SOFTWARE ENGINEERING ECONOMICS

SE 361

By

Muhammad Waseem

WORD OF WISDOM

The most excellent Jihad is that for the conquest of self." (Bukhari)

INFLATION AND DEFLATION

Think about : Year ago you bought some ordinary thing, such as a movie ticket or a gallon of gasoline.

How much did you pay for it?

Now think back to the first time you can remember buying that same kind of thing.

How much did you pay then

The terms inflation and deflation describe long-term trends in prices

INFLATION / DEFLATION

What is it?

an increase in the price level

a decrease in price level

How is it determined?

by comparing the CPI in different years and noting the change

CPI is higher=inflation

CPI is lower=deflation

CPI= Consumer Price Index

INFLATION AND DEFLATION

Under what conditions would you expect to see deflation (fall in price level)?

Inflation can be caused by an increase in aggregate demand

Typical causes for inflation include government price support policies (subsidies) and deficit spending. Less price of oil and

grainDeflation can be caused by a decrease in aggregate demand

Deflation can be caused by more efficient production methods (which lowers production cost) or higher availability of resources

PRICE INDICES:MEASURING INFLATION AND DEFLATION

Inflation (or, deflation) is measured using a price index.

A price index is the ratio (expressed as a percentage) of the historical price of goods or services at some point in time to the price of the same goods or services at another point in time.

STEPS INVOLVE IN DEVELOPING PRICE INDEX

1. Make Market Basket House Hold Market Basket

Corporation Market Basket

2. Pick Up Reference Date Reference Date is Arbitrary

3. Cost on the Reference Date Denominator in Price Index

4. Cost on the Current Date Nominator of Price index

PRICE INDEX FORMULA

POPULAR PRICE INDICES

There are two popular price indices that are used for measuring inflation and deflation

Consumer Price Index [CPI]

Producers Price Index [PPI] More information about CPI and PPI you can find the following site

www.bls.gov/home .htm

http://www.tradingeconomics.com/pakistan/inflation-cpi

CONSUMER PRICE INDEX

Measure price change from the retail purchaser’s perspective Based on the spending

habits of the average household consumer

Buyers perspective

Market basket include Housing Food and drinks Clothing Transportation Medical care Recreation Education

PRODUCER PRICE INDEX

PPI is the Family of price indices that measure the changes in selling price for domestic goods and services before they reach the retail consumer. Seller perspective

For Example Manufacturing Agriculture Forestry Finance Business services Health

THE INFLATION RATE

The inflation rate measures the rate of increase of the corresponding price index and is usually stated as an annual percentage (for example, 2.3%).

The deflation rate is the negative of the inflation rate,.

Inflation rate can be measured in

SINGLE-YEAR ANNUAL INFLATION RATE

AVERAGE ANNUAL INFLATION RATES

SINGLE-YEAR ANNUAL INFLATION RATE

The inflation rate in any single year can be calculated by dividing the difference between the price index at the end of that year and beginning of that year (which is the price index at the end of the previous year) by the price index at the beginning of that year, as follows:

AVERAGE ANNUAL INFLATION RATES

Inflation will almost always span more than one year

There can be variation in the annual inflation rate

Average annual inflation rate can be calculated from price indices

HOME WORK

AVERAGE ANNUAL INFLATION RATES

Purchasing Power and Inflation

INTERESTING LINKS

Purchasing Power Calculator http://buyupside.com/calculators/

purchasepowerjan08.htm

Inflation Calculator - Save Enough to Account for Inflation http://buyupside.com/calculators/inflationja

n08.htm

inflation Rate in Percent for Jan 2000-Present http://inflationdata.com/

Inflation/Inflation_Rate/CurrentInflation.asp

Current Unemployment Rate http://unemploymentdata.c

om/charts/current-unemployment-rate-chart/

Pakistan national statistical data http://www.tradingeconomic

s.com/pakistan/indicators

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Question /Answer

DEPRECIATION

Depreciation addresses How investments in capital

assets are charged off against income over several years

Software itself typically isn't depreciated but if you're working on

proposals with a planning horizon longer than one year, the proposals involve capital assets (such as buildings and equipment)

then depreciation will be an important factor to include in the analysis

INTRODUCTION TO DEPRECIATION

The word depreciation has two different meanings in business decisions First, it refers to how an asset

will lose value over time due to effects such as wear and tear[damage or loss resulting from ordinary use] This will be called

actual depreciation

Second, it refers to how the organization accounts for that loss in value. This will be called

depreciation accounting

ACTUAL DEPRECIATION

There are two general causes for actual depreciation, physical depreciation and functional depreciation

Both can happen at the same time or they may happen separately.

