Can Depreciation Be a Variable Cost? A Comparison between the Straight-Line Method and the Units of Production Method in a Lean Company Context

Abstract:     
International Accounting Standard 16 states that tangible assets’ depreciation method shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. Moreover, it allows a variety of depreciation methods, including the straight-line method, the diminishing balance method and the units of production method, according to the expected pattern of consumption of the asset.

While in principle the three methods are expected to generate depreciation consistent with the consumption of asset, they strongly modify accounting numbers. The choice of depreciation method is expected to influence both the managers’ decision making and financial reporting figures.

This paper focuses on the units of production method (UPM) in order to highlight the effects on both financial figures and managerial decision-making. The paper shows how the UPM transforms depreciation into a quasi-variable cost, therefore affecting volume-based decisions, and finally the break-even point of the firm.

Using a simulation model and comparing UPM to the common straight-line method (SLM), the paper also shows UPM’s effects on financial statements. Depending on market conditions, different return ratios, leverage, and variance in financial indicators are expected, so leading to potential differences in investors’ and financial analysts’ decisions. Also impairment test is modified by the different depreciation method used, both in magnitude and in the time of its occurrence.

Finally, the paper presents the Brevini Power Transmission Group (BPT) case study, an Italy-based company operating in the power transmission industry, with plant in Italy, Germany, and China. The rationale for the analysis of the BPT case study is threefold. Firstly, BPT is a capital-intensive company, and therefore the choice of a depreciation method is of a paramount importance for the effects it can produce on the decision-making process as well as the accounting figures and results the company discloses.

Secondly, BPT employs the Overall Equipment Effectiveness (OEE) as one of the most important KPIs for efficiency improvement within the lean manufacturing system BPT has implemented over the last years. It qualifies to apply UPM thought the weekly calculation the hours worked by each machine.

Finally, BPT has recently adopted IAS/IFRS choosing the UPM for the depreciation of work centers where it manufactured and assembled his components and whole units. This has led to great differences with respect to the Italian GAAP previously adopted. The choice has impacted on administrative and IT process, and their link to the Manufacturing Information System.

The main contribution of the paper to the extant literature is the focus on the effects that different methods of depreciation have on financial decision-making. At the same time it explores a little employed method for depreciation, comparing it to the widespread SLM.

The paper is also beneficial for practitioners since it integrates a theoretical approach with both simulation and the study of a real company using UPM.

Number of Pages in PDF File: 19

Keywords: depreciation methods, units-of-production method, straight-line method, IAS/IFRS, overall equipment effectiveness, financial decision-making

JEL Classification: M40, M41, M11

working papers series