Depreciation, Gross investment and Net investment

Depreciation, gross investment, and net investment 

 

Depreciation: Depreciation refers to the reduction in the value of fixed assets due to normal wear and tear, the passage of time, or expected obsolescence.

According to L.C.Cropper “Depreciation is the diminution in the value of assets owing to wear and tear, the effusion of time, obsolescence or similar causes.”  

 

According to Northcott & Forsyth, "Depreciation is the reduction in the value of a fixed asset occasioned by physical wear and tear, obsolescence or the passage of time.”

  

For example, a firm invests in a new machine whose expected life of service is 10 years. If each year one-tenth of its original value is getting depreciated. So, instead of considering a bulk investment for replacement after ten years, the firm takes into consideration an annual depreciation cost every year.  

Thus, depreciation is an accounting concept as it is an annual allowance for the wear and tear of a capital good. The firm makes a provision for a depreciation reserve fund in which producers keep the fund reserved for the replacement investment and this fund is the cost of the machinery or the good divided by the number of years of its useful life. 

Depreciation is also known as current replacement cost, the replacement cost of fixed capital, capital consumption allowance, and consumption of fixed capital. 

Causes of Depreciation:

1. Wear And Tear: When fixed assets are used continuously in the production process, their productive capacity and value decrease and depreciation arise.

2. Effusion Of Time: The value of fixed assets also decreases with the passage of time, even if it is not being put in use. intangible fixed assets like a trademark, patents lose their value as time elapse.

3. Obsolescence: it means the fact of being ’out of date.’ It refers to the economic deterioration of assets due to change in technology, improvement in the methods of production or change in market demand due to the change in fashion. There are two types of Obsolescence:

(1) Expected Obsolescence: It refers to a fall in the value of fixed assets due to the change in technology or change in demand.

(2) Unexpected Obsolescence: It refers to a fall in the value of fixed assets due to natural calamities or recession.

Expected Obsolescence is the cause of depreciation and is managed by depreciation reserve fund while unexpected Obsolescence refers to the capital loss and it is not the part of depreciation and is managed through the insurance of the fixed assets.

Investment: Investment refers to the addition in stock of capital. Change in the stock of capital is called ‘capital formation.’ Thus, investment refers to capital formation. 

I= ΔK 

Where 

 I = investment 

ΔK=change in the stock of capital during the year. 

For example 

The stock of the capital of the firm at the beginning of the accounting year = 20 lakhs 

The stock of the capital of the firm at the end of the accounting year=25 lakhs 

 

Investment = the stock of the capital of firm at the end of the accounting year [25]- the stock of the capital of the firm at the beginning of the accounting year[20] = 25 - 20 = 5 lakhs 

 

Investment has two components: Fixed investment and Inventory investment. 

Fixed investment: It refers to the increase in the stock of fixed assets of the firm during an accounting year. It is also called fixed capital formation. 

Significance of fixed investment: 

It raises the production capacity of a producer. 

It helps to maintain a higher level of output in the economy. 

It helps to increase the GDP growth by increasing the higher level of output. 

Inventory investment: It refers to the change in the inventory stock of the firm during an accounting year. 

A firm holds the stock of the finished goods, semi-finished goods and raw material. This is called inventory stock. 

Significance of inventory investment: 

It provides the uninterrupted supply of the inputs in the production process. Uncertainties of the market can be avoided by avoiding day-to-day purchases of raw material by the producer. The stock of finished goods enables the producers to meet the future demand for their products.

There are two types of inventory stock- 

Desired inventory stock- It is the planned inventory stock to meet the future demand of their products. 

Undesired inventory stock-It is unplanned inventory stock that arises because of the less than expected demand of their products and it leads to losses.

Gross investment: It is the total addition to the capital stock of the economy during an accounting year. It includes the expenditure made by the producers on the purchasing of new assets as well as expenditure on the replacement of existing assets. Thus, it includes depreciation[replacement investment] of fixed assets. 

 

Gross investment = Net investment + Depreciation  

 

Net investment: it is the actual addition to the capital stock of the economy during an accounting year.  It includes the expenditure on the purchase of new assets only and excludes depreciation. 

 

Net investment = Gross investment – Depreciation 

Significance of net investment:-It increases the stock of the capital and enhances the production capacity. Thus, it increases the efficiency of labor by generating the opportunity of employment and helps to increase the GDP growth. 

 

Gross investment and Net investment both include fixed investment as well as inventory investment.  

Dr. Swati Gupta

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