Units of production depreciation is a depreciation method that is designed for manufacturing equipment or machinery. It calculates depreciation expense based on the number of products that your machinery or equipment can output each year.
Units of production depreciation cannot be used to get a tax deduction. However, it is one of the six methods of depreciation that you can use to report depreciation for accounting purposes. Units of production is especially useful for manufacturers whose usage of machinery varies with customer demand.If you’re not familiar with how depreciation works in general or would like to learn about other depreciation methods, click here.
It could be a good idea to get in touch with an experienced small business accountant, like those at Bookkeeper360. They have been helping small business owners with depreciation, ongoing monthly bookkeeping, and maximizing deductions for years. Get your first consultation free.
In this article, we will cover the following:
- How Units of Production Depreciation Works
- When to Use Units of Production
- How to Calculate Units of Production Depreciation
- What the Advantages and Disadvantages are of Using Units of Production Depreciation
- How do I Record Units of Production Depreciation for Accounting Purposes?
- Can QuickBooks Help me to Calculate Units of Production Depreciation?
How Units of Production Depreciation Works
Unlike other depreciation methods that use time to determine how much value an asset has lost (i.e. a car that depreciates 20% each year), units of production is based on usage. For manufacturing, the calculation looks specifically at how many units you’ve produced in a given year in order to determine how much value the machine or equipment has lost.
See the full units of production calculation below, along with an example.
There are two main ways depreciation can be used: as a tax deduction, and to report for accounting purposes.
When to Use Units of Production
Although most people think of tax deductions when they hear the word “depreciation,” this isn’t how units of production is actually used. The IRS only permits a few types of depreciation for tax purposes, and units of production is unfortunately not among them.
Instead, units of production is primarily used for internal bookkeeping. For manufacturing businesses in particular, it can help you get a more accurate picture of your profits and losses. Rather than count the entire cost of your machinery in the year you purchased it, units of production spreads this out over the years based on how much you’ve used it. This makes it especially helpful for manufacturers who vary production based on consumer demand.
If you are here to learn about depreciation tax deductions, you’ll likely be using the MACRS depreciation method instead. You’ll also want to make sure you’ve looked into Section 179, which lets qualifying businesses deduct the entire cost of some assets, up to $500,000, in the year of purchase.
How Do I Calculate Units of Production Depreciation?
While most of you will either use a tax software program like TurboTax or have your tax professional calculate depreciation, it is still good to understand how it works.
Here is the formula to calculate units of production depreciation. Below the formula, we’re going to explain how to make these calculations step by step:
Step 1 – Calculate the UOP (units of production) rate using this formula:
(Cost of equipment – Salvage value) / Estimated number of units to be produced by equipment during estimated useful life
Step 2 – Calculate the depreciation expense:
Number of units produced during the current year x UOP rate
Let’s take a look at how to use this formula. In order to calculate units of production depreciation, you will need the following information:
- Cost basis of the asset
- Salvage value of the asset
- Estimated number of units to be produced
- Estimated useful life of the asset
Before we get too deep, it is worth mentioning that for many small business owners, it might make the most sense to get some help from an experienced small business accountant. Depreciation can be tricky, and you don’t want to screw something up that you’ll pay for at tax time.
Bookkeeper360 has a team of small business accountants that have seen it all, know all about depreciation, and have years of experience maximizing deductions for small business owners. Get your first consultation for free.
Cost Basis of the Asset
The cost basis of a fixed asset will generally include payments that you made to get the asset up and running to use in your business. These costs include but are not limited to the purchase price, sales tax, installation charges, shipping or delivery costs, and other costs.
The formula to calculate the cost basis of an asset is as follows:
Cost basis of an asset = Purchase price of the asset + Sales tax + Shipping and delivery costs + Installation charges + Other costs
Salvage Value
The salvage value is the estimated value of the asset if you were to sell it at the end of its useful life. For example, if you had a car that you wanted to trade in for a new one, the value of the old car would be based on the Kelley Blue Book value, which is what the current value of the car is based on the number of miles driven and the overall condition of the car.
