary module).

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  2. thank you! Another queston - As accumulated amortization and depreciation are intangibles, I'd like to remove them from my 5 year forecast to show a clearer asset and equity balance. Is this proper GAAP?

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