The straight-line method and unit of production method are two ways to compute how a fixed asset depreciates, or loses value, over a period of time. According to Cornell Law School, the straight-line depreciation method assumes that the value of the asset steadily decreases throughout the life of the asset, while the unit of production depreciation method assumes that its value decreases faster when it's used more heavily.
Both the straight-line method of depreciation and the units of production method of depreciation offer powerful tools for calculating the value of an asset over time.
Straight-Line Method of Depreciation
The straight-line method of depreciation is often the easiest way to value a depreciating asset such as a piece of equipment in an office or factory. It simply assumes that the asset’s useful life is measured in years, and that it steadily loses value over the course of its life until its value is some final, residual value. Often that is its salvage value, meaning what it can be sold for after its owners no longer have a use for it.
Straight-Line Depreciation Formula
When performing depreciation calculations, you can use this formula:
Depreciation Per Year = (Cost of the Asset – Residual or Salvage Value)/ Useful Life of the Asset
You can find the accumulated depreciation by adding up the depreciation per year for the number of years you are interested in.
Straight-Line Depreciation Pros and Cons
The Corporate Finance Institute explains that the straight-line depreciation method is simple to calculate because it allocates the same depreciation expense for each accounting period. So there is little room for error when accounting for the depreciation expense. Plus, it works well for leased fixed assets.
However, it’s disadvantageous because it doesn’t consider the quick loss of the asset’s value in the first few years of use. In addition, it is somewhat based on guesswork. If the asset becomes obsolete earlier than anticipated due to rapid technological changes, then the calculations won’t be as accurate. Also, the straight-line method ignores the higher maintenance costs of the asset towards the last few years of its useful life.
Straight-Line Method of Depreciation Calculation
For example, suppose a factory robot used to produce hubcaps has a purchase price of $1 million and is assumed to have a useful life of five years, after which point it will be sold for scrap at a value of $100,000.
Straight-line depreciation per year = (1,000,000-100,000)/5 = $180,000.
That means that it will lose a total of $900,000 in value over those five years. Using the straight-line depreciation method, it's assumed that it loses the same amount of value each year, so it's considered to lose $180,000 in value each year.
In some cases, the residual value may be zero because the item is assumed to be worthless at the end of its natural life. For example, a piece of computer spreadsheet software worth $99 at purchase may be obsolete after a three-year useful life. In that case, the calculation is the same, with the software depreciating by $33 each year and worth $66 after one year, $33 after two years and $0 after three years.
Units of Production Method
The units of production depreciation method assumes that actual use, rather than the passage of time, is what determines how an asset depreciates. Rather than depreciating over a number of years, the asset depreciates after it's been used a certain number of times, referred to as units of production.
Units of Production Depreciation Formula
Per CFI, you can use these formulas when using the units of production method:
Depreciation Per Unit = (Original Cost of Fixed Asset – Salvage Value)/Total Production Capacity of Asset in Units
Once you have found the rate of depreciation, then you can use the depreciation expense formula:
Depreciation Expense = Number of Units for The Current Accounting Period * Depreciation Expense Per Unit
Based on the above formulas, you can find the accumulated depreciation by adding up the depreciation expenses for the total number of units your fixed asset has produced so far.
Units of Production Method Pros and Cons
The units of production depreciation method is more accurate for calculating depreciation expenses where there is wear and tear compared to the modified accelerated cost recovery system (MACRS) or straight-line methods. In addition, you can deduct higher depreciation amounts during the years when your asset produces more to offset the higher associated costs.
However, it is not a straightforward calculation method. So it is not a good option for anyone looking for a more straightforward way of accounting.
Units of Production Depreciation Calculation Example
For example, the factory robot that starts life at $1 million may be expected to produce 900,000 total units of hubcaps before reaching the end of its useful life and being sold for scrap at $100,000.
In that case, if the robot is used in one year to produce 450,000 hubcaps, it may depreciate by $450,000 that year, while if it's used a second year to produce 300,000 hubcaps, it may only depreciate in value by $300,000 that year. If it sits idle for a year, it won't depreciate at all.
Using the unit of production method rather than the straight-line method requires you to predict how often an asset will be used to predict how quickly it will depreciate, and to track its usage to record its depreciation, but it can be more accurate for assets whose depreciation is heavily based around wear and tear rather than mere age.
Different Methods for Different Assets
California State University, Northridge notes that different depreciation methods, including the MACRS and double-declining balance, make more sense for different assets and tax purposes, depending on IRS rules. For example, a factory robot is more likely to experience wear and tear as it produces hubcaps than a piece of software as it produces spreadsheets.
Doubling hubcap production will likely shorten the robot's life, but an Excel spreadsheet program will become obsolete at the same rate whether it's used once or hundreds of times in a year. For that reason, it will likely make more sense to use the straight-line method with the software and the units of production method with the robot.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.