Physical depreciation literally means that the asset is

wearing out and it cant do its job as well as it used to. For example, wear and tear

The more it's used, the more it wears out. Physical depreciation also includes

natural fall such as rust, corrosion, decomposing,, and so

on.

Rust =Become destroyed by water, air, or a corrosive such as an acid

Corrosion= Wearing away by chemical action

Software isn't a physical thing, so it can't be affected by physical depreciation

On the other hand, software professionals are

sometimes responsible for, or have influence on, decisions about computer hardware, peripherals, and computing facilities

ACTUAL DEPRECIATION

There are two general causes for actual depreciation, physical depreciation and functional depreciation

Both can happen at the same time or they may happen separately.

Functional Depreciation

Functional depreciation means that the environment where the asset is operating has changed, and the asset isn't well matched to that new environment

One kind of functional depreciation is obsolescence[The process of becoming obsolete; falling into neglect or becoming out of date]

Another type of functional depreciation is when the demand on the asset increases to the point where the asset can't meet that demand.

DEPRECIATION ACCOUNTING

The key idea in depreciation accounting is that corporations are taxed on profit (net income), not gross income:

Profit = Gross income – Expenses

Depreciation accounting effectively treats the original cost of an asset as a prepaid expense

Instead of charging the entire cost as an expense when that asset is bought, depreciation accounting spreads the cost over the life of the asset

It's important to recognize that the depreciation amounts in depreciation accounting are not actual cash-flow instances

The actual cash-flow instance happens when the company buys the asset.

DEPRECIATION ACCOUNTING

One theoretical alternative to depreciation accounting would be to allow the company to write off the entire expense in the year an asset was bought

This would make the income taxes for that year unrealistically low, whereas the income taxes for the remainder of the asset's life would be unrealistically high

Depreciation accounting is the tax authorities' attempt to make each year's income taxes as realistic as possible.

Any asset that

Is used in a business or trade

Is used for producing income

Has a known lifespan that is more than 1 year

VALUE-TIME FUNCTIONS

A value-time function is a mathematical function that models how an asset loses value over time.

The simplest value-time function is known as

straight-line.

The straight-line value-time function assumes that the asset loses value at a constant rate (i.e., as a fixed percentage of the asset's original value) over its lifetime.

VALUE-TIME FUNCTIONS

Example

An asset that originally cost $10,000 and has a 10-year expected life is assumed to have a value of $3,000 7 years after it was bought.

VALUE-TIME FUNCTIONS

Another value-time function is called declining-balance.

The declining-balance value-time function assumes that the asset loses value as a fixed percentage of its remaining value over its lifetime

(e.g., it's worth 20% less than it was the year before). Using an 80% declining-balance value-time function, a $10,000 asset would be assumed to be worth $8,000 after 1 year, $6,400 after 2, $5,120 after 3, etc.

BOOK VALUE

The book value of an asset is the tax authorities' best estimate, based on depreciation accounting, of that asset's actual value

Another way of looking at book value is that it's the part of the asset's acquisition cost that hasn't been charged off by depreciation accounting.

Book value may not be the asset’s actual value

BOOK VALUE

The book value in any year can be calculated by subtracting the depreciation amount in one year from the book value from the previous year.

BookValueyear(t) = BookValueyear(t–1) – Depreciationyear(t–1)

DEPRECIATION METHODS

The U.S. tax code has defined different depreciation methods three times in the recent past:

Before 1981

1981 through 1986

1987 and beyond

The Next lecture explains each of the depreciation methods prescribed during these times.

DEPRECIATION METHODS BEFORE 1981

Before 1981, the organization could choose any one of four different methods for depreciating any asset:

Straight-line depreciation

Declining-balance depreciation

Declining-balance switching to straight-line depreciation

Sum-of-the-years-digits depreciation

WHY BEFORE 1981First, and most important, looking at each

of these methods gives a broad survey of different approaches to depreciation accounting.

Second, the earlier depreciation methods are a good foundation for understanding the method used today.

