Under the units of production method, the amount of depreciation charged to expense varies in direct proportion to the amount of asset usage. Thus, a business may charge more depreciation in periods when there is more asset usage, and less depreciation in periods when there is less usage. It is the most accurate method for charging depreciation, since this method is linked to the actual wear and tear on assets. However, it also requires that someone track asset usage, which means that its use is generally limited to more expensive assets. Also, you need to be able to estimate total usage over the life of the asset in order to derive the amount of depreciation to recognize in each accounting period.
Follow these steps to calculate depreciation under the units of production method:
Estimate the total number of hours of usage of the asset, or the total number of units to be produced by it over its useful life.
Subtract any estimated salvage value from the capitalized cost of the asset, and divide the total estimated usage or production from this net depreciable cost. This yields the depreciation cost per hour of usage or unit of production.
Multiply the number of hours of usage or units of actual production by the depreciation cost per hour or unit, which results in the total depreciation expense for the accounting period.
If the estimated number of hours of usage or units of production changes over time, incorporate these changes into the calculation of the depreciation cost per hour or unit of production. This will alter the depreciation expense on a go-forward basis. A change in the estimate does not impact depreciation that has already been recognized.
Do not use the units of production method if there is not a significant difference in asset usage from period to period. Otherwise, you will spend a great deal of time tracking asset usage, and will be rewarded with a depreciation expense that varies little from the results that you would have seen with the straight-line method (which is far easier to calculate).
It is not cost-effective to use the units of production method if the resulting information is not used by the readers of a company's financial statements. Thus, the cost associated with the creation of more accurate depreciation information may not prove to be worthwhile if it does not lead to specific actions.
Units of Production Depreciation Example
Pensive Corporation’s gravel pit operation, Pensive Dirt, builds a conveyor system to extract gravel from a gravel pit at a cost of $400,000. Pensive expects to use the conveyor to extract 1,000,000 tons of gravel, which results in a depreciation rate of $0.40 per ton (1,000,000 tons / $400,000 cost). During the first quarter of activity, Pensive Dirt extracts 10,000 tons of gravel, which results in the following depreciation expense:
= $0.40 depreciation cost per ton x 10,000 tons of gravel
= $4,000 depreciation expense
The units of depreciation method is also known as the units of activity method.