ACQUISITION, USE AND RETIREMENT OFCAPITAL ASSETS IN INDUSTRY -

DISCUSSION OF ASSUMPTIONS WHENESTIMATING THE CAPITAL STOCK

Jan Karlsson, UN/ECE Statistical Division, Geneva

F:\USERS\KARLSSON\CAPSTOCK\short.DOC 9 February 1999

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CONTENT

1. INTRODUCTION

2. CHANGING COMPOSITION IN INVESTMENT2.1 From stand alone machines to flexible manufacturing cells and flexible

manufacturing systems2.2 Costing structure2.3 Shift towards machine investment2.4 Shift towards R&D expenditures

3. HYPOTHESIS ABOUT OUTPUT STREAMS AND DEGREE ANDMODE OF UTILIZATION OF CAPITAL ASSETS

3.1 Constant output3.2 An example3.3 Most machines are integrated into systems3.4 Replacement of whole systems3.5 Increasing degree of utilization - higher ratio of machine investment3.6 Comments to an inventory of age-, type- and technology distribution of the 1989

stock of metalworking equipment in the United States3.7 Implications for measuring the value of capital stock

4 INVESTMENT BEHAVIOUR AND ASSUMPTIONS ON DECAY,SERVICE LIVES AND MODE OF RETIREMENT

4.1 A criterion for investment decision - internal rate of return4.2 Flows of income and costs for maintenance and repair4.3 Decay and ageing4.4 Input decay4.5 Output decay4.6 A process of continuous replacement investment, often according to plan4.7 Desired capital stock4.8 Most investment projects are interdependent4.9 Service lives for assets: primary and secondary service lives

5. A SUMMARY OF PRACTICES IN BUSINESS ACCOUNTING

6. CONCLUSIONS

References

ANNEX 1: Traditional methods for investment calculationsANNEX 2: Notes on the theory for investment behaviour

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1. INTRODUCTION

The difficulties of accurately measuring capital stocks are well known. Directsurveys would be preferable but are deterred by their high costs as well as by the factthat many companies do not keep up-to-date records of all their assets. This is inparticular the case concerning retirement of assets (scrapped or sold or just left idle).When a company has written off an asset, it is not unusual that it disappears from therecords as well as from companies’ financial account.

Gross fixed capital formation (GFCF) on the other hand can be ratheraccurately measured. On the bases of GFCF and certain assumptions concerningservice lives of assets, the Perpetual Inventory Method (PIM) is used to estimate thecapital stock. Despite the uncertainty of asset life assumptions of PIM it is, as ispointed out in [1], widely used in statistical offices. Several different approacheshave been recommended in order to improve the accuracy. One approach suggeststhe use of a combination of direct observation of capital assets and PIM. Anotherapproach focuses on simulation of different types of mortality functions, based onvarious assumptions of retirement of asset. For the calculation of the net capital stocka further set of assumptions concerning depreciation are simulated.

In this article it is argued that many of these assumptions seem even lessappropriate than hitherto, given present day investment behaviour in industry andhow the assets are actually used. It is also argued that when models of measuringcapital stock are developed, much more solid and hard facts must be gathered aboutthe present day investment behaviour, investment planning and productionorganization in industry, which in turn determines the length of service life, degree ofutilization and patterns of retirement.

Based on observations of present-day production and investment behaviour inindustry, a number of hypothesis is postulated in this paper concerning input andoutput decay and mode of retirement for key production systems (large integratedmanufacturing systems). These hypothesis differ somewhat from those discussed atthe Second Meeting of the Canberra Group on Capital Stock Statistics at the OECD,September/October 1998. The limitation to key production system is important tonote because capital goods are heterogeneous - even within the same category ofasset.1

Conclusions for key production system can, however, radically differ from,say, simple stand alone machines, hand-held tools and other types of investment

1 A manual lathe for instance cannot be compared with a computerized-numerically controlled(CNC) lathe. A stand alone CNC lathe can not be compared with a CNC lathe integrated into acomputer controlled cell. In [2] Diewert notes “the tremendous amount of heterogeneity” in thecomposition of output from different firms in the same industry. He concludes that “this heterogeneitymakes comparisons of real output and productivity across firms in the same industry somewhatdubious, since their outputs may not be comparable”. The combination of various types of assets witha certain amount of labour and labour skill structure is determined not only by the type output but alsoon volume of outputs, range of output variants and batch sizes. There is thus also a heterogeneity inthe use and configuration of capital assets between firms within the same industry branch.

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objects, which can be acquired more or less "over the counter" and instantly replacesimilar worn out or otherwise retired equipment.

Before discussing the hypothesis mentioned above, attention should be drawnto the radically new production technologies and production organisations, whichhave been developed in the last 30 years. The main structural change in this respect isthe shift from stand-alone machining systems, set up according to a functional workorganisation, to computer-integrated manufacturing processes where the materialflow and the information flow are organised in well-balanced system which producesthe right amount of goods and services at the right time for current demand. These areissues which are illustrated in detail in a more extended version of the present paper.This text might, however, be somewhat too lengthy for readers primarily interested incapital stock statistics in a national accounts environment and is therefore notincluded here. Nevertheless, it is important to be aware of the reality one is trying tomeasure, in particular when such important changes have taken place as in this area,which, moreover, is already laden with measurement problems. This information isessential when making assumptions, which by their nature have to be generalised,about issues such as length of service life, income flows, input and output decay anddepreciation. A short section is also devoted to issues of methods of investmentcalculation and investment behaviour.

An implication of the new production methods is a sharply increased degree ofthe machine utilisation and, which as will be shown below, significant changes in thecomposition of total investment in industry.

2. CHANGING COMPOSITION IN INVESTMENT

2.1 From stand alone machines to flexible manufacturing cells andflexible manufacturing systems

The configuration of production systems, in particular in batch-producingindustries, have gradually changed from stand-alone machines, arranged according tofunctional layouts, to flexible computerized manufacturing cells and systems (typicalmachine configurations of cells and systems are illustrated in [3]). Such cells andsystems constitute today a very large part of total machine investment. Certainly,industry is still investing in individual stand alone machines but the share of suchmachines is diminishing rapidly. When a cell has been developed, tested andcertified, it will normally be integrated with several other cells which togetherconstitute the computer-controlled manufacturing system.

