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What Is 'Amortization'?

Amortization is the process of spreading the cost of a resource investment over its estimated useful life. Amortization can help you determine if a potential investment is worth it.

Amortization is a prediction: it depends on an accurate assessment of useful life. If you're wrong in your assessment, your assesment may be misleading.

Using Amortization is smart, but remember it's a prediction, so act accordingly.

Josh Kaufman Explains 'Amortization'

You've created the toy of the century: a stuffed animal that looks and acts exactly like a real dog, but doesn't need to be fed, watered, or let out in the middle of the night.

Kids go absolutely crazy for your Prototype, and parents are already throwing their credit cards at you to make sure they get one the minute it's available. It's a foregone conclusion that you'll sell millions.

There's only one problem: in order to make these faux dogs affordable, you'll have to tool up a major factory, which will cost at least $100 million. Your bank account has nowhere near $100 million in it-that's a heck of a lot of money.

How can a business afford something as expensive as a factory and still make money?

Amortization is the process of spreading the cost of a resource investment over the estimated useful life of that investment.

In the case of the faux dog factory, let's assume the factory is capable of producing 10 million units during its useful life. On a per-unit basis, that brings the cost-per-unit of the factory down to $10. If you sell every unit you produce for $100, that's a very healthy Profit Margin.

Amortization can help you determine whether or not a big expense is a good idea. As long as you have a reliable estimate of how much it will cost and how much you can produce, Amortization helps you figure out whether or not investing large amounts of Capital makes sense.

For example, a book designer may choose to purchase a copy of Adobe InDesign, the software commonly used by professionals to typeset books. Compared to most software packages, InDesign is pricey: a single-user license costs $700. Is it worth it? The answer depends on how many books the designer uses the software to typeset.

If they never complete a project, they've wasted their money. If they use it to typeset ten books for $1,000 each, they've earned $10,000 by making a $700 investment-not bad at all. Amortized across ten projects, the cost of the software is only $70 a project, or less than 1% of the revenue the project brings in.

The designer's credit card may hurt when the purchase is made, but the tool offers the ability to earn more money than would be possible otherwise, Amortization depends on an accurate assessment of useful life, which is a prediction.

Amortization doesn't work well if you don't sell what you produce or if your equipment wears out more quickly than expected. Predictions are tricky business-if you're wrong in your estimate, your investment may cost a lot more on a per-unit basis than you originally assumed.

Crocs makes funny-looking rubber shoes. After becoming an unexpected hit, the company ramped up for huge volumes: they opened a factory in China and started producing millions of shoes in the expectation that they'd continue to sell each unit produced.

As it turned out, Crocs were a fad-sales plummeted, and the company was stuck with lots of expensive manufacturing capacity and huge amounts of inventory it couldn't sell. Amortization couldn't save the company from careening toward bankruptcy.

Using Amortization to figure out whether or not a big investment is worth it is smart-just remember you're making a prediction, and proceed accordingly.

Questions About 'Amortization'

• Does your business require expensive investments?
• By making this investment, can you do things you otherwise couldn't?
• Assuming your estimates are accurate, what's the per-unit amortized cost of the investment?

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"Before every action, ask yourself: will this bring more monkeys on my back? Will the result of my action be a blessing or a heavy burden?"

Alfred A. Montapertauthor of The Supreme Philosophy of Man: The Laws of Life

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