Depreciation is most useful in accounting for the loss in value for assets with a short or fixed service life. The matching principle, used in accrual accounting, is an accounting convention that attempts to match revenues and profits made with the costs incurred over a particular time period. As assets may incur a large initial cost, depreciation allows this cost to be spread over the useful life of the equipment.
Depreciation is an accounting term used to help spread the cost of buying an asset over a period of time. As the asset is worn down by wear and tear, depletion, decay, rot, or inadequacy, both the cost and value of the asset are written off on the balance sheet. There are several different ways to account for deprecation, and units of production is one of them.
The type of depreciation methodology used affects both the income statement and balance sheet. Depreciation creates an expense which lowers profits on the income statement and the net value of the asset on the balance sheet. The asset will continue to be written off until it reaches $0 value or what is referred to as a "salvage value." This is the remaining or "scrap" value of the asset after depreciation. Both records are considered a noncash expense as they do not affect the cash flow of a company. Depreciation stops when book value is equal to the scrap value of an asset.
Units of Production
There are several types of depreciation methods which include straight line (most common), declining balance, activity depreciation, sum of the years' digits, units of time, group depreciation, composite depreciation and units of production. Units of product method is expressed in the total number of units expected to be produced from an asset and is generally computed in three basic steps.
The first variable to compute is the "depreciable cost." Depreciable cost is the original cost of the asset minus the salvage value (if any). The next variable to compute is "depreciation per unit." This is calculated by dividing the depreciable cost by the total units expected to be produced by the asset. The third variable to calculate is the actual depreciation expense, which is recorded on the income statement. Depreciation expense equals depreciation per unit multiplied by the number of units produced during the year.
Let's say you just bought a piece of manufacturing equipment for $50,000. The estimated salvage value of the equipment after 5 years, is $10,000 and is expected to produce 10,000 units. Calculate the depreciable cost by subtracting the salvage value from the original cost. This is equal to $40,000. The depreciation per unit is the depreciable cost divided by the number of units the equipment is expected to produce. This equals $40,000 divided by 10,000 or $4. If you produced 2,000 units in one year, then the depreciation expense for that year, using the units of production method would be $8,000 and the book value of the asset is reduced to $42,000.