How to Calculate Depreciation: Methods & Formulas

Fundamental Components for Depreciation

Depreciation in accounting allocates a tangible asset’s cost over its estimated useful life. This process systematically expenses the cost as the asset generates revenue. Accurate depreciation calculation requires understanding several fundamental components.

Asset Cost

Asset cost is the total amount a business incurs to acquire and prepare an asset for its intended use. This includes the purchase price and additional expenditures like shipping, installation, testing, and setup fees. For example, a machine’s cost includes its purchase price, freight charges, and installation fees.

Salvage Value

Salvage value, or residual value, is the estimated amount a company expects to receive from selling or disposing of an asset at the end of its useful life. For instance, an old delivery truck might still have scrap or trade-in value. Salvage value can sometimes be zero if the asset has no remaining worth.

Useful Life

Useful life is the estimated period an asset is expected to be productive and generate economic benefits. This estimate can be expressed in years, units of production, or other usage measures. For example, machinery might have a 10-year useful life or be expected to produce a certain number of units. This is the period a specific business expects to use the asset, which may differ from its physical lifespan.

Straight-Line Depreciation Calculation

The straight-line method is a common approach that distributes an equal amount of depreciation expense over each period of an asset’s useful life. This method assumes the asset provides equal benefit throughout its service period and is suitable for assets losing value consistently over time.

The formula for straight-line depreciation is:
Annual Depreciation Expense = (Asset Cost – Salvage Value) / Useful Life

Consider a company that purchases equipment for $100,000. This equipment has an estimated useful life of 5 years and a salvage value of $10,000. To calculate the annual depreciation, first determine the depreciable base by subtracting the salvage value from the asset cost, which is $100,000 – $10,000 = $90,000. Then, divide this depreciable base by the useful life of 5 years. The annual depreciation expense will be $90,000 / 5 years = $18,000. This $18,000 expense is recorded annually for five years.

Declining Balance Depreciation Calculation

The declining balance method is an accelerated approach, recording higher depreciation expenses early in an asset’s life and lower expenses later. This method suits assets that lose value or productivity quickly in initial years, like technology or vehicles. The double-declining balance method is a common variant, applying twice the straight-line depreciation rate. It applies a fixed depreciation rate to the asset’s book value each year. The formula calculates the straight-line rate (1 / Useful Life) and doubles it, applying this accelerated rate to the asset’s beginning book value annually.

For example, if equipment costs $50,000 with a 5-year useful life and a $5,000 salvage value, the straight-line rate is 1/5, or 20%. The double-declining balance rate would be 20% x 2 = 40%. In Year 1, depreciation is $50,000 (book value) x 40% = $20,000, leaving a book value of $30,000. In Year 2, depreciation is $30,000 x 40% = $12,000, resulting in a book value of $18,000.

This process continues, but depreciation stops when the asset’s book value reaches its salvage value. For instance, in Year 3, $18,000 x 40% = $7,200, leaving a book value of $10,800. In Year 4, $10,800 x 40% = $4,320, which would bring the book value to $6,480. Since the salvage value is $5,000, the depreciation in the final year (Year 5) would be limited to $1,480 ($6,480 – $5,000) to ensure the book value does not fall below the salvage value.

Units of Production Depreciation Calculation

The units of production method calculates depreciation based on an asset’s actual usage or output, not the passage of time. This approach suits assets whose wear and tear directly relate to their activity, such as manufacturing machinery or vehicles. It allows for higher depreciation in periods of high usage and lower expense in periods of low usage, better matching the asset’s cost to generated revenue.

The calculation involves two steps. First, determine the depreciation rate per unit by dividing the depreciable cost (Asset Cost – Salvage Value) by the total estimated units the asset will produce. Second, multiply this rate by the actual units produced during the period to find the depreciation expense.

For illustration, assume a machine costs $50,000, has a salvage value of $5,000, and is expected to produce a total of 90,000 units over its useful life. The depreciable cost is $45,000 ($50,000 – $5,000). The depreciation rate per unit is $45,000 / 90,000 units = $0.50 per unit. If the machine produces 15,000 units in its first year, the depreciation expense for that year would be $0.50 per unit x 15,000 units = $7,500.

Sum-of-the-Years’ Digits Depreciation Calculation

The sum-of-the-years’ digits (SYD) method is another accelerated depreciation method, resulting in higher expenses in an asset’s earlier years. This method recognizes that assets may be more productive or lose more value initially, systematically allocating a larger portion of the cost to these beneficial periods.

To apply the SYD method, first calculate the sum of the years’ digits. This can be done by adding the digits of the asset’s useful life (e.g., for a 5-year life: 5+4+3+2+1 = 15) or using the formula n(n+1)/2, where ‘n’ is the useful life in years. Each year’s depreciation fraction is then determined by dividing the remaining useful life by this sum, starting with the highest number.

The annual depreciation expense is calculated by multiplying this fraction by the asset’s depreciable cost (Asset Cost – Salvage Value). For instance, consider an asset costing $60,000 with a $10,000 salvage value and a 4-year useful life. The depreciable cost is $50,000. The sum of the years’ digits is 4+3+2+1 = 10. In Year 1, the fraction is 4/10, so depreciation is $50,000 x (4/10) = $20,000.