When calculating depreciation, an asset's salvage value is subtracted from its initial cost to determine total depreciation over the asset's useful life. From there, accountants have several options to calculate each year's depreciation.
What is Depreciation?
Depreciation measures an asset's gradual loss of value over its useful life, measuring how much of the asset's initial value has eroded over time. For tax purposes, depreciation is an important measurement because it is frequently tax-deductible, and major corporations use it to the fullest extent each year when determining tax liability.
Accountants use several methods to depreciate assets, including the straight-line basis, declining balance method, and units of production method. Each method uses a different calculation to assign a dollar value to an asset's depreciation during an accounting year.
How to Calculate Salvage Value
Regardless of the method used, the first step to calculating depreciation is subtracting an asset's salvage value from its initial cost. Salvage value is the amount for which the asset can be sold at the end of its useful life. For example, if a construction company can sell an inoperable crane for parts at a price of $5,000, that is the crane's salvage value. If the same crane initially cost the company $50,000, then the total amount depreciated over its useful life is $45,000.
Suppose the crane has a useful life of 15 years. At this point, the company has all the information it needs to calculate each year's depreciation. The simplest method is straight line depreciation. This means that there is no curve to the amount of appreciation, whether that is an immediate 30% depreciation seen when driving new cars off the lot or an increased depreciation when an item is close to needing major repairs. Using this method, depreciation is the same every year. It equals total depreciation ($45,000) divided by useful life (15 years), or $3,000 per year. This is the most the company can claim as depreciation for tax and sale purposes.
How Salvage Value is Used
This is most commonly seen in motor vehicle accidents when the insurance company makes a decision whether to "write-off" a damaged car as a total loss instead of cutting the check needed to make the necessary repairs. The insurance company decided that it would be most cost-beneficial to pay just under what would be the salvage value of the car instead of fixing it outright.
Another example of how salvage value is used when considering depreciation is when a company goes up for sale. The buyer will want to pay the lowest possible price for the company and will claim higher depreciation of the seller's assets than the seller would. This is often heavily negotiated because, in industries like manufacturing, the provenance of their assets comprise a major part of their company's top-line worth.
The Bottom Line
Salvage value is a commonly used, if not often discussed, method of determining the value of an item or a company as a whole. Investors use salvage value to determine the fair price of an object, while business owners and tax preparers use it to deduct from their yearly tax liabilities.