Unit of Production Depreciation Definition
Unit of production depreciation, also called as activity method, calculates depreciation based on the unit of production and ignores the passage of time over the useful life of an asset, in other words, unit of production depreciation is directly proportional to production. It is mainly used in the manufacturing sector.
The value of the same asset may be different due to its usage. For example, one asset X produce 10 units, and another asset Y produce 20 units, both are the same asset, but the depreciation of Y will be higher as compared to X asset because of more unit produced.
Unit of Production Depreciation Formula
We will segregate the unit of production depreciation formula into two parts to understand it in a better way.
Step #1: The depreciation per unit formula is represented as below,
Step #2:The depreciation Expense formula is represented as below,
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For eg:
Source: Unit of Production Depreciation (wallstreetmojo.com)
Cost: It includes purchased price, installation, delivery charge, incidental expenses.
Salvage Value: it is the value that will receive at the end of the life of an asset.
Estimated Unit of Production: It is basically an estimation of the unit produced by the asset over its useful life.
Example of Unit of Production Depreciation Method
Let’s discuss an example of a unit of production depreciation methodDepreciation MethodDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more.
Suppose an item of asset acquired on 5th Jan at the cost of $ 50000 has estimated the use of 20000 hours. During the first year, the said equipment used 4000 hours. The estimated salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000.read more is $ 4000.
Solution:
Step #1: First, we need to calculate the depreciation rate per unit; the calculation will be as below.
- Depreciation per Unit = ($50000 – $4000) / 20000 Hours
- Rate per Unit = $ 2.3 per Hour
Step #2: Then, we need to calculate depreciation for the particular year based on depreciation rate per hour; the calculation will be as below.
- Depreciation Expense = 4000 Hours × 2.3 per Hour
- Depreciation Expense (Total Depreciation) = $ 9200
- Value of Asset after Depreciation = ($ 50000-$9200) = $ 40800
- Suppose in 2nd year the said equipment used 8000 hours then the depreciation amount will be –
- Total Depreciation = 8000 hours × 2.3 per Hour = $ 18400
- Value of Asset after Depreciation = ($40800-$18400) = $22400
- As we can see, the depreciation amount is increasing due to an increase in the production unit.
Change in Unit of Production Depreciation Method
- As per old accounting standard change in depreciation method treated as a change in accounting policyAccounting PolicyAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.read more and depreciation charged on retrospectively;
- As per the new accounting standard change in depreciation method will be treated as a change in accounting estimate and depreciation charge prospectively over the useful life of an asset.
- The difference arising due to change in the unit of production method charge to profit and loss a/c. Suppose as per the old method depreciation amount is $ 1000, but as per the new method, depreciation amount is 2000.
- In this case, extra depreciation arises due to change in a new method, and we will debit ($2000-$1000) $ 1000 additional amount to profit and loss a/c.
- Suppose if as per old method depreciation amount is $ 4000, but as new method depreciation amount is $ 3000.In this case($4000-$3000), $ 1000 will be credited to profit and loss a/c.
Advantages of the Unit of Production Depreciation Method
The different advantages related to the unit of production depreciation method are as follows:
- It is charged based on usage of the asset and avoid charging unnecessary depreciation. For example, machinery produced 5000 units in 340 days. Under this method, depreciation will be charged based on 5000 units, which for 340 days rather than full-year hence it provides matching concept revenue and cost.
- It is beneficial in determining the efficiency of an asset.
- Under this method, cost, i.e., depreciation matches with revenue, i.e., production.
- Under this method, the business can track their profit and loss more accurately as compared to the straight-line methodStraight-line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more. For example, 1000 units produced by the machinery in 320 days and remaining days the machinery was idle.
- Under this method, depreciation charged on the basis of 320 instead of the full year. But under the straight-line method, depreciation will charge for the full year; therefore, as you can see, the unit production method more accurate to derive profit and loss as compared to the straight line.
- Larger depreciation in most productive years can help to offset the higher costs associated with higher production levels because depreciation is direct Proportionate to unit production. More the production higher the depreciation.
- For example, suppose in the first-year assets produced 1000 units and 2nd year 2000 units, then production cost in 2nd year will be higher, and the amount depreciation will also be higher as compared to 1 year.
- This method is very useful in manufacturing business because depreciation is charged on the basis of unit produced instead of full-year or part-year.
Disadvantages of Unit of Production Depreciation
The different disadvantages related to the unit of production depreciation are as follows:
- This method provided depreciation based only on usage, but in reality, there is an end number of factors that cause a reduction in the value of an asset.
- For example, depreciation also arises due to the efflux of time. Sometimes manufacturing assets remain idle in a factory. Still, in this method, depreciation can not charge when a machine is idle in the factory due to which true value of the asset can not be derived by using this method.
- Practically it is challenging to calculate depreciation under this method due to complexity. For example, there are multiple assets, and each asset produces different units in a particular year. To keep track of each asset is very difficult, primarily where goods are produced in multiple processes.
- Under this method, the value of the two same assets may be different because of its usage.
- This method can not be used for tax purposes because, in this case, depreciation is not consider based on unit produced; instead, they charge depreciation, which is followed under tax regime.
Limitations
The different limitations related to the unit of production depreciation are as follows:
- This method can’t apply where the machine remains idle in the factory. For example, an asset produces 1000 units in 350 days and remains idle for 15 days. In this case, depreciation will calculate based on 1000 units, i.e., only for 350 days. Depreciation for the idle period, i.e., 15 days, will not be calculated; hence it opposes passage of time.
- This method can not apply to assets other than manufacturing assets such as building and furniture.
- It is difficult to derive the correct value of depreciation under this method because it applies only to users and ignores the efflux of time.
- This method can not be used by all businesses such as trading company, service industry because, under this business, depreciation is not calculated based on unit produced; rather, they follow the straight-line method or WDV methodWDV MethodThe Written Down Value method is a depreciation technique that applies a constant rate of depreciation to the net book value of assets each year, resulting in more depreciation expenses recognized in the early years of the asset's life and less depreciation recognized in the later years of the asset's life.read more.
Conclusion
The Unit of production depreciation method basically applies to manufacture assets where idle time is less and production is efficient. Nowadays, this method is more popular in determining the efficiency of an asset. It provides depreciation for each asset based on its production efficiency. The selection of this method is very critical because we need to keep track of each asset and their production, so before the selection of this method, please ensure everything is in control; otherwise, it will be challenging to use this method.
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