How to Calculate Units of Production Depreciation

Depreciation is an accounting process that allocates the cost of a tangible asset over its useful life. This systematic expensing reflects the asset’s wear and tear or obsolescence as it contributes to generating revenue. The units of production method directly links an asset’s depreciation to its actual usage or output, rather than just the passage of time. This approach provides a more accurate representation of an asset’s diminishing value for machinery or equipment whose utility is tied to the volume of work they perform.

Key Components of Units of Production Depreciation

To calculate depreciation using the units of production method, three foundational pieces of information are necessary. First is the asset’s cost, which includes the initial purchase price and all expenditures to get the asset ready for its intended use, such as shipping fees, installation charges, and testing costs.

Second is the salvage value, the estimated residual worth of the asset at the end of its useful life, representing the amount a company expects to recover from selling or disposing of it. The difference between the asset’s cost and its salvage value is the total amount depreciated over its operational life.

Finally, the estimated total units of production refers to the total output or activity the asset is anticipated to generate throughout its useful life. This could be measured as items produced, miles traveled, or hours flown. This estimate defines the asset’s overall productive capacity.

Calculating the Depreciation Rate Per Unit

The first step is to determine the depreciation rate per unit. This rate represents the portion of the asset’s depreciable cost allocated to each unit of output or activity. The formula is: (Asset Cost – Salvage Value) / Estimated Total Units of Production.

For example, if a machine costs $500,000, has an estimated salvage value of $20,000, and is expected to produce 240,000 units in its lifetime, the depreciable amount is $480,000 ($500,000 – $20,000). Dividing this by the 240,000 estimated units yields a depreciation rate of $2.00 per unit. This per-unit rate remains constant over the asset’s life, providing a consistent measure for each unit produced.

Determining Annual Depreciation Expense

The next step involves calculating the actual depreciation expense for a specific accounting period, such as a year. This is achieved by multiplying the depreciation rate per unit by the actual number of units produced during that period. This method ensures the depreciation expense directly correlates with the asset’s real-world usage; higher utilization incurs higher depreciation, while lower usage results in less.

Consider the machine from the previous example with a depreciation rate of $2.00 per unit. If in its first year of operation, the machine produces 10,000 units, the annual depreciation expense would be $20,000 ($2.00 per unit x 10,000 units). If in the second year, production increases to 50,000 units, the depreciation expense for that year would be $100,000 ($2.00 per unit x 50,000 units). This fluctuating expense accurately reflects the asset’s contribution to revenue generation based on its activity.

Tracking Depreciation Over the Asset’s Life

The annual depreciation expense is consistently applied to the asset throughout its operational life. Each year, the calculated depreciation is added to the asset’s accumulated depreciation account, a contra-asset account that reduces the asset’s book value on the balance sheet. This process continues until the asset’s book value (its cost minus accumulated depreciation) reaches its estimated salvage value.

This method effectively allocates the asset’s cost over its productive capacity rather than a fixed time frame. It ensures that the cost of using the asset is expensed in proportion to the benefits derived from its actual use, aligning with the accounting principle of matching expenses with the revenues they help generate.