Depletion ExpenseDefined along with Formula & How to Calculate

Written By:
Lisa Borga

Depletion expense is defined as a reduction in an asset’s value, often a natural resource, as it is extracted, used, or exploited.

This is written as an expense and charged against the asset, thereby reducing its value.

This is very often used in cases where a natural resource is being extracted, such as lumber, gas, or coal, as a logical means to charge the cost of using an asset to expense.

This process differs from the similar concept of depreciation in that there is no fixed useful life.

Instead, with depletion expense, the asset is depleted as it is sold, and usage could change significantly from one period to the next.

How to Calculate Depletion Expense

In order to calculate depletion expense, the total number of units that are consumed will be multiplied by their per-unit cost.

The formula for this looks like this:

Depletion Expense = Depletion Rate × the Number of Units Extracted in the Current Period

The Different Kinds of Depletion Expense

There are two different kinds of depletion expenses which we will list below.

Cost Depletion

The cost depletion method allocates the costs of extracting natural resources and then charges the costs as operating expenses.

To determine to amount to be allocated, it is necessary to determine the total amount of the resource and then allocate a certain proportion of the cost of this resource against the amount of the resource being extracted typically in a one-year period.

For example, suppose Company X locates a vein of iron ore which the company believes will produce 300 tons of iron ore.

Company X makes an investment of $150,000 in order to be able to mine the ore.

The company extracts 15 tons of iron ore during the first year.

This means they will have the following depletion expense.

Depletion Expense = ($150,000/300) x 15

Depletion Expense = $7,500

Let’s look at another example.

Suppose ABC Oil buys an oil field in Colorado for $2 million.

The company estimates that the field contains 1,000,000 gallons of oil.

During year one, ABC oil extracts and sells 150,000 gallons of oil.

This means ABC Oil would record $300,000 of depletion for the first year.

Depletion Expense =  ($2,000,000/1,000,000) x 150,000

Depletion Expense = $300,000

Percentage Depletion

Percentage depletion will multiply a set percentage based on the type of resource being used against the gross income earned from the asset.

This depletion method can be used for nearly all natural resources, with the exception of timber.

These depletion rates are defined by the IRS and vary based on the particular material which is being used.

Though the IRS does not limit the dollar amount of depletion, which can be deducted from income under this method, it can only be taken if a property earns a net income.

Further, it is also limited to a maximum of 50% of net income minus exploration costs.

For example, let’s consider ABC Miners, which just purchased a limestone mine in Nevada for $10 million.

They estimate that they can extract a total of 5,000,000 tons of limestone from the quarry.

This means the cost allocated to each ton of limestone would be $2.

During the first year of mining, ABC Miners extracts 250,000 tons of limestone from the mine.

The depletion expense would be calculated as follows.

Depletion Expense = Number of Units That Have Been Consumed x Depletion Value Per Unit

Depletion Expense = 250,000 x $2 = $500,000.

This means that ABC Miners will record a depletion expense of $500,000 for the year.

How is Depletion Different from Depreciation?

Depletion is a highly similar concept and is often mistaken for depreciation, but the two are unique concepts.

Where these two concepts are similar is in that both are used to calculate the decline in value of a given asset.

Generally Accepted Accounting Principles guide which of these concepts will be used in a given situation depending on the asset or resource in question.

With depletion, an asset’s value is being reduced due to its physical consumption and is typically applied to natural resources.

With depreciation, the asset’s value is being reduced over the passage of time due to wear and tear, and this is typically applied to tangible assets such as machinery and vehicles.

For example, a wood crusher would be a costly piece of equipment for a business that could be depreciated starting from the moment it is placed into service because it will be continuously used, meaning it will suffer wear and tear.

However, as lumber is cut down instead of wear and tear, the finite resource itself is being used up.

So, instead, depletion is used to record the decrease in value of the asset as it is consumed.

Both of these methods have considerable value for helping a company understand the change in the value of an asset as well as to understand the current value that it holds.

Key Takeaways

Depletion expense is the reduction in the value of an asset, particularly natural resources, over a given period of time as it is used.

Depletion expense is a non-cash expense and resembles depreciation and amortization; however, it differs in that there is no set period of time.

Depletion only occurs based on the usage of the asset.