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.
This article is part of a larger series on Bookkeeping.
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 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.
The units of production depreciation method allocates depreciation expense based on the number of units produced by your company’s machineries and equipment. Unsure how to account for units of production depreciation in the books? Bench can help you account for depreciation properly. Get 2 months free if you register now.
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, 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.
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 | 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 |
Units of Production Depreciation Calculation for Multiple Years
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
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
2. Calculate the Depreciation 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 X 19 cents = $1,900
- 2023 depreciation = 13,400 units X 19 cents = $2,546
- 2024 depreciation = 16,000 units X 19 cents = $3,040
- 2025 depreciation = 19,500 units X 19 cents = $3,705
3. 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 was $38,000. Once accumulated depreciation reaches $38,000, the asset is fully depreciated and any additional units produced do not generate any depreciation expense.
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.
