If you are planning to sit the Project Management Professional (PMP)© exam then you will need to understand budgeting and the knowledge area known as Project Cost Management. While the main topics in this area are covered in our PMP© exam preparation course, there is one interesting little subject that does not get a mention in the Guide to the Project Management Body of Knowledge (PMBOK© Guide), but which has relevance both for Project Cost Management and Project Procurement Management.
This is depreciation and it is something that all Project Managers need to be aware of. Self-employed people know that they can claim certain business expenses on their tax returns. This reduces their tax liability at the end of the tax year. However, large-scale capital expenses, such as property purchases or certain types of plant and machinery, are subject to a different form of tax treatment.
Unfortunately, the rules pertaining to depreciation allowances vary from budget to budget and from item to item. So, currently in Ireland, you may claim 12.5% of the value of your plant and machinery over an eight year period. In other words, you may write off these items totally over eight years (12.5 x 8 = 100%). This is an example of “straight-line” depreciation. It also might explain why kitchen appliance vendors tend to offer eight year guarantees.
However, it is possible to negotiate with the revenue commissioners and be granted what is called “accelerated” depreciation. This is where you can write off more of the value in the early years. There are two ways to calculate this:
- Double Declining Balance. If the government insists that the item be depreciated over eight years, it might agree to a scheme whereby, instead of claiming 12.5% of the total value each year, you can claim 25% of the total value in the first year. Then, for the second year, you reduce the total value by 25% and claim 25% of the remainder and so on. So, if we had spent €1,000,000 on a machine, we could depreciate it as follows:
- Year 1 tax claim: €1,000,000 x 25% = €250,000
- Year 2 tax claim: €1,000,000 – €250,000 = €750,000 x 25% = €187,500
- Year 3 tax claim: €750,000 – €187,500 = €562,500 x 25% = €140,625
- Year 4 tax claim: €562,500 – €140,625 = €421,875 x 25% = €105,468.75
- Year 5 tax claim: €421,875- €105,468.75 = €316,406.25 x 25% = €79,101.56
- Year 6 tax claim: €316,406.25 – €79,101.56 = €237,304.69 x 25% = €59,326.17
- Year 7 tax claim: €237,304.69 – €59,326.17 = €177,978.52 x 25% = €44,494.63
- Year 8 tax claim: €177,978.52- €44,494.63 = €133,483.89 x 25% = €33,370.97
If we have only eight years to depreciate the item entirely, this does not look like a good option, because we are only able to claim back €899,887.08 of the original cost! However, the usual practice is to depreciate an asset until it reaches its scrap value and then replace it, so this may not be a problem.
- Sum of Years. This is a strange calculation. The first step is to count the years (up to eight in our example) and add them together. So we have 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 = 36. Now, for each year, we calculate:
- Year 1 tax claim: €1,000,000 x 8/36 = €222,222.22
- Year 2 tax claim: €1,000,000 x 7/36 = €194,444.44
- Year 3 tax claim: €1,000,000 x 6/36 = €166,666.67
- Year 4 tax claim: €1,000,000 x 5/36 = €138,888.89
- Year 5 tax claim: €1,000,000 x 4/36 = €111,111.11
- Year 6 tax claim: €1,000,000 x 3/36 = €83,333.33
- Year 7 tax claim: €1,000,000 x 2/36 = €55,555.56
- Year 8 tax claim: €1,000,000 x 1/36 = €27,777.78
At least, by using this technique, the whole €1,000,000 is claimed over the eight years.
If you have an aversion to calculations like this, you are probably asking yourself: why bother? Would it not make sense to space the tax write down evenly, so that you get a decent benefit towards the end of the item’s life, when maintenance costs are high? However, to explain why companies are keen to depreciate assets as quickly as possible, you need to understand another concept called “present value”. This concept only merits a single mention in the PMBOK© Guide (page 198), but it explains why accountants have dreamed up these accelerated depreciation schemes. Essentially, a dollar today is worth more than a dollar tomorrow.
So if we take a straight-line depreciation approach to our €1,000,000 purchase, we will be able to claim €125,000 every year. However, by the time we get to the eight year, if inflation has been averaging 2% per annum, the present value of the last €125,000 is actually €106,686.30. Compare that to the sum of digits version – our €27,777,78 claim for year eight has a present value of €23,708.07.
But besides the purely monetary benefits of accelerated depreciation, our knowledge of the depreciation scheme available will influence the build or buy decision. If we can write off the purchase price against tax, that could swing the balance in favour of purchasing. Of course, we have to weigh that against any grants that are available that encourage us to build our own. Things are never straight forward in project management!