In the balance sheet of a company, assets and liabilities are recorded. Current assets are short-term liquid assets that can be converted into cash easily. However, the non-current assets have physical and non-physical assets. The physical assets are machinery, plant, equipment, furniture, etc. The physical assets are usually the capital assets of the company.
The capital assets benefit an organization for more than one accounting period. Therefore, the purchase of such an asset is debited to the asset account instead of the expense account. However, the amount debited to the asset account is realized as an expense throughout the asset’s useful life.
The process of systematic allocation of an asset’s value over its’s useful life is called depreciation. There are different methods of depreciation that are used across different companies and for varying purposes. For instance, the straight-line method is used for internal reporting, and accelerated depreciation methods are applied for tax purposes.
Similarly, the unit of production method is a depreciation method used across various industries and business entities to systematically allocate asset costs. This article will go through the unit of production method, how it works with an example, and a comparison with other depreciation methods.
What Is the Unit Of Production Method?
Unit of production method can be defined as,
Unit of production method is a depreciation method of systematically allocating an asset’s cost. However, the method considers the usage of the asset in different financial periods instead of the average useful life.
Or,
In many manufacturing industries, the assets are depreciated not based on their useful life. Instead, the depreciation is based on the usage of an asset. It is done by estimating the output from the asset over the useful life.
The unit of production method is commonly used in manufacturing companies. However, this method of depreciation cannot be applied to get tax deductions. Unit of production method can be used for internal reporting purposes. The companies working in the industries having seasonal demand can use the unit of production method. It will accurately match the revenues with the expenses in the financial statements.
Formula For Unit Of Production Method
The unit of production method calculates the amount of asset’s value that has been lost upon its usage. However, other methods account for the depreciation over the financial period regardless of whether it was used.
An average cost per unit is applied to the total units produced by the machine or plant in a financial period to determine depreciation under the unit of production method. The applied rate is the ratio of the asset’s total value minus residual value to the estimated number of units a machine produces over the useful life.
We can write the formula of Unit of Production Method as follow:
Annual depreciation = (Assets value X Units produced during the financial period)/ Estimated total production
The asset value to be reported in the formula is calculated as,
Asset Value(Depreciable Value) = Original Cost Of Asset – Residual Value
Some important definitions regarding the formula are as follow:
- Original Cost of Asset: It is the historical cost of the capital asset at which the company purchased it. The historical cost of an asset includes the purchase price, transportation, installation fees, sales tax, etc.
- Residual Value: Residual value or salvage value estimates the value asset will still have at the end of its estimated useful life. For instance, if you own a car, what will you be able to get if your car is totaled.
- Estimated number of units to be produced: The estimated total production or estimated number of units to be produced is defined in the unit of production method. This number signifies the output of a machine over its useful life.
- Estimated useful life: Estimated useful life is the time for how long a machine will remain useful until it gets replaced. IRS Publication 946 is a helpful tool for the appropriation of an asset’s useful life.
Unit Of Production Method Vs. Units Produced
There is a general misconception about the unit of production method vs. units produced.
When we talk about the ‘unit of production method,’ it clearly means that the unit is used by a business entity for measuring its output production. It can be kilogram, liters, hours, production runs, or a number of units produced, etc.
Contrary to that, the unit produced is the number of units produced in a given period. Therefore, it must be understood that a right phrase is a unit of production and not the units of production.
Example Of Unit Of Production Method
Let’s try to understand the concept of the unit of production method with an example.
Kabeer Inc. purchased a machine that cost $150,000. As per estimates, the machine was expected to give 7000 kgs or 280,000 units output.
The residual value of the machine was estimated to be $10,000. Now you’ve to find the depreciation of the machine according to the unit of production method.
According to the data available at the date of calculation:
The machine has already produced 500 kgs output and 18,000 units.
The depreciation of the machine in question can be found by both units as follow:
- 500 Kgs output has been produced.
