Unit of Production Method - Meaning, Example
Read about the unit of production method of depreciation calculation. Learn its formula, calculation process, advantages, and disadvantages.
Izhar Ahmad27 Dec, 2023
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The unit of production method is one technique to determine how an asset's value depreciates over time. When an asset's worth is more closely linked with the quantity of units it creates than the duration of its usage, it becomes valuable.
When using the Unit of Production method, it is usual to take larger depreciation deductions in years when the asset is utilized extensively. This can help balance out periods when the equipment is not used as much. By using this method, companies may be able to offset other higher production expenses by displaying a higher depreciation expenditure during years of greater productivity.Also Read- What Is a Stock Market? Meaning, Functions And Types
Unit of Production Method Meaning
Unit of production depreciation, commonly known as the activity method, is directly related to production as it computes depreciation using the unit of production and does not account for time spent on an item during its useful life. Its main use is in the manufacturing industry. Unit of Production Method Formula The initial cost of the equipment minus its salvage value is divided by the anticipated number of units the asset should generate given its useful life to get the depreciation charge for a given year. Afterwards, multiply that quotient by the total units (U) utilized this year. Formula: DE = [(Original Value− salvage value)/ Estimated Production Capability] × U where: DE = Depreciation Cost U = Units annuallySteps to Calculated Depreciation Cost by Unit of Production Method
The following procedures can be used to determine the depreciation expenditure when employing the unit of production method: Step 1: Instead of estimating the fixed asset's useful life in years, the first step is to estimate it in units produced. Step 2: Deduct the expected salvage value, or the value that remains after the fixed asset's useful life is assumed, from the fixed asset's purchase price. Step 3: To calculate the depreciation per unit of output, divide the projected production capacity by the cost basis of the fixed asset, net of the salvage value assumption. Step 4: Multiplying the number of units produced by the rate of depreciation per unit yields the depreciation expenditure reported in the accounting period.Also Read- What is Commerce? Meaning, Types, Examples
Unit of Production Method Example
A crude oil processing facility is expected to generate 60 million barrels of crude oil throughout its useful life. The plant's residual worth is $2 million. The plant's base price is $15 million. In its first year of operation, the company produced 3 million barrels. The depreciation is computed using these data as follows: Expense for depreciation = (15 - 3) x 2 / 60 =0.40 million As a result, the processing plant's depreciation expenditure is $0.4 million.Facts Related to the Unit of Production Method
The unit of production method differs from straight-line or other time-based methods for estimating depreciation. Here are some facts to help you in understanding it better.- When the assets produce units, the unit of production method is considered the most accurate. This allows the company to precisely monitor its revenue and losses. A chronology-based strategy might not be as precise given the situation when the assets produce units.
- In addition, when an asset begins producing units, the unit of production method is considered to decline. The process is complete only when either the machine's cost has been entirely recovered or it has produced all of the units intended.
Advantages of Unit of Production
Let us first consider the benefits of the unit of production method:- The method allows companies to show a larger depreciation when the asset is at its most productive.
- The method makes use of the full value of assets as the depreciation is recorded only once the asset starts producing units.
- It helps in tax deductions. The Higher the depreciation expense in the fruitful or productive years, the higher the chances of countering costs of production; thereby, aiding in higher revenue in the productive years.
- It is a more precise way for calculating profits and losses.
- It is an accurate way to figure out how the item is depreciating throughout the course of its useful life.
- It is a more suitable method for determining the asset's effectiveness.
- The method aligns depreciation with revenue.
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Disadvantages of Unit of Production
The unit of production technique has several disadvantages:- The main disadvantage is that it ignores other potential ways in which an asset's value may decrease, considering solely its utilization as a factor in depreciation.
- It is a challenging method to implement in real life. This is true since a company actually employs a variety of tools and resources to construct a product or unit. Calculating the worth of every one of these assets would be a tedious and challenging process.
- When determining the valuations of the two identical assets, the approach may produce different answers. Any firm would want to avoid such uncertainty.
- When it comes to tax computations, the IRS prohibits using this technique.
- The technique does not apply to assets such as furniture, construction, or trade firms; it is only applicable to industrial assets.
Unit of Production Method of Depreciation FAQs
What is the production method of accounting?
This indicates that the business separates the expenses of the goods from the costs incurred for producing byproducts immediately.
What are the three types of production?
Primary production, secondary production, and tertiary production are the three types of production.
What is an example of depreciation?
A good example would be if you spent Rs1,0000 on a piece of machinery. Given that the machine has an average usable life of ten years, its value would decline by ten percent per year.
What is the symbol for depreciation?
δ is the symbol. In macroeconomics, this symbol is frequently used to represent depreciation, or a change in a variable.
What are the three names of depreciation?
Depreciation is also known as the current replacement cost. The expense of replacing fixed capital. Allowance for capital consumption.
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