Units of production depreciation is a depreciation method that allows businesses to determine the value of an asset based upon usage. Common in manufacturing, it’s calculated by dividing the equipment’s net cost by its expected lifetime production. Multiplying this rate by the asset’s output for the year gives you the depreciation expense.
You cannot use units of production depreciation to get a tax deduction. However, it is one of the four methods of depreciation that you can use to report depreciation for accounting purposes. Units of production are especially appropriate for manufacturers whose usage of machinery varies with customer demand because it matches revenues and expenses. It also reflects wear and tear on assets more accurately.
How Units of Production Depreciation Works
Most depreciation methods use time passed to determine the value an asset has lost, such as a car that depreciates 20% a year. Units of production depreciation reduces the value of equipment or machinery based upon its usage―often in units produced. So depreciation expense fluctuates with customer demand and actual wear on the asset.
To calculate units of production depreciation expense, you will apply an average cost per unit rate to the total units the machinery or equipment produces each year. This rate will be the ratio of the total cost of the asset less its salvage value to the estimated number of units it is expected to produce during its useful life.
When to Use Units of Production
Units of production depreciation work well for businesses that use machinery or equipment to make a product. It can provide a more accurate picture of profits and losses by spreading the cost of such assets over the years based on usage. This is helpful for manufacturers since production fluctuates with consumer demand.
Alexander J. Sannella, a professor of accounting and information systems at Rutgers Business School, notes that units of production is also used to write down natural resources like oil.
“You can make an argument that it can be beneficial at any business where the loss of value is directly related to production. If a small business has a machine that can only produce a certain number of T-shirts, units of production depreciation might be a good option. It had to be used on an asset that has a fairly defined output.”
The IRS does not allow units of production for tax purposes, so it is primarily used for internal bookkeeping. At tax time, you’ll likely be using the MACRS depreciation method. You’ll also want to make sure you’ve looked into Section 179 depreciation, which lets qualifying businesses deduct the entire cost of some assets, up to $1 million in the year of purchase.
How to Calculate Units of Production Depreciation
To calculate units of production depreciation, you need to divide the cost of the asset (less its salvage value) by the total units you expect the asset to produce over its useful life. Then you will multiply this rate by the actual units produced during the year.
The units of production depreciation formula is:
1. Calculate the Units of Production Rate
Calculate the units of production rate using the formula:
Cost basis of asset – salvage value / Estimated total units to be produced over estimated useful life
To calculate the units of production rate, you will need to gather several pieces of data, which we describe in detail below. These include the cost of the asset as well as the estimated number of units you expect it will produce over its useful life.
The key information you’ll need to calculate the units of production rate is:
- Cost basis of the asset: The cost basis of a fixed asset is the total amount paid to get the asset up and running for use in your business. This typically includes the purchase price, sales tax, installation charges, shipping or delivery fees, and other costs.
- Salvage value of the asset: This is the estimated value of what the asset would be worth if you were to sell it at the end of its useful life. For example, if you wanted to trade in an old car, it’s value would most likely be based on the Kelley Blue Book value—the current value of the car based on the number of miles driven and its overall condition.
- Estimated number of units to be produced: The units of production method is based on the premise that the wear and tear on the machinery is the result of the number of units it is expected to produce over its useful life. This figure is typically based on historical information and production estimates.
- Estimated useful life: The estimated useful life is the length of time that you expect to use the asset before it wears out and needs to be replaced. It can be difficult to figure out how long an asset can be used. Although units of production depreciation isn’t used for tax purposes, IRS Publication 946 is a helpful tool for figuring out useful life.
Once you have this material, you’re ready to perform the calculation. It’s simply a matter of filling in the formula.
2. Calculate the Depreciation Expense
The second step in calculating units of production depreciation is to determine the number of units the machine produced during the current year and multiplying this by the units of production rate you computed in the previous step. In the sewing machine annual depreciation example below, we show you how to calculate the depreciation expense.
