When a company depreciates an asset, it spreads the expense of the purchase over multiple years instead of over just one year. Choosing to depreciate rather than immediately expense a purchase means a bigger profit margin the year of purchase. However, it also means a slightly lower profit margin for all subsequent years that the asset is in service.
Depreciation Basics When a business buys something, it must classify it as either an expense or an asset. An expense is an cost that provides a short-term service to the business or will be used up quickly. Office supplies, salaries and rent are all examples of expenses. In contrast, other items --buildings, equipment, computers, furniture and vehicles-- will last for at least a year and should be classified as assets.
Generally accepted accounting principles dictate that businesses should depreciate assets. Rather than immediately recording the expense of an asset, a business depreciates it by spreading the expense over the expected useful life of the asset. For example, instead of recording a $40,000 vehicle expense right away, a business may record a $4,000 expense each year for 10 years.
Effects of Depreciation
Recording depreciation increases expenses and lowers net profit. Since net profit margin equals net profit divided by revenue, a lower net profit mean a lower profit margin. Depreciation creates a smaller expense and a higher profit margin the year of purchase compared to immediately expensing an asset. For example, say that the company had revenues of $500,000 and expenses of $300,000 and it purchases the $40,000 vehicle. If it expenses the vehicle right away, the profit margin would be as follows:
- Revenues: $500,000
- Expenses: $340,000
- Net profit: $160,000
- Net profit margin: $160,000 divided by $500,000 or 32 percent.
Now, compare that to net profit margin if the business decides to depreciate the vehicle at $4,000 a year instead of immediately expensing the purchase:
- Revenues: $500,000
- Expenses: $304,000
- Net profit: $196,000
- Net profit margin: $196,000 divided by $500,000 or 39 percent.
While depreciation creates a higher profit margin the year of purchase, it creates a lower one for all subsequent years. That's because, if it was expensed, there would be no additional expense added in years two through ten. If it's depreciated, there's an extra $4,000 of depreciation expense in subsequent years, which in turn lowers the profit margin.