Depreciation is one of those fundamental tenets of the economy that can be incredibly frustrating. This is especially when you don’t know why the causes of depreciation and why is it happening to your goods. As both a business owner and a consumer, it’s critical to understand what depreciation is and what causes depreciation. So that you can better account for it in your daily life and at work.
In this article, we’ll discuss eight of the most common and most important causes of depreciation and how they work. We’ll also provide examples along the way to make it easier to see the different kinds of depreciation at work.
What is depreciation?
Depreciation is the loss of a product’s value over time. Some items depreciate quickly because the product’s value is highly susceptible to one or more causes of depreciation. For example, some lost durability or increased wear and tear, while others depreciate slowly or even appreciate (or gain value) over time.
When you talk about a category of goods, depreciation is often discussed in terms of the average across all of those products rather than the individual depreciation rate for a specific item. Take cars, for example. Cars are known to depreciate rapidly, partly because the market prices of a new car and a like-new car are substantially different. Public perception of the value of a new or used car also contributes to the initial depreciation.
But, a few years down the road, the average rate of depreciation of two vehicles that are otherwise identical can be radically different. If one of those vehicles was in an accident or wasn’t taken care of while the other received regular maintenance and repair and was never damaged on the road, they will have depreciated at different rates over that period.
Difference between depreciation and appreciation
While we aren’t focusing on appreciation in this article, using one example of appreciation will help you understand the core differences between items that depreciate and items that appreciate. Fine wines tend to get more expensive over time. Some bottles becoming so valuable that they stop being seen as luxury beverages. The taste of the wine likely doesn’t matter; instead, it becomes a collector’s item and status symbol.
The appreciation of the wine happens for two core reasons. One is that wine is seen as a luxury good. People who can afford it receive status in return for their ownership. The other reason is scarcity. There are only so many bottles of any given vintage of wine. There will never be more wine from that particular year and vineyard. As bottles are emptied to drink or otherwise destroyed, the availability of those bottles decreases, and increased scarcity increases appreciation.
The eight most important causes of depreciation
This is not an exhaustive list. There are cases of depreciation that defy categorization but remain undeniably real. While rare, items can depreciate for no specifically known reason. Though the truth is that these items often fall under depreciation by a change in public perception. The goal here is to understand why depreciation happens most often. Moreover, you need to learn to anticipate the types that are most common for the items you use every day. Be it as a consumer or a business owner. The objective is not to provide precise predictions for all the various forms of depreciation that could impact your propertyhttps://srsr.io/sell/due-diligence-and-intellectual-property-protecting-your-businesss-assets/.
Expiration of legal rights
Legal rights to a product are usually applied to intellectual property (IP) rather than the physical goods that come out of that IP. For example, a novel is much more valuable to the author and their descendants before the copyright on that title expires.
An inventor who patents a new design for a specific tool receives a greater benefit from that patent expiration. This is because they can lease the right to use their design to manufacturers. After that, they might still benefit from the production and sale of their invention. However, they’ll also likely have more competition, which reduces the value.
While an owner maintains legal rights to an item, the item is more valuable than before those rights expire. In some cases, the value of that item might also depreciate based on how much longer the owner maintains exclusive legal rights over it. An example of this is when brand-name drugs leave their exclusive period and a generic version starts being produced. The competition for a generic alternative often forces the price of the name brand down.
One way to get around depreciation caused by the expiration of legal rights is by tweaking or changing the product enough to protect your exclusive right over that IP. This is one reason medication manufacturers often tweak their medicines just before the legal patent expires. This is also one of the reasons that Disney is producing new live-action versions of their classic films because they can maintain their copyright over that depiction of their characters by producing something new before the copyright expires.
Wear and tear caused by use
One of the most common and unavoidable causes of depreciation is the use of an item for its intended purpose. Let’s go back to the car example from the beginning. If two people bought the same model of a car on the same day with the same trim level and even the same color, but one of them put twice as many miles on that car in a year, that vehicle would depreciate faster. That’s because the wear and tear of a vehicle is often measured in part by the number of miles driven/the number of miles that vehicle is expected to be able to drive in its functional life. Even with a perfect maintenance record and brand-new replacement parts, anytime something goes wrong, the number of miles on a vehicle will depreciate its value.
Take another example: a simple wooden pencil. As you use the pencil, you have to sharpen it to expose the graphite inside. In this case, you can see depreciation as it happens. At some point, that pencil will either be so small that it’s no longer useful or will run out of graphite, rendering it useless. Other kinds of wear and tear on a pencil can also reduce its value, like a used-up eraser or bite marks on the wood. That kind of damage doesn’t necessarily interfere with the pencil’s primary use. It makes marks on paper, but it does decrease its value.
