The two main reasons for depreciation in capital goods are : 1. Normal Wear and Tear and 2. Expected obsolescence
Fixed assets (like machinery, building) depreciate in value In the process of production. Simply put, depreciation means loss of value of fixed capital assets during production.
In other words, depreciation is the value of existing capital stock that has been consumed (used up) in the process of producing output.
Fall in value of fixed assets due to normal wear and tear, and expected obsolescence is called consumption of fixed capital. This is sometimes also called current replacement cost of reproducible fixed assets.
The loss of value in capital goods is mainly due to two reasons:
(i) Normal wear and tear and (ii) expected obsolescence. Let us understand how fixed capital goods depreciate in value.
(i) Normal wear and tear:
We know that during production process, capital goods like machines, tools, buildings, trucks, rail engines, roads, etc. wear out. In other words, production of goods and services involves wear and tear of fixed capital. It is a regular feature of fixed capital.
You cannot use a machine for ever. Its productive capacity goes on declining with normal use in production leading to fall in its value. This depreciation or fall in value due to normal wear and tear is called consumption of fixed capital.
(ii) Expected obsolescence:
Obsolescence is another reason for depreciation. Obsolescence refers to the loss of value of a fixed asset due to change in technology or change in demand for goods and services.
Sometimes capital goods like machines become obsolete (disused) due to (a) change in technique of production or (b) due to change in fashion resulting in fall in demand for goods and services which the machine produces. Take the case of steam engine of railways which is becoming obsolete due to Introduction of diesel engine which, in turn, is giving place to electric engine.
Thus, fall in value of steam engine is due to expected obsolescence. This is called technological obsolescence. Similarly, we have seen that demand for nylon cloth went down because it went out of fashion when terylene blends appeared in the market.
Thus, machine which was producing nylon cloth became obsolete (discarded) which led to fall in its value. Loss in value due to expected or foreseen obsolescence is called depreciation (in value) or consumption of fixed capital.
In national accounting, gross variables (like gross Income, gross profit, gross investment, etc.) are inclusive of depreciation (i.e., consumption of fixed capital). When we deduct depreciation from gross value of output, we get net value of output.
Depreciation is used to differentiate net from gross. We have already studied the concept of gross domestic capital formation. It is called gross since it includes value of depreciation. Thus, to find out net domestic capital formation, depreciation should be deducted. In short, difference between gross and net is the value of depreciation.
The following statements further clarify it:
Net Product = Gross Product-Depreciation
Net value added = Gross value added – Depreciation
Net domestic capital formation = Gross domestic capital formation – Depreciation
Fall in value of fixed capital due to natural calamities (Like earthquakes, floods, fires) and unforeseen factors like war, thefts, etc. is called capital loss (and not depreciation). Provision of funds made by an enterprise for replacement of worn out fixed capital over its expected life is called Depreciation Provision. Funds thus accumulated over lifetime of the asset are used to replace the worn out assets with a new asset.