Unit of Revenue Method
The Unit of Revenue Method is a variation of the Unit of Production Method, applied specifically for the depreciation of intangible assets like patents or for the amortization of capitalized costs such as those associated with film production, software development, or customer acquisition costs. In this method, depreciation or amortization expense is calculated based on the proportion of revenue generated during the period in relation to the total estimated revenue expected to be generated over the asset’s useful life.
This method is particularly useful when the economic benefits from an asset are expected to be realized in proportion to the revenue it generates.
Formula:
To apply the Unit of Revenue Method, the following formula is used to calculate the rate of depreciation or amortization per unit of revenue:
Amortization per Unit of Revenue = Total Cost − Residual Value / Total Estimated Revenue
Amortization for each accounting period is then calculated as:
Amortization Expense for the Period = Amortization per Unit of Revenue × Revenue Generated in the Period
Advantages:
- Direct Link to Revenue: This method links the amortization or depreciation directly to the revenue an asset generates, making it more reflective of the asset’s economic use.
- Flexibility: Useful for assets where revenue generation varies significantly over different periods.
Disadvantages:
- Complexity: Requires accurate tracking of revenue generated by the asset, which can be administratively challenging.
- Estimation Uncertainty: The total expected revenue must be estimated at the outset, and any deviation from this estimate could lead to inaccuracies in amortization or depreciation calculations.
By using the Unit of Revenue Method, companies can more closely match the cost of intangible assets or capitalized costs to the revenue they generate, providing a more accurate representation of their financial situation.
Example of the Unit of Revenue Method
Let’s consider a hypothetical example involving a software company, SoftTech Inc., that has spent $2 million developing a specialized software product. The company expects to generate a total of $10 million in revenue from this software over its useful economic life and estimates a residual value of $200,000 for the software at the end of its life.
Step 1: Determine the Total Cost
The total development cost of the software is $2 million.
Step 2: Estimate the Residual Value
SoftTech estimates a residual value of $200,000 for the software at the end of its useful life. This could be the value derived from further updates or licensing the software in the future.
Step 3: Estimate Total Units of Revenue
SoftTech expects that the software will generate a total revenue of $10 million over its useful economic life.
Step 4: Calculate Amortization per Unit of Revenue
Using the Unit of Revenue Method formula, we calculate the amortization per unit of revenue:
Amortization per Unit of Revenue = Total Cost − Residual Value / Total Estimated Revenu
Amortization per Unit of Revenue = $2,000,000 – $200,000 / $10,000,000
= $1,800,000 / $10,000,000
= $0.18 per dollar of revenue
Step 5: Calculate Amortization for the Period
Assume that during the first year, the software generates revenue of $2 million. To find the amortization expense for this period, we multiply the amortization per unit of revenue by the revenue generated during the period:
Amortization Expense for the Year = Amortization per Unit of Revenue × Revenue Generated in the Yea
Amortization Expense for the Year = $0.18x $2,000,000 = $360,000
Summary
For the first year, SoftTech would record an amortization expense of $360,000 based on the revenue generated by the software. This helps the company better match the cost of the intangible asset to the revenue it generates, providing a more accurate representation of its economic value.
By using the Unit of Revenue Method, SoftTech can more closely align its amortization expense with actual revenue, providing a clearer picture of the software’s profitability and impact on the company’s financial health.
