Units of Production Depreciation Method, also known as Units of Activity and Units of Usage Method of Depreciation, calculates depreciation on the basis of expected output or usage.
For example, a machine may be depreciated on the basis of output produced during a period in proportion to its total expected production capacity. Therefore, useful life of an asset under Units of Production Method is stated in terms of production output or usage rather than years of service.
Depreciation per annum = (Cost – Residual Value) / Useful Life
The Formula for calculation of depreciation under Units of Production Method is as follows:
Stage of Completion % =
Value of Work Certified as complete
Total Expected Production or Usage
- Cost includes the initial and any subsequent capital expenditure.
- Residual Value is the estimated scrap value at the end of the useful life of the asset. Since residual value is expected to be recovered at the end of an asset’s useful life, there is no need to charge the portion of asset’s cost equaling the residual value.
Example - Units of Production Depreciation
Oil PLC installs a crude oil processing plant costing $12 million with an estimated capacity to process 50 million barrels of crude oil during its entire life. Production during the first year of operation is 2 million barrels. Expected residual value of the processing plant is $2 million.
Depreciation charge for the first year is calculated as follows:
Depreciation Expense = ($12 – $2m) x 2 / 50 = $0.4 million
Example - Units of Usage (Activity) Depreciation
Plastic LTD purchases a steel mould costing $1 million to be used in the production of plastic glasses. The mould could be used in 8 production batches after which it will have a scrap value of $.2 million. During the first year, the company manufactures 2 batches of glasses.
Depreciation charge for the year is calculated as follows:
Depreciation Expense = ($1 – $0.2m) x 2 / 8 = $0.2 million
Considerations - Advantages and Disadvantages
Units of Production Method may be appropriate where there is a high correlation between activity of an asset and its physical wear and tear. As no depreciation under this method is charged when an asset remains idle, it is not appropriate for depreciating assets that suffer a significant decrease in their earning potential with the passage of time for reasons such as technological obsolescence.