In our last post we talked about the most common method of calculating the amount of depreciation to be included in a business’ operating expenses for a particular piece of equipment; the straight-line method.
In this post we’ll talk about the other two main methods that are much less commonly used. These are called the units of production method and the reducing balance method.
Units of production method
This is especially suited to the depreciation of equipment that is used in a manufacturing process, since the amount of depreciation that is charged in an accounting period is directly related to the output of the machinery or equipment during that time.
There are three components to the calculation;
- Firstly, the cost of the equipment
- Secondly, its expected total unit output over its useful life
- And thirdly, any residual value the equipment may have at the end of its useful life
Let’s use the same equipment that we used in the straight-line example to illustrate how the units of production method works. If you recall, the equipment cost 100,000 and had an estimated residual value of 20,000, leaving us with a depreciable value of 80,000.
But with the units of production method, the useful life is determined by units produced by the equipment rather than by time, as was the case in our straight-line method example.
So, let’s say that the directors of the business estimate that the equipment will produce 40,000 units before it has to be scrapped.
We can now calculate what the depreciation amount will be for each unit produced, using the following formula;
80,000(depreciable value) / 40,000 (estimated total units of production) = 2.
This means that each time the equipment produces one unit, there will be depreciation of 2 accounted for as an operating expense.
At the end of the accounting period, the total number of units produced during the year is multiplied by 2 to arrive at the total amount of depreciation for that piece of equipment for that year.
Reducing balance method
The reducing balance method is suited to those assets that quickly become technologically obsolete or which use a greater proportion of their productive value in the early years of ownership.
In this method the directors of the business select a percentage of the value of the asset that will be applied in each accounting period to calculate depreciation.
The three components of this calculation would then be;
- Firstly, the cost of the asset
- Secondly, its expected useful life measured by time
- Thirdly, a percentage of the value that will be applied annually to depreciate the asset over its expected useful life
Going back again to our example of a piece of equipment costing 100,000 and with an expected useful life of 5 years, let’s say that the directors decide to depreciate it at 50% per accounting period and let’s also say that the business acquired the equipment on the first day of the accounting period.
In the first accounting period, the amount of depreciation would be calculated as follows;
100,000 (initial cost) multiplied by 50% = 40,000.
In the second year, the original cost of the equipment is not used in the calculation. Instead the reduced balance of 40,000 is used as the base figure. The calculation of depreciation for the second accounting period would then be;
40,000 (the reduced balance) multiplied by 50% = 20,000
That process then continues until the equipment reaches the end of its useful life or is disposed of. Whatever balance is left at the end of the useful life is deemed to be the equipment’s residual value.