The extended version of the present paper illustrates with concrete examplesthe effects which can be realized when companies switch from conventional systems,consisting mainly of stand alone machines - where both the "one-hoss shay" and inputand output decay were possible and frequent - to computerized production systems,based on product-oriented organizations, in which every stage in production isdemand driven.

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2.2 Costing structure

A typical cell consists of:(a) a number of different types of machines, material handling systems and

computers and control systems of different sizes, with a cost share of some 40-60%;

(b) peripherals, special tools and other system specific equipment, sometimesdeveloped in-house, with a typical cost share of 20-30%; and

(c) systems engineering and integration, including various types of software, witha typical cost share of 20-30%.

When the cell after its primary service life, denoted by T, is replaced by a newcell, what happens then with the various components of the first cell? Some of themachines, usually the larger and expensive ones, are overhauled and refurbished forintegration into new cells. Others are either scrapped, sold (which seems to be quitemarginal judging from information in annual report by companies) or used as stand-alone machines for special purpose production, often with a very low degree ofutilization.

Peripherals, special tools and other system specific equipment, on the otherhand, have hardly any remaining value after T. Car companies, for instance, recordseparately special tooling, which has a much shorter depreciation period than otherequipment.

Systems engineering and integration have hardly any market value unless theuser company would go into that business. It becomes, like goodwill, part of thegeneral capital of the company.

2.3 Shift towards machine investment

During the last 30 years, the share of machine investment in total investmentin the manufacturing industry has increased significantly. In Sweden, for instance, itincreased from some 70% in the early 1970s to 85% in the middle of 1990’s asconcerns total industry (ISIC rev.2: 2+3). For the engineering industries (ISIC rev.2:38), it increased from about 65% to almost 90% in the same period (see figure 1). Itis likely that many other OECD countries show ratios with similar trends andmagnitude. This shift in machine investment is to a large degree the result of the newproduction technologies and organizations described above. Another way of puttingit is that there has been a very significant increase in the output per factory m 2 .

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Source: Statistics Sweden.

2.4 Shift towards R&D expenditures

GFCF and R&D expenditures are highly complementary and the boundariesbetween these two variables are becoming more and more blurred. While the longterm trend of GFCF as a percentage of value added has been rather stable there hasbeen a significant increase in share of R&D to value added. This is, in particular, thecase in the engineering industries. In 1993, R&D in the Swedish engineeringindustries (ISIC rev. 2: 38) was 1.5 times larger than GFCF. In thetelecommunications and semiconductor industries it is not unusual to find largeinternational companies that spend twice as much on R&D as on GFCF (example ofR&D/GFCF ratios for 1997 for a few companies: Microsoft 3.9; Ericsson 3,2;Hewlett-Packard 1.5; IBM 0.8). Some companies have even started to capitalize partsof their R&D expenditures. In SNA 93, on the other hand, all the outputs of R&D are"treated as being consumed as intermediate inputs even though some of them maybring future benefits". This might indeed seem very strange to the companiesmentioned above as well as to, for instance, large pharmaceutical companies. Theywould without doubt consider R&D as an essential part for their future benefits andsurvival.

Figure 1 The share of machine investment in total investment in the Swedish engineering industries and total industry

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Year

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cent

age

shar

e

Engineering industries (ISIC rev. 2: 38; as from 1992 ISIC rev. 3: 28-35)

Total industry (ISIC rev. 2: 2+3; as from 1992 ISIC rev. 3: C+D)

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3. HYPOTHESIS ABOUT OUTPUT STREAMS AND DEGREEAND MODE OF UTILIZATION OF CAPITAL ASSETS

3.1 Constant output

Based on the discussion in section 2 above, it is reasonable to assume (and totest the hypothesis) that most of the advanced types of industrial machines beinginstalled in recent years have constant output over their primary service life (thisconcept to be defined below). Present day production organizations would not allowotherwise. A very large share of the machines in an enterprise, at least those thathave a high degree of utilization, are computer-controlled and integrated intocomputer-controlled production system. In such systems, flows of services fromindividual pieces of equipment are not allowed to diminish over time. Eachcomponent of the system must be balanced and stable. The mean-time-between-failure for the system as a whole is a function of the mean-time-between-failure forthe individual components of the system.

In the transport equipment industry and electrical and electronics industry, totake some examples, the production system must satisfy very rigorous specificationsconcerning quality and tolerances. A subcontractor, for instance, will only be chosenas a supplier if he satisfy ISO 9000 certification concerning quality. This in turnimplies that each component of the system must have constant performance during itis effective usage.

General assumptions that some machines through physical deteriorationcauses a diminishing output of services while others have a constant flow until itbreaks (one-hoss shay) are simply not realistic today. No serious company would use“ one-hoss shay” type of equipment. Retirement is usually done in a planned manner,years ahead. It is definitely not the case that companies wait to replace machines untilthey break. Given that specified and regular services are carried out, machines andmachine systems normally have rather well defined length of service life. Unless theyare overhauled companies do not risk using them longer than the planned life time, inparticular if they are key machines in a production system.

3.2. An example

An industrial robot, for instance, used in stand-alone mode or integrated into asystem with 100 other robots and many other types of equipment, is usually designedfor remaining in operation for, say 40,000 hours (provided regular service is carriedout). During these 40,000 hours, the output is practically constant. Normally, withproper maintenance its accuracy, speed etc. do not deteriorate. After 40,000 hours itis either refurbished with new drives and other types of overhaul and can work20,000-30,000 hours more, or taken out of operation (scrapped, sold to anothercompany for overhaul, or standing idle: that it would be used as reserve capacity inthe unlikely event that it may be needed) because a new generation of robots is on themarket with more powerful control system, better accuracy etc.

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3.3 Most machines are integrated into systems

As was discussed above, a very large share of machines and equipment inindustry, in particular those with less than 5-10 years old, are integrated intocomputer controlled production and administrative systems. In 1994, about 42% oftotal GFCF in machines in the Swedish engineering industries (ISIC rev.3: 28-35)consisted of computer-controlled machines, 31% for the total manufacturing industry(Source: Statistics Sweden).