Units of Production Depreciation Examples
Below are two examples of how to calculate depreciation for fixed assets using the units of production depreciation method. The first is for a sewing machine, and the second is for a crane purchased for your factory. The units of production depreciation method requires the cost basis, salvage value, estimated useful life, total estimated lifetime production, and actual units produced for the sample calculations.
This table shows the information used in the sample calculations:
|Fixed Asset||Cost Basis||Salvage||Useful Life||Total Estimated Units Produced over useful life||Actual Units Produced for period|
|Sewing Machine||$5,000||500||7 years||105,000||15,000|
Sewing Machine Annual Depreciation Expense Calculation
To calculate the annual depreciation expenses for the sewing machine, we’re going to calculate the units of production rate first. Once that’s complete, we will calculate the depreciation expense.
The steps to calculate the unit of production depreciation expense for the sewing machine in year one are:
1. Calculate the Units of Production Rate for the Sewing Machine
(Cost basis – salvage value) / Estimated units produced over useful life = Units of production rate
($5,000 – $500) / 105,000 = .043
2. Calculate the Sewing Machine Depreciation Expense
Actual units produced X Units of production rate = Depreciation expense for Year 1
15,000 X .043 = $645
Crane Annual Depreciation Expense Calculation
To calculate the annual depreciation expenses for the crane, we’re going to calculate the units of production rate first. Once that’s complete, we will calculate the depreciation expense.
The steps to calculate the unit of production depreciation expense for the crane in year one are:
1. Calculate the Units of Production Rate for the Crane
(Cost basis – salvage value) / Estimated units produced over useful life = Units of production rate
($7,000 – $700) / 91,000 = .069
2. Calculate the Crane Depreciation Expense
Actual units produced X units of production rate = Depreciation expense for Year 1
13,000 .069 = $897
Advantages & Disadvantages of Using Units of Production Depreciation
Units of production depreciation can work very well for manufacturing firms that use assets to produce output. The depreciation charges reflect actual wear and tear on such equipment and match revenues and expenses. However, this method can’t be used by all businesses or for tax purposes. Tracking usage can also be a headache.
Advantages of Units of Production Depreciation
The advantages of using units of production depreciation include:
- Depreciation expense is directly tied to the wear and tear on the asset: Unlike other methods, units of production depreciation writes down machinery and equipment based on its usage as opposed to time. This more accurately reflects the declining physical value of the asset.
- Units of production depreciation accurately match revenues and expenses: Because this method is based on asset usage, expenses fluctuates with customer demand. This allows us to match revenues generated to expenses and produce financial statements, providing a more realistic view of what is taking place in the business.
Disadvantages of Units of Production
The disadvantages of units of production depreciation include:
Units of production depreciation are only useful to manufacturers: If you don’t manufacture a product, tying depreciation to asset usage makes little sense. Instead, it may be more practical to use a method like Section 179 depreciation, which allows a complete write-off of some assets in the year they’re put into use.
Units of production depreciation aren’t allowed for tax purposes: Instead, you’ll need to use MACRS, Section 179, or straight-line depreciation on your tax return. 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, but it adds extra work.
Computing units of depreciation can be cumbersome: This is particularly true if you do it yourself. It can be tricky to measure output, and you must recalculate depreciation expense each period.
Units of production depreciation work well for manufacturers. Expensing an asset based on usage can provide a more accurate and timely picture of its decline in value. However, tracking equipment usage doesn’t work for a lot of businesses, plus you also can’t use units of production depreciation for tax purposes. For that, you will most likely use MACRS.
How to Record Units of Production Depreciation for Accounting Purposes
To record units of production depreciation for financial accounting purposes, you will need to prepare a journal entry, maintain records on each of the individual assets, and prepare a depreciation schedule to keep track of book and tax expenses.
The three steps to record units of production depreciation expense are to prepare the units of production depreciation expense journal entry, maintain records on the assets, and prepare depreciation schedules.
