Units of Production Method

• The Bottom Line: This is a depreciation method that expenses an asset based on its actual usage—not the passage of time—giving you a much truer picture of a company's profitability in industries built on heavy machinery, like mining or manufacturing.
• Key Takeaways:
  • What it is: A way to calculate an asset's “wear and tear” expense based on how much it produces (e.g., tons mined, miles driven, or widgets stamped) rather than how old it is.
  • Why it matters: It provides a more realistic view of earnings by perfectly matching the cost of using a machine to the revenue that machine helps generate, a core principle for understanding a company's true economic reality.
  • How to use it: Use it to sanity-check the earnings of industrial or resource companies. If they use this method, their profits will rise and fall with production, which is honest. If they don't, their profits might be artificially smoothed, hiding underlying business volatility.

Imagine you buy a brand-new, top-of-the-line pickup truck for your construction business. You know that over its life, this truck won't just vanish; it will slowly wear out. The accounting term for this gradual “using up” of an asset is depreciation. Depreciation is a real business expense, just like salaries or electricity, and it reduces a company's reported profit. Now, how should you account for the truck's declining value? One way, the most common and simple, is the straight-line method. You might say, “This truck will last me 10 years, so I'll just record one-tenth of its cost as an expense each year.” This is easy, predictable, and perfectly fine for many assets, like an office desk or a filing cabinet. But does it reflect reality for your workhorse truck? What if, in the first year, a massive building boom means you're running that truck 18 hours a day, seven days a week, hauling immense loads? And what if, in the second year, a recession hits and the truck sits in the garage for months on end? According to the straight-line method, the “expense” of the truck is identical in both the boom year and the bust year. Your gut tells you that's not right. The truck obviously suffered far more wear and tear during the busy year. This is where the Units of Production method comes in. It's a more logical, reality-based approach for assets whose value is consumed through use, not time. Instead of thinking in years, you think in units of output. For your truck, the “unit” might be miles driven or hours operated. You might estimate the truck is good for 200,000 miles. With the Units of Production method, the depreciation expense isn't a fixed annual amount. It's a variable cost that directly mirrors how much work the truck did.

• Heavy-use year (drove 50,000 miles): High depreciation expense.
• Low-use year (drove 5,000 miles): Low depreciation expense.

This method perfectly captures the economic truth: the truck was “used up” more in the first year than the second. It applies this logic to the machinery that forms the backbone of the global economy: mining shovels, oil rigs, factory assembly lines, and airplane engines. It's the accountant's way of acknowledging that some things wear out, while others just fade away.

“The basic nuts and bolts of business—the things that make it tick—are things you have to know if you’re going to be a successful investor.” - Warren Buffett ¹⁾

For a value investor, accounting is the language of business. But it's a language that can sometimes be used to obscure rather than clarify. The Units of Production method, when used appropriately, is a dialect of honesty. It matters deeply because it aligns the financial statements with the on-the-ground reality of the business, which is paramount for any value-oriented analysis. 1. A Commitment to Economic Reality: Value investors, in the tradition of Benjamin Graham, are detectives searching for a company's true, durable earning power. They are allergic to accounting tricks that make earnings look smoother or better than they really are. The Units of Production method is a powerful tool for realism. When a mining company's revenue falls 50% because commodity prices collapsed and they shut down half their mines, their depreciation expense on the idle equipment should also fall dramatically. This method ensures that it does. It prevents a company from reporting artificially high costs (and thus lower, “sandbagged” profits) during a boom and artificially low costs (and thus higher, misleading profits) during a bust. 2. Sharpening the Calculation of Intrinsic Value: The ultimate goal of a value investor is to calculate a business's intrinsic value and buy it at a significant discount. A key input for this calculation is a realistic estimate of owner_earnings or free_cash_flow. Depreciation is a major component of this. By using a depreciation method that accurately reflects the consumption of capital assets, an investor gets a much cleaner, more reliable number for the “maintenance capital expenditures” needed to keep the business running. This leads to a more trustworthy valuation. In essence, better depreciation data leads to a better intrinsic value estimate. 3. Understanding Cyclical Businesses: Many of the world's most capital-intensive businesses—in energy, materials, and heavy industry—are intensely cyclical. Their fortunes ebb and flow with the broader economy. An investor who doesn't understand this cycle will buy at the peak of euphoria and sell at the bottom of despair. The Units of Production method acts as a built-in “cyclicality gauge” on the income_statement. When you see depreciation expense skyrocket alongside revenue, it confirms the company is running its machinery full-tilt to meet booming demand. Conversely, when depreciation collapses, it's a clear signal that the machines have gone quiet. This prevents you from being fooled by an unnaturally stable earnings-per-share number from a company that uses a less-realistic depreciation method to smooth things over. In short, the Units of Production method helps an investor answer a critical question: Are the reported profits a true reflection of the value being created, or are they an artifact of a chosen accounting method? For a value investor, the answer to that question is everything.

While you won't typically be calculating this yourself from scratch, understanding the mechanics is crucial to intelligently interpreting a company's financial statements and identifying potential red flags.

