Depreciation Methods: Units of Production and

Reducing Balance

from businessbankingcoach.com

in association with

Last time the topic of the

presentation was the

straight-line method of

calculating depreciation.

In this presentation

we’ll cover the other

two main methods

that are much less

commonly used.

Firstly, the 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;

the cost of the equipment

its expected total unit

output over its useful

life

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 = 2

40,000

estimated total units of production

The depreciable value

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.

Secondly, the other

method of calculating

depreciation is called

the 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

are;

the cost of the asset

its expected useful life

measured by time

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 financial year

and, to keep things simple, let’s also say

that the business acquired the equipment

on the first day of the financial year.

In the first year, the

amount of depreciation

would be calculated as

follows;

The initial cost of 100,000

multiplied by 50%, which results in

a depreciation figure for the first

year of 50,000.

Depreciable

value of asset

Depreciation

percentage

Amount of

depreciation

Depreciated

value of asset

Year 1 100,000 50% 50,000 50,000

So, it looks like this…….

In the second year,

the initial cost of the

equipment is not used

in the calculation.

Instead the reduced

balance of 50,000 is

used as the base

figure.

The calculation of

depreciation is then;

The reduced balance

of 50,000 multiplied by

50%, which gives us a

depreciation figure for

the second year of

25,000.

Depreciable

value of

asset

Depreciation

percentage

Amount of

depreciation

Depreciated

value of

asset

Year 1 100,000 50% 50,000 50,000

Year 2 50,000 50% 25,000 25,000

So now, it looks like this…….

In the following year, that reduced

balance of 25,000 is used as the base

figure in the calculation.

That same process

then continues until the

equipment reaches the

end of its useful life or

is disposed of.

Depreciable

value of

asset

Depreciation

percentage

Amount of

depreciation

Depreciated

value of asset

Year 1 100,000 50% 50,000 50,000

Year 2 50,000 50% 25,000 25,000

Year 3 25,000 50% 12,500 12,500

Year 4 12,500 50% 6,250 6,250

Year 5 6,250 50% 3,125 3,125

Like this…….

Whatever balance is left at the end of

the useful life is deemed to be the

equipment’s residual value.

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