The unit of production method is a unique way to calculate the depreciation of an asset based on its actual usage. This approach is ideal for assets whose value is more closely tied to the number of units they produce rather than the number of years they are in use. It allows businesses to take higher depreciation deductions in peak production years, offsetting those with lower costs during less active periods.
Unlike time-based depreciation methods such as straight-line or accelerated depreciation, the unit of production method focuses on practical usage.
Key Takeaways
- The unit of production method bases depreciation on an asset’s actual output rather than its age.
- Ideal for assets with significant wear and tear due to usage, like specific machinery or production equipment.
- Enables higher depreciation expenses in productive years, helping to offset increased production costs.
Formula for the Unit of Production Method
Depreciation expense for a given year is calculated by dividing the asset’s original cost, minus its salvage value, by the total number of units it is expected to produce over its useful life. This quotient is then multiplied by the number of units produced during the current year.
DE = [(Original Value - Salvage Value) / Estimated Production Capability] × Units per Year
Where:
DE = Depreciation Expense
Benefits of the Unit of Production Method
This depreciation method is advantageous as it reflects the actual wear and tear on assets due to production levels. Companies claim larger depreciation deductions in more productive years, reducing taxable income at times of greater operational costs. This approach offers a more accurate picture of profits and losses for businesses heavily reliant on production equipment.
Implementation
Depreciation begins when an asset starts producing units and ends once its cost is fully recovered or it reaches the estimated production capacity, whichever comes first.
Comparison: Unit of Production vs. MACRS Methods
The Modified Accelerated Cost Recovery System (MACRS) is a standard tax depreciation method, using a declining balance switching to straight-line depreciation. It isn’t linked to an asset’s production levels, but similar exclusions can allow for more accurate methods like the unit of production method. Businesses must choose this method by the tax return due date for the year the asset is placed in service.
Related Terms: straight-line depreciation, accelerated depreciation, MACRS, salvage value, capacity, wear and tear.
References
- Internal Revenue Service. “Publication 946: How To Depreciate Property”.
- Internal Revenue Service. “Publication 946: How To Depreciate Property”.
