Units of production method

What Is Units of Production Method?

The units of production method is an accounting technique used to calculate the depreciation of an asset based on its actual usage or output, rather than solely on the passage of time. This method falls under the broader category of accounting and depreciation and is particularly relevant for assets whose useful life is more closely tied to how much they are used or what they produce. Instead of allocating a fixed amount of depreciation expense each period, the units of production method assigns more expense during periods of high usage and less during periods of low usage, providing a more accurate reflection of an asset's consumption and wear and tear.³³ It's often applied to fixed assets like machinery, vehicles, or equipment, where the decrease in value directly correlates with their operational activity.

History and Origin

The concept of matching expenses with the revenues they help generate is a fundamental principle in accounting, forming the philosophical basis for various depreciation methods. While a single, definitive origin for the units of production method is not pinpointed to a specific date or inventor, it developed as a logical extension of accrual accounting principles. As businesses acquired significant capital expenditure in the form of machinery and equipment that generated revenue based on usage, accountants sought methods to allocate the cost of these assets proportionally to their actual economic consumption. This approach aligns with the objective of standard-setting bodies like the Financial Accounting Standards Board (FASB) to establish and improve Generally Accepted Accounting Principles (GAAP) that foster decision-useful financial reporting.³², International standards, such as those outlined in IAS 16, also provide guidance on various depreciation methods, including the units of production approach, emphasizing the allocation of an asset's depreciable amount systematically over its useful life.³¹,³⁰

Key Takeaways

The units of production method calculates depreciation based on an asset's actual output or usage.
It is particularly suited for assets whose wear and tear are directly proportional to their activity.
This method results in variable depreciation expense, higher in periods of heavy usage and lower in periods of light usage.
It provides a more accurate matching of an asset's cost with the revenue it helps generate.
Unlike time-based methods, it requires tracking the actual output or usage of the asset.

Formula and Calculation

The units of production method calculates depreciation in two main steps: first, determining the depreciation cost per unit, and second, applying that rate to the actual units produced in a period.

The formula for depreciation cost per unit is:

\text{Depreciation Cost Per Unit} = \frac{\text{Cost of Asset} - \text{Salvage Value}}{\text{Estimated Total Units of Production}}

Once the depreciation cost per unit is determined, the annual depreciation expense is calculated as:

\text{Annual Depreciation Expense} = \text{Depreciation Cost Per Unit} \times \text{Actual Units Produced in Period}

Where:

Cost of Asset: The original purchase price of the asset, including all costs necessary to get it ready for its intended use.
Salvage value: The estimated residual value of the asset at the end of its useful life.
Estimated Total Units of Production: The total number of units or hours the asset is expected to produce or operate over its entire useful life.
Actual Units Produced in Period: The actual number of units produced or hours operated by the asset during the specific accounting period.

Interpreting the Units of Production Method

Interpreting the units of production method involves understanding that it ties the consumption of an asset's economic benefits directly to its operational activity. When financial statements are prepared using this method, a higher volume of production in a given period will result in a larger depreciation expense, which then reduces reported net income. Conversely, lower production volumes will lead to less depreciation expense. This approach is generally considered to provide a more accurate depiction of an asset's true economic decline for assets whose value is intrinsically linked to their usage.²⁹

This method allows for a more precise allocation of the asset's cost to the periods that benefit most from its use, reflecting the matching principle in accounting. It highlights how the value of specific equipment is consumed as it contributes to production, impacting both the income statement through higher operating expenses and the balance sheet through a reduction in the asset's carrying value.

Hypothetical Example

Consider a manufacturing company, "Widgets Inc.," that purchases a new machine for $100,000. The machine is expected to produce a total of 500,000 widgets over its useful life and has an estimated salvage value of $10,000.

First, calculate the depreciation cost per unit:

\text{Depreciation Cost Per Unit} = \frac{\text{\$100,000 (Cost)} - \text{\$10,000 (Salvage Value)}}{\text{500,000 (Estimated Total Units)}} = \frac{\text{\$90,000}}{\text{500,000 units}} = \text{\$0.18 per unit}

Now, let's calculate the annual depreciation expense for two different years based on actual production:

Year 1: Widgets Inc. produces 120,000 units. $\text{Annual Depreciation Expense (Year 1)} = \text{\$0.18 per unit} \times \text{120,000 units} = \text{\$21,600}$
Year 2: Due to lower demand, Widgets Inc. produces only 80,000 units. $\text{Annual Depreciation Expense (Year 2)} = \text{\$0.18 per unit} \times \text{80,000 units} = \text{\$14,400}$

This example illustrates how the depreciation expense fluctuates with the actual production levels, providing a clearer picture of the asset's cost consumption relative to its output. The total accumulated depreciation would increase by these amounts each year.

