Why is depreciation considered a cost of owning a car?

Question

I thought depreciation is the loss in value of a car after purchase. Why then is it considered a cost of owning a car?

Answer 1

It is a cost, but it's not a cost in addition to the initial cost of the vehicle. It's a way of spreading the cost of the vehicle over time.

If you buy a car for $20k, you could think of the "cost" of that car as $20k and be done. Depreciation is not meaningful to you; any money you get back from selling the car is "a bonus".

Or, you could think of the cost of the car as an initial payment, with a plan to drive it for 5 years and then sell it for $8k (you have no control over either of those values, but conceptually it's what depreciation represents). You would then think of the cost as "$12k/60 months" or $200 per month. The actual change in value is not linear, but unless you plan to sell the car sooner, it doesn't really matter. Do you care if the car in your garage is worth $15k or $12k unless you plan to sell it?

Now, most people don't think of cars that way - they think of either a monthly payment, or the full payment if paying with cash, as the "cost". But depreciation is another way to think of the cost of owning a car.

Answer 2

When you buy an asset like a car or a house, the money you spend doesn't just disappear, it's traded for something that is (in theory) worth the same amount. If you buy a car for $10k, that transaction does not see you lose a worth of $10k, since you now own the car itself, which you could (in theory) sell to someone else for $10k. If after the first year of ownership the car would only sell for $9k, the car has cost you $1k that year - it didn't cost you $10k that year, since it still has $9k worth of value.

Depreciation is a way of tracking the actual value of the car over time. If you have some unique car that doesn't depreciate in value (which is exceedingly rare), the purchase price is actually not a cost of ownership, since when you ultimately sell the car for the same price you bought it, you will not have spent any money at all on the title. The purchase price isn't the cost of ownership directly, it's the purchase price minus what the car is currently worth.

Generally, a car's value decreases over time, and you can view depreciation as a way of accounting for the initial cost over time - it's a bookkeeping exercise as to how you choose to view it. After 10 years, your car purchased for $10k may be worth $0, and it's a bit of an academic exercise as to whether you consider that costing you $1k per year, or $10k in the first year and $0 each year thereafter. It's not always terribly important for personal car ownership (although it can give you a better estimate of per-year costs, accounting for the car's remaining value when you get rid of it), but there can be meaningful tax implications in cases like businesses buying capital equipment.

Answer 3

When someone says car depreciation is a cost of car ownership, this generally means the person views that the initial purchase cost used to acquire an asset is not an expense, but the drop of the car's value is. This is akin to the Matching Principle in financial reporting: We should see the expense (cost) occurring when the asset (car) is being consumed, not when the asset is bought. This is one kind of Accrual Method, the opposite of what most people do: Viewing the moment of the outflow of cash as when an expense occurring (the Cash Method).

Example 1: Cash Purchase

Consider a person who buys a car for $100,000 cash. The value of the car drops $10,000 per year for the first five years. The person sells the car for $50,000 at the end of the fifth year ownership. Following the principle in the first paragraph, this is how the cost (expense) of owning the car in each year:

• The drop of the $10,000 value (depreciation expense of the car).
• Gas or electricity, repair, service, parking expenses.

If following the Cash Method, the expense of each year would be the follows:

• First Year only, $100k expense to buy a car.
• Between Year 1 to Year 5: Gas or electricity, repair, service, parking expenses.
• Fifth Year only, $50k income.

Example 2: Financed Purchase

Consider a person who buys the same car as Example 1. This time, this person buys the car with a loan with a down payment of $20,000. Following the principle in the first paragraph, this is how the cost (expense) of owning the car in each year:

• The drop of the $10,000 value (depreciation expense of the car).
• Gas or electricity, repair, service, parking expenses.
• Interest payment. (not monthly payment)

Using Cash Method, it would be:

• First Year only, $20k expense to buy a car.
• Between Year 1 to Year 5:
  • Gas or electricity, repair, service, parking expenses.
  • Total of loan monthly payments.
• Fifth Year only, income equal to cash received when selling the car. ($50k minus loan balance)

Implications

You may see some people encourage thinking using the first method (Accrual Method), because it is considered better representing your actual financial position. However, most people use the second method (Cash Method), which has the advantage of simplicity and works in many situations.

To circle back to your question:

I thought depreciation is the lost in value of a car after purchase, then why is it considered a cost to own a car?

Your may be thinking using the second method (Cash Method), while the other person is thinking using the first method (Accrual Method).

Answer 4

Depreciation is far more meaningful for businesses than individuals. While you may or may not find it useful to think about the depreciation of your personal vehicle, depreciation is a significant expense on a business's books.

"Taking depreciation" allows the business to deduct a portion of any asset's capital cost each year on its tax return. In the US, and, I suspect most everywhere else, this deduction is not available for personal vehicles, residences, etc.

Depreciation of a business asset also explicitly recognizes that the asset will be "used up" and eventually have to be replaced. The "depreciation schedule" an accountant uses to calculate the number (theoretically) reflects the useful life of the asset, whether it's a vehicle (several years, let's say), a piece of production machinery (probably longer), or a building.

The residual book value (if there is any) when the asset is replaced is either written off as an expense if the asset is scrapped, or subtracted from the proceeds of selling it, reducing the revenue that has to be recognized from the sale. Keep in mind that book value is calculated from tax rules and usually does not precisely reflect market value.

Answer 5

It may help to remember that the other accounting approach for the car would be to expense it all in the first year, then count anything you're paid for it when you get rid of it as income.

Depreciation just distributes the expected final cost over multiple years. Which, for business, yields a better picture of the company's net assets. It may be overkill for personal property unless you are required to depreciate rather than expense.

(For a while, I had the choice of depreciating or expensing work equipment. I always expensed it when possible since I didn't want to do the more complicated paperwork and nobody really cared what my net worth was.)

Answer 6

The only logical way of calculating cost to own is "money you had before - money you had after you were done owning it", if you had spent money on nothing else. Usually, when you are finished with a car, you get back some of the money you spent on it, because you sell or trade it in, so this calculation includes selling it. Obviously the amount you get depends on how much it depreciated, that's why it's part of cost.

Perhaps you are misunderstanding "cost to own" as "amount of money needed to acquire the car". Financially, there are many ways to structure a payment, and it is not important how big a check you are writing initially. For example, you can buy the car for a price of "$1", because that is down payment for a loan. Does it make sense to say the car cost you $1, when you have to keep making $500 payments on the loan? Of course not. Cost to own means total cost of being able to use the car from start to finish.

Answer 7

Whenever you spend money, you should know how much you spend and what you get for it, and what it is worth.

You can buy a car for $20,000 and say “I bought a brand new car for $20,000”. That’s one way to look at it. Now you figure out that you can sell the car for $16,000 after a year, $13,000 after two years, and so on. And you say to yourself “I pay $4000 to drive a brand new car for a year”, and “I pay $3,000 to drive a one year old car for a year”. So you look at the deprecation instead of the payout.

That lets you make better decisions. Is driving the brand new car worth $4,000 to you? If yes, buy brand new. If no, buy one year old. Is driving a five year old car worth $1500 to you or would you rather pay more for a newer car? That’s how you can decide whether you sell your car after five years or keep driving it. Looking at depreciation can make the decision clearer to you.

(That said, many people hate changing cars, so they buy brand new and drive the car until it falls apart).