UNITS OF PRODUCTION Method of Depreciation
How to Calculate Depreciation Using the Units of Production Method
Introduction to Depreciation
- James introduces the topic of depreciation, specifically focusing on the Units of Production method. He defines depreciation as the reduction in book value of a tangible fixed asset due to various factors such as use, wear and tear, time passage, or obsolescence.
Understanding the Units of Production Method
- The Units of Production method is described as a variable cost depreciation approach where expenses reflect actual physical usage of an asset.
- An example is provided involving a sawmill machine purchased for $10,000 with a residual value of $1,000 and an expected production capacity of 150,000 units.
Steps to Calculate Depreciation
Step 1: Gather Information
- Key details about the asset are noted: cost ($10,000), residual value ($1,000), and total useful units (150,000).
Step 2: Build a Depreciation Schedule
- A depreciation schedule consists of six columns: Year, Opening Book Value, Number of Units Produced, Depreciation Expense, Accumulated Depreciation, and Closing Book Value. Tracking units produced is essential for calculating depreciation expense accurately.
Step 3: Calculate Values for Each Period
- In year one (first accounting period), the opening book value matches the asset cost at $10,000. The number of units produced in this year is recorded as 18,000.
Calculating Depreciable Cost and Expense
- The depreciable cost is defined as the difference between asset cost and residual value ($9,000). This amount will depreciate over its useful life.
- The depreciation per unit is calculated by dividing depreciable cost by total useful units ($9,000 / 150,000 = $0.06 per unit).
Applying Calculations to Determine Expenses
- For year one’s depreciation expense calculation: multiplying units produced (18,000) by depreciation per unit ($0.06), results in an expense of $1,080.
Impact on Financial Statements
- This amount represents what will be written off on the income statement. Notably:
- Depreciation per unit remains constant while production levels vary each year.
- Thus depreciation expense acts as a variable cost reflecting actual usage.
Accumulated Depreciation and Closing Book Value
- Accumulated depreciation equals total expenses incurred; initially matching year one's expense at $1,080.
- Closing book value at year's end becomes $8,920 after subtracting this expense from opening book value.
Continuing Calculation Process Over Years
Year Two Example:
- In year two with only 13,000 units produced:
- The same constant rate applies ($0.06/unit).
- Resulting in a new depreciation expense calculation leading to accumulated totals that adjust closing values accordingly.
Visual Representation