1. Prepare the Units of Production Depreciation Expense Journal Entry
I recommend you record depreciation expense monthly, just as you would your financial statements, like your profit and loss statement and balance sheet report. A journal entry is the best way to record depreciation expenses and accumulated depreciation.
The journal entry starts with debit depreciation expense, which increases total expenses on the profit and loss statement. This is followed by a credit to accumulated depreciation, which appears on the balance sheet report and reduce the net value of all fixed assets. You can create a journal entry in a few minutes in QuickBooks,
Here is the journal entry you might record for the sewing machine using the units of production depreciation method:
2. Maintain Records on the Assets
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.
You will want to keep these documents in a separate file for each asset. Keeping track of all your records is always important, but you may need these if you ever decide to have audited or reviewed CPA-prepared financial statements.
Remember, too, that the unit of production depreciation method is not for tax purposes, so you need to choose an additional method for taxes. Whatever method you choose, you will also need to keep records for it because the IRS requires supporting documentation for fixed assets. In the event of an audit, you need to produce these records to back-up the cost basis of the asset and show that you owned it.
3. Prepare Depreciation Schedules
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. If you don’t use QuickBooks, then I recommend using a spreadsheet program like Microsoft Excel to create your depreciation schedules.
Here is an example of the info that you need to include in your depreciation schedule:
Depreciation Schedule: 7-Year Property
|Date Put in Service||Description||Cost||Recovery Period (years)||Depreciation|
|January 1, 2019||Sewing machine||$5,000||7||$645||$500|
|January 1, 2019||Crane||$7,000||7||$897||$500|
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, like the one from Sage. These programs are designed to help you keep detailed records on all fixed assets and perform depreciation calculations.
How QuickBooks Can Help 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. To track fixed assets in QuickBooks, you need to set up each asset on the Chart of Accounts.
The following example shows how to set up a fixed asset account in QuickBooks so you can use units of production depreciation.
1. Set Up the Asset Account
The first step is to set up an account for the fixed assets you want to depreciate. You can find this option by clicking on the gear icon and selecting Chart of Accounts from the Your Company Column. This brings up the screen for creating an account.
The fields you need to complete are listed below:
- Category type: Select Fixed Assets.
- Detail type: Select the type of fixed asset you want to set up like 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 and as of date: Enter the original cost of the asset and the date of purchase.
- Depreciation and 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.
2. Run a Chart of Accounts Report
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. QuickBooks Online creates a chart of accounts based on the industry you selected at startup. If you want to track something that’s not on the default list, you need to set up another account.
Below is a snapshot of a chart of accounts report:
You can export this report to Excel and add the information you need to create your depreciation schedules as we discussed.
Frequently Asked Questions (FAQs) About Units of Production Depreciation
We’ve tried to describe the units of production depreciation method, how it is used, and how to calculate it, but you might still have questions. We’ve answered some of the most common ones here. If you have others, post it in the comment section or check out the Fit Small Business forum.
How do you calculate units of production depreciation?
Units of production depreciation can be calculated in two steps. First, you divide the asset’s cost basis―less any salvage value―by the total number of units the asset is expected to produce over its estimated useful life. Then, you multiply this unit cost rate by the total number of units produced for the period.
What is the units of production method?
The units of production method is based on the usage of an asset instead of the passage of time. How much depreciation you record depends on the number of units it produces each period. However, your expense tends to go down when sales drop and increase when actual production is high with units cost of production depreciation.
Manufacturers like units of production depreciation because it matches revenues and expenses. This method is also used to measure the depletion of natural resources in industries like oil drilling. It is most applicable to assets where usage can be accurately measured.
What is the units of activity method?
Units of activity method is another term for units of production depreciation. An asset’s activity can be measured in units produced, but it can also be based on the hours it’s used or the number of operations it can perform. For example, you might base the depreciation of business-owned vehicles based on the miles driven.
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 units of production depreciation and how it works. However, if you are still having trouble grasping how it works or don’t want to take the time to mess with it, get in touch with a small business accountant.