In 1993, computer and other information technology goods, measured ininflation-adjusted dollars, made up almost half of total business spending onequipment in the United States (source: Business Week, June 13, 1994 based on datafrom Commerce Dept. and BLS). The share for industrial machinery fell from 32%in 1975 to 18% in 1993.

The rapidly rising importance of computers (which is more narrowly definedas in the source above) in total business investment, which normally accounts for wellover 50% of total fixed investment, was analysed in detail in the OECD EconomicOutlook, Volume 57, June 1995. In real terms, computers increased their share from4.7% of total business investment in 1985 to 20% in 1994. In that publication a veryimportant conclusion was drawn with respect to service lives of assets:“The risingimportance of computers and related equipment, which are subject to particular rapidrate of scrapping and obsolescence, has contributed to what appears to be a generaltrend towards shorter-lived capital equipment in the business sector. This trend hasexisted since at least the 1960s and has been reflected in steadily rising rates of fixedcapital consumption in many countries”.

3.4 Replacement of whole systems

Sometimes various pieces of a system are replaced individually but more oftenthe whole system is taken out of operation and replaced by a new one when itspredetermined length of service life has been reached.

3.5 Increasing degree of utilization - higher ratio of machineinvestment

Production systems in batch-producing industries (engineering industries,furniture, saw mills etc.) are more and more being operated in two or more shifts -many systems operate unmanned or with limited manning. In the process industries(pulp and paper, iron and steel, chemical industry etc.), the production system is oftendominated by one gigantic system that operates around the clock with down time foroverhaul only at Christmas and summer vacation. A paper company can basicallyconsist of one or several half-a-$billion machine systems.

In the process industry, which is characterized as capital intensive andknowledge poor (with the exception of the chemical industry), the capital stock has

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for long time been used as described above. As a result of increasing share ofmachine investment also in batch producing industries, which can be characterized asknowledge intensive but poor on capital assets (e.g. engineering industries), there hasbeen a shift from traditional one-shift operations to using the equipment in two oreven three shifts per day (in some countries this flexibility has been obtained byreducing the work week to 35 hours).

3.6 Comments to an inventory of age-, type- and technologydistribution of the 1989 stock of metalworking equipment in theUnited States

Every five year the magazine American Machinist used to carry out verydetailed surveys for the United States of the stock and age distribution of metalworking machine tools for a wide range of types of machines. Unfortunately, thistype of survey ceased after the completion of the 1989 survey whose results arebriefly summarised below. In view of the continuous shift towards numericallycontrolled (NC) machines and towards machining systems rather than stand-alonemachines, it is reasonable to assume that the present age distribution has beensignificantly compressed, compared with the 1989 distribution. In other words, anincreasing share of stand alone conventional machines, with a much lower unit valuethan NC machines, have been retired.

3.6.1 Summary of the results

1. In 1989, about 26% of all metal cutting machines in the United States were 20years old or more (see table 1). 16% were less than 5 years. Metal formingmachines followed more or less the same age distribution.

2. Joining and assembly equipment and the aggregate “ other equipment” had alower mean age.

3. Metal cutting machines:Numerically Controlled (NC) machines accounted for 11% of all machinebut for 27% of all machines which were less than 5 years old (40% of all NCmachine were less than 5 years).

4. For certain types of metalcutting machines, the NC share was much higher:22% of all boring machines were of NC type and 52% of all boring machineswith less than 5 years were of NC type (see table 2).

10Table 1

Stock of metal cutting machines, metal forming machines, joining and assembly equipment and otherequipment */ in the United States at mid 1989, broken down by age and , when applicable on NC and non-NC

machines. Number of units

Total 0 - 4 yrs 5 - 9 yrs 10 - 19 yrs 20 - yrsSelected metal cutting machines:NC turning machines 74,077 30,949 26,048 14,999 2,081 Non-NC turning machines 330,357 28,526 52,497 121,836 127,498 NC boring machines 10,688 2,917 3,376 3,039 1,356 Non-NC boring machines 37,372 2,688 6,239 14,449 13,996 NC drilling machines 10,383 2,921 2,823 3,459 1,180 Non-NC drilling machines 274,623 31,103 60,017 100,811 82,692 NC machining centers 53,585 23,813 19,548 8,729 1,495 NC milling machines 28,260 10,064 11,357 5,771 1,068 Non-NC milling machines 220,846 27,354 53,609 82,484 57,399 NC gear cutting machines 804 443 98 89 174 Non-NC gear cutting&finishing machines 28,705 911 1,994 10,553 15,247 NC grinding machines 12,747 5,285 3,341 3,111 1,010 Non-NC grinding machines 422,100 57,791 104,487 148,143 111,679 Total metal cutting machines 1,870,753 292,163 449,681 640,864 488,045 % age distribution 100.0 15.6 24.0 34.3 26.1 Total NC metal cutting machines 197,072 79,231 68,628 40,402 8,811 % NC share of all machines 10.5 27.1 15.3 6.3 1.8 % age distribution 100.0 40.2 34.8 20.5 4.5 Total non-NC metal cutting machines 1,673,681 212,932 381,053 600,462 479,234 % NC share of all machines 89.5 72.9 84.7 93.7 98.2 % age distribution 100.0 12.7 22.8 35.9 28.6 Total metal forming machines 456,028 51,593 94,847 171,002 138,586 % age distribution 100.0 11.3 20.8 37.5 30.4 Total NC metal forming machines 17,888 7,514 6,001 3,363 1,010 % NC share of all machines 3.9 14.6 6.3 2.0 0.7 % age distribution 100.0 42.0 33.5 18.8 5.6 Total non-NC metal cutting machines 438,140 44,079 88,846 167,639 137,576 % of all machines 96.1 85.4 93.7 98.0 99.3 % age distribution 100.0 10.1 20.3 38.3 31.4 Joining & assembly equipment 395,273 83,208 135,951 122,287 53,827 % age distribution 100.0 21.1 34.4 30.9 13.6 Other equipment */ 712,217 349,926 198,763 116,624 46,904 % age distribution 100.0 49.1 27.9 16.4 6.6 Source: American Machinist, November 1989, 14th inventory of metalworking equipment.*/ Plastic moulding machines, heat treatment equipment, baking and drying ovens, cleaning & finishing

Table 2

Percentage share of NC machines within each type of machine in the United States at mid 1989

Total 0 - 4 yrs 5 - 9 yrs 10 - 19 yrs 20 - yrsTurning machines 18.3 52.0 33.2 11.0 1.6Boring machines 22.2 52.0 35.1 17.4 8.8Drilling machines 3.6 8.6 4.5 3.3 1.4NC machining centers 100.0Milling machines 11.3 26.9 17.5 6.5 1.8Gear cutting machines 2.7 32.7 4.7 0.8 1.1Grinding machines 2.9 8.4 3.1 2.1 0.9Source: Op.cit.

