The straight line method and unit of production method are two ways to compute how an asset depreciates, or loses value over time. The straight line method assumes that its value steadily decreases from year to year, while the unit of production method assumes that its value decreases faster when it's used more heavily.
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 has a useful life, usually measured in years, and that it steady loses value over the course of its life until its value is some final, residual value. That often is its salvage value, meaning what it can be sold for after its owners no longer have a use for it.
For example, a factory robot used to produce hubcaps worth $1 million at purchase time might be assumed to have a useful life of 5 years, after which point it will be sold for scrap at a value of $100,000. 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.
Unit of Production Method
The unit of production 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.
For example, the factory robot that starts life at $1 million may be expected to produce 900,000 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
Different depreciation methods make more sense for different assets. For example, a factory robot is more likely to experience wear and tear as it produces hubcaps than a piece of software will be as it produces spreadsheets. Doubling hubcap production will likely shorten the robot's life, but a 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 unit of production method with the robot.
Video of the Day
Brought to you by Sapling
- University of California, Northridge: Depreciation, Amortization, Depletion
- Investopedia: Unit of Production Method
- Accounting Coach: How Do I Compute the Units of Production Method of Depreciation?
- Valuation Academy: Depreciation Methods- Straight Line, Double Declining, Units of Production
- Accounting Explained: Units of Production Method of Depreciation
- Accounting Tools: Straight Line Depreciation
- Investopedia: Residual Value
- Investopedia: Salvage Value