Estimated Useful Life
The estimated useful life generally means the length of time that you will be able to use the asset before it wears out and need to be replaced. The IRS has taken the guesswork out of determining the useful life by providing what it deems as the recovery period for business equipment. I have provided a summary table below for 3, 5, and 7 year property. You can find the full list of properties in IRS Pub 946.
Depreciation Recovery Periods for Business Equipment
| Recovery Period | Types of business equipment |
|---|---|
| 3-year property | Tractor units and horses over 2 years old |
| 5-year property | Cars, taxis, buses, trucks, computers, office equipment (computers, calculators, copiers), research equipment, cattle |
| 7-year property | Office furniture and fixtures such as desks, files and safes |
Estimated Number of Units to be Produced
The units of production depreciation method is based on the premise that the wear and tear of the machinery is a direct result of the number of units that machinery is expected to produce over its useful life. Using historical information and your production figures for the future, you will have to estimate the number of units that will be produced over the estimated life of the asset.
For example, if the estimated life of a widget maker that you purchased is 5 years, then you will have to determine the number of products that will be manufactured by that widget maker during its 5 year life. If the estimated number of units changes over time, you will need to adjust the calculation of the depreciation expense.
Putting it All Together
Once you have calculated the cost basis, salvage value, estimated number of units to be produced, and the estimated useful life of the asset, then you are ready to calculate the depreciation expense. The formula for calculating units of production depreciation requires two steps.
Step 1 – Calculate the UOP (units of production) rate using this formula:
(Cost – Salvage value) / Estimated number of units to be produced during estimated useful life
Step 2 – Calculate the depreciation expense using the units of production depreciation method:
Units of production during the current year x UOP rate
To show how the formulas work, we will walk through a couple of examples on how to calculate depreciation for fixed assets using the units of production depreciation method.
Examples: Let’s say you purchased a brand new crane and a sewing machine to use in your factory. In the table below, I have provided you with the fixed assets, the cost basis of each, and the estimated useful life based on the IRS recovery period table discussed previously.
| Fixed Asset | Cost Basis | Salvage Value | Useful Life (years) |
|---|---|---|---|
| Sewing Machine | $5000 | $500 | 7 |
| Crane | $3000 | $300 | 7 |
Sewing Machine Annual Depreciation Expense Calculation:
- Step 1 – ($5000 – $500) / 105,000 = .043 Units of production rate
- Step 2 – (105,000/7) X .043 = $645 Depreciation expense for Year 1
Crane Annual Depreciation Expense Calculation:
- Step 1 – ($3000 – $300) / 105,000 = .026 Units of production rate
- Step 2 – (105,000/7) X .026 = $390 Depreciation expense for Year 1
What Are the Advantages & Disadvantages of Using Units of Production Depreciation?
The units of production depreciation method is only beneficial to manufacturing companies. If you don’t manufacture a product then there is very little benefit to using the units of production method. However, if you are a manufacturing business, one advantage of using the units of production depreciation method is that the amount you can expense is directly tied to the wear and tear of the equipment and machinery used to manufacture your products.
If you manufacture jeans, depreciation expense will be higher during those times where demand is high and you have to produce a lot of jeans to fulfill our customer orders. On the other hand, when demand is not so high and you are producing fewer jeans, depreciation expense will be lower because you are producing fewer units (jeans).
From an accounting perspective, this allows us to match the revenue generated (# of jeans sold) to our expenses (depreciation), which will produce more accurate financial statements and a realistic view of what is actually taking place in the business.
A couple of disadvantages of using the units of production depreciation method are as follows:
- Unfortunately the units of production depreciation method is not acceptable for tax purposes. For tax purposes, you’ll need to use MACRS, Section 179, or straight line depreciation. It’s acceptable to have two sets of books for depreciation: one for getting a tax deduction, and one for recording depreciation for accounting purposes.