Practical Applications

The units of production method is highly effective in industries where the wear and tear on assets are directly related to their usage or output. This makes it particularly applicable in:

Manufacturing: For machinery and equipment that produce a specific number of units, such as textile looms or assembly line robots.²⁸
Mining and Natural Resources: For drilling rigs, excavation equipment, or processing plants, where depreciation can be based on the tons of ore extracted or barrels of oil produced.²⁷ Major accounting firms often discuss specific applications for capital-intensive sectors like oil and gas.²⁶
Transportation: For vehicles, aircraft, or ships, where depreciation can be tied to miles driven, flight hours, or cargo hauled.²⁵
Printing and Publishing: For printing presses or high-volume copiers, depreciation can be based on the number of pages or copies produced.²⁴
Construction: For heavy construction equipment like bulldozers or cranes, depreciation can be linked to hours of operation or projects completed.²³

This method ensures that the cost of an asset is allocated proportionally to the revenue-generating activities it supports, aligning with financial reporting principles. The Internal Revenue Service (IRS) also provides guidance on various depreciation methods, including the units of production, in contexts like tax depreciation, although the method for financial reporting may differ from tax reporting.²²,²¹

Limitations and Criticisms

Despite its theoretical accuracy in matching expense with usage, the units of production method has several limitations and criticisms:

Difficulty in Estimation: Accurately estimating the total useful life in terms of units or hours can be challenging. Overestimating or underestimating total production capacity will lead to inaccuracies in the depreciation rate, potentially misstating the asset's carrying value and the periodic expense.²⁰
Tracking Requirements: This method demands meticulous record-keeping of actual usage or output for each depreciable asset. This can be administratively burdensome and costly, especially for businesses with many assets or complex production processes.¹⁹
Not All Assets Wear by Usage: Some assets, such as buildings or office furniture, depreciate more due to obsolescence or the passage of time rather than direct usage. For these fixed assets, time-based depreciation methods are more appropriate. Even if an asset is idle, it may still lose value.¹⁸
Volatility in Net Income: Because the depreciation expense fluctuates with production levels, it can lead to more volatile reported net income, which might complicate financial analysis and forecasting.¹⁷
Not Permitted for Tax Purposes in All Jurisdictions: While useful for financial reporting, the units of production method may not be the primary method allowed for tax depreciation by authorities like the IRS, which often prescribe systems like MACRS (Modified Accelerated Cost Recovery System).¹⁶,¹⁵ Companies might use this method for internal accounting but a different one for tax filings.¹⁴
Assumptions and Scrutiny: The method introduces more assumptions, particularly regarding the estimation of total production capacity, which can lead to more discretionary decisions and potentially more scrutiny from stakeholders regarding the accuracy of reported financial figures.¹³

Units of Production Method vs. Straight-Line Depreciation

The units of production method and straight-line depreciation are two common ways to allocate the cost of a tangible asset over its useful life. The fundamental difference lies in the basis of allocation.

Feature	Units of Production Method	Straight-Line Depreciation
Basis of Allocation	Actual usage or output (e.g., units produced, miles driven, hours operated).	Passage of time (equal amount each period).
Depreciation Expense	Varies from period to period based on activity levels. Higher in periods of heavy use, lower in periods of light use.¹²	Remains constant each period, regardless of asset usage.¹¹
Applicability	Best for assets whose wear and tear is directly linked to usage, like manufacturing machinery or vehicles.¹⁰	Suitable for assets that lose value evenly over time, such as buildings or office furniture.⁹
Complexity	More complex; requires tracking actual output and recalculating expense periodically.⁸	Simpler; annual expense is fixed and easy to calculate.⁷
Matching Principle	Generally provides a better match of expense with revenue for production-oriented assets.⁶	May not accurately match expense with revenue if asset usage fluctuates significantly.⁵

Confusion often arises because both methods aim to systematically reduce an asset's book value over its economic life. However, they serve different purposes depending on the nature of the asset and how its value is consumed. While the units of production method offers a more precise reflection of an asset's economic consumption based on activity, the straight-line method provides simplicity and predictability.

FAQs

Q: Why would a company choose the units of production method over other depreciation methods?

A: Companies often choose the units of production method when the wear and tear, and thus the decline in value, of an asset is directly correlated with its usage or the number of units it produces. This method provides a more accurate matching of the asset's cost to the revenue it helps generate, especially for manufacturing equipment or vehicles.

Q: What types of assets are best suited for units of production depreciation?

A: Assets like factory machinery, mining equipment, vehicles (based on mileage), and aircraft (based on flight hours) are ideal for the units of production method because their useful life and depreciation are closely tied to their operational activity.⁴,³

Q: Does the units of production method affect a company's taxes?

A: For financial reporting, the units of production method impacts the income statement and balance sheet by influencing the depreciation expense and the asset's carrying value. For tax purposes, many jurisdictions, including the U.S. with the IRS, have specific rules and methods (like MACRS) that may or may not align directly with the units of production method used for financial statements.²,¹

Q: Is estimating total units of production difficult?

A: Estimating the total units an asset will produce over its useful life can be challenging. It requires careful consideration of historical data, industry standards, maintenance schedules, and expected operational efficiency. Inaccurate estimates can lead to misstated depreciation expenses.