Harvard business reports (1930)

512 HARVARD BUSINESS REPORTS company. The only arguments that can be advanced for a simple, unweighted arithmetic average rate, would be that it was simple, and that all rates involved some exercise of judgment. In the present case, these arguments do not appear conclusive. The other alternative was that of classifying the equipment on the basis of its probable life. An average depreciation rate for each class would then be determined. It is probable that the depreciation rate for each class of equipment would be an unweighted average rate. The various class rates would then be combined into a single depreciation figure in which, presumably, each class rate would be weighted according to the proportionate investment represented by that particular equipment. Such a plan would have an obvious advantage over the former. There would still be some error introduced unless conscious weighting was resorted to in determining the class rates. Theoretically, at least, a weighted figure would have some advantage here over the unweighted. It is to be doubted, however, if the attempt to carry the weighting to such an extreme would result in enough additional accuracy to make it worth the effort. The advantage of using weighted rates of depreciation may be made clearer if an illustration is used. It would appear that Ford Theaters, Incorporated, invested $5,000 in carpets, $15,000 in an organ, $7,500 in booth equipment, and $2,000 in decorative furniture for the Alameda Theater. Carpets depreciated at 33^3%, the organ at 10%, booth equipment at 30%, and decorative furniture at 15% per year. On the basis of a straight average, this would mean approximately a 22% depreciation on an investment of $29,500, or at the rate of about $6,490 per year. On the other hand, if weighted averages were used, the computation would have somewhat different results. Assuming that the organ would normally be taken care of by setting aside $1,500 a year for 10 years; carpets, $1,666 for three years; booth equipment, $2,250 for a little over three years; and decorative furniture at $300 a year for 15 years, the total per year for these four items would then amount to $5,716. The composite depreciation rate, based on this analysis, would be 19.37% of the total investment of $29,500. If this reasoning be correct, then Ford Theaters, Incorporated, would be setting aside $774 more a year on these four items than was necessary. It is apparent, of course, that for the equipment as a whole, the differential might be more or less than this amount. The importance of selecting a depreciation policy will be apparent when one considers the real purpose of setting aside the depreciation fund. Presumably, this objective is that of establishing sound control of the finances of the corporation. If the executives honestly believed that $6,490 would be necessary to cover four items for which $5,716 actually was required, it is apparent that no true picture of the situation