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Units of Production Depreciation is the amount of depreciation that an asset (or sometimes company) has taken over time. It’s calculated by subtracting the original cost from what it would have been worth if sold at a certain point in time and then dividing that number into how many years passed since its release date.
Production Depreciation is the process of deducting from the value of an asset over a period of time. Production Depreciation can be calculated by multiplying the units of production, which is how many units are produced during that period, times the rate per unit.
Units of Production Depreciation is a way of determining the worth of an asset based on its use. It’s determined by dividing the equipment’s net cost by its estimated lifetime output, which is common in manufacturing. Depreciation expenditure is calculated by multiplying this rate by the asset’s annual production.
To claim a tax deduction, you can’t utilize units of production depreciation. It is, however, one of the four depreciation techniques that may be used to declare depreciation for accounting reasons. Because it aligns revenues and expenditures, units of production are particularly useful for enterprises whose equipment utilization varies with consumer demand. It also more properly depicts asset wear and tear.
How Depreciation of Units of Production Works
The majority of depreciation techniques rely on the passage of time to calculate the worth of an item, such as a vehicle that depreciates 20% every year. Depreciation in units of production diminishes the value of equipment or machinery depending on its use, which is frequently measured in units produced. As a result, depreciation expenditure varies depending on consumer demand and asset wear.
You’ll use an average cost per unit rate to the total units the machinery or equipment generates each year to determine units of production depreciation costs. This rate will be calculated as the ratio of the asset’s entire cost, less its salvage value, to the projected number of units it will create throughout its useful life.
When Should You Use Production Units?
Businesses that employ machinery or equipment to create a product benefit from units of production depreciation. By distributing the cost of such assets across the years depending on utilization, it may present a more realistic picture of earnings and losses. Because output changes with customer demand, this is beneficial to producers.
Units of production are also used to write down natural resources like oil, according to Alexander J. Sannella, a professor of accounting and information systems at Rutgers Business School.
“You might argue that it would be advantageous in any firm where the loss of value is directly tied to productivity. Units of production depreciation may be a viable alternative for a small firm with a machine that can only make a set number of T-shirts. It is required to be applied to a resource with a well-defined outcome.”
Because the IRS doesn’t recognize units of output for tax reasons, it’s mostly utilized for internal accounting. You’ll most likely use the MACRS depreciation technique when filing your taxes. You’ll also want to check at Section 179 depreciation, which allows eligible firms to deduct the whole cost of specific assets in the year of purchase up to $1 million.
How to Calculate Depreciation in Units of Production
Divide the asset’s cost (minus its salvage value) by the total units you estimate the equipment to generate during its useful life to compute units of production depreciation. Then multiply this rate by the total number of units generated over the year.
The depreciation formula for units of output is:
1. Determine the rate of production in units.
Use the formula to get the units of production rate:
Anticipated total units to be generated throughout asset’s estimated useful life / Asset’s cost base – salvage value
You’ll need various pieces of information to determine the units of production rate, which we’ll go over in detail below. These figures reflect the asset’s purchase price as well as the expected number of units it will create throughout its useful life.
To determine the units of production rate, you’ll need the following information:
- The cost basis of a fixed asset is the entire sum spent to get the item up and running and ready for usage in your firm. The purchase price, sales tax, installation fees, shipping or delivery fees, and other expenditures are usually included.
- The asset’s salvage value is the projected value of what it would be worth if it were sold at the end of its useful life. For example, if you wanted to trade in an old automobile, the Kelley Blue Book value—the current worth of the car based on the number of miles traveled and its general condition—would most likely be used.
- The units of production technique is based on the assumption that the wear and tear on the equipment are proportional to the number of units it is projected to produce throughout its useful life. This value is usually calculated using historical data and production projections.
- The expected useful life of an asset is the amount of time you expect to utilize it before it breaks down and has to be replaced. It’s not always easy to determine how long an asset may be utilized. Despite the fact that depreciation in units of production isn’t utilized for tax reasons, IRS Publication 946 is a valuable tool for determining useful life.
Once you have this information, you may begin the computation. It’s only a question of filling in the blanks in the formula.
2. Determine the Depreciation Charge
The second step in calculating units of production depreciation is to figure out how many units the machine produced in the current year and multiply that amount by the units of production rate you calculated earlier. We demonstrate how to calculate depreciation expenditure in the sewing machine yearly depreciation example below.
