Depreciation of assets is an important accounting concept. Most businesses understand depreciation from a tax perspective but it’s equally important in the accounting world. Depreciation reflects the cost of usage of assets and needs to be taken into consideration when presenting profit or loss and performance of a company. There are many ways of depreciating assets and the unit of production is one of them. This article will be digging deeper into this depreciation method.
Units of Production [Defined]
Time is usually a key component of how to calculate depreciation of an asset (as seen in the straight line or the accelerated methods). With units of production, that’s not the case. The name of the method is a pretty good giveaway, this method of depreciation depends on the number of units produced by an asset during a financial period.
Calculating depreciation with this method makes a lot of sense since it’s relying on how much an asset is used instead of relying on time passed which can be less accurate if an asset hasn’t been used at the same capacity from one year to another. It’s very fitting for manufacturers.
What’s Special With Units of Production Method?
Units of production rely on the production level of an asset. Using this method can result in very different depreciation expenses between financial periods; heavy usage will result in high depreciation expenses and minimal usage will result in low depreciation expenses.
When a company increases production for a specific financial year, it generally means the related sales are increasing which creates higher demand. With units of production, increasing production will also increase the depreciation expense since the asset is being used more frequently. In accounting, one of the main goals is to paint an accurate picture of a company’s financial situation. The units of production method help reflect the accurate picture of a company where revenues are dependent on production. The depreciation cost will be increasing along with usage and revenue rather than a timeline-based depreciation method where the depreciation expense has no relation with the usage of the asset.
This method can show a very detailed depreciation expense for an asset where management can calculate the depreciation as soon as the asset is in production.
An asset will begin depreciating as soon as it starts producing units and will reach its end of life at the soonest between when management estimates it can no longer produce any more units or when the cost has been recovered in its entirety.
Read More:
How to Calculate Depreciation Expense: Straight Line Method
Formula [Units of Production]
This depreciation method is based on the key component of units produced by an asset. Unlike the timeline-based depreciation methods where management determines the useful life of an asset based on number of years, this method is a little less straightforward. Let’s look at a step-by-step in how we determine depreciation with units of production:
- Unit Production Rate: A first step in calculating depreciation expense under the units of production method is to determine what is the unit production rate of an asset.
This is calculated using the following formula:
(Original cost of the asset – salvage value of the asset)
Estimated unit production capacity
Where:
- Original cost means the purchase price of the asset including any delivery or setup costs.
- Salvage value means the expected value of the asset at the end of its useful life.
- Estimated unit production capacity means the number of units expected to be produced by an asset throughout its useful life. For example, this can be based on industry data or management experience with similar assets.
- Calculate depreciation expense using the unit production rate: Once the unit production rate is determined, the depreciation expense is easy to calculate.
We simply use the following formula:
Unit Production Rate (from step 1) x units produced by the asset
Based on the formula above, depreciation expense can be calculated as frequently as desired by management as long as the information regarding the total units produced by the asset is available.
When to Use Units of Production?
Not all companies can use the units of production method to calculate depreciation. This is most appropriate for companies owning equipment or machinery for producing goods where each item produced can cause wear and tear to the assets.
Further, this method requires more calculation and estimation than the other types of depreciation methods. A company using this method of depreciation needs to calculate the depreciation expense every year since it changes depending on the level of production. You can’t simply pre-determine an automated entry to account for depreciation as you would with timeline based depreciation methods since you cannot predict the level of production for future years. This method is also not accepted for tax purposes so using units of production to determine depreciation will need a conversion to the tax depreciation expense.
A little more effort is required with this method but for companies owning machinery and equipment used in production, it’s well worth the extra mile simply because this method gives a true picture of the costs involved for using an asset. For management, this is helpful for budgeting and determining profitability on items sold.
Read More:
Double Declining Balance Method Formula (How to Calculate)
Units of Production : Example
Let’s look at the example of Carl’s Construction Company (“CCC”). Say CCC produces tiles using a specialized machinery called “TilesPro”. CCC acquired TilesPro for $25,000 and based on industry data, the salvage value of TilesPro is $3,000. The sellers of TilesPro indicated that this machine is expected to be able to produce 100,000 tiles during its useful life. For the year ended 30 December 2023, CCC produced 16,000 tiles. How much is the depreciation expense for the year ended 2023 using the units of production method?
We will calculate the depreciation expense using the steps learned above:
Step 1: We calculate the unit production rate.
(Original cost $25,000 – salvage value $3,000) = $0.22
Estimated production capacity 100,000
The depreciation rate is basically $0.22 per tile produced.
Step 2: We calculate the depreciation expense for 2023 using the unit production rate.
Unit production rate $0.22 x units produced in 2023 16,000 = $3,520
For 2023, the depreciation expense would be $3,520.
Now let’s say in 2024, CCC produced 35,000 tiles. What would be the depreciation expense for 2024?
We would simply multiply the unit production rate of $0.22 with the 35,000 tiles produced, which equals a depreciation expense of $7,700. This shows how the depreciation expense can fluctuate between the years.
Final Thoughts: Units of Production
Units of production is a depreciation method that relies on how heavily an asset is used by a company versus other standard depreciation methods that usually relies on a timeline. This is well suited for companies owning equipment and machinery that accumulates wear and tear depending on production. It’s a precise method of calculating depreciation but it’s a more laborious method. A company should determine whether the extra effort is worthwhile before adopting this depreciation method.
