Straight-Line vs. Units of Production Depreciation
- Depreciation methods affect how businesses report asset values and profitability.
- Choosing the right method is essential for accurate financial reporting and decision-making.
- This section evaluates both straight-line depreciation and units of production depreciation, comparing their strengths, weaknesses, and applications.
Self review
Try and recall the definition of depreciation.
Evaluating Straight-Line Depreciation
- Straight-line depreciation is widely used due to its simplicity and consistency, but its assumptions can lead to inaccuracies.
- Business use it because:
- It enables predictable annual expenses aid budgeting and financial planning.
- It complies with accounting standards and regulatory expectations.
- It's best suited for assets with steady usage and long lifespans (e.g., buildings, office furniture).
- However, it can also overvalue assets that depreciate rapidly in early years (e.g., vehicles, electronics) and ignore varying levels of asset usage, potentially distorting profitability.
Example
A retail company using straight-line depreciation for delivery trucks might misrepresent their value, as wear and tear is higher in initial years than later years.
Evaluating Units of Production Depreciation
- Units of production depreciation is more accurate for assets linked to output but demands detailed tracking.
- Businesses use it as it:
- Ensures depreciation reflects actual wear and tear, aligning expenses with production cycles.
- And is more accurate for manufacturing, logistics, and mining industries where assets are used inconsistently.
- Yet, it is still tricky because it requires tracking of usage, which can be time-consuming and expensive.
- This makes budgeting difficult due to fluctuating annual depreciation costs.
Exam technique
If an asset’s usage fluctuates significantly, units of production better matches cost allocation to revenue generation.
The Method's Suitability Depends
| Aspect | Straight-Line Method | Units of Production Method |
|---|---|---|
| Calculation | Fixed annual depreciation | Varies based on usage |
| Simplicity | Easy to calculate and apply | Requires detailed usage tracking |
| Reflects Usage | Does not consider actual usage | Aligns depreciation with usage |
| Consistency | Provides predictable expenses | Expenses vary with usage |
| Best For | Assets with consistent use (e.g., office furniture) | Assets with variable use (e.g., machinery, vehicles) |
Exam technique
- When evaluating methods in an exam, justify the choice based on asset usage and business context.
- Generic answers like “straight-line is simpler” will not score high marks.
Hint
- Manufacturing businesses often prefer units of production due to fluctuating asset usage.
- Service-based firms may opt for straight-line depreciation for simplicity.
