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View Full Version : Loan payments vs depreciation


JimmyStew
03-20-2009, 10:43 PM
Could someone explain why, when determining overhead costs, you would use depreciation of equipment over actual loan payments? It seems that by using the actual amount you are paying you have a more accurate picture of true cash flow, whereas with depreciation you are dealing with a theoretical number.

For example, I purchase a new piece of equipment this year and take out a loan for $24,000 at 0% for two years. Each month my cash flow shows $1000 leaving based on actual loan payments whereas if I base it on depreciation over say 5 years, I would only expect $400 coming off the books each month.

Fvstringpicker
03-20-2009, 10:58 PM
In a sense you are correct. Depreciation is a non-cash expense that accountants add back to net income when producing a cash flow statement. But don't confuse cash flow with net income. In cost accounting its called sunk cost, (viz, you've already paid for the machine, or obligated to pay for it, so you exclude depreciation when deciding to take or reject a job.) depreciation is excluded because the money is already spent. Ya'll please consider this and don't make me have to go through the calculations. I just finished grading final exams and posting grades.

JimmyStew
03-20-2009, 11:14 PM
If I understand what you are saying, you are agreeing with my assumptions? In figuring my actual overhead, I should consider the money that leaves my bank account each month, i.e. my loan payment. So at the end of 2 years, while the equipment becomes less of an asset each month (depreciation) it isn't actually costing me anything in terms of hard cash, thus would no longer be considered in my overhead calculations.

Fvstringpicker
03-21-2009, 12:13 AM
If you look up "direct costing" you'll see. Cost are put into two categories, direct and indirect. Direct cost are generally incremental and increase as activity increases (fuel, repairs, supplies) Indirect cost are generally fixed and remain the same through a relevant range of activity. (property taxes, licenses, insurance, utilities) Since indirect cost are not affected by activity,within a range, they are not counted in a make/buy/sell decisions. Depreciation is considered an indirect cost because the money is spent buying the equipment and not depreciating the equipment. when you buy it, you've already incurred the cost regardless of whether or not or the extent you use it.

JimmyStew
03-21-2009, 08:40 AM
I understand the difference between direct and indirect costs. Where I am confused or unclear relates to how to I should "divvy" up my overhead to my hourly rate. How much do I need to charge per hour of work to cover my overhead or fixed expenses for the year? So back to the original question, if I have a loan payment each month of $1000 on a piece of equip that would depreciate the equivalent of $400 each month, wouldn't I be better off using the $1000 figure in my overhead calculation? It seems everywhere I look, depreciation is always listed as an item to consider.

haybaler
03-21-2009, 09:38 AM
your missing the picture. depreciation is what the machine is actually costing you for the amount of time usable to you. It doesn't matter if your loan is 5 years or if you pay cash for the machine. In your backwards way of thinking, if you paid cash for the machine your monthly payments would be $0, so the machine would be free. Every time you use a piece of equipment your taking "equity" (even if there is no equity in the machine IE loan) out of it, if you don't figure that cost into your jobs you will be out of business fast.

Fvstringpicker
03-21-2009, 04:10 PM
I hate to interject this but there is a difference between setting your hourly rates and deciding whether or not to accept or reject a job based on these rates. I may have misconstrued what you were asking.
In determining your hourly rates, you need to include the using up of the equipment, which may be different than the depreciation rates. For example, I have a Toro that's full depreciation but only about half way or less through is useful life. Your method of claiming note payments will work if the length of the note possibly coincides with equipment life. You could have a similar problem if the note is three years and the equipment last seven or eight If the note payment last longer than the equipment you're coming up short because your still paying on the note when you have to replace the equipment. In the final analysis, what you're trying to do is set your rates where you're likely to recover your equipment cost (and all other cost) plus a profit by the time the equipment is retired.
As a practical matter, I'd set my rates according to hours of expected equipment life and tweak it to cover cash flow differences.