The process is a simple, three-step logical progression. Let's stick with our workhorse truck example. First, you gather the key data points:

• Asset Cost: The all-in, capitalized cost to acquire and ready the asset. Let's say $60,000.
• Salvage Value: The estimated residual value of the asset at the end of its useful life. What you could sell it for as scrap or on the secondhand market. Let's estimate $10,000.
• Total Estimated Production Capacity: The total number of “units” the asset can produce over its entire life. For our truck, we'll use miles. Let's estimate 200,000 miles.

With this data, the calculation is as follows:

1. Step 1: Calculate the Depreciable Base. This is the total amount of value that will be expensed over the asset's life.
   • `Depreciable Base = Asset Cost - Salvage Value`
   • `$50,000 = $60,000 - $10,000`
2. Step 2: Calculate the Depreciation Rate Per Unit. This tells you how much expense to recognize for each unit of production.
   • `Rate Per Unit = Depreciable Base / Total Estimated Production Capacity`
   • `$0.25 per mile = $50,000 / 200,000 miles`
3. Step 3: Calculate the Depreciation Expense for the Period. This is the final number that appears on the income statement. You simply multiply the rate by the actual usage in that period (e.g., a year or a quarter).
   • `Depreciation Expense = Rate Per Unit * Actual Units Produced`
   • If the truck was driven 30,000 miles in Year 1, the expense is: `$0.25 * 30,000 = $7,500`
   • If the truck was driven only 8,000 miles in Year 2, the expense is: `$0.25 * 8,000 = $2,000`

As a value investor, your job is not to be an accountant but a skeptical business analyst. Here’s what to look for:

• Appropriateness: The first question is, should this company be using this method? For a software company or a bank, it makes no sense. For a mining, oil & gas, or transportation company, it's often the most intellectually honest method. Check the company's annual report footnotes on accounting policies to see what they are depreciating and how.
• The Big Assumption: The entire calculation hinges on one massive estimate: Total Estimated Production Capacity. This is the easiest place for a company's management to be either overly optimistic or “strategic.” If management overestimates an asset's lifetime capacity, it will result in a lower depreciation rate per unit. This, in turn, understates the annual depreciation expense and inflates reported profits in the short term. Always be skeptical of these estimates. Compare them to those of close competitors. A company claiming its mining trucks will last for 2 million tons while all its peers assume 1.5 million tons deserves intense scrutiny.
• Consistency: Look for consistency in application over time. If a company suddenly changes its estimated production capacity for a large fleet of assets, read the footnotes carefully to understand why. Was it due to a new maintenance program that genuinely extends asset life, or is it a move to manage quarterly earnings expectations?

Interpreting the Units of Production method isn't about a “good” or “bad” number. It's about understanding the story the numbers are telling about the business's operational intensity and the reasonableness of the assumptions management is making.

Let's compare two hypothetical copper mining companies, “Steady Ore Inc.” and “True-Wear Mining.” Both are identical in every way, except for their choice of depreciation method. On January 1st, each company buys an identical fleet of new haul trucks for a total of $100 million.

• Salvage Value (estimated): $10 million.
• Useful Life (estimated): 10 years or 20 million tons of hauled ore.

Now, let's see how their income statements look over two years with very different business conditions.

In the boom year, True-Wear Mining reports a lower profit because its depreciation expense is higher. A superficial investor might see this and conclude that Steady Ore is the more “profitable” and better-managed company. A value investor, however, would recognize that True-Wear's accounting is simply more honest about the true cost of generating that year's revenue.

In the bust year, the tables turn. Steady Ore is forced to report the same high, fixed depreciation expense even though its trucks are barely running. This pushes their profits down significantly, perhaps even into a loss. True-Wear, on the other hand, reports a much lower depreciation expense that reflects the reality of their idle fleet. Over the full life of the trucks, both companies will report the exact same total depreciation ($90 million). But year by year, True-Wear Mining provides an investor with a far more accurate and useful picture of its operational health and true profitability.

• Superior Matching: Its greatest strength is its adherence to the accounting matching principle. The expense of using an asset is recorded in the same period as the revenue it helps to generate.
• More Realistic Profitability: It paints a truer picture of a company's financial performance, especially in cyclical industries where production levels can vary wildly from year to year.
• Improved Comparability: When comparing two companies in the same heavy industry, the one using the Units of Production method often provides a more transparent view, allowing for a better “apples-to-apples” analysis of operational efficiency.

• The Estimation Trap: The method's accuracy is entirely dependent on the initial estimate of the asset's total production capacity. A flawed or manipulated estimate can distort earnings for years. This is the number one area for an investor to approach with skepticism.
• Ignores Obsolescence: The method assumes an asset's value declines only through use. It completely ignores the passage of time, which can lead to technological or functional obsolescence. A perfectly good piece of equipment with low usage might still become worthless if a newer, revolutionary technology emerges.
• Limited Applicability: It is only suitable for a narrow range of tangible assets. It is completely inappropriate for intangible assets like patents, buildings (which decline due to age and weather, not “units of shelter provided”), or office computers (which become obsolete over time regardless of keystrokes).

• depreciation
• straight_line_depreciation
• double_declining_balance_method
• assets
• income_statement
• free_cash_flow
• intrinsic_value
• margin_of_safety