What it means
Most depreciation methods allocate cost by time, so the same amount is charged each year regardless of whether the asset was busy or idle. The unit of production method links the charge to output instead.
This matches the cost to the revenue the asset helps to earn, which is a core accounting idea known as matching. It works well for assets whose life is naturally measured in output, such as a printing press that can produce a set number of pages, a delivery fleet measured in kilometres, or a mine measured in tonnes extracted.
The company must estimate the total number of units the asset will produce over its life. That estimate is the main judgement in the method.
Each year the company multiplies the cost per unit by the units actually produced that year. A quiet year produces a low charge and a busy year a high one.
The total depreciation over the asset's life still equals its cost minus its expected salvage value, which is what it is expected to be worth at the end. The method gives a fairer picture for businesses with seasonal or uneven demand, because profit is not distorted by a fixed depreciation charge in slow months.
It does need good records of usage, such as machine hours or output counters. If actual use differs sharply from the original estimate, the company should revise the estimate and adjust future charges.
Tax rules often prescribe their own depreciation schedules, so the accounting charge and the tax allowance can differ. Auditors will check that the estimate of total units is reasonable and applied consistently.
The method is allowed under common accounting standards, provided the pattern reflects how the asset's benefits are used up. The method also helps with decisions about replacement and impairment.
If the production counter shows that the asset is being used up much faster than planned, the business knows sooner that it will need a new one and can plan the cash for it. A sharp fall in expected output may also be a sign that the asset is worth less than its carrying value, which would call for a review.
In practice
Real-world examples.
Example
A quarry buys a crusher for $2,000,000 with an estimated output of 4,000,000 tonnes and no salvage value. Depreciation is $0.50 a tonne, so a year producing 600,000 tonnes carries a charge of $300,000.
Example
A courier company depreciates its vans by kilometres driven. A van costing $48,000 with an $8,000 salvage value and a 400,000 km life is charged 40,000 / 400,000 = $0.10 per km.
Example
A printing firm has a press rated for 10,000,000 impressions. In a busy election year it runs far more jobs and its depreciation charge rises, which matches the higher revenue from that work.
Formula
Calculation
Depreciation per unit = (cost - salvage value) / total estimated units
Annual depreciation = depreciation per unit x units produced in the year
A company buys a packaging machine for $500,000. It expects the machine to be worth $50,000 at the end of its life and to produce 900,000 packs in total. Depreciation per unit = (500,000 - 50,000) / 900,000 = 450,000 / 900,000 = $0.50 a pack. In a year when the machine produces 90,000 packs, depreciation is 0.50 x 90,000 = $45,000, and in a quiet year of 40,000 packs it would be 0.50 x 40,000 = $20,000.Case study
Seen in the real world.
Marlstone Packaging is an illustrative, fictional manufacturer that bought a specialist filling line for $1,200,000. At first it used straight-line depreciation of $120,000 a year, even though the line ran at full capacity in summer and stood idle for months in winter.
The finance manager noticed that profit looked weak in quiet years and unrealistically strong in busy ones. She switched to the unit of production method using an estimate of 12,000,000 units over the machine's life, with a salvage value of $0.
The charge became $0.10 a unit, so a summer month with 400,000 units carried $40,000 and a quiet month with 50,000 units carried only $5,000. The illustrative result was that monthly profit followed activity more closely, which made the management reports easier to interpret. The auditors accepted the change after checking the production counters and the estimate of lifetime output, and the company disclosed the method in its accounting policies.
Watch out
Common mistakes.
- Forgetting to subtract the salvage value, which overstates total depreciation.
- Using an unrealistic estimate of total units, which then makes every annual charge too high or too low.
- Treating the method as the same as straight-line, when it varies with usage and can produce a different charge each year.
Questions
People also ask.
When is the method most suitable?
It suits assets whose wear and value depend on output, such as machines, vehicles and mineral extraction equipment.
What happens if actual production is much higher than estimated?
The company revises the estimate of total units, and the remaining depreciable amount is then spread over the revised remaining units.
Is the method allowed for tax?
Tax authorities usually prescribe their own schedules, so the accounting charge and the tax deduction can differ, and local rules apply.
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