Unit of Production Method Definition
The Unit of Production Method is a depreciation method that measures the depreciation of an asset based on its usage and not just passage of time. When the unit of production method is used to gauge depreciation of an asset, the useful life of the asset is related to its usage over time, in terms of the units it produces for the period it was in use.
Using this method, the actual usage of an item counts more than the passage of time. If the asset is rarely used, its depreciation will be lesser and an asset will have greater depreciation for years when it is heavily used.
A Little More on What is the Unit of Production Method
The annual amount of depreciation of an asset is calculated by deducting the original cost of the asset from the salvage value and divide by the estimated units the asset should produce in its useful life. Thereafter, the realized number is multiplied by the units used in the current year.
More explicitly, depreciation expense for a fiscal year is calculated using the formula below:
Depreciation expense = [Estimated production capability/(Original value−Salvage value) ]×Units per year
There are some important things you should note about unit of production method. They include the following:
- The unit of production method is a method of depreciation in which the depreciation of an asset is calculated using its actual usage and not the passage of time.
- This method is closely related to the units an asset produces during its useful life.
- Different depreciation expenses can be estimated for an asset using the unit of production method.
- An asset will have a higher depreciation in years it is more productive and have a lower depreciation in years when less productive.
What Does the Unit of Production Method Tell You?
The unit of production method plays a vital role in the calculation of depreciation of assets owned by a company. For specific years in which an asset is put into use and have more unit productions, a company can claim higher depreciation deductions. When the equipment is also less production, lower depreciation deductions can be claimed.
Larger depreciation deductions play significant roles in helping a company offset expenses relating to the huge production output for the period of time, such as, labor costs, utility costs, wages, cost of raw materials and others.
The unit of production method also enables a business estimate is loss and gains for a period of time.
The Difference Between Unit of Production and MACRS Methods
Aside from unit of production method, there are other methods of measuring the depreciation of assets. Another method commonly used for depreciation is the modified accelerated cost recovery system (MACRS). This depreciation method is commonly used for tax purposes, it is a standard way to depreciate assets using a declining balance for a period of time.
As required by the Internal Revenue Service, businesses depreciate assets using MACRS when filing their tax reports.
However, MACRS did not accurately track losses and profits that an asset generate over time like the unit of production method.
References for “Unit of Production Method”
Academic research for “Unit of Production Method”
Valuation of international oil companies, Osmundsen, P., Asche, F., Misund, B., & Mohn, K. (2006). Valuation of international oil companies. The Energy Journal, 49-64.
International oil company valuation: The effect of accounting method and vertical integration, Misund, B., Osmundsen, P., & Sikveland, M. (2015). International oil company valuation: The effect of accounting method and vertical integration. Petroleum Accounting and Financial Management Journal, 34(1), 1.
Benefits of applying different depreciation methods of long-term tangible assets in a company, Stungurienė, S., & Christauskas, Č. (2013). Benefits of applying different depreciation methods of long-term tangible assets in a company. Socialiniai mokslai, (4), 38-47.
The Effect on Business Decisions of Changes in Tax Depreciation Policy, Edmonds, W. J. (1955). The Effect on Business Decisions of Changes in Tax Depreciation Policy. National Tax Journal, 8(1), 99-113.
What concept of depreciation for fixed assets is most useful today?, Smith, C. W. (1951). What concept of depreciation for fixed assets is most useful today?. Journal of Accountancy (pre-1986), 92(000002), 166.
Some Problems of Depreciation, Wellen, C. W., & Lipscomb, O. (1954). Some Problems of Depreciation. Tex. L. Rev., 33, 886.
Resumptions and developments regarding the management of the depreciation methods, Ilincuta, L. D. (2013). Resumptions and developments regarding the management of the depreciation methods. Metalurgia International, 18(3), 202.
Review of accounting gimmicks called depreciation, Lawrence, O. A., & Okechukwu, U. A. (2013). Review of accounting gimmicks called depreciation. Open Journal of Accounting, 2(02), 39.