What Is the Unit of Production Method & Formula for Depreciation?

What Is the Unit of Production Method?

The unit of production method is a method of calculating the depreciation of the value of an asset over time. It becomes useful when an asset's value is more closely related to the number of units it produces rather than the number of years it is in use. This method often results in greater deductions being taken for depreciation in years when the asset is heavily used, which can then offset periods when the equipment experiences less use.

This method can be contrasted with time-based measures of depreciation such as straight-line or accelerated methods.

The Formula for the Unit of Production Method Is

Depreciation expense for a given year is calculated by dividing the original cost of the equipment less its salvage value, by the expected number of units the asset should produce given its useful life. Then, multiply that quotient by the number of units (U) used during the current year.

 $\begin{aligned} &\text{DE}=\left[\frac{(\text{Original Value}\ -\ \text{Salvage Value})}{\text{Estimated Production Capability}}\right ]\times\text{U}\\ &\textbf{where:}\\ &\text{DE}=\text{Depreciation Expense}\\ &\text{U} = \text{Units per year} \end{aligned}$​DE=[Estimated Production Capability(Original Value − Salvage Value)​]×Uwhere:DE=Depreciation Expense​

What Does the Unit of Production Method Tell You?

Essentially, the units of production depreciation expense claimed in a year is based upon what percentage of an asset's production capacity was used up during that year. This depreciation method can help companies take larger depreciation deductions in years when a given piece of equipment is more productive. Companies claim depreciation on a piece of equipment or property for bookkeeping purposes, but also for tax deductions. Larger deductions in more productive years can help offset other, higher costs associated with higher production levels.

The unit of production method most accurately measures depreciation for assets where the "wear and tear" is based on how much they have produced, such as manufacturing or processing equipment. Using the unit of production method for this type of equipment can help a business keep track of its profits and losses more accurately than a chronology-based method such as straight-line depreciation or MACRS methods.

The unit of production method depreciation begins when an asset begins to produce units. It ends when the cost of the unit is fully recovered or the unit has produced all units within its estimated production capacity, whichever comes first. 

Unit of Production vs. MACRS Methods 

The modified accelerated cost recovery system (MACRS) is a standard way to depreciate assets for tax purposes. Instead of being dependent on the number of units an asset might produce, this depreciation method involves calculations that result in the asset's value being depreciated with a declining balance for a set period of time, then switching to a straight-line depreciation method to finish the depreciation schedule.

For tax purposes, the IRS requires businesses to depreciate property using the Modified Accelerated Cost Recovery System (MACRS), but it allows businesses to exclude property from this method if it can be accurately depreciated by another method such as the unit of production method. To use this method, the owner must elect exclusion from MACRS by the return due date for the tax year the property is initially placed into service. 

For more information regarding this election and the specifics of how to make the election, see IRS Publication 946, How to Depreciate Property.