Salvage value: How is it calculated?

Definition

Salvage value, also known as residual value or scrap value, is the estimated monetary worth of an asset at the end of its useful life.

What is salvage value?

Salvage value represents the amount that an asset is expected to be worth after it has been fully depreciated or used up. Salvage value is an important concept in accounting, finance, and asset management, influencing decisions related to depreciation, asset valuation, and overall financial planning.

In the context of depreciation, salvage value is a key component in calculating the depreciation expense of an asset. The formula commonly used is straight-line depreciation:

Depreciation expense = (Cost of asset − Salvage value) / Useful life

Some assets may have a salvage value of zero, indicating that they are expected to have no residual worth after being fully depreciated.

In the case of damaged or totalled assets, the salvage value may be considered in insurance claims to determine the overall loss or value of the asset.

What are the different depreciation methods?

Different depreciation methods are used to allocate the cost of an asset over its useful life. Here are the main types:

Straight-line depreciation: Allocates an equal amount of depreciation each year over the asset’s useful life. It is calculated by dividing the cost of the asset minus its salvage value by the number of years of its useful life.

Declining balance depreciation: An accelerated method where the asset depreciates faster in the earlier years. The most common type is the double-declining balance method, which doubles the straight-line rate.

Sum-of-the-years’-digits (SYD) depreciation: Another accelerated method that applies a decreasing fraction to the depreciable base. The sum of the years’ digits is calculated, and a fraction is applied each year to the depreciable amount.

Units of production depreciation: Depreciation is based on the asset’s usage, activity, or units produced. It is calculated by dividing the total cost minus salvage value by the total expected production units, then multiplying by the units produced in the period.

Each method suits different types of assets and business needs, impacting financial statements and tax calculations differently.

Salvage value vs. book value

Salvage value and book value are key concepts in accounting. Salvage value refers to the estimated residual value of an asset at the end of its useful life, representing the amount a company expects to recover upon disposal. Book value, on the other hand, is the value of an asset as recorded on the balance sheet, calculated as the original cost minus accumulated depreciation.

While salvage value is used in depreciation calculations to determine an asset’s total depreciable amount, book value reflects the current accounting value of the asset, indicating its remaining worth after depreciation.

Example of salvage value

ABC Manufacturing Company purchased a specialised machine for £50,000, with an estimated useful life of 10 years. The salvage value is estimated to be £10,000.

Using straight-line depreciation, the annual depreciation expense would be

£50,000 / 10 years = £5,000 per year.

The annual depreciation expense is then subtracted from the initial cost to determine the book value over the years.

Year 1 book value = £50,000 – £5,000 = £45,000

Year 2 book value = £45,000 – £5,000 = £40,000

… (and so on)

In the 10th year, the book value will be £50,000 – (9 x £5,000) = £5,000.

In this example, the salvage value of £10,000 represents the anticipated residual worth of the machinery after 10 years of use.