Question

What is the capital consumption allowance?

Short answer

Capital consumption allowance, also known as depreciation, is the money that companies set aside each year to replace worn-out or obsolete assets thus ensuring continued productivity.

Step-by-step solution

Defining Capital Consumption Allowance

The capital consumption allowance, also known as depreciation, is the amount of money that businesses set aside in order to replace worn-out or obsolete assets, like machinery, equipment, or buildings. It's an accountancy related idea that tries to spread the cost of an asset over its useful life.

Explaining its significance in economics

In economic analysis, capital consumption allowance represents the annual depreciation charge necessary to bring the nation's capital stock back to its value at the beginning of the year. This is to ensure that the capital resources of the business or the economy does not degrade over time due to physical wear and tear or even obsolescence. This allows for consistent productivity and economic output.

Practical application

For example, imagine a company buys a machine that has a useful life of 10 years and costs $100,000. Each year, the company would set aside $10,000 (the cost of the machine divided by its useful life) in its capital consumption allowance. This ensures that when the machine has depreciated fully at the end of its working life, funds will be available to replace the machine, therefore maintaining the productivity of the company.