Production units method

The production units method is a depreciation method that charges depreciation by allocating the depreciable cost of an asset in proportion to the annual output or production of the asset. It is also known as the units of production method or the output method.

Explanation:
Under the production units method, depreciation is charged based on the actual usage or output of the asset. It is commonly used for assets that are subject to wear and tear or have a limited useful life, such as machinery, equipment, or vehicles.

The method calculates depreciation by dividing the depreciable cost of the asset by its estimated lifetime output or production capacity. The depreciable cost is the cost of the asset minus its estimated residual value, which is the value of the asset at the end of its useful life.

The formula to calculate depreciation using the production units method is as follows:

Depreciation expense = (Depreciable cost / Estimated lifetime output) x Actual output

Let's understand this with an example:

Suppose a company purchases a machine for $50,000 with an estimated lifetime output of 100,000 units and an estimated residual value of $5,000. In the first year, the company produces 10,000 units using the machine.

Depreciable cost = Cost of the asset - Estimated residual value
Depreciable cost = $50,000 - $5,000 = $45,000

Depreciation expense = (Depreciable cost / Estimated lifetime output) x Actual output
Depreciation expense = ($45,000 / 100,000) x 10,000 = $4,500

Therefore, the depreciation expense for the first year using the production units method is $4,500.

Advantages of the production units method:
1. It allocates depreciation based on the actual usage or output of the asset, which provides a more accurate reflection of the asset's wear and tear.
2. It is suitable for assets with varying levels of usage or production in different periods.
3. It aligns depreciation expense with the revenue generated from the asset.

Limitations of the production units method:
1. It requires accurate tracking and recording of the actual output or production of the asset.
2. It may result in fluctuating depreciation expenses from year to year, depending on the level of output.
3. It may not be suitable for assets that do not directly contribute to the production or output of the business.

Overall, the production units method is a useful depreciation method for businesses that want to allocate depreciation based on the actual usage or output of their assets. It provides a more accurate representation of the asset's value and helps in determining the asset's true economic benefit to the business.