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5. In the middle of 1989, between 27% and 55% of the NC machines, dependingon type of machine, in the United States were less than 5 years (see table 3).For non-NC machines the corresponding range was 3% and 14%.

6. Table 4 compare the age structure of machine tools in the United States withthat of other G-7 countries. The data, which were collected in the period1975-1983, show similar age distribution for United States, Canada, Germanyand France. Japan and to some degree also Italy had a higher share ofyounger machines (for the United Kingdom a comparison is less clear cut).There are reasons to believe that the age distribution has now been morecompressed and more uniform between the G-7 countries, because of thetechnology shifts discussed above as well as of significant changes in theinvestment behaviour for machine tools among the countries concerned.

Table 3 Age distribution of selected metal cutting machines in the United States, mid 1989

Total 0 - 4 yrs 5 - 9 yrs 10 - 19 yrs 20 - yrsNC turning machines 100 41.8 35.2 20.2 2.8Non-NC turning machines 100 8.6 15.9 36.9 38.6NC boring machines 100 27.3 31.6 28.4 12.7Non-NC boring machines 100 7.2 16.7 38.7 37.5NC drilling machines 100 28.1 27.2 33.3 11.4Non-NC drilling machines 100 11.3 21.9 36.7 30.1NC machining centers 100 44.4 36.5 16.3 2.8NC milling machines 100 35.6 40.2 20.4 3.8Non-NC milling machines 100 12.4 24.3 37.3 26.0NC gear cutting machines 100 55.1 12.2 11.1 21.6Non-NC gear cutting&finishing machines 100 3.2 6.9 36.8 53.1NC grinding machines 100 41.5 26.2 24.4 7.9Non-NC grinding machines 100 13.7 24.8 35.1 26.5Source: Op.cit.

Table 4 Age structure of machine tools in selected countries. Percentage distribution

Age USA Canada Germany France Italy Japan UKstructure 1983 1978 1980 1980 1975 1981 19820 - 2 150 - 4 14 15 160 - 5 410 - 7 41 350 - 80 - 9 34 41 34 35>=13 yrs 37>=15 yrs 48 29>=18 yrs >=20 yrs 32 37 32 27Source: American Machinist, Nov. 1983, 13th inventory of metalworking equipment.Note: The year indicated under the country name refers to the year of meaurement.

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3.6.2 Output from numerically-controlled (NC) machines vis-à-visconventional machines

A large share of the NC machines is integrated into systems, which arenormally in operation 12-24 hours per day. Because of their high degree of utilisationand productivity, a rough guess is that computer-controlled machines (some 20%of all machines) account for 80% or more of output. That companies maximise theutilisation of the NC machines is natural given the large difference in price comparedwith conventional machines. In 1996, for instance, the average unit value in theapparent consumption of metalworking machine tools in the United States was almost$130,000 compared with less than $2,000 for conventional non-NC machines, seetable 5.

Non-NC machines are used as stand-alone machines with a low degree ofutilisation, in particular the older machines - for certain odd jobs such as developmentof prototypes, special orders etc.

Table 5 Apparent consumption of machine tools in the United States and Germany in 1996

United States GermanyNumber of Total value Unit value Number of Total value Unit value

units $1,000 $1,000 units DM 1,000 DM 1,000NC horizontal lathes 10,615 925,758 87.2 3,865 831,518 215.1 Non NC horizontal lathes 5,991 107,004 17.9 3,175 250,068 78.8 NC milling machines, knee-type 1,871 163,756 87.5 19,208 non NC milling machines, knee-type 8,372 69,587 8.3 4,508 Other NC milling machines 2,674 499,455 186.8 Other non NC milling machines 2,802 21,437 7.7 Machining centres 12,525 1,446,580 115.5 2,632 575,459 218.6 Multi-station transfer lines 599 402,767 672.4 591 927,364 1,569.1 Unit construction machines 174 230,404 1,324.2 NC sharpening machines 605 70,920 117.2 non NC sharpening 13,356 5,640 0.4 NC grinding machines other than flat-surface 1,556 339,069 non NC grinding machines other than flat-surface 2,775 55,375 Total metalworking machine tools 6,989,569 7,190,962 of which : NC machines 35,057 4,504,426 128.5 22,411 5,513,526 246.0 non-NC 1,368,713 2,485,143 1.8 79,084 977,472 12.4 other not specified 699,964 Percentage NC machines 64.4 76.7Source: International Statistics of Machine Tools 1996, CECIMO 1998.

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3.7 Implications for measuring the value of capital stock

Assuming we have three categories of machines:1. Advanced machining systems with a high degree of utilization (some 80% of

total output)2. Stand alone machines for odd jobs or tasks3. Idle old machines, which are practically never used.

In calculating the net stock from the present value of future income streams itwould be logical to attach a value close to zero to (3) and a very low value to (2).

4 INVESTMENT BEHAVIOUR AND ASSUMPTIONS ONDECAY, SERVICE LIVES AND MODE OF RETIREMENT

4.1 A criterion for investment decision - internal rate of return2

Text books in investment calculus usually tell us that companies decide toinvest in a certain object if the internal rate of return i exceeds a cut-off rate r, usuallythe long term interest rate. The internal rate of return i is calculated according toformula (1) below in which Yt denotes the value of the flow of income, Ut cost forrepair and maintenance, T the estimated length of service life which is determinedaccording to experience or from specifications given by the equipment suppliers, theremaining value S at the end of the service life and K total investment cost.

