Economic life
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2012 by Marty J.Schmidt. Revised 1 March 2012.
The Meaning of Economic Life, Depreciable Life, Service Life, and Ownership Life.
With arguably few exceptions, most tangible assets used in business have a finite life span—usually a period of several years or more with a well defined beginning and end. The life span concept is central to asset life cycle management (methods for guiding asset acquisition, use and disposal). The concept is the heart of total cost of ownership (TCO) analysis (methods for uncovering the full range of costs brought by asset ownership).
Asset life span is in fact defined and measured in several different ways:
- Depreciable Life is the time period over which an asset can lawfully be depreciated. Each year of depreciable life, a depreciation expense is calculated and declared for the asset using standardized accounting methods. This expense lowers the book value (balance sheet value) of the asset, lowers the company's reported income, and creates a tax savings.
When the its depreciable life is over, the asset is said to be fully depreciated or fully expensed. If the asset is kept beyond that point, its book value is called either its residual value or its salvage value. Asset residual (or salvage value) is typically just a few percent of the asset's original purchase price or it may even be 0. (See the encyclopedia entry on depreciation).
For some assets, management can simply choose a number of years for the depreciable life, based on the the asset's expected useful life. For other kinds of assets, however, the depreciable life is prescribed by the country's tax authorities. In the US, for instance, computing hardware has a prescribed depreciable life of 5 years, and depreciation must follow the MACRS (Modified Accelerated Cost Recovery System) depreciation schedule. - The asset's Economic life is the number of years in which the asset returns more value to the owner than it costs to own, operate, and maintain. When these costs exceed returns, the acquisition is beyond its economic life.
The asset's economic life must be known in order to estimate investment metrics such as net present value, internal rate of return, and return on investment. An asset's expected economic life is also an important consideration for vendors and customers alike when establishing warranties and service plans.
An assets economic life can be shortened or terminated by a number of different factors, including: - Wear, degradation, or damage which can lower asset performance and raise maintenance and operation costs.
- Obsolescence, which can raise maintenance costs and render asset performance relatively inefficient when compared to more current alternatives.
- Changes in company operations, product offerings, or the company's business model, which reduce the value certain assets can deliver.
- An asset's Service life is the number of years the acquisition will actually be in service.
All of the above "lives" may be different, and all may contribute to the owner's judgement as to what the ownership life should be.
- An asset's Ownership life is the complete length of time that a decision to own the asset has financial consequences.
- Ownership life begins when the decision to acquire the asset begins causing costs. This may include costs that occur before the actual arrival or asset use begins, such as loan origination fees, planning costs, transportation costs, or set up costs.
- Ownership life ends when the asset stops causing costs and in fact has no continuing financial impact of any kind. This means, for example, that all costs of disposal or decommission have been paid, and it is no longer carried in an asset account on the company's balance sheet.
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