Depreciation Examples for Units of Production
The units of production depreciation technique is used in two instances below to compute depreciation for fixed assets. The first is for a sewing machine, and the second is for a crane that your firm has acquired. For the example computations, the units of production depreciation method necessitate the cost base, salvage value, projected usable life, total expected lifetime production, and actual units produced.
Calculation of Annual Depreciation Expenses for Sewing Machines
We’ll first determine the units of production rate before calculating the yearly depreciation charges for the sewing machine. We’ll compute the depreciation charge after that’s done.
The following are the processes to determine the sewing machine’s unit of production depreciation expenditure in year one:
1. Determine the rate of production in units. for the Sewing Machine
Units of production rate = (Cost basis – salvage value) / Estimated units produced throughout the usable life
.043 = ($5,000 – $500) / 105,000
2. Calculate the Depreciation Cost of a Sewing Machine
Depreciation expenditure for Year 1 = Actual units produced X Units of production rate
.043 x 15,000 = $645
Calculation of Crane Annual Depreciation Expenses
To figure out the crane’s yearly depreciation costs, we’ll start by figuring out the units of output rate. We’ll compute the depreciation charge after that’s done.
The following are the processes to determine the crane’s unit of production depreciation expenditure in the first year:
1. Determine the rate of production in units. for the Crane
Units of production rate = (Cost basis – salvage value) / Estimated units produced throughout the usable life
.069 = ($7,000 – $700) / 91,000
2. Determine the cost of depreciation for the crane.
Depreciation expenditure for Year 1 = Actual units produced X Units of production rate
$897 = 13,000.069
Advantages & Disadvantages of Using Units of Production Depreciation
For manufacturing companies that employ assets to create output, units of production depreciation may be highly useful. Depreciation costs correspond to revenues and expenditures by reflecting real wear and tear on such equipment. This strategy, however, is not applicable to all enterprises or for tax reasons. It’s also a pain to keep track of your consumption.
Benefits
The following are some of the benefits of adopting units of production depreciation:
- Depreciation costs are directly related to asset wear and tear: unlike other systems, units of production depreciation depreciates machinery and equipment based on use rather than time. This more closely represents the asset’s decreasing physical worth.
- Revenues and costs are correctly matched by units of production depreciation: Because this system is based on asset utilization, expenses change with consumer demand. This enables us to match revenues to costs and compile financial statements, giving us a more accurate picture of what’s going on in the organization.
Disadvantages
Manufacturers are the only ones who benefit from depreciation units: It makes little sense to tie depreciation to asset utilization if you don’t create a product. Instead, a technique like Section 179 depreciation, which enables a full write-off of certain assets in the year they’re put to use, maybe more realistic.
Depreciation of units of output is not permitted for tax purposes: Instead, on your tax return, you’ll need to employ MACRS, Section 179, or straight-line depreciation. It’s OK to keep two sets of records for depreciation: one for tax reasons and one for accounting ones, but it adds additional effort.
Calculating depreciation units may be time-consuming: This is especially true if you do it on your own. Measuring production may be difficult, and you must recalculate depreciation expenditure every quarter.
Manufacturers benefit from depreciation in units of output. When you expense an asset depending on its use, you might get a more accurate and timely view of its value loss. However, for many organizations, monitoring equipment utilization is ineffective, and you can’t utilize units of production depreciation for tax reasons. You’ll almost certainly utilize MACRS for this.
How to Calculate Depreciation in Units of Production for Accounting Purposes
To keep track of book and tax costs, create a journal entry, keep records on each of the individual assets, and create a depreciation plan.
Preparing the units of production depreciation expenditure journal entry, maintaining asset records, and preparing depreciation schedules are the three phases in recording units of production depreciation expense.
1. Prepare the Depreciation Expense Journal Entry for the Units of Production
I propose that you track depreciation expenditure on a monthly basis, just as you would your profit and loss statement and balance sheet report. Depreciation costs and cumulative depreciation are best recorded using a journal entry.
The journal entry begins with a debit depreciation expenditure, which raises the profit and loss statement’s total costs. The net value of all fixed assets is reduced by a credit to cumulative depreciation, which shows on the balance sheet report. In QuickBooks, you may make a journal entry in a matter of minutes.
