Units of Production Depreciation: Calculating Wear and Tear

yellow pipesDepreciation is the amount of reduction in the value of an asset, and happens to almost anything that is worth money. Pretty much everything that has value begins depreciating once it’s purchased and used, such as a car, a computer, or furniture, and the main causes of this decrease of value is wear and tear. When a business purchases an asset, it’s necessary for the accountant to calculate the asset’s depreciation in order to figure out how much value will be lost during each period of the accounting cycle. There are several ways of calculating the depreciation amount, and the one we are discussing today is the units of production method. The accounting industry is all about calculating the value of various aspects of a business, and this course on the basics of accounting, along with this article on the accounting ratios will give you a better idea of what it’s all about.

More on Units of Production

Like the saying goes, “there’s more than one way to skin a cat,” and calculating an asset’s depreciation value is no different. The following methods are the most widely used in the accounting world:

  • Straight-Line Method
  • Reducing Balance Method
  • Sum-of-Years’ Digit Method
  • Unit of Production Method

There are no regulations that dictate what type of depreciation method a firm should use, so the method that is ultimately chosen must properly account for each specific asset’s decrease in value. While the different methods of depreciation may suit different situations, the units of production method tends to be the most straightforward and accurate. With this method, the amount of depreciation is directly proportional to the amount of asset usage, meaning that the more an asset is used, the more depreciation is accounted for in that period, and conversely, the less wear and tear on an asset, the lower the depreciation value for that particular period. If the asset sits idle for the year, there is zero depreciation.

This method of depreciation requires that someone track the usage of each asset, and as a result, only larger or more expensive assets, such as machinery and buildings are depreciated. If you already know some basic accounting, but need to step up your game for your future business, this course on accounting for startups will get you ready to keep your financial affairs in order.

Units of Production Formula

Let’s next talk about how to actually calculate depreciation using this method. First, we’ll start off by showing the formula:

depreciation = (number of units produced/life in number of units) x (cost – salvage value)

Some of the values in this formula are pretty cut and dry, but others must be reasonably estimated. Because no one can know for sure the amount of units that the asset will produce over its lifetime, this must be approximated. Also estimated is the salvage value of the asset that can be attained when it is no longer usable by the firm. Other factors, such as the number of units actually produced, as well as the cost of the asset, are both amounts that will be known by the accountants. If arithmetic isn’t exactly your strong point, this course on the fundamentals of math will help you brush up on the basics.

Example of Depreciation

Now that you have the tools to be able to calculate an asset’s depreciation value, let’s take a look at an example, then plug the values into the formula.

On July 1, 2012, a factory was purchased by JB Inc. for $85 million to make bobble heads. The accountants estimated the salvage value of the factory at the end of its life would be $6 million. They also estimated that the factory would be able to produce 100 million bobble heads over the course of its life span. The amount of bobble heads that the factory was actually able to produce for the year ending 2012 was 6 million. How much has the value of the factory depreciated over the course of the year 2012?

Using the formula from above, simply input the values into it:

depreciation = (number of units produced/life in number of units) x (cost – salvage value)

depreciation = (6/100) x (85 million – 6 million) = $4.74 million

Using estimations along with actual hard figures, the accountants have figured out that the factory will depreciate by $4.74 million due to the amount of wear and tear that took place over the course of six months between purchase in July and the end of the year. This is information that not only will be useful to them, but to anyone curious about their operation. If you’re already familiar with the basics of accounting, but would like to make a career out of it, this course on becoming a CPA will show you how to make the big accounting bucks.