What are the 3 Ways to Calculate Depreciation?
Your Step-By-Step Guide to Calculating Inventory Depreciation
What your inventory is worth will likely decrease every month, which is why you need to understand how to calculate inventory depreciation. There are 3 main ways to do this: straight-line depreciation, double-declining balance depreciation, and sum of years depreciation. While your accountant will keep track of these on a depreciation schedule for you, you should still understand what the different depreciation options are, when they are useful, and how they are calculated.
We’ll walk you through all 3 ways to calculate inventory depreciation and show you a sample depreciation schedule to help you understand.
1. Straight-Line Depreciation
The simplest way to calculate the depreciation of an asset is straight-line depreciation, which evenly spreads out the cost of an item over multiple years.
For example, if you buy a machine that costs $20,000 with the intent of using it for 4 years, the cost can be written off as $5,000 per year for every year the machine is used. This assumes there is no salvage value for the machine.
Salvage value is the amount you’re able to sell the machine for once you’re done using it. If there is salvage value, the calculation looks like this:
annual depreciation expense = (cost of asset – salvage value) / estimated useful life in years
If the above example with the $20,000 machine with an estimated 4-year lifespan has a salvage value of $2,000, the annual depreciation expense is calculated as:
($20,000 – $2,000) / 4 years = $4,500 per year
This calculation can be important for your business because it can be used to calculate income tax deductions for certain assets like patents, software, and non-residential property.
2. Double-Declining Balance Depreciation
If you need to expense more depreciation during the first few years of an asset’s lifespan and less during later years, double-declining balance depreciation may be what you need. Double-declining balance depreciation is perfect for assets like computers and cars, which devalue faster in the early years.
You cannot use double-declining balance depreciation to get a tax deduction, but you can use it for accounting purposes. The formula for double-declining balance depreciation is:
depreciation expense = 2 x (1/ estimated useful life in years) x book value at the beginning of the year
For example, if you buy a $30,000 car that you expect to last you 10 years, the first year, the double-declining balance depreciation would look like:
depreciation expense = 2 x (1/10) x $30,000 = $6,000
The second year, the double-declining balance depreciation would look like:
depreciation expense = 2 x (1/10) X $24,000 = $4,800
The third year, the double-declining balance depreciation would look like:
depreciation expense = 2 x (1/10) x $19,200 = $3,840
And so on, until the end of the tenth year.
You should record your double-declining balance depreciation on your company books on a monthly basis. To calculate this number, you divide your annual depreciation expense by 12.
3. Sum of Years Depreciation
Sum of years digits depreciation is another accelerated depreciation method that allows you to expense a greater part of an asset’s cost during the first few years of use. Like double-declining balance depreciation, sum of years digits depreciation is not a viable strategy for calculating your tax deduction. You can use it for accounting purposes, and, like double-declining, it’s a good way of recording assets that lose value quickly.
Calculating a sum of years digits depreciation expense is a multistep process. First, you’ll need to calculate the sum of years using the following formula, where n = the number of estimated years of useful life remaining at the beginning of the fiscal year.
n(n + 1) / 2 = SYD
For example, if you have a computer that costs $2000 and is expected to last 5 years:
5(5+1) / 2 = 15 SYD
Next, you’ll need to calculate:
n / SYD = applicable fraction
The applicable fraction for your example computer will be:
5/15 = ⅓ – applicable fraction
Last, you’ll calculate the depreciation expense for year 1:
(cost – salvage value) x applicable fraction = depreciation expense
If your computer has a salvage value of $500, this step looks like:
($2000 – $500) x ⅓ = $500 – depreciation expense
For year 2, you will not need to recalculate the first step as the sum of years will remain the same. You’ll just recalculate the applicable fraction and the depreciation expense again, with the relevant numbers.
4/15 = .26667
($2000 – $500) x .26667 = $400 – depreciation expense
For year 3, the calculation will look like:
3/15 = ⅕
($2000 – $500) x ⅕ = $300 – depreciation expense
And so on until the years of useful life remaining is zero.
A depreciation schedule organizes the depreciation of your company’s long-term assets. It calculates a depreciation expense for every asset and determines the cost of every asset over the useful life of that asset. Accountants use depreciation schedules to track the beginning and end of accumulated depreciation.
Depreciation schedules usually include the following information:
- Description of the asset
- Date of purchase
- How much it cost
- The useful life (how long the company expects to use the asset)
- The salvage value (the resale value when the company is done using the asset)
- The depreciation method
- The depreciation for the current year
- The total depreciation from date of purchase until today
- The net book value
An example of a depreciation schedule using the examples from the explanations above, and assuming it’s Jan 1, 2019, would be:
As you can see, the depreciation schedule gives you a great bird’s-eye view of what your assets are currently worth, what they’ll be worth at the end of the year, and how much longer you have before you need to replace them. Being able to see all this information at a glance will make it easier for you to budget for future purchases and calculate what risks you can afford to take right now.
Using the right depreciation method for each asset and having it all organized in a depreciation schedule will help you understand the financial side of your business better. Depending on the asset, it could also save you money on your taxes.
While your accountant will be keeping track of your depreciation schedule and any applicable straight-line depreciation tax deductions, it’s important for you to understand what these terms and schedules mean. Hopefully, this article has helped.