DEPRECIATION IN WATERWORKS OPERATION
Leonard Metcalf, of Metcalf & Eddy, consulting civil engineers of Boston, is the author of a paper on the. above subject, from which FIRE AND WATER ENGINEERING makes the subjoined abstract:
The fact that structures deteriorate with age and through other causes is well known to owners of property. Nevertheless, substantial recognition has not generally been given to this fact in the operation of waterworks, by providing a depreciation fund or account, to be earned by the rates, against which fund the cost of all abandoned structures and replacements should be charged. The decision of the Supreme Court of the United States upon the Knoxville Water Works case, delivered by Mr. Justice Moody, and handed down in January, 1909, gives emphasis to the need of practical recognition of depreciation by managers of public service corporations, and will effectually estop hereafter any corporation from making claim for the effect of depreciation of its property that has failed to earn, through the agency of its rate, a sufficient fund to meet this depreciation. Exception might he made in the plants which have not yet passed through the formative period, or which, by reason of heavy reconstruction expenses, have not been able to lay aside a suitable depreciation fund without increasing the rates. Such plants may have preferred to temporarily suspend the laying aside of a depreciation allowance, in the hope of making good the deficit a few years later, rather than to bear the public odium of temporary increase in rates. It seems reasonable to assume that a public service commission would take the same view. Without attempting a lengthy discussion of this subject, it may lead to clearness and be of service to lay down some of the principles which should govern us in making depreciation allowances in valuation, and which should have influence in the operation of a waterworks plant. Depreciation may be defined as the loss in value of a structure, resulting from wear and tear and other causes not covered by the repair and renewal accounts, or from loss in ability, with the lapse of time, to meet the demands of the service for which it was designed or to which it is being devoted. Three broad classes in depreciation have been recognized: 1, physical depreciation; 2, functional depreciation; 3, contingent depreciation. Physical depreciation covers the deterioration of the structure through wear and tear, or similar causes, which result in its actual gradual inability to meet the required service, in spite of repairs and renewals from time to time. Functional depreciation covers the loss in value, growing out of the necessity of abandoning the structure, on account of obsolescence, change in method of operation, improvement of the art, increase in capacity of plant, or other similar causes. Contingent depreciation should cover such loss in value of the structure as cannot logically be included in the other two items, and as shall make possible the gradual distribution, through a period of years, of any extraordinary depreciation item incurred in a single year, and thus have a steadying influence upon the financial operations of the company, relieving it of the burdens incident to the violent fluctuations in value which might result were such items charged directly to maintenance account. It is to be assumed, of course, that these items are properly chargeable to depreciation or maintenance. to the end that the capital investment may be unimpaired. Under this classification contingent depreciation may include such work as the cost of re-locating the street mains, growing out of changes in grade or surface of the street by the municipality, the construction of subway or conduit systems by the municipality (in the case of telephone companies the placing of wires underground which had previously been overhead), and finally, as a matter of expediency, such major expenses as might otherwise be charged to maintenance account—such as those growing out of serious losses from damage done by bursting mains, due to unforseen and reasonablv unpreventable conditions—such as flaws in the material which cannot be determined by inspection; electrolysis by stray electric currents, etc. While it may be urged that such expenses should be charged to operation—or better, maintenance—we submit that such a course of procedure does injustice to the company through causing a false impression as to its financial ability to meet the losses, by seriously curtailing the annual earnings for the year during which the loss was incurred, when the distribution of the losses over a period of years, through the agency of such a contingent depreciation account, would show no marked affect upon the earnings and annual statement of the company. The actual rate of depreciation, in any given structure, may be exceedingly erratic. Take, for instance, the case of a pump in a waterworks pumping station. A year after the new machine is installed, it is a better machine for the service than it was upon the day of its erection, for the reason that not only have flaws in construction been made good, but the actual wearing parts of the machine have come down to a good bearing, so that the machine, as a whole, operates with better economy than at the beginning of its life. The pump may continue to be substantially as valuable to the works for a considerable period of years, until it is outgrowm in size and a new machine has to be added to take care of the increased service. This pump then becomes a spare machine, operated only at times of light load, and has suffered a marked depreciation in value because it will not meet all of the demands of the service successfully, although it may assist in increasing the economy of operation of the station by making possible the shutting down of the new large or larger unit which had to be purchased, when the consumption is not sufficient to develop good economy in the large machine. The old pump may contine in service for many years, reaching a period when it is so small as to be of value only as one of several spare machines, when its value is very heavily depreciated. It will thus he seen that it is practically impossible, as an accounting problem, to attempt to follow the lifehistory of the individual machines or structures making up the waterworks plant, and, as a practical matter, it is sufficient if there is laid aside, annually, from the income from the rates, a fund which will make good, from year to year, the losses by depreciation, or which will, in other words, replace the old structures, as put out of service, without injury to the capital account. If the assumption as to the life of the plant as a whole is substantially correct, errors in assumption as to the-useful life of its component parts are not so serious, though substantial accuracy is desirable for its effect upon rate making problems or considerations. Granting that the waterworks should lay aside an annual depreciation account which, with or without its accretions— depending upon the method of raising and maintaining this fund—will be sufficient to maintain in the hands of the corporation monies which will enable it to replace each component part of the plant at the end of its useful life, thus maintaining the investment unimpaired, “What method is the most satisfactory for accomplishing this end—that is, for determining the annual sum which shall be contributed to the depreciation fund?” Two general methods are in common use—the so-called “sinking fund” method and the “straight line” method. The sinking fund method, as it name implies, consists in laying aside each year, during the period of life of the structure under question, a sum which with its annual accretions, compounded annually at an assumed rate of interest, will leave in hand, at the end of the useful life of the structure, a sum equal to its original cost less its scrap value. Owing to the fact that the scrap value of the structure frequently is little more than sufficient to cover the cost of its removal, and that, in the case of a long-lived structure, the present worth of the scrap value would be exceedingly small, engineers have generally omitted the correction for the scrap value of the structure and have assumed, unless the life of the structure was comparatively short, that the scrap value was negligible. In the case of very short-lived structures, it is better that the cost of the structure should be charged off to operating expense, rather than to capital account with large annual allowance for depreciation. The straight-line method consists in laying aside an annual sum proportioned to the length of useful life of the structure. Thus, if the life of the structure be assumed at 30 years, one-thirtieth of the difference between the original cost of the structure and its final scrap value shall be contributed to the depreciation. fund during the entire life of the structure. The corporation will thus have in hand, at the end of the thirty-year period of life, a sum of money equal to the original cost of the structure. Mention might also be made of what might be termed the individual analysis method of computing depreciation.” for use in cases where unusual local conditions or temporary circumstances might be dominating factors. As this method is rather in the nature of a modification of the other methods cited than a specific method of computing depreciation. no further comment is needed upon it.
