Depreciation and Cash Flow
Depreciation is considered to be one of the components of the cost of production, but it is a different type of cost. To produce a product a company may have to spend on material, labor and overheads. But it does not have to spend anything as depreciation. The spending has already taken place in the form of cost of the asset. Now a portion of such cost is attached to the cost of production. Thus the cost of a product consists of the current cost like material cost, labor cost, etc. and the apportioned cost (depreciation) when a company recovers from the customer cost of its product plus profit.
Actually, the outgo for the company is only the current cost of the product. Thus the amount collected towards depreciation and profit is available with the company in the form of liquid funds. This is known as operational fund flow.
For example, a company manufactures a product at a cost of $200. This cost consists of material $60, labor $40, overheads $60 and depreciation $40. If the company sells the product at Rs. 280 then it will make a profit of $80 per unit but the operational fund flow from the sale would be $ 120 because out of $280 collected from the customer$160 will go towards payment of current cost and hence the balance of left is $120 which is equal to the profit plus depreciation. As the company may have to pay tax on the profit $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 method of depreciation charged. 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 once later has to be consistently followed and cannot undergo frequent changes. Before making a final decision implication of tax payments, impact on dividend distribution, cost flow implications, etc. must be fully analyzed.