The units of production depreciation formula is: Depreciation Expense = Unit Production Rate x Units Produced. To find the unit production rate, you must know the original value of the asset, its expected salvage value, and how many units the asset is expected to produce over its lifetime. This formula is: Unit Production Rate = (Original Value – Salvage Value) / Estimated Unit Production.
Depreciation is a commonly misunderstood business accounting concept. Many business owners are familiar with the concept of depreciation only as it applies to taxes. Although the depreciation calculation is an important component of your tax filing, there is so much more to depreciation than a line item on your tax return.
Units of production depreciation is one of four types of depreciation you can use for managerial accounting purposes. This depreciation method helps you calculate how to reduce the value of a fixed asset in your business based on the number of units it produces in a given period of time.
Here, we’ll take a closer look at how units of production depreciation is used, how to calculate it, and determine whether this depreciation method is right for your business.
Depreciation is a calculation that reduces the value of a fixed asset. It is usually calculated based on a period of time, but it can also be calculated based on usage over a period of time. Depreciation doesn’t correlate with a business’s cash flow, which can make it a confusing concept. Instead, the depreciation calculation is made and entries are recorded into your bookkeeping software on a recurring basis.
Depreciation records the reduction of a fixed asset’s value and usefulness. A fixed asset is typically a large purchase—such as furniture, equipment, buildings, and sometimes even intangible items like copyrights—that is not expected to be depleted within a 12-month period.
As time passes or as the asset is used, its value decreases. This loss of value doesn’t coincide with the purchase of the asset, so instead of recording the entire purchase of the asset as an expense, the company’s bookkeeper makes adjusting entries into the accounting software to recognize the asset’s loss of value over time.
There are four types of depreciation businesses can use for managerial accounting purposes:
For tax purposes, your tax professional will use a depreciation system called MACRS (modified accelerated cost recovery system). MACRS is a type of accelerated depreciation, and it is calculated from tables the IRS publishes for each type of property.
We’ve written a complete guide on depreciation that goes into these different types of depreciation in detail. For now, just be aware that there are several different ways you can calculate depreciation in your business for management purposes and a completely different set of rules your tax professional will follow for your tax return.
Next, let’s dive deep into the units of production depreciation method.
Unlike other depreciation methods, units of production depreciation—or units of activity depreciation, as it’s sometimes called—is not calculated based on the amount of time an asset is in service. Instead, units of production depreciation is calculated based on the use of the asset.
Units of production depreciation is used primarily for manufacturing equipment, although it can also be used to calculate the depletion of natural resources. Basing the depreciation of manufacturing equipment solely on the length of time it is in use doesn’t make sense because customer demand—and therefore the wear and tear on the equipment—doesn’t always ebb and flow in conjunction with time.
There is a downside to units of production depreciation, though: It is cumbersome to calculate. The calculation must be done in two steps, and unlike with depreciation methods based on time, you have to recalculate your depreciation expense each time the asset’s output changes. You must determine whether the extra time and effort required to calculate units of depreciation expense makes sense for your business.
As mentioned above, units of production depreciation is calculated in two steps.
The units of production depreciation formula is:
Depreciation Expense = Unit Production Rate x Units Produced
To calculate the unit production rate, you must know the original value (or purchase price, including taxes, delivery fees, setup fees, etc.) of the asset, its expected salvage value, and how many units the asset is expected to produce over its lifetime. The formula, then, is:
Unit Production Rate = (Original Value – Salvage Value) / Estimated Unit Production
Let’s say your business produces the ever-popular Widget. You buy a brand new WidgetMaker 3000 for $10,000. With sales taxes, delivery fees, and setup fees, the total of your WidgetMaker 3000 purchase comes to $11,500.
Original Value = $11,500
You know the industry-standard salvage value of a WidgetMaker 3000 is $2,500.
Salvage Value = $2,500
And you also know a properly maintained WidgetMaker 3000 is expected to produce 90,000 Widgets during its lifetime.
Estimated Unit Production = 90,000
Now we can plug these numbers into the formula above to get the units of production rate for your WidgetMaker 3000:
Unit Production Rate = ($11,500 – $2,500) / 90,000
Unit Production Rate = $9,000 / 90,000
Unit Production Rate = $0.10
Each Widget you produce using your WidgetMaker 3000 reduces the value of the machine by $0.10.
One of the beauties of the units of production depreciation method is you can calculate depreciation with as much detail as you desire. Many businesses will still calculate depreciation on a yearly basis, but you might choose to calculate depreciation quarterly or even monthly. This can be helpful if you are trying to determine your costs with a high degree of accuracy.
Let’s say you’ve decided to record depreciation on a monthly basis. Your Widget production for the past three months is as follows:
In Step 1, we determined the units of production rate for your WidgetMaker 3000 was $0.10/Widget. To arrive at the depreciation expense, we will multiply the number of Widgets produced each month by $0.10 to arrive at the depreciation expense for the month.
Finally, it’s time to make the following journal entries into your accounting software:
These entries will increase your expenses—and decrease the profit—on your profit and loss statement by $100, $750, and $75, respectively. They will also reduce the book value of your assets on your balance sheet by the same amount.
At the end of Month 3, your balance sheet will have line items that look something like this:
Fixed Assets: WidgetMaker 3000 $11,500
Accumulated Depreciation: WidgetMaker 3000 -$925
Total Fixed Assets $10,575
Notice we don’t change the value of the WidgetMaker 3000 itself; instead, the reduction of the asset’s value is reflected by a negative amount in accumulated depreciation for the asset.
The units of production depreciation method is more cumbersome to calculate than most of the other depreciation methods. You have to adjust the calculation from one period to the next based on the asset’s usage, meaning you can’t set up an automatically posting depreciation entry in your accounting software. And you can’t use units of production depreciation for tax purposes.
So, is it worth the effort to use units of production depreciation in your business?
The added effort of using units of production depreciation gives you better insights into the true cost of running your equipment. This, in turn, can help you determine if your pricing model is profitable. It can also help you determine how quickly you are likely to fully deplete the value of your equipment.
If you decide to use units of production depreciation, keep in mind that your tax preparer will still make a separate depreciation calculation for tax purposes. This means your tax depreciation won’t line up exactly with your book depreciation, but as long as you are aware of this and know why the two amounts don’t match, it won’t cause a problem.
If you’re still not sure whether it makes sense for you to use the units of production depreciation method for your business, consult with your accountant or bookkeeper. They will be able to walk you through not only the pros and cons of using units of production depreciation, but they will also be able to help you set up the systems necessary for tracking the information needed to make the calculation.
Billie Anne Grigg is a contributing writer for Fundera.
Billie Anne has been a bookkeeper since before the turn of the century. She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. She is also a guide for the Profit First Professionals organization.
Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.