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Unit of Production Depreciation

The decrease in the value of an asset due to the normal wear and tear, time effect and due to the obsolescence, etc is called depreciation. Amortization is also a part of depreciation. Unit of production depreciation method is used to calculate the depreciation on an asset.

Unit of Production Method

The unit of production depreciation method is applicable in the case of assets like plant and machinery. Because, in the case of plant and machinery, the wear and tear will depend on their usage.

This method of the depreciation is based upon the number of units a plant or machinery produces in the year. The estimated total production of the asset becomes the criteria for calculating the depreciation on that asset.

This method is applicable where the value of an asset is closely related to the units it will produce. Therefore, in the year when production is high, the depreciation charge in that year will be high. Similarly, in the year when the productivity is low, the depreciation charge in that year will be low. In this way, the plant which is running at its 40 percent capacity will generate 60 percent less depreciation charge.

Example

The useful life of an airplane is measured in the number of decompression cycle i.e. the number of the takes offs and the number of time the plane is exposed to the pressure. Therefore, in this case, the unit of production method can be relevant to calculate the depreciation of the fuselage and cabin of the plane.

Another example

A machine has the capacity to produce 2,00,00,000 meters of cloth in its life. So using the unit of production method to calculate the depreciation is advisable in this case.

Under the unit of production depreciation method, the amount of depreciation for a given year is calculated by dividing the total number of units produced by estimated total production in units. Then, multiply this figure with the total depreciable amount of the asset. Formula

Annual Depreciation= Units Produced during the year/Estimated total production* Depreciable value

Where depreciable value is calculated by subtracting the salvage or scrap value from the original cost.

Depreciable value= original cost- salvage or scrap value

Example

A numerical example for a unit of production method

XYZ Ltd. purchases a piece of machinery for Rs. 3,00,000 on 1st April. The estimated useful life of the machinery is 10 years and the estimated scrap value is of Rs. 30,000. The company sells the asset at the scrap value at the end of the 10th year. The machine is expected to produce 20000 units during its life. The production pattern is as follows:

 Year Production 1-3 3000 units per year 4-7 2000 units per year 8-10 1000 units per year

Calculate the amount of depreciation. Pass the necessary journal entries.

Solution:

Calculation of depreciation using Units of Production method

Depreciable Value= Original cost – Scrap value= 3,00,000-30000=2,70,000

Annual Depreciation= Produced during the year/Estimated total production* Depreciable value

 Year Annual Depreciation 1-3 3000/20000*2,70,000=40500 4-7 2000/20000*2,70,000=27000 8-10 1000/20000*2,70,000=13500
Journal entries in the books of XYZ Ltd.
 Date Particular Amount(Dr.) Amount(Cr.) 1st year 01-Jan Machinery A/c   Dr. 300000 To Cash A/c 300000 (being machinery purchased) 1st -3rd year 31-Dec Depreciation on machinery A/c Dr. 121500 To Machinery A/c 121500 (being depreciation charged (40500*3)) 31-Dec Profit and loss A/c  Dr. 121500 To Depreciation on machinery A/c 121500 (being depreciation on machinery transfer to profit and loss A/c) 4th-7th years 31-Dec Depreciation on Machinery A/c Dr. 108000 To Machinery A/c 108000 (being depreciation charged (27000*4)) 31-Dec Profit and loss A/c  Dr. 108000 To Depreciation on machinery A/c 108000 (being depreciation on machinery transfer to profit and loss A/c) 8th-10th years 31-Dec Depreciation on Machinery A/c Dr. 40500 To Machinery A/c 40500 (being depreciation charged (13500*3)) 31-Dec Profit and loss A/c  Dr. 40500 To Depreciation on machinery A/c 40500 (being depreciation on machinery transfer to profit and loss A/c) 10th year 31-Dec Cash A/c Dr. 30000 To Machinery A/c 30000 (being machine sold) 31-Dec Machinery A/c Dr. 0 To Profit and loss A/c (being no profit or no loss from sale)
Machinery A/c of XYZ Ltd.
 Date Particular Amount Date Particular Amount Year 1-3 Year 1-3 01-Jan To Cash A/c 300000 31-Dec By Depreciation A/c 121500 31-Dec By Balance c/d 178500 300000 300000 Year 4-7 Year 4-7 01-Jan To Balance b/d 178500 31-Dec By Depreciation A/c 108000 31-Dec By Balance c/d 70500 178500 178500 Year 8-10 Year 8-10 01-Jan To Balance b/d 70500 31-Dec By Depreciation A/c 40500 10th year 10th year 31-Dec To Profit And Loss A/c 0 31-Dec By Cash A/c 30000 (no profit in sales) (Sales) 70500 70500

This method is used where the activity of an asset and the physical wear and tear of the asset are interconnected. The advantage of the unit of production method is that due to the direct connection between the depreciation charge and assets used in the production, the expanse can be easily allocated to the time period in which it has occurred.

The disadvantage of this method is that there is no depreciation charge in case the assets remain idle. Therefore, it is not right for depreciating assets that suffer a decrease in their utilization capacity with the passage of time for reasons like technology obsolescence. Another disadvantage is that this method needs careful maintenance of the records of production and usage. Also, this method cannot be applied to all the assets that are depreciable like assets such as building and furniture where depreciation depends upon the passage of time.

Conclusion

In conclusion, this method is useful when the life of an asset is calculated in terms of the output (number of units machine will produce), working hours(hours the machine will be of service) or mileage (used by transport industry). But, it is hard to apply this method in real-life situations. Because the asset does not depreciate only on the basis of production levels. There are multiple factors that lead to the depreciation of the asset. Therefore, charging depreciation only on the bases of production level will not be appropriate. Also, it is not easy to estimate the number of units the particular asset will produce before it has to be salvaged.

Last updated on : June 6th, 2019

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