(1)( )

Y U

i

S

iKt t

tt

T

T

−+

++

− ==

∑ ( )1 10

1

The profitability of an investment calculated according to the internal rate ofreturn method is of course an important criterion but it is far from being the only one.Certain investments are strategic with implications for the companies’ long termdirection.3 Such investment as well as those which are strongly dependent on othercomplementary investments are determined partly on other criteria than the internalrate of return.

2 Asztély [4].

3 Investment can be classified according to the following breakdown: pilot investment, “showroom” investment, strategic investment, replacement investment, rationalization investment andexpansion investment.

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4.2 Flows of income and costs for maintenance and repair

The following five patterns will be discussed:

(1) Constant income flows (Y t) and constant repair and maintenance costs (U t) inthe period T, where T is the estimated techno/economic primary service life. Basedon assumptions about operating efficiency vis-à-vis future replacement investmentsand on how the particular investment object fits into the overall investment schemes,T is estimated or defined by the user company. It can also be estimated by theequipment/system suppliers, which guarantee certain operating efficiency, mean-time-between failures etc. for a given time period, provided regular maintenance is carriedout.

(2) During an initial period t’ of running-in, trouble shooting and adjustmentincome flows are raising. As from t = 0, income flows and repair and maintenancecost are constant until T (see figure 2. The concepts in figure 2 are also discussed insection 4.9 below).

Figure 2. Generalised illustration of income flows and service livesfor key manufacturing systems

Source: UN/ECE.

(3) Based on either (1) or (2) above, it is assumed that there is a flexibilitycomponent in the investment (which is understood to comprise of a majormanufacturing system; assembly lines for cars, car components, household equipmentetc.) which allow the system to increase its degree of utilization from two 8-hourshifts to three shifts, resulting in an increase in income flows to k*Yt as from t = T’and maintenance and repair costs h*Ut , where k >1 and h > 1. Usually T is thenreduced to T”.

Time

Output

TT’’T’ T2T1t’

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(4) Income flows, either immediately after the investment becomes operational orafter an initial adjustment period, are constant but repair and maintenance costs areraising.

(5) Income flows declines [(a) constant amount, (b) constant rate, (c) hyperbolic,or (d) decreasing rate] while repair and maintenance costs are raising (see Blades in[5]).

In text books and articles about capital stock measurements references areoften made to the case of the “ one hoss shay” and light bulbs. These referencesmight be inappropriate because there are now, in reality, no substantial investments,which can be characterised in that way. Besides, light bulbs are rather intermediateconsumption than capital goods.

4.3 Decay and ageing

Decay is a result of usage. It results in declining output compared with anidentical new machine. Ageing, whether a machine has ever been in operation ornot, results in increasing operating inferiority compared with the best available newmachine. The combination of decay and ageing of a particular asset of a certainvintage is its operating inferiority. While the operating inferiority of an asset, e.g. amachine system, increases by time the average yearly capital cost (annuity) decreasesas the cost is distributed on a longer time period (see figure 3 and the MAPI methodin annex 1).

In [6] Triplett says: “ Most capital goods, however, lose productiveness as theyage, and so exhibit some form of decay” . This statement seems valid only for somecapital goods. In the manufacturing industry, however, there are reasons to reject thishypothesis as concerns key capital goods used in the manufacturing process. A papermaking machine, for instance, tends to increase its output during the first years due toadjustment and fine tuning, after which output remains constant.

A general statement that “ replacement investment should take place only tomaintain output that is lost through output decay and retirement” , as is cited byTriplett [6], is probably valid only for certain type of assets, e.g. hand held tools andsuch simpler equipment. Instead, replacement investment it is more likely to occur atthe so called adverse minimum, that is where in time the sum of capital cost plusoperating inferiority reaches its minimum (see figure 3).

4.4 Input decay

In many articles and text books about capital stock measurement in the contextof national accounts it is often assumed there is an input decay. Undoubtedly thereare capital goods with input decay but several investigations point to the contrary.Present-day practises in industry also speak against such an assumption.

Figure 3. Average capital costs and operating losses of equipment

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as a function of the number of years in operation

Source: UN/ECE: Recent Trends in Flexible Manufacturing, New York 1996.

In a study on the machines in the Swedish engineering industries, Wallander[7] concluded that no significant increase or decrease in maintenance and repair costswith age could be determined. A previous study concerning cars had given the sameresult [8]. In a study by the Gothenburg School of Economics [9] concerning the useof 128 boring machines and 213 turning machines at the ABB plant in Västerås,Sweden, it was concluded that the repair and maintenance costs only increased by afew tenths of a percentage per year against an assumption of 2% per year. It shouldalso be remembered that this study was made in the early 1960's when machines weremostly operated on a stand alone basis - a breakdown would thus not have thecatastrophic effect as when they are integrated into systems and for this reason regularmaintenance and overhaul was not as urgent as now.

In a study on construction machinery (60 objects) in 1963, Nordgren [10]found that repair and maintenance costs seemed to be constant in relation to time ofusage. He also concluded, that there is a functional degradation in the sense that aftera certain time of usage they are “ assigned” easier tasks. In modern daymanufacturing this would imply that when a production system has been phased outfor a more efficient new system the individual machines in the old system can beassigned as back-up capacity in stand alone mode, used for small batch production(e.g. for prototypes).

Against these results can me mentioned the pioneering work carried out byTerborgh for the Machinery & Allied Products Institute (MAPI). In [11] Terborghassumed an average yearly increase in maintenance and repair costs of 5 to 10%during the first 8-11 years for textile machinery, buses, cars and trucks and for thefirst 20 years for machine tools, agricultural machinery and locomotives. It should

Average capital costsplus operating lossesOperating losses

Average capital costs

Adverseminimum

Minimum

Costs

Year

17

remembered, however, that these results refer to the period just after the war andpractices have changed radically since then.

When a company invests in a major manufacturing system, e.g. a computercontrolled assembly line for a certain range of computers, stoves, cars etc., then thatline is likely to operate in the range of 12-24 hours per day for, say 5 years, afterwhich it is scrapped, sold or the individual components reused in other parts of thecompany. Maintenance and overhaul is made at regular intervals in order to ensurethat the system as a whole and none of its components break down, which wouldresult in an enormous expense to the enterprise.

