Unit of Production Method
The Unit of Production Method, also known as the Units of Activity Method, is a depreciation method used to calculate the depreciation expense of an asset based on its actual usage rather than the passage of time. This method is particularly useful for assets that have variable levels of activity and where depreciation is more closely related to the asset’s utilization rather than its age.
The Unit of Production Method uses the following formula to calculate depreciation per unit:
Depreciation per Unit = Cost of Asset − Salvage Value / Total Estimated Units of Production
Depreciation for each accounting period is then calculated as:
Depreciation Expense for the Period = Depreciation per Unit × Units Produced in the Period
Steps to Apply the Method:
- Determine the Cost of the Asset: This is the original cost to acquire the asset, including any costs to bring it to its intended use.
- Estimate the Salvage Value: This is the estimated value of the asset at the end of its useful life.
- Estimate Total Units of Production: This is an estimate of the total number of units that the asset will produce over its useful life.
- Calculate Depreciation per Unit: Use the formula to find the depreciation expense per unit of production.
- Calculate Depreciation for the Period: Multiply the depreciation per unit by the actual number of units produced in the accounting period.
Example of the Unit of Production Method
Let’s consider a hypothetical example involving a construction company, BuildCo, that has recently acquired an excavator for $200,000. The machine has an estimated useful life of 8 years and a salvage value of $20,000. BuildCo estimates that the machine will be used for a total of 16,000 hours over its lifetime.
Step 1: Determine the Cost of the Asset
The original cost of the excavator is $200,000.
Step 2: Estimate the Salvage Value
The estimated salvage value of the excavator at the end of its useful life is $20,000.
Step 3: Estimate Total Units of Production
BuildCo expects that the excavator will be used for 16,000 hours over its useful life.
Step 4: Calculate Depreciation per Unit
Using the Unit of Production Method formula, we can find the depreciation expense per hour of usage:
Depreciation per Unit (Hour) = Cost of Asset − Salvage Value / Total Estimated Units (Hours) of Production
Depreciation per Hour = $200,000 – $20,000 / 16,000
= $180,000 / 16,000
= $11.25 per hour
Step 5: Calculate Depreciation for the Period
Assume that during the first year, the excavator is used for 2,000 hours. To find the depreciation for this period, we multiply the depreciation per unit by the actual number of units (hours, in this case) used during the period:
Depreciation Expense for the Year = Depreciation per Hour × Hours Used in the Year
Depreciation Expense for the Year = $11.25 x 2,000 = $22,500
For the first year, BuildCo would record a depreciation expense of $22,500 for the excavator, based on its actual usage.
- Budgeting and Cost Planning: Knowing the depreciation expense based on actual usage allows BuildCo to better plan its budgets and operating costs.
- Financial Reporting: This method provides a more accurate measure of the excavator’s wear and tear, which is reflected in the company’s financial statements.
- Asset Management: BuildCo can also make more informed decisions regarding maintenance schedules or potential replacement of the excavator, based on its rate of depreciation tied to actual use.
By using the Unit of Production Method, BuildCo gains a more accurate and flexible approach to depreciating assets whose wear and tear are directly related to their level of activity or use.