The Units of Production Method is a method of depreciation in which depreciation expense is calculated according to the actual production or level of use of an asset. Unlike depreciation methods that are mainly based on the passage of time, this method links the depreciation charge directly with the actual output produced by the asset.
Under this method, a greater amount of depreciation is charged in the years when the asset is heavily used and produces more units. Similarly, a lower amount of depreciation is charged when the asset produces fewer units.
Therefore, depreciation expense may differ from one accounting year to another depending on the actual production of the asset.
Basic Principle of Units of Production Method
The Units of Production Method is based on the principle that the cost of an asset should be allocated according to its actual productive use.
When an asset is acquired, its total estimated production capacity during its useful life is determined. The depreciable cost of the asset is then divided by its estimated total production to calculate the depreciation cost per unit of production.
The depreciation expense for a particular accounting period is calculated by multiplying the depreciation cost per unit by the actual number of units produced during that period.
Thus, an accounting period with higher production will have a higher depreciation expense, while an accounting period with lower production will have a lower depreciation expense.
Formula for Units of Production Method
The annual depreciation expense under the Units of Production Method is calculated as follows:
Annual Depreciation Expense = [(Cost of Fixed Asset − Residual Value) ÷ Estimated Total Production] × Actual Production
The formula may also be expressed as:
DE = [(OV − SV) ÷ EPC] × Units Produced during the Year
Where:
DE represents Depreciation Expense.
OV represents the Original Value or Original Cost of the asset.
SV represents the Salvage Value or Residual Value of the asset.
EPC represents the Estimated Production Capacity of the asset.
The number of units produced during the year represents the actual production of the asset during the accounting period.
Depreciation Cost per Unit
Before calculating annual depreciation expense, the depreciation cost per unit is determined.
The formula is:
Depreciation per Unit = (Cost of Asset − Salvage Value) ÷ Estimated Total Production
The difference between the cost of the asset and its salvage value represents the depreciable amount of the asset.
This depreciable amount is divided by the total estimated production capacity to determine the amount of depreciation associated with each unit of production.
Once the depreciation per unit has been calculated, the same per-unit rate is multiplied by the actual production of each accounting period.
Example of Units of Production Method
Suppose an asset has an original cost of $70,000, an estimated salvage value of $10,000, and an expected total production capacity of 6,000 units.
The depreciable amount of the asset is:
$70,000 − $10,000 = $60,000
The depreciation cost per unit will be:
$60,000 ÷ 6,000 units = $10 per unit
Therefore, depreciation of $10 is charged for every unit produced by the asset.
The annual depreciation expense is calculated by multiplying $10 by the actual number of units produced during the accounting year.
Calculation of Annual Depreciation
If the asset produces 1,000 units during the first year, depreciation expense will be:
1,000 × $10 = $10,000
If the asset produces 1,100 units during the second year, depreciation expense will be:
1,100 × $10 = $11,000
Similarly, if production increases to 1,400 units, depreciation expense will be:
1,400 × $10 = $14,000
Thus, depreciation expense increases when actual production increases.
Depreciation Schedule under Units of Production Method
| Units of Production | Depreciation Cost per Unit | Depreciation Expense | Accumulated Depreciation | Book Value at Year-End |
|---|---|---|---|---|
| Original Cost | — | — | — | $70,000 |
| 1,000 | $10 | $10,000 | $10,000 | $60,000 |
| 1,100 | $10 | $11,000 | $21,000 | $49,000 |
| 1,200 | $10 | $12,000 | $33,000 | $37,000 |
| 1,300 | $10 | $13,000 | $46,000 | $24,000 |
| 1,400 | $10 | $14,000 | $60,000 | $10,000 |
The table shows that the depreciation cost per unit remains constant at $10, but the total depreciation expense changes according to the number of units produced.
Accumulated depreciation increases as depreciation is charged, while the book value of the asset gradually decreases.
Book Value under Units of Production Method
The book value of the asset is calculated by deducting accumulated depreciation from its original cost.
Book Value = Original Cost − Accumulated Depreciation
For example, after the first period, accumulated depreciation is $10,000. Therefore:
Book Value = $70,000 − $10,000 = $60,000
After the second period, accumulated depreciation becomes $21,000. Therefore:
Book Value = $70,000 − $21,000 = $49,000
The book value continues to decrease as the asset is used for production.
Depreciation up to Scrap Value
Under the Units of Production Method, depreciation continues until the book value of the asset becomes equal to its scrap or salvage value.
In the given example, the original cost of the asset is $70,000 and its scrap value is $10,000. Therefore, the maximum total depreciation that can be charged is $60,000.
Once accumulated depreciation reaches $60,000, the book value of the asset becomes:
$70,000 − $60,000 = $10,000
The $10,000 balance represents the scrap value of the asset. No further depreciation is charged after the book value reaches this amount.
At the end of the depreciation process:
Accumulated Depreciation + Scrap Value = Original Cost
In the given example:
$60,000 + $10,000 = $70,000
Thus, the original cost of the asset is equal to the sum of accumulated depreciation and the remaining scrap value.
Accounting Treatment of Depreciation
The depreciation expense calculated according to the actual production of the asset is recorded as an expense of the accounting period.
The accounting entry is:
Depreciation Expense A/c Dr.
To Accumulated Depreciation A/c
For example, if the asset produces 1,000 units and depreciation expense is $10,000, the accounting entry will be:
Depreciation Expense A/c Dr. $10,000
To Accumulated Depreciation A/c $10,000
The depreciation expense is charged to the Income Statement, while accumulated depreciation increases and reduces the carrying amount of the asset in the Balance Sheet.
Difference between Units of Production and Straight Line Method
Under the Straight Line Method, the same amount of depreciation is generally charged every year throughout the useful life of the asset. The calculation is mainly based on the passage of time.
Under the Units of Production Method, depreciation is based on the actual number of units produced by the asset. Therefore, annual depreciation expense may increase or decrease depending on the level of production.
Thus, Straight Line Depreciation provides an equal annual charge, whereas the Units of Production Method provides a production-based depreciation charge.
Exam Focus
The Units of Production Method calculates depreciation according to the actual production or use of an asset. Greater depreciation is charged in years when the asset is heavily used and produces more units.
The formula is:
Annual Depreciation = [(Cost of Fixed Asset − Residual Value) ÷ Estimated Total Production] × Actual Production
The depreciation cost per unit remains constant, while the total depreciation expense changes according to actual production.
Depreciation stops when the book value of the asset becomes equal to its scrap or salvage value.
At the end of the depreciation period:
Accumulated Depreciation + Scrap Value = Original Cost
The Units of Production Method is an activity or production-based method of depreciation and not mainly a time-based method.