3.8 : Calculating Depreciation: Units of Production Method

The units of production method for depreciation bases the depreciation expense on the actual usage or output of the asset rather than its estimated useful life. The method estimates the total number of units an asset will produce over its useful life. Then, the depreciation expense is calculated each year based on how many units were produced that year.

For example, suppose Horizon Industries purchases a machine for $100,000, with an expected production capacity of 500,000 units and a scrap value of $10,000. In that case, depreciation is calculated by subtracting the scrap value from the purchase price and dividing it by the total expected output. This results in a depreciation rate of $0.18 per unit. If the machine produces 50,000 units in the first year, the depreciation expense would be $9,000. In the second year, if production increases to 60,000 units, depreciation would rise to $10,800.

This approach provides a realistic allocation of the asset's cost based on actual usage but requires accurate production estimates and detailed tracking. This method is beneficial for assets like manufacturing and processing equipment, where wear and tear is directly related to the production level.