Units of production

What Is Units of Production?

Units of production is a depreciation method that allocates the cost of a tangible asset based on its actual usage or output, rather than solely on the passage of time. This approach falls under the broader category of depreciation methods within accounting, providing a more precise matching of an asset's expenses with the revenue it helps generate. Unlike time-based methods, which expense an equal amount each period, the units of production method recognizes higher depreciation in periods of high usage and lower depreciation in periods of low usage, directly reflecting the asset's wear and tear.

History and Origin

The concept of depreciation accounting, as it is largely recognized today, began to gain prominence in the 1830s and 1840s, coinciding with the growth of industries that relied heavily on expensive and long-lived fixed assets, such as railroads. These early industries faced challenges in accounting for the deterioration and eventual replacement of their plant and equipment. Over time, regulatory bodies, like the Interstate Commerce Commission in 1907, began to prescribe systems of accounts that required depreciation accounting for various transportation and communication industries. This historical development underscored the evolving understanding that assets diminish in value not just by age, but by their active use in generating economic benefits.⁹

Key Takeaways

• The units of production method allocates an asset's cost based on its actual output or usage.
• It provides a more accurate matching of depreciation expense with the revenue generated by the asset's use.
• This method is particularly suitable for assets where wear and tear are directly proportional to their activity, such as manufacturing machinery or vehicles.
• Calculating depreciation using this method requires estimating the total expected output or usage over the asset's useful life.
• The depreciation expense can fluctuate significantly from year to year, reflecting varying levels of production.

Formula and Calculation

The formula for calculating depreciation expense using the units of production method involves two main steps. First, determine the depreciation cost per unit. Second, multiply that rate by the actual units produced in the period.

Step 1: Calculate Depreciation per Unit

Where:

• Cost: The original capital expenditure of the asset.
• Salvage value: The estimated residual value of the asset at the end of its useful life.
• Total Estimated Production: The total expected output or usage (e.g., units, hours, miles) over the asset's entire useful life.

Step 2: Calculate Depreciation Expense for the Period

Where:

• Units Produced in Period: The actual number of units the asset produced during the current accounting period.

Interpreting the Units of Production

Interpreting the depreciation calculated using the units of production method involves understanding its direct link to an asset's operational activity. A higher depreciation expense in a given period indicates that the asset was used more intensively and, consequently, incurred greater wear and tear. Conversely, a lower expense reflects less usage. This method provides a dynamic view of an asset's value consumption, aligning the allocation of its cost with the actual economic benefits it provides. It offers a more realistic portrayal of an asset's contribution to net income and profitability, especially for businesses where asset utilization varies significantly. When analyzing financial statements, the depreciation figure derived from the units of production method directly correlates with the scale of operations and the intensity of asset usage.⁸

Hypothetical Example

Consider a manufacturing company, "Widgets Inc.," that purchases a specialized machine for $200,000 to produce widgets. The machine is expected to produce a total of 500,000 widgets over its useful life, with an estimated salvage value of $20,000 at the end of its operational period.

To calculate the depreciation:

1. Calculate Depreciation per Unit:

   • Depreciable Base = Cost - Salvage Value = $200,000 - $20,000 = $180,000
   • Depreciation per Unit = $180,000 / 500,000 units = $0.36 per unit

2. Calculate Annual Depreciation Expense:

   • Year 1: Widgets Inc. produces 80,000 widgets.
     • Depreciation Expense = 80,000 units * $0.36/unit = $28,800
   • Year 2: Widgets Inc. produces 120,000 widgets due to increased demand.
     • Depreciation Expense = 120,000 units * $0.36/unit = $43,200

This example illustrates how the depreciation expense fluctuates with the actual production volume, providing a clearer picture of the operating costs associated with the machine's use each year.

Practical Applications

The units of production method is particularly valuable in industries where the wear and tear on fixed assets are directly tied to their usage rather than their age. Common applications include:

• Manufacturing: For machinery and equipment that produce a measurable number of units, such as textile looms, packaging machines, or assembly line robots.⁷
• Mining and Natural Resources: Heavy machinery used in extraction, such as drilling rigs, excavators, and processing equipment, often depreciates based on the volume of ore extracted or oil and gas reserves produced.⁶
• Transportation: Vehicles, aircraft, and heavy-duty trucks can be depreciated based on miles driven or flight hours, directly reflecting their operational use and wear.⁵

This method allows businesses to more accurately reflect the true cost accounting of production in their income statement and maintain a more accurate asset value on their balance sheet. The Financial Accounting Standards Board (FASB) provides guidance, such as ASC 360, on the accounting for property, plant, and equipment, which includes requirements for disclosing the depreciation methods used.⁴

Limitations and Criticisms

Despite its theoretical accuracy in matching costs with benefits, the units of production method has several limitations. A primary challenge is the difficulty in reliably estimating the total expected usage or output of an asset over its entire useful life. Unforeseen changes in market demand, technological obsolescence, equipment breakdowns, or maintenance issues can significantly alter actual usage from initial projections, leading to potential inaccuracies in depreciation calculations.³

Another criticism is the complex and time-consuming nature of record-keeping. Businesses must meticulously track the actual units produced, hours operated, or miles driven for each asset, which can be burdensome, especially for companies with numerous assets or diverse production lines.² Furthermore, this method is generally not suitable for assets whose value declines primarily due to factors other than usage, such as obsolescence or the passage of time. Examples include office furniture, buildings, or intangible assets, where physical deterioration is not directly linked to production volume.¹ For some assets, the effort involved in tracking usage may outweigh the marginal benefit of increased accuracy compared to simpler methods, potentially leading to higher administrative costs.

Units of Production vs. Straight-Line Depreciation

The units of production method and straight-line depreciation are two common ways to allocate the cost of an asset over its useful life, but they differ fundamentally in their underlying assumptions.

While the units of production method aims for a more accurate matching of an asset's cost to its generated revenue, straight-line depreciation offers simplicity and predictability, resulting in consistent depreciation expense each year. The choice between these methods depends on the nature of the asset and the pattern of its economic benefit consumption.

FAQs

Why would a company choose the units of production method?

A company would choose the units of production method when an asset's useful life is primarily determined by its usage rather than the passage of time. This method provides a more accurate reflection of how the asset's value is consumed, allowing for better matching of depreciation expense with the actual revenue it helps generate. It is particularly beneficial for assets that experience significant wear and tear directly correlated with their output.

How does salvage value affect units of production depreciation?

Salvage value reduces the total amount of an asset's cost that can be depreciated. In the units of production formula, the salvage value is subtracted from the asset's original cost to determine the "depreciable base." Only this depreciable base is allocated over the asset's total estimated production, meaning the asset's book value will not fall below its salvage value.

Can units of production be used for tax purposes?

For tax purposes in the United States, the Internal Revenue Service (IRS) generally mandates the Modified Accelerated Cost Recovery System (MACRS) for most tangible property. While the units of production method can be used for financial reporting to reflect economic reality, it is often not permissible for federal income tax calculations unless specifically allowed for certain types of property. Businesses must adhere to IRS guidelines, which may differ from Generally Accepted Accounting Principles (GAAP) for financial reporting.

Is the units of production method suitable for all types of assets?

No, the units of production method is not suitable for all types of fixed assets. It is most appropriate for assets whose value diminishes in direct proportion to their usage or output, such as manufacturing machinery, vehicles (based on mileage), or mining equipment (based on extracted volume). Assets like buildings, office furniture, or intangible assets, which tend to depreciate due to factors like obsolescence or time rather than direct usage, are typically better suited for other depreciation methods, such as straight-line depreciation.