Unit of Production Depreciation Method

The unit of production depreciation method is a way to allocate the cost of an asset based on its usage rather than time.

What is Unit of Production Depreciation Method?

The unit of production depreciation method is a way to allocate the cost of an asset based on its usage rather than time. This method is particularly useful for assets whose wear and tear is more closely related to the amount they are used rather than the passage of time.

For example, a machine used in a factory might depreciate more with higher usage, so unit of production depreciation provides a more accurate reflection of its expense.

The unit of production depreciation method is designed to match the cost of an asset with the revenue it generates based on its actual usage. Here’s a detailed breakdown of the method:

Steps to Apply the Unit of Production Depreciation Method

1. Determine Initial Cost and Residual Value
   • Initial Cost: This is the purchase price of the asset, including any costs necessary to bring it into its intended use (e.g., installation, transportation).
   • Residual Value: This is the estimated amount the asset will be worth at the end of its useful life, after accounting for wear and tear. It’s also known as salvage value.
2. Estimate Total Production Capacity
   • This involves estimating the total number of units the asset is expected to produce or the total hours it will operate over its useful life. This could be:
     • Number of units produced (e.g., a machine’s output)
     • Total hours of operation (e.g., a vehicle’s engine hours)
     • Total miles driven (for vehicles)
   • Accurate estimation of production capacity is crucial because it directly affects the calculation of depreciation.
3. Calculate Depreciation Expense per Unit
   • To find the amount of depreciation allocated to each unit of production, you need to determine the depreciable cost. This is the cost of the asset minus its residual value.
   • Depreciable Cost = Initial Cost – Residual Value
   • Next, divide the depreciable cost by the total estimated production capacity.
     • Depreciation Expense per Unit= Depreciable Cost/ Total Production Capacity
4. Apply Depreciation Expense to Actual Production
   • Once you have the depreciation expense per unit, you multiply it by the actual number of units produced or hours used during the accounting period.
     • Depreciation Expense for Period=Depreciation Expense per Unit × Actual Units Produced

Example

Suppose a company buys a machine for $100,000 and estimates that it will have a residual value of $10,000. The machine is expected to produce 1,000,000 units over its useful life.

1. Calculate Depreciable Cost: Depreciable Cost=$100,000−$10,000=$90,000
2. Calculate Depreciation Expense per Unit: Depreciation Expense per Unit=$90,000/1,000,000 units=$0.09 per unit
3. Apply Depreciation Expense to Actual Production: If the machine produces 50,000 units in a year: Depreciation Expense for the Year=$0.09 per unit×50,000 units=$4,500

Advantages

• Accuracy: It provides a more accurate expense allocation for assets that are used more or less intensively in different periods.
• Matching Principle: It better matches expenses with the revenue generated by the asset in each period.

Disadvantages

• Estimation Challenges: It relies on accurate estimates of total production capacity, which can be difficult to predict.
• Complexity: Calculations can be more complex compared to methods like straight-line depreciation, especially when dealing with varying production levels.

In summary, the unit of production depreciation method aligns depreciation expense with actual asset usage, providing a clear reflection of an asset’s wear and tear based on its operational output.