Units of production is a popular depreciation method that allows businesses to allocate the cost of a fixed asset based upon its use. Common in manufacturing, the units of production rate is calculated by dividing the equipment’s depreciable cost by its expected lifetime production. Multiplying this rate by the asset’s output for the year gives you the depreciation expense for that year.
You cannot use units of production depreciation to calculate your tax deduction. However, it’s one of the four methods of depreciation allowed for United States Generally Accepted Accounting Principles (US GAAP). Units of production are especially appropriate for manufacturers whose usage of machinery varies by year because it matches the cost of the machinery to the revenue that it creates. It also reflects the wear and tear on machinery more accurately.
Key Takeaways
- Depreciation is an allocation of the asset’s cost over its useful life.
- The units of production depreciation formula is: Units of Production Rate x Actual Annual Units Produced
- This depreciation method computes depreciation based on usage, which approximates the cost of the fixed asset consumed based on the number of units produced.
- The IRS doesn’t allow the units of production method for tax purposes. You can use the method for financial accounting, but you’ll need to compute modified accelerated cost recovery system (MACRS) depreciation for tax reporting.
How To Calculate Units of Production Depreciation & Example
Step 1: Calculate the Units of Production Rate
As shown above, to calculate your units of production rate, you’ll need the following:
- Cost basis of the asset: This 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 the asset at the end of its useful life. You must forecast this value at the time the asset is placed in service. In many cases, the estimated salvage value of a piece of machinery may be little more than its value as scrap metal. The salvage value is also called residual value, scrap value, or break-up value.
- Estimated number of units to be produced over its useful life: If you forecast too few units, you’ll assign too high of a cost to units produced early in the machine’s life, and no cost to the units produced at the end of the life. In contrast, if you forecast too many units, you assign too low a depreciation cost per unit and won’t fully depreciate the asset before it reaches the end of its useful life.
Once you have this material, you’re ready to perform the calculation. It’s simply a matter of filling in part 1 of the formula above.
Step 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 multiply the figure by the units of production rate you computed in Step 1.
Step 3: Calculate Accumulated Depreciation
Accumulated depreciation is the sum of depreciation expenses over the current and all prior years. The adjusted basis of your machine is the difference between the asset’s net cost and the total accumulated depreciation.
Total accumulated depreciation isn’t allowed to exceed the machine’s net cost, and it should equal the net cost of the machine. Any units manufactured in excess of this amount won’t be assigned any depreciation expense, because the machine is fully depreciated, meaning it has no remaining adjusted basis.
Step 4: Record Depreciation Expense
To record depreciation, you must make a journal entry debiting Depreciation Expense and crediting Accumulated Depreciation. AssetAccountant, our best fixed asset management software, prepares depreciation journal entries automatically and forwards them to your accounting software. Read our AssetAccountant review to learn more about the feature and the platform.
Here is a sample journal entry recording $645 of depreciation expense:
Debit | Credit | |
|---|---|---|
Depreciation Expense | $645 | |
Accumulated Depreciation | $645 |
Depreciation computation is only one aspect of fixed asset accounting. Read our guide on fixed asset accounting for more information on the four things you need to know.
In this example, we’ll show how to calculate the units of production depreciation for several years on a machine purchased in 2022. Let’s assume the following information:
- Cost of machine: $40,000
- Residual value: $2,000
- Estimated number of units to be produced over the life of the machine: 200,000
- Units produced in 2022: 10,000
- Units produced in 2023: 13,400
- Units produced in 2024: 16,000
- Units produced in 2025: 19,500
Step 1: Calculate the Units of Production Rate
By using the same formula discussed above, the units of production rate should be:
Units of Depreciation Rate = (40,000 – 2,000) ÷ 200,000 = 0.19 per unit
Step 2: Calculate the Depreciation Expense for Each Year
The same depreciate rate per unit is used for the entire life of the asset, so we can easily calculate depreciation for each year:
- 2022 depreciation = 10,000 units × 19 cents = $1,900
- 2023 depreciation = 13,400 units × 19 cents = $2,546
- 2024 depreciation = 16,000 units × 19 cents = $3,040
- 2025 depreciation = 19,500 units × 19 cents = $3,705
Step 3: Calculate the Track Accumulated Depreciation
Accumulated depreciation after the four years of depreciation is the sum of all depreciation claimed, or $11,191.
Be sure to track this amount each year, and never let it exceed the original depreciable value of the asset, which is $38,000 ($40,000 – $2,000). Once accumulated depreciation reaches $38,000, the asset is fully depreciated, and any additional units produced do not generate any depreciation expense.
When To Use Units of Production Depreciation
Units of production depreciation work well for businesses using machinery or equipment to make a product, as the depreciation charges reflect actual wear and tear on such equipment and match revenues and expenses. 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.
The IRS doesn’t allow units of production depreciation for tax purposes, so it’s primarily used for internal bookkeeping. At tax time, you’ll likely be using the MACRS depreciation method. You’ll also want to ensure you’ve looked into bonus depreciation and the Section 179 deduction, which let qualifying businesses deduct the entire cost of many assets in the year of purchase.
You may also be interested in our bonus depreciation vs Section 179 deduction comparison to see the differences between the two IRS methods of deducting fixed asset cost.
Pros & Cons of Units of Production Depreciation
| PROS | CONS |
|---|---|
| Depreciation expense directly tied to the wear and tear on the asset | Not allowed for tax purposes |
| Units of production depreciation accurately match revenues and expenses | Difficult to track and maintain since reconciliation is needed for tax purposes |
| Depreciation expense is more reflective of actual operations as it is based on output | Fluctuation in units of production rates as a result of asset improvements like significant repairs |
Frequently Asked Questions (FAQs)
It is a variable cost because depreciation charges vary depending on the number of actual units produced.
Its main advantage is that it computes depreciation based on actual production. It means that depreciation charges match the activity level of production.
Bottom Line
Units of production depreciation can be calculated in four 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.
