Depreciation: Units-of-Activity: Videos & Practice Problems

The units of production method, also known as the units of activity method, is a common approach to calculating depreciation for fixed assets that a company intends to use for more than a year. Depreciation allows businesses to allocate the cost of an asset over its useful life, reflecting the asset's consumption and wear over time. This method is particularly useful when the asset's usage can be measured in terms of output rather than time.

When applying the units of production method, three key variables are essential: the initial cost of the asset, the estimated useful life in terms of output, and the residual value. The initial cost represents the total expenditure on the asset. The useful life, in this context, is quantified by the number of units the asset is expected to produce or the total miles it will be driven, rather than a time frame in years. Lastly, the residual value, also referred to as salvage or scrap value, is the estimated worth of the asset at the end of its useful life.

The formula for calculating depreciation per unit of output in the units of production method is as follows:

Depreciation per unit = \(\frac{\text{Cost} - \text{Residual Value}}{\text{Total Units of Output}}\)

In this formula, the numerator represents the depreciable base, which is the total amount of depreciation that will be allocated over the asset's useful life. The denominator reflects the total expected output, such as the number of miles driven or units produced. This method allows for a more accurate reflection of an asset's value as it correlates depreciation directly with its usage, making it particularly effective for assets whose wear and tear is closely tied to their output.

When a company purchases an asset like a delivery truck, it must account for depreciation, which reflects the asset's usage over time. In this case, Johnson and Johnson and Johnson Company acquired a truck for $42,000, with an estimated useful life of 120,000 miles and a residual value of $2,000. The depreciation method used here is the units of production method, which calculates depreciation based on the actual usage of the asset—in this case, miles driven.

To determine the depreciation expense for the first year, we first calculate the depreciation per unit (or per mile). This is done using the formula:

Depreciation per unit = (Cost - Residual Value) / Useful Life

Substituting the values:

Depreciation per unit = ($42,000 - $2,000) / 120,000 miles = $0.33333 per mile

During the first year, the truck was driven 36,000 miles. To find the total depreciation expense for that year, we multiply the miles driven by the depreciation per unit:

Depreciation Expense = Miles Driven × Depreciation per unit

Depreciation Expense = 36,000 miles × $0.33333 = $12,000

The journal entry to record this depreciation expense would be:

Debit: Depreciation Expense $12,000
Credit: Accumulated Depreciation $12,000

Next, to find the net book value of the truck at the end of the first year, we subtract the accumulated depreciation from the original cost:

Net Book Value = Cost - Accumulated Depreciation

Net Book Value = $42,000 - $12,000 = $30,000

Thus, at the end of the first year, the net book value of the truck is $30,000. This method of calculating depreciation allows the company to easily determine the expense for each year based on the actual usage of the truck, as long as the miles driven are provided.

The units of production method is a depreciation approach that allocates the cost of an asset based on its usage, specifically measured in miles for vehicles. In this example, we consider a truck with an estimated useful life of 120,000 miles and an initial cost of $42,000. The depreciation rate is calculated at approximately $0.33 per mile, which is derived from the total cost divided by the estimated useful life in miles.

At the start, the net book value of the truck is the full purchase price of $42,000. In the first year, if the truck is driven for 36,000 miles, the depreciation expense is calculated as:

Depreciation Expense = Miles Driven × Depreciation Rate = 36,000 miles × $0.33 = $12,000.

This reduces the net book value to $30,000 ($42,000 - $12,000) and results in accumulated depreciation of $12,000.

In the second year, if the truck is driven for 24,000 miles, the depreciation expense is:

Depreciation Expense = 24,000 miles × $0.33 = $8,000.

Now, the accumulated depreciation totals $20,000, bringing the net book value down to $22,000.

For the third year, with 30,000 miles driven, the depreciation expense becomes:

Depreciation Expense = 30,000 miles × $0.33 = $10,000.

This increases the accumulated depreciation to $30,000 and the net book value to $12,000.

In the fourth year, if the truck is driven for 18,000 miles, the depreciation expense is:

Depreciation Expense = 18,000 miles × $0.33 = $6,000.

The accumulated depreciation now totals $36,000, leaving a net book value of $6,000.

By the fifth year, the total miles driven reaches 108,000, leaving only 12,000 miles of estimated useful life. If the truck is driven for 16,000 miles, we can only depreciate for the remaining 12,000 miles:

Depreciation Expense = 12,000 miles × $0.33 = $4,000.

This brings the accumulated depreciation to $40,000, aligning with the depreciable base of $40,000 ($42,000 cost - $2,000 residual value). The net book value is now $2,000.

In the sixth year, if the truck is driven for an additional 8,000 miles, no further depreciation is recorded since the asset has been fully depreciated. The accumulated depreciation remains at $40,000, and the net book value stays at the residual value of $2,000.

This method emphasizes the importance of tracking usage to accurately reflect the asset's value over time, ensuring that depreciation aligns with actual wear and tear based on operational use.