Career Development

How To Calculate Depreciation

March 8, 2021

Making an expensive purchase for your company of equipment or property can often mean a tax deduction for your business. Tax rules require you to spread the total cost of asset purchases you want to deduct as a business expense over its estimated useful life. To do so, you can use one of several ways to calculate depreciation. In this article, we will discuss what depreciation is and how to calculate it using four primary methods.

Related: What Is Accounting?

What is depreciation?

Depreciation is an accounting technique used to allocate the cost of an asset over time, usually its useful life, which is defined as an estimate of how long in years the asset is likely to remain in service — or useful — and generate revenue. When your company purchases an asset, you can deduct that cost as a business expense, but federal tax regulations require you to spread the total cost over its estimated useful life.

Depreciation shows the expense of using an asset over time and is unrelated to its physical condition. An example would be if you purchased a piece of machinery for your company at a total cost of $1,000. The average useful life of that piece of machinery is 10 years, so it would decrease in value by 10% each year.

Related: What Is an Asset?

Why would I use depreciation?

Depreciating assets means you may have more control over your finances because you can determine how much you'll deduct in taxes for those assets each year. Depreciation can help you spread out a large expense for your company over multiple years instead of it showing up in your accounting books as one major expense in a single year.

Related: What Is Depreciation? Definition and Example

How to calculate depreciation

There are four primary ways of calculating depreciation:

  • Straight-line depreciation: This is the most common method and is used to split the value of an asset evenly during its useful life.
  • Double-declining balance depreciation: This method is used to depreciate more of an asset's value immediately after you buy it and less value later in its life.
  • Sum-of-the-year's digits depreciation: This method is used to depreciate more of an asset's cost in the earliest years of its useful life.
  • Units of production depreciation: This method is used to depreciate a piece of equipment based on how much work it does or will do.

Here is how to calculate depreciation of an asset using each of the four methods with an example for each one:

Straight-line depreciation

Smaller businesses often will use the straight-line depreciation method if they don't have an accountant or tax advisor. To calculate using the straight-line depreciation method:

  1. Subtract the salvage value from the asset cost.
  2. Divide that number by its useful life.

The formula looks like this:

(Asset cost - salvage value) / useful life = Depreciation value per year

Here's an example:

Your office buys an office cubicle system for $15,000. The salvage value of the system is $500, and it has a useful life of 10 years. To find out how much you can deduct in taxes each year, you use the formula:

(15,000 - 500) / 10 = $1,450

You can deduct $1,450 per year for the 10 years of the system's useful life.

Double-declining balance depreciation

If you want to recover more of an asset's early value, you may choose to use the double-declining balance method of depreciation. To calculate using this method:

  1. Double the amount you would take under the straight-line method.
  2. Multiply that number by the book value of the asset at the beginning of the year.
  3. Subtract that number from the original value of the asset for depreciation value in year one.
  4. Repeat the first two steps.
  5. Subtract the new number from year one's value to find year two's value.
  6. Continue repeating steps for subsequent years.

The formula looks like this:

(2 x straight-line depreciation rate) x book value = Declining balance per year

Here's an example:

The $15,000 office cubicle system depreciates over 10 years, so its straight-line depreciation rate is 10%. For the first year of the system's life:

(2 x .10) x 15,000 = $3,000

You can deduct $3,000 of the system's value in its first year. For year two, the value is now $12,000 so for year two:

(2 x .10) x 12,000 = $2,400

You then can deduct $2,400 from the first-year value of $12,000 to find the second year value of $9,600. You would continue the process for years three through 10.

Sum-of-the-year's digits depreciation

If you decide you want to recover more of an asset's upfront value but with a more even distribution over time, you can use the sum-of-the-year's digits method or SYD. To calculate:

  1. Add up the digits in the asset's useful life. If the life is 15 years, you add 1 + 2 + 3 + 4 + 5 = 15 is the SYD
  2. Divide the asset's remaining lifespan by the SYD.
  3. Subtract the salvage value from the asset cost
  4. Multiply the two numbers.

The formula looks like this:

(Remaining lifespan / SYD) x (asset cost - salvage value) = SYD depreciation the first year

Here's an example:

Your office cubicle system costs $15,000, has a salvage value of $500, and will depreciate over a 10-year useful life. Adding the digits for the system's useful life would be: 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55

(10 / 55) x (15,000 - 500) = $2,610 for the first year deduction

Each year, the system's lifespan reduces by one, so the second year equation would be:

(9 / 55) x (15,000 - 500) = $2,372 for the second year deduction

Units of production depreciation

Businesses that want to deduct a piece of equipment that creates a product can use the units of production method of depreciation. You can also use this method if you can measure usage of the asset in hours. To calculate using this method:

  1. Subtract the salvage value from the asset cost.
  2. Divide that number by the estimated number of hours in the asset's useful life to get cost per hour.
  3. Multiply the number of hours (or units of production) in the asset's useful life by the cost per hour for total depreciation.

The formula looks like this:

(Asset cost - salvage value) / hours of useful life = Units of production depreciation cost per hour

Cost per hour x hours of useful life = Total depreciation

Here's an example:

Jonathan's House of Tabletops purchases a material cutting machine for $75,000. It has a salvage value of $6,000 and has a useful life of 90,000 hours. To find the units of production cost per hour:

(75,000 - 6,000) / 90,000 = $.76 cost per hour

To find the total depreciation of the machine:

.76 x 90,000 = $69,000

The machine will depreciate by $69,000 during its useful life.

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