Using the units of production depreciation technique, this is the journal entry you would make for the sewing machine:
2. Keep track of your assets.
Be careful to maintain track of any receipts, titles, contracts, or other documentation that verify you own the asset in addition to depreciation. The purchase date and the price you paid for the item should be included in these records.
This documentation should be kept in a separate file for each item. Keeping track of all your documents is always vital, but you may need them if you elect to have your financial accounts audited or examined by a CPA.
Remember that the unit of production depreciation technique is not applicable to taxes, thus you’ll need to pick another method. Whatever technique you adopt, maintain records because the IRS needs supporting evidence for fixed assets. In the case of an audit, you must submit these documents to support the asset’s cost basis and demonstrate that you held it.
3. Make a depreciation schedule
To keep track of all assets, you’ll also need to construct depreciation schedules. These schedules will make it simpler for you to maintain track of both systems for all of your assets if you utilize units of production for accounting and MACRS for tax reasons.
Depreciation schedules are straightforward to establish in QuickBooks Online. If you don’t have QuickBooks, I suggest creating your depreciation schedules in a spreadsheet application like Microsoft Excel.
Here’s an example of the kind of information you’ll need in your depreciation schedule:
Property Depreciation Schedule: 7-Year
Depreciation expenditure is not calculated by QuickBooks. This is true for the majority of accounting software. If you have enough assets to warrant the expenditure, however, look into fixed asset software systems such as Sage’s. These applications are intended to assist you in keeping thorough records on all fixed assets and calculating depreciation.
How QuickBooks Can Aid with Units of Production Depreciation Calculation
You may use QuickBooks to keep track of all of your fixed asset acquisitions so you don’t have to start from zero with a depreciation plan. To keep track of fixed assets in QuickBooks, you’ll need to create a Chart of Accounts for each one.
The following example demonstrates how to create a fixed asset account in QuickBooks so that you may depreciate units of production.
1. Create an asset account.
The first step is to create a depreciation account for the fixed assets you’ll be depreciating. This option may be found by choosing Chart of Accounts from the Your Company Column after clicking on the gear icon. This will take you to a page where you may create an account.
In QuickBooks Online, add the Asset Account to the Chart of Accounts.
The fields you must fill out are as follows:
- Select Fixed Assets as the category type.
- Select the sort of fixed asset you wish to create, such as Vehicles.
- Name: Type the asset’s name here.
- In this box, you may either repeat the information from the name field or provide any extra information about the item.
- Original price and current date: Enter the asset’s original purchase price and the date it was purchased.
- Depreciation and as of date: Enter any already taken depreciation. Tip: If you began depreciating the asset before putting it up in QuickBooks, you’ll just need to fill in one area.
2. Generate a Chart of Accounts Report.
You may run a chart of accounts report and filter it to just reveal fixed assets once you’ve established the fixed asset in QuickBooks. QuickBooks Online generates a chart of accounts depending on the industry you choose when you first started using the program. You’ll need to create a new account if you wish to monitor anything that isn’t on the default list.
An example of a chart of accounts report is shown below:
Fixed Assets are shown in the QuickBooks Chart of Accounts.
You may export this report to Excel and fill in the blanks with the information you’ll need to generate your depreciation schedules.
Frequently Asked Questions (FAQs)
We’ve done our best to explain the units of production depreciation technique, how to apply it, and how to calculate it, but you may still have questions. Here are some of the most frequently asked questions.
How do you compute depreciation in units of production?
Depreciation of manufacturing units may be estimated in two phases. To begin, multiply the asset’s cost basis (minus any salvage value) by the total number of units it is projected to generate during its estimated useful life. The total number of units produced for the time is then multiplied by this unit cost rate.
What are the units of measurement for the manufacturing method?
The units of production technique is based on the use of an asset rather than time. The amount of depreciation you record is determined by how many units it generates each period. However, with units cost of production depreciation, your spending tends to go down when sales decline and up when real output is high.
What are the activity method’s units?
Depreciation in units of activity is another phrase for depreciation in units of output. The activity of an asset may be assessed in units generated, but it can also be quantified in hours utilized or operations performed. You may, for example, base the depreciation of business-owned automobiles on the number of miles traveled.
Conclusion
Now that we’ve covered everything you wanted to know about units of production depreciation (and everything you didn’t), you should have a good understanding of how it works.
