DEFINITION of ‘Unit of Production Method’
The unit of production method is useful when an asset’s value is more closely related to the number of units it produces than the number of years it is in use. This method results in greater deductions being taken for depreciation in years when the asset is heavily used. Depreciation expense for a given year is calculated by dividing the original cost of the equipment less the salvage value by the expected number of units the asset is expected to produce given its useful life. Then, multiply that quotient by the number of units used during that year. The equation looks like this:
[(original cost-salvage value)/estimated production capability] x units produced that year
Essentially, the depreciation expense claimed in a year is based upon what percentage of an asset’s production capacity was used up during that year.
BREAKING DOWN ‘Unit of Production Method’
There are two reasons why an owner might claim depreciation on a piece of equipment or property. The first reason is bookkeeping purposes. The second reason is tax deductions.
The unit of production method is most commonly used for bookkeeping purposes and most accurately measures depreciation for assets where their “wear and tear” is based on how much they have produced, such as manufacturing or processing equipment. Using the unit of production method for this type of equipment can help a business keep track of its profits and losses more accurately than a time-based method such as straight-line depreciation or MACRS. Unit of production method depreciation begins when an asset begins to produce units. It ends when the cost of the unit is fully recovered or the unit has produced all units within its estimated production capacity, whichever comes first.
For tax purposes, the IRS requires businesses to depreciate property using the Modified Accelerated Cost Recovery System (MACRS), but it allows businesses to exclude property from this method if it can be accurately depreciated by another method such as the unit of production method. To use this method, the owner must elect exclusion from MACRS by the return due date for the tax year the property is initially placed into service. For more information regarding this election and the specifics of how to make the election, see IRS Publication 946 (2016), How to Depreciate Property.