Depreciation FormulaDefined along with Formulas and Methods for Calculating Depreciation
What is Depreciation Expense?
Depreciation expense is a non-cash expense that is charged to fixed assets to reduce the book value of each asset over its useful life.
This expense will then show up on the business’s income statement.
Generally, assets such as buildings, equipment, furniture, motor vehicles, and other tangible fixed assets are depreciated.
Depreciation Expense Formulas
There are several methods of depreciation that are used to compute the depreciation on a business’s assets.
We will discuss three of the commonly used methods.
These are the straight-line depreciation method, the units of production method, and the diminishing balance method.
There are some terms that we will explain that will be useful in using the formulas for these methods.
- Cost of an Asset: The cost of an asset is the price the business paid for the asset along with the other costs necessary to put the asset to use. These costs would include items such as transportation, taxes, installation, and initial setup.
- Useful Life: The useful life of an asset would be the period of time a business expects to derive benefits from the asset.
- Salvage Value: Salvage value is the amount a business expects an asset to be worth at the end of its useful life.
Straight Line Depreciation Method
The formula for the straight-line depreciation method is:
Annual Depreciation Expense = (Cost of the Asset – Salvage Value) / Useful Life of the Asset
Straight-line depreciation is the most commonly used method of depreciation.
With this method of depreciation, the value of the asset is reduced uniformly over its useful life.
Straight-line depreciation is a very straightforward method of depreciation.
To calculate depreciation using this method, first, the salvage value of an asset is subtracted from the cost of the asset, and this total is divided by the useful life of the asset.
Example
Company A purchased an asset for $8,000 with an expected useful life of seven years.
The business expects the salvage value of the asset to be $1,000.
Calculate the depreciation that the business should record on its income statement.
Answer
Cost of the Asset: $8,000
Salvage Value: $1,000
Asset’s Useful Life: 7 years
Straight line depreciation for the asset would be computed as follows:
Annual Depreciation Expense = (Cost of the Asset – Salvage Value) / Useful Life of the Asset
Annual Depreciation Expense = ($8,000 – $1,000) / 7 years
Annual Depreciation Expense = $1,000
The business should charge $1,000 to its income statement each year and reduce the value of the asset by $1,000 per year as well.
Units of Production Method
The formula for the units of production depreciation method is:
Unit of Production Rate = (Cost of Asset – Salvage Value) / Useful Life in the form of Units Produced
The units of production method of depreciation is used to calculate depreciation for assets when their value is more associated with the units they produce than with their useful life span.
This method of depreciation is often used in manufacturing.
It is one of the methods of depreciation used under Generally Accepted Accounting Principles.
However, this method cannot be used for calculating a business’s tax deduction for depreciation.
Example
Company B sells coffee and pastries.
They recently bought a coffee machine for $63,000.
This coffee machine is expected to produce 300,000 cups of coffee in its useful life.
The machine has a salvage value of $3,000.
Calculate the depreciation expense and closing value of the asset for each year until it is fully depreciated.
Answer
Cost of Asset: $63,000
Salvage Value: $3,000
Useful Life in the form of Units Produced: 300,000
The depreciation calculated using the units of production depreciation method would be:
Unit of Production Rate = (Cost of Asset – Salvage Value) / Useful Life in the form of Units Produced
Unit of Production Rate = ($63,000 – $3,000) / 300,000
Unit of Production Rate = .20
Depreciation Expense = Actual units produced x Units of production rate
| Year | Cups of Coffee Made | Unit of Production Rate | Opening Value of Asset | Depreciation | Closing Value of Asset |
| 1 | 50,000 | .20 | $60,000 | $10,000 | $50,000 |
| 2 | 55,000 | .20 | $50,000 | $11,000 | $39,000 |
| 3 | 61,000 | .20 | $39,000 | $12,200 | $26,800 |
| 4 | 53,000 | .20 | $26,800 | $10,600 | $16,200 |
| 5 | 49,000 | .20 | $16,200 | $9,800 | $6,400 |
| 6 | 57,000 | .20 | $6,400 | $11,400 | $0 |
Diminishing Balance Method
The formula for the diminishing balance method of depreciation is:
Depreciation Rate = (Book Value – Salvage Value) x Depreciation Rate
The diminishing balance method of depreciation, or as it is also known, the reducing balance method, calculates depreciation as a percentage of the diminishing value of an asset.
The value of the asset being depreciated diminishes or reduces each year because this method users the book value of the asset for calculating the depreciation instead of the principal amount.
Example
Company C purchased a croissant puff pastry production line machine for $9,000 that cost an additional $1,000 for shipping and installation.
The business estimates the machine will have a salvage value of $1,000.
The company wants to depreciate the machine using the diminishing balance depreciation method with a rate of depreciation of 30%.
The asset is expected to have a useful life of five years. Calculate the amount of depreciation for each year and the closing value of the asset at the end of each year.
Answer
Cost of Asset: $10,000
Salvage Value: $1,000
The depreciation for the asset using the diminishing balance method would be calculated as follows:
Depreciation Amount for year one = (Book Value – Salvage Value) x Depreciation Rate
Depreciation Amount for year one = ($10,000 – $1,000) x 20%
Depreciation Amount for year one = $1,800
The closing value for year one is calculated by subtracting the depreciation from the opening value of the asset.
$10,000 – $2,700 = $7,300.
The depreciation for the remaining years can be calculated in the same way.
| Year | Opening Value of Asset | Salvage Value | Depreciation Rate | Depreciation Amount | Closing Value of Asset |
| 1 | $10,000 | $1,000 | .30 | $2,700 | $7,300 |
| 2 | $7,300 | $1,000 | .30 | $1,890 | $5,410 |
| 3 | $5,410 | $1,000 | .30 | $1,323 | $4,087 |
| 4 | $4,087 | $1,000 | .30 | $926.10 | $3,160.90 |
| 5 | $3,160.90 | $1,000 | .30 | $648.27 | $2,512.63 |
The machine has a book value of $2,512.63 at the end of its useful life.
You will subtract the $1,000 salvage value from this and expense the $1,512.63.
This method of depreciation is good for assets that have greater productivity in their early years of service.
It also works well for assets that become obsolete quickly.
Importance of Depreciation
Depreciation is important as a way for a business to keep track of the estimated book value of an asset as it is used over a period of time.
The depreciation formula helps businesses calculate the amount they can depreciate each year so as to spread the cost of an asset over its useful life.
This is advantageous for a business because it keeps the business from having to expense the often high costs of fixed assets in one accounting period.
The depreciation formula is also useful for reducing a business’s tax liability.
The depreciation formula is used to calculate the depreciation of a business’s fixed assets.
This depreciation can be written off as an expense on a business tax return, thus reducing their tax liability.
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New Mexico State University "Calculating Depreciation" Page 1 . February 16, 2022
Cornell Law School "Straight-line depreciation" Page 1 . February 16, 2022
Harper College "ACCOUNTING FOR LONG-TERM ASSETS" Chapter 9. February 16, 2022