Depreciation is a portion of the Company’s fixed assets considered as a decrease in value due to usage of assets.
This value is called depreciation expense. This does not require whether the asset is partially or fully used during the accounting period.
Methods for Calculating Depreciation Expense:
There are different methods used to calculate depreciation expenses by different organizations according to their policies. Some of the methods are:
- Straight Line Method
- Units of Production Method
- Sum of Year digits
- Double declining Method
The above methods can be used for calculating depreciation expenses. But International Accounting Standards prefer to use the straight-line method.
Because it provides a uniform expense throughout the life of an asset. But you can choose any of them according to your policy and business needs.
What is Units of Production Method?
Some organizations prefer to calculate the depreciation expense of their production noncurrent assets on their usage. Its means that their base is units produced by the plant instead of a number of estimated useful life.
In this method, the amount of depreciation expense is much higher in the period of heavy production compared to the periods of low production.
Formula to Calculate Units of Production Method:
In this method, we use the units produced as the base price instead of estimated useful life.
The Salvage value is subtracted from the total cost of an asset and divided by estimated production capability. The result is then multiplied by Units per year.
Let’s have a look at the formula:
For further clarification have a look at the following example:
Company name ABC has the following data from the previous five years. You are required to calculate the depreciation by using the Units of Production Method.
The Production plant is purchased by the company five years ago. At that time installation and purchase, cost is $500,000. While the estimated salvage value at the end of its life will be $20,000.
|Years||Production In Units|
The estimated production capability at the time of purchase for this plant was 10,000,000.
For year 1 = [(500,000 – 20,000)/ 1,000,000] * 50,000
For year 2 = [(500,000 – 20,000)/ 1,000,000] * 30,000
For year 3 = [(500,000 – 20,000)/ 1,000,000] * 40,000
For year 4 = [(500,000 – 20,000)/ 1,000,000] * 70,000
For year 5 = [(500,000 – 20,000)/ 1,000,000] * 10,000
So if you analyze the above data it is proved that in year 4 the production is the highest. And the depreciation expense is also the highest with an amount of 33,600.
While in the year 5 the production is at the lowest side with only 10,000 units to be produced. That’s why the depreciation expense is on the lowest side.
Outcomes of Units of Production Method:
In this method, depreciation expense is acted as a variable expense. Which is fixed by units and change with the production.
This method helps the companies to adjust their depreciation expense according to seasonal effects.
The other benefit of this method is that the expense should be higher when wear and tear are high in the period. This method helps seasonal companies to adjust their revenue and income according to the seasonal effect.
If they use the straight-line method, they will have very high profits in the periods when production and sales were high but there will be low profits when the sales and productions were on the low side. Because in both the cases depreciation was charged at a fixed price.