1. Problem Definition
Continue from Blog W10 after choosing Project A, B and E. Project Manager of PT ABC were requested by CEO to determine appropriate depreciation method on PSC. He need to determine which method is appropriate on executing Project A, B and E due to PSC Contract Expiration will be end of 2021, SKK Migas stated that all of the project should be finish on 2016. And there will be sole cost and no cost recovery whether the project was delayed until 2017.
The condition urge the Project Manager assess the appropriate depreciation method on executing Project A, B and E.
As a project manager of PT ABC (Oil Industry), Mr. B need to calculate depreciation and compare one method with the other method.
Cost Recovery is basically a reimbursement of cost spent by the Contractor. Cost recovery calculation is done separately for Oil and Gas costs, but most PSCs allows for transfer of cost, in case of insufficient revenue.
2. Identify the Feasible Alternative
Depreciation is the decrease in value of physical properties with the passage of time and use. More specifically, depreciation is an accounting concept that establishes an annual deduction against before-tax income such that the effect of time and use on an asset’s value can be reflected in a firm’s financial statements. Depreciation is permanent and continuing diminution in the quality, quantity or value of an asset. There are 5 (five) depreciation methods need to analyse.
A. Straight Line (SL)
Same depreciation that charged over the entire useful life
Straight line Depreciation = ((Cost – Salvage) / Life)
B. Double Declining Balance (DDB)
A type of declining balance depreciation method in which depreciation rate is double the straight-line depreciation rate
Excel Formula for DDB: DDB(cost, salvage, life, period, factor)
C. Units of Production (UOP)
Depreciation charge varies each period in proportion to the change in level of activity
Units of Production Depreciation = Total Cost x (Prod / Total Prod)
D. Sum of The Year Digits (SYD)
Method of computing depreciation in which the depreciable cost of a tangible capital asset is first multiplied by the number of years of its remaining useful life and then divided by its SYD which is computed by using the shorthand formula below.
Excel Formula for SYD: SYD(cost, salvage, life, per)
E. Modified Accelerated Cost Recovery System (MACRS)
A method of depreciation assigns specific types of assets to categories with distinct accelerated depreciation schedules. Here is the table of depreciation rate for recovery period.
As a project manager of PT ABC (Oil Industry), Mr. B need to propose depreciation methods that gives best project economic (indicate by High NPV).
3. Development of the outcome for Alternatives
Project Manager of PT. ABC, Mr B. will choose depreciation methods that produce high NPV of Cost of Capital return (Cost Recovery). In PSC, Depreciation of Capital Expenditure use assumption 0 MMUS$ at year six and Capex Depreciation is part of cost recovery method for cost of capital (Asset) that will be given to Contractor . The faster/earlier the return of investment (cost recovery), the more interesting the project is (Depreciation Acceleration).
Capital expenditure is depend on Project Capital of Project A, B and E. and MARR is 24.83% (already defined in W15 using WACC, Project Scoring Risks and Country Risk Premium), the calculation of 5 (five) depreciation methods as follows:
Mr B. determine selection of preferable alternatives would be based on : depreciation method that produce high NPV (fastest recovery of capital expenditure), but also Mr. B also considering which project will absorb depreciation earlier because PT ABC PSC Contract will end by 2021. Mr. B need to secure their expenditure cost recovery from SKK Migas earlier. And there will be sole cost and no cost recovery whether the project was delayed until 2017.
Depreciation is an accounting process of allocating cost of tangible and/or capital assets to expense in a systematic and rational manner to those period expected to benefit from the use of the assets. PSC depreciation will be calculated started from the beginning year in which the assets is Placed into Service (PIS) with a full year depreciation allowed the initial year. The method used in the declining balance and full depreciation at the end of asset a depreciation life.
5. Analysis and Comparison of the Alternatives
Mr B. compare the NPV of every project with different depreciation method.
Based on the graph above, the highest NPV belongs to SL depreciation method in Project E and the lowest NPV belongs to UOP depreciation method in Project A.
Mr B. give more prioritization on depreciation method which result in a larger share of depreciation being charged during the earlier years of the asset’s life .
The most preferable depreciation method for PT ABC is UOP Method since it has the largest share of the depreciation is being charged during the earlier years of the asset’s life.
6.Selection of the Preferred Alternative
First, Project Manager get Project Objectives from CEO as an Asset Manager :
Second, Mr B. calculate and compare depreciation method between Project A, B and E using 5 depreciation method.
Third, Mr. B compare the largest share of the depreciation is being charged during the earlier years of the asset’s life.
From All decision variable, Mr B. concludes that UOP Method since it has the largest share of the depreciation is being charged during the earlier years of the asset’s life.
7. Performance Monitoring and the Post Evaluation of Result
The exercise above shows that UOP Method is chosen because it has the largest share of the depreciation is being charged during the earlier years of the asset’s life. The decisions what depreciation method needs to be chosen begin when the company places asset in service; and depend on asset type and the total amount of asset.
In spite of SL Method has the highest NPV compare the other method, Mr B. also have big concerns on considering which project will absorb depreciation earlier because PT ABC PSC Contract will end by 2021. Mr. B need to secure their expenditure cost recovery from SKK Migas earlier. And there will be sole cost and no cost recovery whether the project was delayed until 2017.
Therefore Mr B. choose The UOP Method since it has the largest share of the depreciation is being charged during the earlier years of the asset’s life. Which mean the PT ABC Capital Expenditures will be cost recovery earlier by SKK Migas rather than using the other method, whether the other method has a higher NPV.
The company should monitor every time they place asset in service. They have to decide which depreciation method they are going to choose, and what is the downside of selecting a depreciation method than the others.
- Sullivan, William G., Wicks, Elin M. & Koelling, C. Patrick. Engineering Economy, 5th Edition, Prentice Hall 2012
- Azizurrofi, A.A. (2015). W7_AAA_Depreciation Options (Production Sharing Contract). Retrieved from : https://garudaaace2015.wordpress.com/2015/04/18/w7_aaa_depreciation-options-production-sharing-contract/
- Internal Revenue Service (IRS). Which Depreciation Method Applies. Retrieved from: http://www.irs.gov/publications/p946/ch04.html#en_US_2012_publink1000107543
- Elisabeth Nurani (2013). W12_Eli_Comparison of Depreciation Methods Retrieved from : https://mercureaace2013.wordpress.com/2013/04/10/w12_eli_comparison-of-depreciation-methods/
- Wahyu Wijanarka (2015) W11_WW_Depreciation on Production Sharing Contract Retrieved from : https://garudaaace2015.wordpress.com/2015/07/13/w11_ww_depreciation-on-production-sharing-contract/