Depreciation and Cash Flow
Depreciation is a component of the cost of production, but it is a different type of cost.
To produce a product, a company may have to spend on materials, labor, and overheads. But it does not have to spend anything as depreciation. The spending has already taken place in the form of the cost of the asset.
Now, a portion of such cost is attached to the cost of production. Thus, a product’s cost consists of the current cost (e.g., cost of materials and labor) and the apportioned cost (depreciation) when a company recovers from the client the product cost plus profit.
Actually, the outgoings for the company are only the current costs of the product. Therefore, the amount collected toward depreciation and profit is available to the company in the form of liquid funds. This is known as operational fund flow.
Suppose that a company manufactures a product at a cost of $200. This cost consists of the following:
- Materials = $60
- Labor = $40
- Overheads = $60
- Depreciation = $40
If the company sells the product at $280, then it will make a profit of $80 per unit.
However, the operational fund flow from the sale would be $120 because out of $280 collected from the customer, $160 will go towards the payment of current costs and, hence, the balance left is $120, which is equal to the profit plus depreciation.
As the company may have to pay tax on the profit of $80, the net operational fund flow can be said to be the gross operational flow less tax payable.
In the above example, assuming the tax to be 60% of the profits, the net operational fund flow would be $72.
The quantum of operational fund flow cannot be influenced by the depreciation method used. Any variation in the quantum of depreciation can influence the quantum of profit, but the depreciation and the quantum of profit put together will not change.
The policy regarding depreciation is framed at the top level of management. A decision on a method must be consistently followed and cannot undergo frequent changes.
Before making a final decision, the implications for tax payments, dividend distribution, cost flow, and other relevant factors must be fully analyzed.