4.5 Output decay

It was argued above that for key manufacturing systems it is realistic toassume that they, after an initial period of adaptation and running-in operations,provide more or less constant output during their primary service life. For othertypes of equipment, often stand-alone or simple type of equipment for which theeconomic life time is more uncertain, it might be realistic to assume some outputdecay through wear and tear, lack of maintenance etc.

4.6 A process of continuous replacement investment, oftenaccording to plan

An individual investment (if it concerns a major investment object) can beanalysed in isolation only if it can be assumed that the company will never againundertake that kind of activity for which the investment was made. The normal case,however, is that the company wants to continue this particular activity. This impliesthat some times before (often years) the optimal or, which is often the case, thepredetermined time of usage has been reached, a decision has to be taken to replacethe first investment object. This second set of investments determines anotherreplacement investment and so on. If the company intends to continue its activityindefinitely we could talk about an indefinite chain of replacement investments. Ifthey had the same length of service life and operating performance (which they ofcourse do not have but assumed here in order to simply the formula) then the presentvalue of capital would be

(2)( ) ( )

( )( )

Y U

r

S

rK

r

rt t

t Tt

T T

T

−+

++

−

+

+ −=∑

1 1

1

1 11

(The variables in (2) are defined in section 4.1). A common method forcalculating when replacement investment should be done is the MAPI method (seeannex 1).

18

4.7 Desired capital stock

Fixed capital formation by firms is determined by expectations or assumptionsof certain levels of output and profit. These expectations change continuously whichimplies that in each period in time there is a desired level of capital stock, denoted Kt

*,which is normally different from the actual capital stock, denoted Kt . When Kt

* ≠Kt firms either invest or disinvest. As investment takes time this difference canusually not be eliminated in the same time period. The actual capital stock cantherefore be seen as an adjustment process of previous desired levels of capital stocks.This process of adjustment is conceptually elaborated in annex 2. It is also shownhow investment can be expressed as a function of the desired capital stock.

4.8 Most investment projects are interdependent

An investment in a particular machine system, for instance, is usuallydependent on existing stock of machines and layouts as well as on planned futureinstallations. When various investment projects are closely interactive then it is ofcourse difficult to estimate the income flows from individual investments. In suchsituations cost minimisation becomes the criteria for decisions.

4.9 Service lives for assets: primary and secondary service lives

For investment calculations as well as when estimating capital stocks, thevalue of T is of critical importance.

The service life of an investment T is not only dependent on input or outputdecay, when such are present, but also, and in particular, on the increasing operatinginferiority, compared to new and more efficient equipment. The service life of aparticular asset is also heavily dependent on the difference in time when it wasacquired, irrespectively if it was put into operation or not, and when a newimproved model was released. (A new 386 computer had a much shorter servicelife if it was bought 2 months before the release of 486 computers, compared to thesame computer acquired 2 years earlier.)

It has been argued in this article that for many types of equipment, theeconomic service life is predetermined. After the period T, the user company and/orthe equipment/system supplier cannot assure constant output and mean-time-betweenfailure without refurbishing the equipment or the whole system. T is also determinedby model changes, e.g. for cars, and/or estimated time for the so called “ adverseminimum” when competing investment objects become more profitable (see figure3).

What happens then after T (which will be called primary service life)? Thereare three alternatives:

(a) The equipment is scrapped or sold. In other words, it is permanently removedfrom the company;

19

(b) It is refurbished (e.g. change of drives, pumps etc.) and integrated into a newmanufacturing system with constant output. The primary service life is extended toT1 (see figure 2).

(c) The equipment is taken out of the manufacturing system and assignedcompletely new tasks, often carried out in stand alone mode for small batchproduction, e.g. prototype production, or as reserve capacity, training or just standingidle waiting to be scrapped. The equipment enters a secondary service life T2 - Tduring which the output is only a fraction of what is used to be. In all the examplesmentioned, it can no longer be seen as continuing its service life, in terms of thefunction for which it was bought.

5 A SUMMARY OF PRACTICES IN BUSINESSACCOUNTING

A survey of the practices in the valuation of gross and net capital stock wascarried out for some 20 large multinational corporations. The main conclusions of thesurvey of are summarised below:

Property, plant and equipment:Property, plant and equipment is carried at acquisition or production cost,

except for revaluation adjustments, less scheduled depreciation over their estimateduseful lives, taking into account any expected residual values. Revaluationadjustments are allowed under certain circumstances in accordance with accountingprinciples generally accepted.

Periodically, companies evaluate the carrying value of long-lived assets to beheld and used, including goodwill and other intangible assets, when events andcircumstances warrant such a review. The carrying value of a long-lived asset isconsidered impaired when the anticipated undiscounted cash flow from such asset isseparately identifiable and is less than its carrying value. In that event, a loss isrecognized based on the amount by which the carrying value exceeds the fair marketvalue of the long-lived asset. Fair market value is determined primarily using theanticipated cash flows discounted at a rate commensurate with the risk involved.Losses on long-lived assets to be disposed of are determined in a similar manner,except that fair market values are reduced for the cost to dispose.

Depreciation:Basically there are three types of depreciation methods: straight-line, declining

balance (normally accumulated depreciation of approximately two-thirds of thedepreciable cost during the first half of the estimated useful lives) and a combinationof the two (starting with the of use declining balance method of depreciation,switching to the straight-line method as soon as the latter results in higherdepreciation). Depreciation is computed based on estimated useful lives of theassets.

20

Nonscheduled depreciation is provided when an impairment of the value ofassets occurs or is anticipated. In order to increase the informative value of financialstatements, accelerated depreciation recorded in some companies’ financial statementsto increase tax-deductions has not been recognized in the consolidated financialstatements.

Depreciation can be done according to plan and for tax purposes. Companiesnormally claim the maximum depreciation deduction allowable for tax purposes. Thedifferences between depreciation for tax purposes and planned depreciation is notedas depreciation in excess of plan. Depreciation in excess of plan is reported asappropriations, accumulated extra depreciation, which is included in untaxed reserves.

