When you’re selling an old car, used clothes, or an iPhone that’s several models old, it’s safe to assume that you’re not asking for the price you bought it for.
All of our assets naturally come with a lifespan, during which their value slowly decreases.
In business terms, this is known as depreciation.
For business owners, knowing how to calculate depreciation will help you get a clear picture of what expenses you’re actually facing each year.
While fixed assets like machinery and real estate may seem like items you simply own, their value is actually constantly shifting due to age, demand, and general wear and tear.
This creates an indirect expense that will impact your financial statements and reduce your net income.
In this article, we’ll dive further into what depreciation is and why it’s important.
In addition, we’ll guide you through how to calculate depreciation.
What Is Depreciation?
Depreciation can most simply be defined as a decline in value that occurs throughout an asset’s useful life, which is the estimated time frame in which the asset can continue to help your business earn.
In terms of accounting, depreciation is a method of spreading out the cost of an asset over the course of this useful life.
This allows your business to spread out the full cost of a piece of equipment or machinery over time, so your income statement doesn’t show a huge, unnecessary spike.
When considering depreciation, it’s important to note that this process only affects tangible assets, such as vehicles, computers, machinery, and inventory — essentially, anything you can measure.
Intangible assets, like patents and brands, instead go through a process called amortization that similarly decreases their value over time.
Why Do I Need to Calculate Depreciation?
The main reason that you need to know how to calculate depreciation is the fact that not doing so leads to an inaccurate representation of your company’s net income.
When you don’t consider an asset’s depreciation rate, your net income leaves the assumption that the true value of the asset is greater than it actually is.
Depreciation is also important to calculate because depreciation expenses are actually tax deductible in the United States.
Instead of maximizing your deductions in your first year of owning an asset, your calculations will allow you to distribute the deductions you receive over the asset’s useful life.
How to Calculate Depreciation: 3 Depreciation Methods
Figuring out the amount of depreciation that should be reported each year can be a tricky process to master.
This is because depreciation is largely calculated using estimations that include the useful life of the asset and the estimated salvage or scrap value of the asset at the end of its lifespan.
That said, it’s easy to make subjective decisions that make your financial statements look better to investors when calculating depreciation.
In order to increase your objectivity and use the most ethical practices, we recommend consulting with your accountant or a third-party expert throughout this process, no matter which method you choose.
1. Straight-Line Depreciation Method
The straight-line method is the most common route that business owners take, as it’s also the simplest to complete.
All you need to do is plug in the right numbers to this formula:
(Asset Cost – Salvage Value) ÷ Useful Life = Annual Depreciation Expense
As you may see, the straight-line depreciation rate stays stable throughout the number of years the asset has in its useful life.
This method allows you to evenly spread out your expenses over time.
2. Double-Declining Balance Depreciation Method
For most assets, it’s actually more accurate to say that your asset will decrease in value far faster in the first few years than it will in its later years.
This is because the value of an asset with any form of wear and tear will rapidly drop from its value as a brand new product, whereas the impact of use lessens relatively over time.
Before we dive further into this method of depreciation, here’s the simple formula for calculating your depreciation rate, which you’ll need for our next formula:
(100 ÷ Useful Life) x 2 = Depreciation Rate
For example, if an asset’s useful life is 5 years, you’d use the formula “(100 / 5 ) x 2” to get a depreciation rate of 40%.
Now that you have your rate of depreciation, here’s the basic formula for the double-declining balance method:
Book Value x Rate of Depreciation = Current Year’s Depreciation Expense
In your first year, you’ll plug in your starting book value, which is the full cost of the asset, into the formula to get your first year’s depreciation expense.
The next year, you’ll plug in the asset’s current book value — which should be the starting book value, minus the first year’s expense — to get the second year’s depreciation expense.
As you continue to use the current book value for a given year, you’ll notice your depreciation expenses getting smaller over time.
3. Units of Production Depreciation Method
The units of production method is useful when you want to gauge each year’s depreciation based on the amount that an asset was actually used.
One scenario that shows why taking use into account matters is when you buy a car.
If you add 5,000 miles on it the first year, but add 12,000 miles to it the next year, it’s clear that your car depreciated in value more the second year than the first. In this scenario, the double-declining balance method wouldn’t actually be accurate.
That said, here’s the formula you can use to calculate units of production depreciation:
(Asset Cost – Salvage Value) × Number of Units Produced This Year ÷ Estimated Units Produced in Useful Life = Current Year’s Depreciation Expense
If measuring based on number of units produced doesn’t make sense for any given asset, some business owners will plug in the number of hours the asset was used instead.
Frequently Asked Questions
Understanding depreciation is key to understanding how much the assets in your company are actually worth.
To help you learn more about calculating this unique business expense, here are our answers to frequently asked questions:
1. Is it possible for my asset to have no salvage value at the end of its useful life?
If you’ve determined that your asset can only be tossed and can’t even be sold for parts once its usefulness has run dry, your salvage value can be $0.
There’s nothing wrong with a $0 scrap value, as some assets naturally become fully outdated or worn to the point that they’re junk over time.
In this scenario, your total depreciation expenses over the years will be equal to the asset’s original cost.
2. What happens if my asset depreciates faster than expected?
Sometimes, assets can reach the end of their useful life before the time frame that you estimated.
In these cases, the remaining depreciation expenses that you estimated to be split over multiple years will instead be spread out over the course of a single year.
This will have an impact on your accuracy and on that year’s net income, but because depreciation can be difficult to fully predict, this should still be okay for accounting purposes.
3. Are there depreciation calculators that I can use online?
If you want to make your calculations a bit easier, you can find plenty of free depreciation calculators online that will help you cut down the time you’re spending.
This set of depreciation calculators allow you to use various methods of depreciation, including the ones mentioned in this article.
You will still need to provide your own estimates for scrap value, useful life, and more, but these calculators are shortcuts to finding your annual depreciation expenses.
Know Your Assets’ True Worth
Knowing how to calculate depreciation is the best way to prevent an overestimation of your asset’s worth.
By using the formulas provided in this article, you can rest assured that your business income statements are as accurate as possible.
While there’s still some subjectivity that can’t fully be eliminated from depreciation, doing the calculation in the first place will give you the clearest possible picture about how your company is really doing.
Next on your business calculation to-do list, we recommend learning all about free cash flow, another term that will keep you realistic about your company’s financial progress.
Another plus: Free cash flow doesn’t require you to cut your depreciation expenses from your final total.