Annual depreciation = (Depreciable Value X Units Produced During the Financial Period) / Estimated Total Production
Annual depreciation = ($140,000 X 500)/7,000
Annual depreciation = $10,000.
- 18000 units have been produced
Annual Depreciation = (Depreciable Value X Units Produced During the Financial Period) / Estimated Total Production
Annual depreciation = $140,000 X 18,000/280,000
Annual depreciation = $9,000.
*Depreciable Value = Cost of Asset – Residual value
Depreciable value = $150,000 – $10,000
Depreciable Value = $140,000
Journal Entries
Let’s understand the journal entries of depreciation under the Unit of Production method with another example.
Javier textiles mill bought a machine that cost $100,000 at the beginning of the financial year. The company follows normal financial starting from Jan 1st and ending in December. According to the estimates, the machine was found out to have a useful life of 8 years with a salvage value of $5,000.
Under the unit of production method, it is expected that the machine will produce 20,000 units during its useful life.
According to a probability distribution, the pattern of periodic production is as follow:
For the first three years: 3500 units per year
From 4th to 6th year: 2000 units per year
During 7th and 8th year: 1750 units per year.
What will be the depreciation for every year?
It can be calculated by the formula of depreciation.
Annual Depreciation = (Depreciable Value X Units Produced During the Financial Period) / Estimated Total Production
| Year Of Depreciation | Annual Depreciation |
| Year 1 – 3 | $95,000 X 3,500/20,000 = $16,625 |
| Year 4 – 6 | $95,000 X 2,000/20,000 = $9,500 |
| Year 7 – 8 | $95,000 X 1,750/20,000 =$8,312.5 |
Journal Entries in Books Of Accounts
On the purchase of machinery, the journal entry will be:
| Description | Debit($) | Credit($) | ||
| Machinery account | $100,000 | |||
| Cash account | $100,000 |
The 1st year to 3rd year depreciation will be recorded as,
| Description | Debit($) | Credit($) | ||
| Depreciation on machinery account | $49,875 | |||
| Machinery account | $49,875 |
| Description | Debit($) | Credit($) | ||
| Profit & loss a/c | $49,875 | |||
| Depreciation on machinery account | $49,875 |
Depreciation for the 4th to 6th year will be as follow:
| Description | Debit($) | Credit($) | ||
| Depreciation on machinery account | $28500 | |||
| Machinery account | $28500 |
| Description | Debit($) | Credit($) | ||
| Profit & loss a/c | $28500 | |||
| Depreciation on machinery account | $28500 |
Depreciation for 7th and 8th year will be as follow:
| Description | Debit($) | Credit($) | ||
| Depreciation on machinery account | $28500 | |||
| Machinery account | $28500 |
| Description | Debit($) | Credit($) | ||
| Profit & loss a/c | $28500 | |||
| Depreciation on machinery account | $28500 |
At the end of useful life, an entry would be passed after selling machinery at $12,000.
| Description | Debit($) | Credit($) | ||
| Cash account | $12,000 | |||
| Machinery account | $12,000 |
| Description | Debit($) | Credit($) | ||
| Machinery account | $7000 | |||
| Profit & loss account | $7000 |
Unit Of Production Method Vs. MACRS Method
As discussed earlier, that unit of production method cannot be used for tax purposes. There are other depreciation methods allowed for tax purposes.
MACRS or the modified accelerated cost recovery system is a permissible method of depreciation for tax purposes. In the MACRS, the asset’s value is depreciated by using a declining balance over the time period.
MACRS on the principle that a machine’s efficiency is higher in the beginning years than the ending years. Therefore, the productivity is also higher in the beginning years. That’s why more costs should be allocated when the machine is generating more revenue.
According to disclosures of IRS, most business entities depreciate their assets by MACRS for tax returns.
Conclusion
In this article, we’ve tried to explain the concept of ‘unit of production method’ and how companies can depreciate their assets based on machinery and equipment output.
