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Chapter 1.5® - Units of Production Amortization Method, Effects on Net Book Value & Accumulated Amortization

If the capacity of capital assets used is almost the same every period, the best amortization method is straight-line amortization. However, if the usage of the capital asset varies significantly from one period to the next, the best method to use is the Units of Production amortization method. As an example, a real estate builder may use construction equipment one month, and thereafter not use it for many months.

Thus, when use of the equipment varies from period to period, units of production amortization method is the best way to match revenues generated from the capital asset to the expense. Units of production method charges a varying amount to amortization expense each period; it is calculated in a 2 step process:

 1) Subtract the asset’s salvage value from its total cost and divide the total number of units expected to be produced during asset’s useful life. This measurement can be done in hours, kilometres, grams, kilograms, or any other unit of measure, as long as it is consistent and measurable. 2) Calculate the amortization expense for each period by multiplying the # of units produced times the amortization rate / unit.

To illustrate the Units of Production amortization method, consider a similar scenario of BB company from the straight-line method. BB Company bought a high-end machine on January 1st, 2004 for \$15,000 and used it throughout its predicted useful life of 5 years, through to December 31st, 2008; salvage value is \$3000. The machine is expected to produce a total of 40,000 units of a particular beverage over its useful life. Here’s how the calculations would work out:

 1) Amortization per Unit = (Total Cost – Estimated Salvage Value) / Total estimated units of production (\$15,000 - \$3000) / 40,000 units = \$0.30/unit 2) Amortization Expense = Amortization per Unit x Units produced in period \$0.30 / unit x 8,000 beverages = \$2,400

 Year # of Units Amortization per Unit Amortization Expense Accumulated Amortization Net Book Value \$15,000 2004 8,000 \$0.30 \$2,400 \$2,400 \$12,600 2005 12,000 \$0.30 \$3,600 \$6,000 \$9,000 2006 3,500 \$0.30 \$1,050 \$7,050 \$7,950 2007 14,500 \$0.30 \$4,350 \$11,400 \$3,600 2008 2,000 \$0.30 \$600 \$12,000 \$3,000 Total 40,000 ** \$12,000 ***

** Notice the total # of units is 40,000 which equals to the total useful life of the machine.

*** Total amortization expense equals \$12,000

This above graph shows the amortization expense incurred in each year using the units of production amortization method. Notice how the amortization expense fluctuates each year thanks to the # of units actually produced (output) for that year. For instance, the total # of units (output) in 2004 was 8000 units while that number increased to 12,000 in 2005. This means amortization expense in 2004 (\$2,400) was lower than the amortization expense in 2005 (\$3,600).

This above graph shows the decline in net book value of the capital asset using the units of production amortization method. This graph shows a steady decline in the net book value of the capital asset, which is a normal sign. Notice that on December 31st, 2008, we reach the disposal value of \$3,000 after which the asset is expected to be sold or disposed off, thus the net book value calculation stops here.