Wear and tear caused by time or exposure
One of the answers to depreciation caused by use is to own an item and simply not use it. However, that item is still subject to other forms of depreciation — depreciation over time or through exposure. This happens when an item naturally loses value over time for any reason. One example is paper. Paper gets more delicate over time and can become brittle or even crumble when it becomes too old. The paper might be completely unused. However, if it’s too old or wasn’t stored well, it loses the properties that make it valuable.
Cars are another good example. Classic cars are often valued in part based on their age and lack of use. However, not using a vehicle for too long can cause damage to its internal components. Metal can rust or corrode. Using the vehicle will potentially reduce its value, but the value of the vehicle will also depreciate if it isn’t used.
Similarly, items can depreciate over time if they are exposed to damaging conditions, like being left outside or exposed to the sun. A beautiful painting won’t inherently lose value over time. But if it’s placed on a wall across from a large window, the sunlight will bleach the pigments, causing depreciation due to exposure.
Abnormal factors or acts of God
Sometimes items depreciate because of outside abnormal factors that can’t be anticipated or planned around. The world just experienced an abnormal factor that radically changed the value of a lot of goods and services: the pandemic. The pandemic simultaneously increased the value of some items, like toilet paper, masks, and personal protective equipment. At the same time, it rapidly decreased the value of others, work wardrobes, alarm clocks, and travel pillows. The items had not inherently changed in any way, but the abnormal factor of the pandemic radically changed demand.
Going back to the pencil example, one abnormal factor that impacted the value of wooden pencils was the invention of an alternative: the plastic mechanical pencil. Nothing about the wooden pencil had changed, but a refillable alternative decreased demand and depreciated the value of existing wooden pencils.
Acts of God, which in insurance terms are things that could not have been reasonably anticipated or prevented, can also cause depreciation. Being hit by a tornado can depreciate the value of a house, even if it doesn’t cause significant damage. Living in an area prone to natural disasters, particularly flooding, can lead to property devaluation. This holds true irrespective of whether these disasters result in wear and tear or physical damage.
Obsolescence
Obsolescence is one of the most common causes of depreciation in today’s products. Especially when it comes to technology and the devices we use to access it.
Software is most valuable while it’s new, innovative, and before significant competition from similar software exists. At some point, as developers build on the original concepts behind a new piece of software, making updates, improvements, and adding additional features, the original piece of software becomes obsolete. Businesses can get around this kind of obsolescence by providing software updates, patches, and affordable upgrades that bring the original more in line with the competition. Though, this needs to be constantly ongoing work to avoid future obsolescence.
Devices also experience this. Smartphones are a great example. A smartphone can outlast the advancements in technology and features it initially possesses. Eventually, as more improvements are made, a perfectly functional phone can be technically obsolete.
In the last few years, there has been a lot of discussion of planned obsolescence in tech and how to deal with it. But planned obsolescence can be a feature of almost any product. How we choose to deal with obsolescence is and must be an ongoing conversation. In the meantime, products will continue depreciating as they become increasingly obsolete.
General public perception
Some items get caught up in the fads of public perception, and those items often lose their value when the fad is over. Other times, items are affected by slow changes in public perception. Some buildings, vehicles, and decorative items depreciate when public aesthetic preferences change. Even something as simple as the color of a product can contribute to depreciation if that color falls out of vogue.
Or, in a combination of public perception and abnormal factors, items can change value when the public understanding changes. Take Christopher Columbus-themed memorabilia, decorations, and costumes. Retailers who invested in these items to sell around Christopher Columbus Day have faced depreciation in their value as public perceptions of Columbus have shifted and rapid depreciation in states that have changed that holiday.
Natural perishability
Not everything can last forever. If you’ve ever bought from the bargain shelf at your local grocery store, you probably have a good grasp on this one. Items that go bad after a certain amount of time depreciate as they get closer to that expiration date. A gallon of fresh milk is more valuable than a week-old gallon of milk.
Plenty of items experience perishability, though the time frame can be radically different for different items. Makeup is another good example. Most companies recommend replacing makeup products every 12 months. However, some products are specifically designed to last longer. Although, others might perish faster depending on storage conditions and regular use. Regardless of expiry speed, a product’s depreciation increases as it nears the expiration date.
Depletion of resources
The last form of depreciation happens when an item or piece of property has a limited amount of a valuable resource that depletes with use or extraction. Makeup and wooden pencils are both items that are depleted with use. Properties that have natural resources like oil, critical minerals, or lumber are also depleted with extraction. This causes the value of the property to depreciate. Any item that derives at least part of its value from a finite resource that is depleted with use will depreciate any time that resource is used.
Final thoughts: Why does understanding the causes of depreciation matter?
Knowing how items depreciate is important for understanding which items depreciate over time. It can help you budget, plan, and accommodate updates, equipment changes, replacements, or repairs. Adding awareness about depreciation and the causes of depreciation to your business practice offers a lot of benefits and a few downsides, especially when you avoid the frustration of failing equipment and obsolescent software down the line.