How To Calculate Depreciation (With Examples)

Many people prefer to leave anything involving their taxes to an accountant, but becoming familiar with a few key terms and situations could help you in the future. Taxes become a much more interesting subject when it enables you to save lots of money with deductions.

One of the most useful aspects to attempt understanding is how depreciation is calculated.

What is Depreciation?

When you purchase something as a business expense, you’re buying it at a malleable value. Over time, an item’s worth decreases in value due to natural factors. The term used to describe this steady decline is depreciation.

While depreciation initially sounds like a bad thing, it’s very helpful during tax season. Assets that depreciate throughout their usable life are written off or deducted when preparing taxes. These assets can be written off to account for the reality of depreciation.

Examples of assets that depreciate in value include:

• Machinery for a business

• A car

• Buildings or apartments that are rented out

• Technological equipment

However, not everything that you buy is considered a depreciating asset that you can claim on taxes. Some examples of assets that aren’t considered to depreciate include:

• Leased property

• Investments in stocks

• Land

• Art

Causes of Depreciation

The forces behind depreciation are a bit confusing on your first encounter with it. Many people wonder why their stuff is less valuable when nothing has directly happened to it. To clear the air on this, read through the following three main causes of depreciation.

1. Standard wear and tear. The phrase “standard wear and tear” is commonly used when discussing depreciation. This is the type of depreciation that’s seen most often. It refers to the expected disintegration of an item over time. Standard wear and tear are often used to describe the depreciation of rented-out apartments.

   Examples of normal wear and tear depreciation include:

   • Slight stains on a carpet

   • A car seat that’s faded in color after years of use

   • Accumulated debris on a piece of machinery

2. Perishable items. Many businesses that claim depreciation on their taxes do so because they have an inventory of perishable items. Something perishable has a set lifespan before it will inevitably decay if it’s not used. Perishable items are often associated with a restaurant business’s food inventory, but there are other kinds too.

   Examples of perishable items include:

   • Pharmaceuticals

   • Meat and produce

   • Plants

3. Equipment becoming inefficient. Even if a particular piece of machinery perfectly executed its job at one point in time, it usually doesn’t stay that way forever. Equipment either becomes outdated or a new type of technology comes out that makes it practically useless.

   This is another form of depreciation that can be accounted for on a business’ taxes.

The Four Ways of Calculating Depreciation

Now that you have a little background about what depreciation is and how it works, you can learn how to calculate it. There are four ways that you can go about calculating depreciation. They include the following.

1. Straight-line method. The first and most straightforward method of calculating depreciation is the straight-line method. To perform this strategy, you’ll need to estimate the fair lifespan of the asset’s functionality in years and the salvageable value at the very end of this period, which is how much it’s worth at the end of its usable life.

   Once you have these two figures in mind, simply subtract the salvageable value at the end of an asset’s lifespan from its original worth at the beginning. The result from this equation gives you the depreciable cost. This amount must be spread over the asset’s determined life span.

   For example:

   Let’s say you buy a brand new car for $25,000. The car’s estimated lifespan is 15 years and its salvageable value after that period is $7,000.

   After subtracting $7,000 from $25,000, it leaves you with a depreciable cost of $18,000 that must be equally spread out as an expense over the 15-year lifespan. Divide $18,000 by 15 to arrive at a yearly expense deduction of $3,600.

2. Double declining method. Another way to account for expenses of assets that depreciate is the double-declining method. This technique differs from the straight-line method because it is much more accelerated. In fact, it functions in the same way but more than doubles the depreciation rate.

   Take the example of the car again:

   Instead of the yearly deduction being $3,600 continually for the full 15 years, it would be calculated as a declining percentage of the $18,000 total as the years of its lifespan dwindled.

   At a rate of 15%, the first year would be claimed at $2,700 (18,000 X 0.15). Then, the following year would be the rate of 15% applied to the remaining value of $15,300. Making the second year’s deductible $2,295 (15,300 X 0.15). It would continue like this until the end of the valued lifespan.

3. Unit of production method. The unit of production method of calculating depreciation is a little different than the first two techniques. It’s used to calculate depreciation that takes the amount of use that the asset is getting into account, rather than just the amount of time passing.

   A business uses the unit of production method of calculating depreciation to charge more expenses when using an asset a lot and less when the situation is reversed.

   The unit of production method requires an estimated number of how many hours an asset can be used in total. With this value in mind, recall the asset’s original value and salvageable value.

   Subtract the salvageable value from the original cost. Finish by dividing the result by the estimated amount of usable hours. This gives you the depreciation cost per hour of using an asset. Multiply this final depreciation rate amount by the actual number of hours used, and you’ve arrived at your expenses for that tax cycle.

   For example:

   Let’s pretend that the car from the earlier examples was used for a pizza delivery company that estimates 100,000 hours worth of usage in its lifetime.

   First, subtract $7,000 from $25,000 to get 18,000. Divide 18,000 by the 100,000 hours of estimated life that the car has, leaving you with 0.18. That is the depreciation cost per hour of use. If the company used the car for 2,000 hours this year, that value would be multiplied by the per hour depreciation of 0.18 to get $360.

4. Sum of years method. The final tactic for calculating the depreciation of an asset is the sum of years method.

   This is another accelerated form of depreciation calculation, like the double-declining method. It usually results in a business experiencing higher depreciation at the beginning of an asset’s life, which lessens towards its end.

   Even though this method is accelerated, the asset still goes through the same amount of depreciation at the end of its life cycle regardless.

   To calculate using the sum of years technique, it starts the same as every other method. Begin with subtracting the salvageable value from the original cost. After getting this number, you need to find the percentage of depreciation for each year of the asset’s predicted life. This is done by adding the total number of years of an asset’s life cycle.

   Take the example of the purchased car with an expected useful life of 15 years:

   You would add every number like this: 1+2+3+4+5…+15. Alternatively, you can add one to the number of years in an asset’s lifespan, multiply this by the asset’s lifespan again, and divide by two to get the same answer.

   Once you have both of these values, you can use them to find the percentage of depreciation each year by dividing the number of years left until the end of the asset’s life cycle by the total result of the added together lifespan.

   For instance, the example of the car would have a total added together lifespan of 120. If you claimed it as an expense in the first year, you would divide the 15 years left by 120 lifespan total to get 0.125. Multiply this by 100, and the percentage you’re left with is 12.5%. This is the percentage depreciation of the first year.

Author

Sky Ariella

Sky Ariella is a professional freelance writer, originally from New York. She has been featured on websites and online magazines covering topics in career, travel, and lifestyle. She received her BA in psychology from Hunter College.