In the long run. failure to make ample provision for depreciation, either through failure to earn it by the rates or to retain it in the treasury for legitimate corporate use (not for disbursement in dividends), must inevitably upon the one hand make capital apprehensive of the soundness of the management, if not of the project itself (and thus lead to demands for higher returns commensurate with the added risk, or to fiat refusal to go into the project), and, upon the other, force the public to meet this demand by the payment of higher rates than would otherwise be necessary for the service rendered. Cases sometimes arise in which the income of the waterworks may not at the moment justify what appears to be an adequate provision for possible or anticipated depreciation, and in which questions of expediency—growing out of the desire to avoid the public agitation and odium which would follow an attempt to increase rates for this reason—may make it preferable to take the chances of making good present deficiencies in depreciation account by future increments, rather than to raise the water rates temporarily. Such action may be justified provided the past financial history of the works indicates clearly that the growing net income will, with continuity of the existing water rates, in the near future produce a surplus which will wipe out this deficiency. This is particularly true of the allowance to be made for “contingent depreciation.” The diagrams—Plate T based upon the sinking fund method and rates of interest of 3 per cent., 4 per cent., 5 per cent., and 6 per cent., and Fig. 1, based upon the sinking-fund method and rates of interest varying from 2 1/2 per cent, to 4 per cent., dependent upon the assumed length of life—will be found of service for rapid approximate computation or estimating purposes. In this connection it may also be of interest to allude to the fact that Metcalf & Eddy, in reporting to the Boston Finance Commission in 1908 upon the cost of machinery and fair rental therefor, fixed, as an extreme monthly rental, 5 per cent, of the cost of the machinery, assuming that in the case of the larger machinery, which would be likely to have longer life, the rate should be correspondingly reduced. The average length of life of waterworks plants depends upon many factors. Broadly speaking, from 40 to 60 years probably represents the usual range of life of the structures, except in the case of very rapidly growing towns or cities. The Wisconsin Public Service Commission in a recent opinion upon the value of the Fond du Lac, Wis., waterworks, gives the average life of the different waterworks plants examined by it to date as 65 1-4 years. The United States Commerce and Labor Bureau, in its special report upon “Statistics of cities having a population of over 30,000,” in which are included some valuable waterworks statistics, assumes a fiftv-year period of life, corresponding to a 2 per cent, annual rate of depreciation upon the straight-line method of computation, but applies this to the present value of the plant. (If the going value and franchise value are included in the “present value of plant,” this is more nearly equivalent to a 3 per cent, annual allowance for depreciation, based upon the reproduction cost upon which depreciation is usually figured, and would correspond in the above cited tables to an approximate period of life of 33 years which is too short a life for average conditions.) Technically. the depreciation should be based upon the cost of the plant, though it may be applied as a per cent, of present value or gross annual income, for convenience, if errors of assumption be adjusted at intervals of 5 years more or less. The total allowance to be made for depreciation, including contingent depreciation, will probably vary between limits of 1 per cent, and 2 per cent, per annum of the reproduction cost of the property, thoueh in many cases it may lie even beyond these limits. Data are scarcely sufficient at’the present time to fix the proper allowance for contingent depreciation with a reasonable degree of accuracy, ft seems reasonable to anticipate however, that an allowance of not less than one-fourth of I per cent, per annum upon the sinking fund basis should be provided, and in many cases—perhaps in the majority of cases— this allowance will prove inadequate. In this connection it may be of interest to cite the experience of the Knoxville W ater Company, the plant of which in a period of 17 years showed an average annual rate of depreciation, exclusive of proper allowance for repairs and renewals, of 2.12 per cent. Owing to the variation in the amount of the gross income of waterworks, as compared with their cost or value, the depreciation thereon, expressed in percentage of the gross income, is correspondingly variable. Broadly speaking, however, it may be said that the depreciation is likely to amount to 10 per cent., more or less, of the gross annual income of the works. Thus, if we assume a plant having a value of $5,000,000, a gross annual income of 10 per cent, thereof, or $500,000 per year, and a depreciation of 1 per cent, thereof, or $50,000 per year, the depreciation will amount to 10 per cent, of the gross annual income. Assuming value $500,000, gross annual income 12 per cent, equals $60,000, depreciation 1.25 per cent, equals $6,250. the depreciation would amount to 10.4 per cent, of the gross annual income. Assuming value $50,000, gross annual income 16 per cent, equals $8,000. depreciation 1.50 per cent, equals $750, the depreciation would amount to 9.4 per cent, of the gross annual income. How many of you gentlemen, as waterworks superintendents, are charging off 10 per cent, of your gross annual income to depreciation account, unless you are doing it through the agency of a sinking fund to retire the outstanding bonds upon your works?