Units of Production Depreciation: How to Calculate & Formula
Tim is a Certified QuickBooks Time (formerly TSheets) Pro, QuickBooks ProAdvisor, and CPA with 25 years of experience. He brings his expertise to Fit Small Business’s accounting content.
Danielle is a writer for the Finance division of Fit Small Business. She has owned a bookkeeping and payroll service that specializes in small business, for over twenty years.
Units of production depreciation allows businesses to allocate the cost of an asset based upon its use. Common in manufacturing, the units of production rate is calculated by dividing the equipment’s 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 Generally Accepted Accounting Principles (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.
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’ll multiply this rate by the actual units produced during the year.
The units of production depreciation formula is:
To calculate the unit production rate, you must know the original cost of the asset as well as its expected salvage value and how many units the asset is expected to produce in its lifetime.
1. Calculate the Units of Production Rate
As shown above, to calculate your units of production rate, you’ll need the cost of the asset, the salvage value of the asset, and the estimated number of units you expect it’ll 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 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.
- Estimated number of units to be produced: You need to estimate the number of units the machine will be able to produce over its entire 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.
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 this by the units of production rate you computed in the previous step. As discussed in the next step, your annual depreciation cannot cause your accumulated depreciation to exceed your net cost of the asset.
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. Accumulated depreciation should equal exactly the net cost of the machine when you’ve manufactured the exact number of units you estimated in step 1. 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.
4. Record Depreciation Expense
To record depreciation, you must make a journal entry debiting Depreciation Expense and crediting Accumulated Depreciation. You can record this journal entry easily in QuickBooks Online, which we ranked as the best overall small business accounting software.
Here is a sample journal entry recording $645 of depreciation expense:
Debit | Credit | |
|---|---|---|
Depreciation Expense | $645 | |
Accumulated Depreciation | $645 |
When to Use Units of Production Depreciation
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.
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 make sure you’ve looked into Bonus Depreciation and Section 179 depreciation, which let qualifying businesses deduct the entire cost of many assets in the year of purchase.
Pros & Cons of 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.
| 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 | |
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, 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 | Total Estimated Units Produced over useful life | Actual Units Produced for period |
|---|---|---|---|---|
Sewing Machine | $5,000 | $500 | 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’ll calculate the depreciation expense.
The steps to calculate the unit of production depreciation expense for the sewing machine in year one are calculate the units of production rate for the sewing machine and calculate the sewing machine depreciation expense.
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’ll calculate the depreciation expense.
The steps to calculate the unit of production depreciation expense for the crane in year one are calculate the units of production rate for the crane and calculate the crane depreciation expense.
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 X .069 = $897
Bottom Line
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.