Finally, the tax laws could certainly change again in the future, and one of the earlier methods may become prescribed again.

STRAIGHT-LINE DEPRECIATION

Straight-line depreciation assumes that the value of the asset decreases at a constant rate over its useful life

The asset loses a fixed percentage of its original value each year.

Formula

Depreciation=(Accusation Cost – Salvage value)/life in years

Straight-line depreciation is the only method that uses the same depreciation amount each year

BOOKVALUEThe book value of an asset is the value of

that asset on the "books" (balance sheet) of the company.

The book value is not necessarily the same as the fair market value (the amount the asset could be sold\buy for on the open market).

The book value is calculated as the purchase price of the depreciable asset minus accumulated depreciation on that asset

An Example of Straight-Line Depreciation

End of Year

Depreciation Amount in Year

Book Value at End of Year

0 — $7000

1 $1000 $6000

2 $1000 $5000

3 $1000 $4000

4 $1000 $3000

5 $1000 $2000

6 $1000 $1000

DECLINING-BALANCE DEPRECIATION

Declining-balance depreciation assumes that the value of the asset decreases faster earlier in its life and slower later in its life.

Under declining-balance depreciation, the asset loses a fixed percentage of its remaining value over time.

DECLINING-BALANCE DEPRECIATION

The depreciation amount is a fixed percentage, α* of the book value of the asset at the beginning of that year

The formula for calculating the declining-balance depreciation amount in year t is as follows:

Depreciationyear(t) = α* BookValueyear(t–1)

Example of Double Declining-Balance DepreciationEnd of Year Depreciation

Amount in YearBook Value at End of Year

0 — $7000

1 0.33 * 7000 = $2310

$4690

2 0.33 * 4690 = $1548

$3142

3 0.33 * 3142 = $1037

$2105

4 0.33 * 2105 = $695

$1410

5 0.33 * 1410 = $465

$945

6 0.33 * 945 = $312 $633

DECLINING-BALANCE SWITCHING TO STRAIGHT-LINE DEPRECIATION

In this method, the declining-balance formula is used in the early part of the asset's life and the straight-line method is used for the rest

The switch from declining-balance to straight-line happens when the declining-balance depreciation amount becomes less than the straight-line amount

Depreciationyear(t) = max(DecliningBalanceyear(t), StraightLineyear(t))

An Example of 150% Declining-Balance Switching to Straight-Line Depreciation

End of Year Depreciation Amount in Year

Book Value at End of Year

0 — $7000

1 0.25 * 7000 = $1750 $5250

2 0.25 * 5250 = $1313 $3937

3 0.25 * 3937 = $984  

  so switch to $1167 $2770

4 $1167 $1603

5 $1167 $436

6 $436 $0

SUM-OF-THE-YEARS-DIGITS DEPRECIATION

The depreciation factor in any given year is determined by a fraction,

where the numerator is found by counting down from the useful life, and

the denominator is the sum of the numbers from 1 to the useful life.

SUM-OF-THE-YEARS-DIGITS DEPRECIATION

Sum-of-the-Years-Digits Depreciation Formula

Year Year in Reverse OrderDepreciation Factor

1 k k/K

2 k-1 (k – 1)/K

3 k-2 (k – 2)/K

. . . . . . . . .

k-1 2 2/K

k 1 1/K

Six-Year Sum-of-the-Years-Digits Depreciation Schedule

Year Year in Reverse Order

Depreciation Factor

1 6 6/21

2 5 5/21

3 4 4/21

4 3 3/21

5 2 2/21

6 1 1/21

Sum K = 21

An Example of Sum-of-the-Years-Digits Depreciation

End of Year

Depreciation Amount in Year

Book Value at End of Year

0 — $7000

1 $6000 * 6/21 = $1714 $5286

2 $6000 * 5/21 = $1429 $3857

3 $6000 * 4/21 = $1143 $2714

4 $6000 * 3/21 = $857 $1857

5 $6000 * 2/21 = $571 $1286

6 $6000 * 1/21 = $286 $1000

ACCELERATED COST RECOVERY SYSTEM (ACRS), 1981–1986

The accelerated cost recovery system (ACRS) [IRS95] was the defined depreciation method from 1981 through 1986.

All depreciable assets put into service during these years used the ACRS method.

There are two variants of the ACRS method, the prescribed method and the

alternative method.

Coming Lecture