Depreciation Formula (Table of Contents)
What is the Depreciation Formula?
The term “depreciation” refers to the notional amount by which the value of a fixed asset (such as building, plant, machinery, equipment, etc.) is reduced over its entire life span until it reaches zero or its residual or salvage value.
There are three major methods used in the calculation of depreciation:
- Straight-Line Method
- Unit of Production Method
- Double Declining Balance Method
Under the straight-line method, the formula for depreciation is expressed by dividing the difference between the asset cost and the residual value by the asset’s useful life. Mathematically, it is represented as,
Under the unit of production method, the formula for depreciation is expressed by dividing the difference between the asset cost and the residual value by the life-time production capacity, which is then multiplied by the no. of units produced during the period. Mathematically, it is represented as,
Under the double-declining balance method, the formula for depreciation is expressed by dividing the difference between the asset cost and the accumulated depreciation by the asset’s useful life, which is then multiplied by 2. Mathematically, it is represented as,
Examples of Depreciation Formula (With Excel Template)
Let’s take an example to understand the calculation of Depreciation in a better manner.
Depreciation Formula – Example #1
Let us take the example of plant machinery worth $3.50 million with an estimated useful life of 10 years and a residual value of $0.20 million. The machinery is expected to produce 200,000 units over its useful life of 10 years. Calculate the depreciation for the first 2 years under:
- Straight-line method
- Unit of production method, if the machinery produces 16,000 units in year 1 and 20,000 units in year 2
- Double declining balance method
Solution:
Straight Line Method
Depreciation is calculated using the formula given below
Depreciation = (Asset Cost – Residual Value) / Useful Life of the Asset
- Depreciation = ($3.50 million – $0.20 million) / 10
- Depreciation = $330,000 in year 1 and 2
Unit of Production Method
Depreciation is calculated using the formula given below
Depreciation = (Asset Cost – Residual Value) / Life-Time Production * Units Produced
For Year 1
- Depreciation = ($3.50 million – $0.20 million) / 200,000 * 16,000
- Depreciation = $264,000
For Year 2
- Depreciation = ($3.50 million – $0.20 million) / 200,000 * 20,000
- Depreciation = $330,000
Double Declining Balance Method
Depreciation is calculated using the formula given below
Depreciation = 2 * (Asset Cost – Accumulated Depreciation) / Useful Life of Asset
For Year 1
- Depreciation = 2 * ($3.5 million – 0) / 10
- Depreciation = $700,000
Now, the accumulated depreciation at the end of year 1 is $700,0000 or $0.70 million.
For Year 2
- Depreciation = 2 * ($3.5 million – $0.70 million) / 10
- Depreciation = $560,000
Explanation
The formula for depreciation under the straight-line method can be derived by using the following steps:
Step 1: Firstly, determine the value of the fixed asset, which is its purchase price.
Step 2: Next, determine the asset’s residual value, which is the expected value of the asset at the end of its usefulness.
Step 3: Next, determine the useful life of the asset on the basis of general consensus and other operating standards.
Step 4: Finally, the formula for depreciation can be derived by dividing the difference between the asset cost (step 1) and the residual value (step 2) by the useful life of the asset (step 3), as shown below.
Depreciation = (Asset Cost – Residual Value) / Useful Life of the Asset
The following additional steps can be used to derive the formula for depreciation under the unit of production method:
Step 5: So, determine the life-time production capacity of the asset in terms of units. Life-time production capacity indicates the total no. of units that the machine can produce over its entire useful life.
Step 6: Next, determine the no. of units produced during the period under consideration.
Step 7: Finally, the formula for depreciation can be derived by dividing the difference between the asset cost (step 1) and the residual value (step 2) by the life-time production capacity (step 5), which is then multiplied by the no. of units produced during the period (step 6) as shown below.
Depreciation = (Asset Cost – Residual Value) / Life-Time Production * Units Produced
The following additional steps can be used to derive the formula for depreciation under the double-declining balance method:
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Step 8: Figure out the asset’s accumulated depreciation at the end of the last reporting period.
Step 9: Finally, the formula for depreciation can be derived by dividing the difference between the asset cost (step 1) and the accumulated depreciation (step 8) by the useful life of the asset (step 3), which is then multiplied by 2 as shown below.
Depreciation = 2 * (Asset Cost – Accumulated Depreciation) / Useful Life of Asset
Relevance and Use of Depreciation Formula
The concept of depreciation is important from the perspective of financial accounting and reporting. The periodic depreciation is charged to the income statement as an expense according to the matching principle. In other words, the value of the annual depreciation is the portion of the fixed asset that has been used in revenue generation during the year. Further, it also offers a tax benefit, the extent of which in each year varies based on the method of depreciation used.
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