Intangible assets:Research and development costs are normally expended in the financial period

during which they are incurred, except that some companies for certain developmentcosts which are capitalized when it is probable that a development project will be asuccess, and certain criteria, including commercial and technological feasibility, havebeen met (here business accounting has gone one step further than SNA 93).Capitalized development costs are amortized on a systematic basis over their expecteduseful lives.

Software: Costs related to the conceptual formulation and design of licensedprograms are normally expended as research and development. Costs incurredsubsequent to establishment of technological feasibility to produce the finishedproduct are capitalized. The annual amortization of the capitalized amounts is thegreater of the amount computed based on the estimated revenue distribution over theproducts’ revenue-producing lives, or the straight-line method. Periodic reviews areperformed to ensure that unamortized program costs remain recoverable from futurerevenue. Costs to support or service licensed programs are charged against income asincurred, or when related revenue is recognized, whichever occurs first.

Goodwill, representing the excess of purchase price over the fair value of nettangible assets at the date of acquisition of businesses purchased, is normallyamortised on a straight-line basis.

Is capital stock estimated on the basis of business accountingarbitrary because depreciation is done for tax purposes?

This was certainly valid some years ago and might still be valid for smallenterprises and for the low-end of medium-sized enterprises. For most medium-sizedand large companies the depreciation of capital today, at least as concernsdepreciation according to plan, seems to follow closely the true economic life lengthof assets.

It can be argued that as assets which are already fully depreciated and not yetscrapped are not included the valuation the stock, it will in fact be underestimated. Ifthe degree of utilization pattern for assets of different vintages follow what wasdescribed in previous sections of this paper, then it is likely that this underestimationis negligible.

21

Given that the allowed depreciation schemes are much more flexible todaythen before, it would be worth investigate if the net value of the assets of a companyis not more correctly set by internal financial experts than that by using PIM andgeneral assumptions about asset lives.

Theoretically, financial experts in companies are continuously involved in thefollowing decision process:

(a) If the market value of a piece of equipment, or rather a system or a plant, ishigher than the present value of the net income of future revenues and cost streams ofthe system then the system or the plant is sold. The company would then go into anew business area.

(b) If the present value of the net income of future revenues and cost streams ofthe present system is lower than that of a new system then the former is sold,scrapped or retired. Normally this process of phasing in and phasing out new and oldsystems are, as was described in previous sections of this paper, planned years ahead.Almost at the time as when a system is installed, it is decided how long it will be inuse.

The net value of assets in business accounting should be close to what theassets would be worth on the market.

What capital stock measure should be used?From whatever analytical point of view, the gross capital stock measure,

regardless if it is measured at constant replacement cost, current replacement cost orhistorical cost, is from analytical point of view rather meaningless. If a large share ofequipment do not provide declining services due to deterioration (but rather providingconstant output for the planned service life) or if it is not a one-hoss shay, then theproductive capital stock measure is also rather meaningless. This leaves us with thenet capital stock. Here analytical reasons can be found. Companies need to knowthe net value of assets in order to calculate profitability. In fact the whole businessplanning is based on detailed analysis of the profitability of various combinations ofcapital assets and labour (there is not one given production organization but aninfinite number each having a certain capital structure, combined with a certain labourstructure).

Also from macro economic point of view, i.e. concerning estimates ofproduction functions, factor productivities etc., it is the net capital stock that makessense.

In this note, a hypothesis is put forward that the net stock as calculated frombusiness accounting gives a more accurate estimate of the true market value than thatcalculated by using PIM and general assumptions about asset lives and mode ofdepreciation.

22

6. CONCLUSIONS

From both the theoretical and the empirical point of view, PIM seems to be avery uncertain method for measuring the capital stock. The main causes ofuncertainty are the doubt about total length of service life and relative utility over theperiod. The only way forward therefore is to increasingly supplement PIM by (a)regular direct observations of asset lives and asset utility, and (b) much more researchon how equipment is actually used in industry.

The focus on equipment in this paper is, as was shown above, motivated bythe fact that they account for the order of 90% of total investment in industry. Withinthe category "equipment" there is much heterogeneity. Machines from one and thesame machine category can have completely different service lives and degree ofutilization, depending how they are integrated into the production process. It isnecessary to have much better understanding of functional breakdown of equipmentand their mode of utilization. Such understanding should be captured in conjunctionwith direct observations based on sampling techniques. A wealth of information asconcerns service lives is also available in annual reports of the big internationalcorporations.

23

References:

[1] Australian Bureau of Statistics: Direct Measurement of Capital Stock, OECD1998 (Second Meeting of the Canberra Group on Capital Stock Statistics).

[2] Diewert, W.E.: Productivity Measurement Problems , OECD 1998 (SecondMeeting of the Canberra Group on Capital Stock Statistics).

[3] ECE: Recent Trends in Flexible Manufacturing, New York, 1986.[4] Asztély, S.: Investeringsplanering, Uddevalla, 1968 {Investment planning - in

Swedish}.[5] Blades, D.: Measuring depreciation, OECD 1998 (Second Meeting of the

Canberra Group on Capital Stock Statistics).[6] Triplett; J.: Dictionary of Usage on Capital Measurement, OECD 1998

(Second Meeting of the Canberra Group on Capital Stock Statistics).[7] Wallander, J.: Verkstadsindustrins maskinkapital, Stockholm 1962{ The

machine capital in the engineering industries - in Swedish}.[8] Wallander, J.: Studier i bilismens ekonomi, Stockholm 1958 {Studies in the

economy of motoring - in Swedish}.[9] Kiviaed, J.: Maskinålderns inverkan på reparationskostanderna, 1960 {The

influence of the age of machines on the cost of repair and maintenance - inSwedish}.

[10] Nordgren, S.: Några faktorer av betydelse för en maskinparks åldrande ochdöd, 1963 {Some factors of importance for the ageing and death of amachine stock - In Swedish}.

[11] Terborgh, G.: Dynamic Economic Policy, New York 1949.

24

ANNEX 1Traditional methods for investment calculations

There are many methods which may be used in investment appraisals and theselection of the one applied depends on the size and type of investment object, as wellas on that aspect - e.g. profitability versus cash flow - to which the enterprise givespreference.

This section will discuss the methods most commonly used. These methods,which are well-established in industry, will be presented in their basic forms, fromwhich it is possible to derive several variants depending on the factors, which areincluded in the analysis.