- The calculation for Units of Production Depreciation is a bit cumbersome if you have to do it manually.
How Do I Record Units of Production Depreciation for Accounting Purposes?
I recommend you record depreciation expense as often as you should be reviewing your financial statements like your profit and loss statement and Balance Sheet report, which should be monthly. To record depreciation expenses, you will use a journal entry.
The journal entry will debit depreciation expense, which will increase total expenses on the profit and loss statement. The credit to accumulated depreciation will appear on the balance sheet report to reduce the net value of all fixed assets.
In QuickBooks, you can create a journal entry in just a few minutes. Here is the journal entry that we would record for the sewing machine that was purchased in our above example.
| Debit | Credit | |
|---|---|---|
| Depreciation Expense | $645 | |
| Accumulated Depreciation | $645 |
In addition to recording depreciation, be sure to keep track of any receipts, titles, contracts and other documents that prove you own the asset. These documents should include the purchase date and the amount that you paid for the asset. In addition, you will need to create depreciation schedules to keep track of all assets. If you use units of production for book purposes and MACRS for tax purposes, then these schedules will make it easier for you to keep track of both methods for all of your assets.
QuickBooks Online makes it simple to create depreciation schedules. In the Can QuickBooks Help Me to Calculate Depreciation section, we will show you how to do this. If you don’t use QuickBooks, then I recommend using a spreadsheet program to create your depreciation schedules. Here is an example of the info that you will need to include in your depreciation schedule:
Depreciation Schedule: 7-Year Property
| Date Put in Service | Description | Cost | Recovery Period (years) | Depreciation Year 1 (Books) | Depreciation Year 1 (Tax) |
|---|---|---|---|---|---|
| 1/1/2016 | Sewing Machine | $5000 | 7 | $645 | $500 |
| 1/1/2016 | Crane | $3000 | 7 | $390 | $295 |
QuickBooks does not calculate depreciation expense. This is true for most accounting software programs. However, if you have enough assets to justify the investment, then check out fixed asset software programs. These programs are designed to help you keep detailed records on all fixed assets and perform depreciation calculations.
Can QuickBooks Help Me to Calculate Units of Production Depreciation?
You can use QuickBooks to track all of your fixed asset purchases so that you don’t have to create a depreciation schedule from scratch. In order to track fixed assets in QuickBooks, you will need to set up each asset on the chart of accounts. To learn how to set up a new account in QuickBooks, check out our How to Set up the Chart of Accounts video tutorial.
Below is an example of how to set up a fixed asset account in QuickBooks along with a brief description of the required info you will need to complete the set up.
- Category Type: Select Fixed Assets
- Detail Type: Select the type of fixed asset you want to set up (i.e. Vehicles).
- Name: Enter the name of the asset
- Description: Enter the same info as the name field or provide any additional info about the asset in this field.
- Original cost/as of date: Enter the original cost of the asset and the date of purchase.
- Depreciation/as of date: Enter any accumulated depreciation that you may have already taken.
- Tip: You will only complete this field if you started depreciating the asset prior to setting it up in QuickBooks.
Once you have created the fixed asset in QuickBooks, you can run a chart of accounts report and filter it to show fixed assets only. Below is a snapshot of this report:
You can export this report to Excel, add the additional info that you need to include to create your depreciation schedules as we discussed.
If this still sounds confusing, get in touch with a small business accountant who is used to calculating depreciation. The accountants at Bookkeeper360 have years of experience helping small business owners with depreciation, quarterly taxes, and maximizing deductions when April comes around. Get your first consultation free.
The Bottom Line
Now that we have discussed everything that you did (or didn’t) want to know about units of production depreciation, you should have a general idea about production depreciation and how it works. But, if you are still having trouble grasping how it works or just don’t want to take the time to mess with it, get in touch with a small business accountant.
Bookkeeper360 has a team of experienced professionals that have been helping small business owners for years with depreciation, streamlining the books, and maximizing deductions at tax time. Get in touch with them to learn more and get a free consultation.
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