Units of Production Method: A Guide to Calculate Depreciation
When it comes to calculating depreciation, there are different methods that businesses can use. One of these methods is the Units of Production method. This approach allows companies to calculate depreciation based on how much a fixed asset has been used during its useful life.
In this guide, we will take an in-depth look at the Units of Production method and discuss how it works, when it’s appropriate to use, and how you can apply it correctly.
How Does the Units of Production Method Work?
The Units of Production method calculates depreciation by dividing the total cost of an asset by its estimated total production capacity. In simpler terms, this means that businesses can determine how much each unit produced costs in terms of depreciation.
To illustrate this further, let us consider a manufacturing company that uses a machine for production purposes. The machine costs $100,000 and has an estimated useful life span of 5 years with an expected output capacity of 500,000 units before being replaced.
Using the Units of Production method:
1) Divide the total cost ($100K) by estimated total production (500K). This gives us a “per unit” cost estimate for determining depreciation.
2) If in Year 1 only 50k units were produced (10% usage), then multiply our per-unit rate ($0.20) times actual output or usage (50k * $0.20 = $10k).
3) Continue doing step two throughout the lifespan until we’ve reached our end goal.
By using this approach over time, businesses can accurately track their assets’ value as they wear out through repeated use.
When Is It Appropriate To Use The Units Of Production Method?
The Units Of Production method is well suited for assets whose value declines based on usage rather than age or time-related factors such as obsolescence or wear and tear from age alone. For example:
1) Heavy machinery that is used in production processes.
2) Vehicles and equipment that are driven or operated for specific purposes.
This method is also useful when a company’s accounting system is flexible enough to accommodate changes in the rate of depreciation due to fluctuations in usage.
It’s essential to note that while this method can be useful, it may not always be the best option for every business. Companies should consider other factors such as tax implications, cash flow needs, and future plans before making a decision on which depreciation method to use.
How To Apply Units Of Production Method Correctly
To apply the Units Of Production method correctly, businesses need to follow these simple steps:
Step 1: Determine The Total Cost of The Asset
To calculate depreciation using the Units Of Production method, companies must first determine how much they paid for the asset being depreciated. This includes all costs associated with acquiring and preparing the asset for use, such as delivery fees or installation expenses.
Step 2: Estimate The Total Capacity of The Asset
Next, companies need to estimate how many units an asset will produce during its useful life span. For example:
– A manufacturing machine might have an estimated total output capacity of 500K units over five years before needing replacement.
– A delivery truck might have an estimated lifespan of eight years with a total mileage capacity of 200K miles.
Step 3: Calculate Depreciation Per Unit
Once you’ve determined an asset’s cost and its expected lifetime output capacity (or distance traveled), divide these two numbers by each other. This calculation gives us our “per unit” cost estimate for determining depreciation moving forward.
For instance:
If a company expects their $100k machine to produce 500k units over five years before needing replacement ($100K / 500K = .20 per unit). In Year One if only fifty thousand (50k) were made instead of one hundred thousand (100k), then we would multiply the per-unit rate ($0.20) by actual output (50k x $0.20 = $10K).
Step 4: Update Depreciation Record Over Time
As production begins and assets are used, companies should update their depreciation records accordingly. This means tracking how many units have been produced since the asset was acquired and calculating depreciation costs based on that number.
It’s critical to remember that using Units Of Production Method requires ongoing monitoring of production levels as they can be affected by various factors such as market demand or natural disasters.
Conclusion
The Units Of Production method is a useful approach for businesses looking to calculate depreciation based on usage rather than time-related factors such as wear-and-tear or obsolescence. It provides an accurate reflection of an asset’s value over time, allowing companies to make informed decisions about when to replace equipment and how much it will cost.
To apply this method correctly, businesses need to follow specific steps such as determining the total cost of the asset, estimating its total capacity, calculating depreciation per unit, and updating their records over time.
While this method may not always be suitable for every business situation, those who choose it can expect more precise financial reporting and better decision-making abilities regarding long-term asset replacement planning.