Depreciation: The Diminishing Balance Method
Peter Marshall Bsc (Econ) BA MBIM is a Fellow of the Society of Business Teachers, and an experienced educator in business subjects. He is also a prolific author and his books have been translated and sold worldwide. He lives in London, UK.
Diminishing balance method (or reducing balance method)
This method also applies a fixed percentage, but it applies it to the diminishing value of the asset each year—not to the initial value. It is used for assets which have a long life within the firm, and where the biggest drop in value comes in the early years, getting less as time goes on.
Suppose a lathe in an engineering workshop cost £40,000 to buy. In the first year it will fall in value much more than it ever will in later years. The guarantee may expire at the end of the first year. The bright smooth paint on the surface will be scratched and scarred; the difference between its appearance when new and its appearance a year later will be quite obvious. But the next year the change will seem less; who will notice a few more scratches on an already scarred surface? Nor will there be a great drop due to the guarantee expiring, for it will not have started out with one at the beginning of the second year. And so it will go on; the value of the asset will depreciate by smaller and smaller amounts throughout its life. Most people would agree that a three-year-old machine has less value than an otherwise identical two-year-old one, but who could say that a 16-year-old machine really has any less value than a 15-year-old one? Since the value of these assets erodes in smaller and smaller amounts as the years go by, we use the diminishing balance method of calculation.