Units of Production Depreciation Method
Depreciation refers to the decrease in the assets value because of the effect of time, wear and tear, obsolescence because of advancements in technology, etc. Depreciation also comprises amortization. The Units of Production Depreciation Method, also known as the Units of Output Method, plays an important role to determine the charges on the assets depreciation.
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Units of Production Depreciation Formula
The method to charge depreciation on the assets depends on the number of units that are produced throughout the year. The criteria to provide depreciation is the total estimated cost of the production. This is applied when the total equivalent units of production are equal to the value of the asset. Hence, during the years when there is a higher usage of the asset, the depreciation amount is high. Plants and machinery are some of the common assets on which this method is implemented.
Consider, for example, that a given machine has a total capacity for producing 10,00,000 meters cloth during its lifetime. Then in this case it is essential to follow the units of production depreciation method.
The total depreciation amount for a year is determined when the total depreciable amount of the asset is divided by the estimated total production multiplied by the units. This figure is then multiplied by the total number of units that have been produced in the year.
The Units of Production Method Formula is given by
Annual Depreciation = Depreciable Value x \[\frac{\text{Units produced during the year}}{\text{Estimated total production}}\]
The Depreciable value = Original cost - Scrap value
Solved Example to Calculate Units Of Production Depreciation
Example:
A textile company bought machinery for ₹2,00,000 on the 1st of January that has an approximate 10 years of useful life and about ₹20,000 estimated residential value. The asset is sold by the firm at its residential value during the end of 10th year. The expected production units of the machinery is 15,000 during the course of its useful life. The current production pattern of the machinery is:
Determine the Total Amount of Depreciation with the Help of the Units of Production Method. Pass the Required Entries of the Journal and Prepare the Machinery A/c.
Solution:
Calculation of Depreciation With the Help of the Units of Production Method:
Depreciable Value = Original cost – Scrap value
= 2,00,000 - 20,000
= 1,80,000
The Units of Production Method Formula is given by
Annual Depreciation= Depreciable Value х (Units produced During the Year)/(Estimated Total Production)
Journal Entry in the Books of the Textiles Industry is as Follows:
FAQs on Units of Production Method: Depreciation Simplified
1. What is the units of production method of depreciation as per the CBSE Class 11 Accountancy syllabus?
The units of production method is a usage-based approach to depreciation where an asset's cost is allocated over its useful life based on the number of units it produces or the hours it operates, rather than the passage of time. This method aligns the depreciation expense directly with the asset's productivity, meaning higher depreciation is charged in periods of high usage and lower depreciation in periods of low usage. It is based on the principle that an asset wears out as it is used to generate revenue.
2. How is the annual depreciation expense calculated using the units of production method?
The calculation is a two-step process:
Step 1: Calculate the Depreciation Rate per Unit.
Depreciation per Unit = (Original Cost of Asset - Estimated Salvage Value) / Estimated Total Production in Units
Step 2: Calculate the Annual Depreciation Expense.
Annual Depreciation Expense = Depreciation Rate per Unit × Units Produced in the Year
The depreciable cost (Original Cost - Salvage Value) is spread across the total estimated productive capacity of the asset.
3. Can you provide a simple example of calculating depreciation with the units of production method?
Certainly. Imagine a company buys a machine for ₹1,10,000 with an estimated salvage value of ₹10,000. The machine is expected to produce a total of 1,00,000 units in its lifetime.
Step 1: Calculate Depreciation Rate per Unit.
Depreciable Cost = ₹1,10,000 - ₹10,000 = ₹1,00,000
Rate per Unit = ₹1,00,000 / 1,00,000 units = ₹1 per unit.
Step 2: Calculate Annual Depreciation.
If the machine produces 15,000 units in Year 1, the depreciation expense for that year would be:
Depreciation Year 1 = ₹1 per unit × 15,000 units = ₹15,000.
4. When is it more appropriate to use the units of production method over the straight-line method?
The choice depends on how the asset's value is consumed.
- The units of production method is most appropriate for assets whose wear and tear is directly related to usage, not time. This is ideal for manufacturing machinery, vehicles (using kilometres as units), and natural resource extraction equipment. It accurately reflects the matching principle by aligning higher expense with higher production (and revenue).
- The straight-line method is better for assets that lose value due to the passage of time, regardless of use, such as buildings, furniture, and computers where obsolescence is a major factor. It provides a predictable, constant depreciation expense each year.
5. What is the key difference between the units of production method and the depletion method in accounting?
While both methods are usage-based, they apply to different types of assets. The units of production method is used for depreciating tangible, long-term assets like machinery and equipment. In contrast, the depletion method is specifically used to allocate the cost of extracting natural resources, such as oil, coal, timber, and minerals. The underlying concept is the same, but depreciation refers to manufactured assets, while depletion refers to natural resources.
6. What are the main limitations or disadvantages of using the units of production depreciation method?
Despite its accuracy in matching expenses, this method has some key limitations:
- Estimation Difficulty: Accurately predicting the total number of units an asset will produce over its entire life can be very challenging.
- Ignores Obsolescence: The method does not account for technological obsolescence, which can cause an asset to lose value even if it is not being used.
- Record-Keeping: It requires detailed and consistent tracking of the units produced or hours operated, which can be an administrative burden.
- Not Universally Applicable: It is not suitable for assets whose value declines with time rather than use, like office buildings or furniture.
7. How does the units of production method impact the Balance Sheet and Income Statement?
This method has a variable impact year over year. On the Income Statement, the depreciation expense will fluctuate; it will be higher in years with high production, reducing the net income for those periods, and lower in years with less production. On the Balance Sheet, the book value of the asset (Cost - Accumulated Depreciation) decreases variably each year, directly reflecting its consumption through use, rather than a steady decline.
