Unit of Production Method Definition | How Depreciation is Calculated

If you are a business owner with depreciating assets, you’ll want to be familiar with the term, unit of production method, or the units of activity method. You’ll likely overhear this type of language when dealing with your accountant, as it is commonly used for bookkeeping or tax purposes

While there are several ways of calculating an asset’s depreciation value, the unit of production method is particularly useful when an asset’s value is better defined by the number of units it produce, versus the number of years it is used. 

A good example would be manufacturing machinery or a t-shirt printing machine. What do these items have in common? Each one of them has a pretty well-defined estimate on the practical usage to be expected during a period of time. 

Before we go too far, let’s review a list of important key terms you’ll want to understand. 

Depreciation 

The decrease in the value of an asset over its lifetime is known as depreciation. In accounting terms, that means spreading the cost of an asset over a specific period of time.

Salvage Value 

Salvage value is an estimate determined by the book value after the depreciation of an asset is complete. It defines your asset’s value based on what you can expect to receive for selling the asset at the end of its useful life. 

Cost Basis

Cost basis is usually the purchase price or the total amount originally invested, including commissions or fees. 

Depreciable Cost 

The depreciable cost refers to the cost basis of the asset, subtracted by the estimated salvage value at the end of its useful life.

Depreciation Expense 

Depreciation expense is a calculation of the portion of your asset that has been considered consumed in the current period. 

Now that we have gone over some of the important key terms, we can start to explain the formula used for the unit of production method and how it may be useful to your business.

This method of calculating the value of an asset’s depreciation is different from other methods that determine the life of an asset-based on the number of years it has left as its useful life. Other methods such as straight-line (the most commonly used method for calculating depreciation) or accelerated methods use time-based measures to show levels of depreciation. 

The unit of production method measures the depreciation of an asset where the “wear and tear” is based on how many “units” they have produced in a period of time, such as with manufacturing or processing equipment. During a year with higher volume, you’re able to show greater depreciation for that asset. In turn, depreciation will be less during times of low usage. 

This method can be time-consuming, so it’s typically used for more expensive assets because it requires that you track usage. Most tangible assets (besides land) that are used to operate a business can be used to show depreciation, such as buildings, vehicles, machinery, and equipment. The unit of production method can be a helpful tool to track profits and losses for your business using those types of assets. 

It should be note  and unlesss you request exclusion, you are not able to use this method for tax deductions. The Internal Revenue Service (IRS) does allow depreciation to be used for income tax deduction to ensure a business can recover the cost of certain assets, but it has rules and regulations on how you can go about it. Additionally, on their website, you can find a “useful life” table for various classes of assets, which is used to determine its tax depreciation for assets. 

If you think the unit of production method is your best option, you have to elect exclusion from the modified accelerated cost recovery system (MACRS) for the tax year the asset is originally acquired. MACRS is the standard method set by the IRS to depreciate assets for tax purposes. This method is useful when you need to show depreciation over longer periods of time. Faster acceleration allows you to deduct a greater amount in the first few years of an asset’s life and proportionately less later. 

It is not required to use a single depreciation method for all of your business assets. However, it is recommended to consult with an accountant and keep your methods consistent.

How Depreciation is Calculated

Depreciation is actually quite simple to calculate using the unit of production method. Now that you are familiar with the terms, you’ll simply want to plug in the correct criteria.

Before you begin, you will need to gather several pieces of information such as, the cost of the asset and the estimated number of units expected to produce over its useful life.

Let’s break it down:

First, estimate the total number of units it will produce over its useful life. Next subtract the estimated salvage value from the cost basis of the asset, and divide the total estimated production from the depreciable cost. That will give you the depreciation cost per unit of production. Then you multiply the units of actual production by the units of production rate, which gives you the total depreciation expense.

Unit of production depreciation expense formula:

  1. (Cost basis – salvage value) / Estimated units produced during the useful life = Units of production rate
  2. Actual units produced X Units of production rate = Depreciation expense 

Don’t let the formula scare you; it’s much more simple than you think! Once you know the associated values, it’s simple to do the math.

Here is an example of how to calculate the unit of production depreciation expense for a t-shirt printing machine in one year:

Susan recently purchased a t-shirt printing machine for $10,000, and it is estimated to produce 210,000 units over its14-year useful life. The actual units produced by the machine in the first year is 15,000, and the salvage value for the machine is $1,000.

Referring back to the steps above

  1. ($10,000 – $1,000) / 210,000 = .043

  2. 15,000 X .043 = $645

Advantages and Disadvantages

Just like anything else, the unit of production method has its advantages and disadvantages. We’ll go over a couple of the important ones so you can decide for yourself it’s a good fit.

Advantages 

  • Very accurate for showing actual wear and tear on an asset than other models that use a time-based approach.
  • Clearly depicts business revenues and expenses as it is based on asset usage and fluctuates with demand.
  • Helps track profits and losses for bookkeeping

Disadvantages 

  • This method can be time-consuming and difficult to keep track of several assets.
  • Not useful for all businesses as you must be able to show units/hours used over time.
  • The unit of production method is not advisable for tax purposes.

Be sure to review the other methods used to calculate depreciation and consult with an accountant on which one will work best for your specific business needs. Other methods include the modified accelerated cost recovery system (MACRS), the straight-line method, declining balance depreciation, and the sum-of-the-years’ digits method.

Conclusion

The unit of production method is a helpful tool for businesses to show depreciation of an asset during a period of time. It is especially useful when an asset’s value is more relevant to the number of units it produces versus the number of years it is in use.

The unit of production method is not recommended for all businesses. This method is typically used for manufacturing companies that can easily track output. While it does accurately represent the actual wear and tear of your asset, it is not recommended on ower-cost items due to the time involved with tracking its depreciation. 

This method is a helpful tool for bookkeeping to keep track of profits and losses. During a year with more production, you are able to show a greater depreciation for that asset. Likewise, depreciation will be less during times of lower usage, which can help to offset production costs.

The unit of production method cannot be used for tax deductions unless you request exclusion from the modified accelerated cost recovery system (MACRS) to the IRS for that tax year. The IRS has a strict list of rules and regulations to be followed when showing depreciation of assets for tax purposes. When in doubt, it is always best to consult with an accountant on all of your financial business matters. 

Hopefully, this article helped to clear up any confusion related to calculating depreciation using the unit of production method. 

 

Sources:

https://www.principlesofaccounting.com/chapter-10/depreciation-methods/

https://www.accountingfoundation.org/jsp/Foundation/Page/FAFBridgePage%26cid%3D1176164538898

https://www.irs.gov/publications/p946

https://www.accountingcoach.com/blog/compute-units-of-production-depreciation

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