(a) The pay-back method is defined as the time period needed in order to recoverthe original investment cost through the net profit generated by theinvestment. This method, which is simple to use, is mainly applied to make apreliminary financial assessment of investment proposals and to rank them. Italso serves as a criterion for deciding on smaller inexpensive investments.Many enterprises specify that investment for which the capital outlay is lessthan a certain amount need only be appraised with the pay-back method.

The major shortcomings of the pay-back method are, first, that it does notconsider income generated after the pay-back period and, secondly, that itdoes not measure the profitability of an investment but only its liquidityimplications .4

After installation, a computer-controlled manufacturing system frequentlyrequires up to six months or even longer before the full planned operation rateis reached. Furthermore, the net profit resulting from the system oftenincreases continuously over the years owing to successive adjustments of thesystem, thus permitting the realization of the full advantages of its flexibility.In this context, the pay-back method would not be a suitable approach inattempting to justify the investment. It would only reveal that there might beliquidity problems, which, as may be deduced from the above discussion, areinherent in the method.

4

If the cash budget of an enterprise shows the onset of liquidity problems in thenear future, then only projects with a rapid capital return will be considered, whilemore profitable - but long-term - projects might be rejected. In this situation, the pay-back method is a very useful tool.

25

(b) The return-on-investment (ROI) method is defined as the ratio of net profitduring a "normal" year of full production to the total capital outlay of theinvestment. It is usually expressed in percentage terms.

The ROI method is mainly applied for calculating the profitability of smallerinvestment objects having more or less equal yearly returns over their entireeconomic life. Just as the pay-back method, it is a useful tool for making apreliminary evaluation of competing projects.

(c) The net-present-value method takes into account the cash flows generatedover the whole economic life of a project as well as the timing of these cashflows. The net present value (NPV) is calculated as the sum of the discountedyearly differences between cash inflows and cash outflows generated duringthe economic life of the project. The discount rate (r) is usually set to beequal to the actual rate of interest on long-term capital.

If the NPV is equal or larger than zero, the profitability of the investment isequal to or higher than the target rate of return (r). In that case the investmentproposal has passed the profitability test.

(d) The internal-rate-of-return (IRR) method resembles the NPV method. Inthe IRR method a calculation is made of that internal rate of return - denoted(i) - at which the net present value is zero.

The IRR method gives a measure of the profitability of the investment. If it isequal to or higher than (r), the profitability is higher than or equal to the cut-off value set up by the enterprise.

(e) The net-present-value method adjusted for capital utilization .

See ECE [3] for presentation and explanation of the formula. This method ofinvestment calculation is used in connection with large projects, e.g. newplants, large machine investments for expanding capacity and when newproducts are to be launched and new machines installed for that purpose.

(f) The MAPI method was developed in the beginning of the 1950s by theMachinery and Allied Products Institute in the United States. The MAPImethod, which is used mainly for replacement investments, is based on thesame principle as the net-present-value method adjusted for capital utilization.According to the MAPI method, decisions regarding the replacement ofexisting machines and equipment should be based on their age. The basicquestions to be answered are:

- When should existing equipment be replaced?

- What will it cost to use the existing equipment another year?

The MAPI method assumes that existing equipment has an "operatinginferiority" vis-à-vis new equipment (e.g. because of technological progress),

26

which results in continuously increasing operating losses of the existingequipment. These losses are, however, compensated partly by the fact that theaverage capital cost (calculated as the net present value and amortized over agiven number of years) of existing equipment decreases with age. Thatnumber of years of operation where the sum of operating loss and capital costis at the minimum is called "adverse minimum" (see figure 3). This is theoptimum time of usage.

In order to gauge whether or not an existing piece of equipment should bereplaced, the following steps are prescribed by the MAPI method:

1. Identify all those pieces of equipment which could replace the existingone (in the MAPI terminology the latter is called "the defender").Select the one which at present is the best (referred to as "thechallenger").

2. Decide whether or not the challenger should replace the defender.

3. Calculate the present average capital cost and operating loss of thedefender.

4. Calculate, by use of specially developed MAPI-nomograms, theadverse minimum of the challenger.

5. Replace the defender if its adverse minimum is higher than that of thedefender.

The MAPI method has been further developed in order to deal with situationswhen completely new investments are to be appraised. This extended variantof MAPI makes it possible to appraise not only profitability but also theranking of individual projects, which is accomplished by calculating an"urgency rating".

27

ANNEX 2Notes on the theory for investment behaviour

In each point in time it is assumed that there is a desired level of capital stockK*

t . This is often different from the actual capital stock Kt. If K*

t >Kt then a decisionmight be taken to add to the existing stock of capital.5 Investment takes time and thedifference can usually not be eliminated in the same time period. The actual capitalstock is therefore an adjustment process of previous desired levels of capital:

(1) Kt = w0 K*

t + w1 K*

t-1 + w2 K*

t-2 + ............ = w(L) K *

t

where L is a lag operator. There is also a desired composition of capital stock

(2) K*

t = ∑ pi k*

i,j where k*

i,j is the desired amount of capital of type i withthe vintage j (or estimated remaining usage,recommended or planned).

Net investment can be defined as

(3) IN

t = It - IR

t = Kt - Kt-1

where IN

t is net investment, IR

t is replacement investment and It is gross investment.Equations (1) and (3) give

(4) It = w(L)(K*

t - K*

t-1 ) + IR

t

The desired level of capital stock and the adjustment to that level is derivedfrom the assumptions that entrepreneurs are maximising the present value of futureprofits. Assume that the desired level of capital stock (optimal from point of view ofprofit maximizing) is a given level of output

(5) K*

t = β Xt

Then (4) can written as

(6) It = w(L)β (Xt - Xt-1 ) + IR

t

If w(L) is a Koyck-type of distributed lag, which implies that wi = (1-λ)λi fori=0,1,2,... and 0<λ<1, then w(L) = (1- λ)/(1-λL) and then

(7) It = λ (It-1 - IR

t-1 ) + (1 - λ )(K*

t - K*

t-1 ) + IR

t

5 R.F. Wynn & K.Holden: An introduction to Applied Econometric Analysis, London 1974.