How to Calculate Depreciation
Learn the four main depreciation methods — straight-line, declining balance, sum-of-years digits, and units of production — with formulas and examples for each.
What Is Depreciation?
Depreciation is the systematic allocation of a tangible asset's cost over its useful life. When a business buys a piece of equipment for $50,000, it does not expense the full $50,000 in year one. Instead, it spreads the cost across the asset's expected useful life, matching the expense to the periods in which the asset generates revenue. Depreciation reduces taxable income, appears on the income statement as an operating expense, and reduces the asset's carrying value on the balance sheet each year.
Straight-Line Depreciation
Straight-Line Depreciation = (Cost - Salvage Value) / Useful Life in Years. This is the simplest and most widely used method. If a machine costs $50,000, has a salvage value of $5,000, and a 10-year useful life, annual depreciation is ($50,000 - $5,000) / 10 = $4,500 per year. The depreciable base is the cost minus salvage value; the salvage value is what the asset is expected to be worth at the end of its life. Straight-line is appropriate for assets that wear evenly over time, such as buildings, furniture, and certain equipment.
Declining Balance (Accelerated) Depreciation
The declining balance method front-loads depreciation, recognizing more expense in early years when assets are typically more productive. Annual Depreciation = Book Value at Start of Year × Depreciation Rate. For double-declining balance (DDB), the rate is 2 / Useful Life. On the $50,000 machine with a 10-year life, the DDB rate is 20%. Year 1: $50,000 × 20% = $10,000. Year 2: ($50,000 - $10,000) × 20% = $8,000. Year 3: $40,000 × 20% = $8,000 — wait, Year 2 book value is $40,000, so Year 3 book value is $32,000 × 20% = $6,400. You switch to straight-line when it produces a higher annual charge.
Sum-of-Years-Digits (SYD) Depreciation
SYD is another accelerated method. Sum of Years Digits = n(n+1)/2, where n is the useful life. For a 10-year asset, SYD = 10 × 11 / 2 = 55. The depreciation fraction for each year uses the remaining life in the numerator: Year 1 fraction = 10/55, Year 2 = 9/55, and so on. Annual Depreciation = (Remaining Life / SYD) × (Cost - Salvage Value). Year 1: (10/55) × $45,000 = $8,182. Year 10: (1/55) × $45,000 = $818. SYD produces a smoother acceleration than DDB and always reaches exactly the salvage value at end of life.
Units of Production Depreciation
Units of Production ties depreciation to actual usage rather than time. Depreciation per Unit = (Cost - Salvage Value) / Total Estimated Units of Production. Annual Depreciation = Depreciation per Unit × Units Produced That Year. If the machine is expected to produce 200,000 units total and produces 25,000 in year one, depreciation = ($45,000 / 200,000) × 25,000 = $5,625. This method is ideal for manufacturing equipment, vehicles with mileage-based wear, and natural resource extraction, where usage — not time — drives wear and tear.
MACRS: Tax Depreciation in the United States
For federal tax purposes, the IRS mandates the Modified Accelerated Cost Recovery System (MACRS), not GAAP depreciation methods. MACRS assigns assets to property classes (5-year, 7-year, 15-year, etc.) and applies prescribed declining balance rates from IRS tables, switching to straight-line when advantageous. Most machinery and equipment falls in the 5- or 7-year class. Bonus depreciation (currently being phased down from 100%) and Section 179 expensing allow businesses to deduct a large portion of asset costs in year one, providing significant tax deferral.
Book vs. Tax Depreciation
Companies often maintain two separate depreciation schedules: one for financial reporting (GAAP/IFRS) and one for taxes (MACRS for US companies). The difference between book and tax depreciation creates deferred tax liabilities or assets on the balance sheet. When tax depreciation exceeds book depreciation in early years (common with accelerated methods), the company pays less tax now but will pay more later, creating a deferred tax liability. This timing difference reverses in later years as tax depreciation falls below book depreciation.
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