The Machine Hour Method is a depreciation technique that allocates an asset’s cost based on actual usage rather than time. Instead of charging a fixed depreciation amount each year, this method calculates depreciation based on the number of hours a machine is used. This ensures a fairer distribution of expenses, particularly in businesses that rely on machinery for production. Below is a detailed example of how to calculate and record depreciation using the Machine Hour Method.
1. Understanding the Machine Hour Method
Formula:
The depreciation expense is calculated using the following formula:
Depreciation per Machine Hour = (Cost of Asset – Residual Value) ÷ Total Estimated Machine Hours
Annual Depreciation = Depreciation per Machine Hour × Machine Hours Used
- Cost of Asset: The original purchase price of the machine.
- Residual Value: The estimated scrap value at the end of the asset’s useful life.
- Total Estimated Machine Hours: The total operating hours the machine is expected to work.
- Machine Hours Used: The actual hours the machine was used during the accounting period.
2. Example Scenario
Company’s Asset Details:
- A company purchases a machine for $60,000.
- The estimated residual value (scrap value) at the end of its life is $10,000.
- The total estimated working hours over its lifetime are 50,000 hours.
- The machine operates for 8,000 hours in the first year.
Step-by-Step Calculation:
Step 1: Calculate Depreciation Per Hour
Depreciation per Machine Hour = (60,000 – 10,000) ÷ 50,000
= $50,000 ÷ 50,000
= $1.00 per hour
Step 2: Calculate First-Year Depreciation
Annual Depreciation = $1.00 × 8,000
= $8,000
3. Depreciation Schedule
Depreciation expense varies each year based on the machine’s usage.
| Year | Machine Hours Used | Depreciation Per Hour ($) | Depreciation Expense ($) | Accumulated Depreciation ($) | Book Value ($) |
|---|---|---|---|---|---|
| 1 | 8,000 | 1.00 | 8,000 | 8,000 | 52,000 |
| 2 | 10,000 | 1.00 | 10,000 | 18,000 | 42,000 |
| 3 | 7,500 | 1.00 | 7,500 | 25,500 | 34,500 |
| 4 | 12,000 | 1.00 | 12,000 | 37,500 | 22,500 |
| 5 | 12,500 | 1.00 | 12,500 | 50,000 | 10,000 (Residual Value) |
4. Journal Entry for Machine Hour Depreciation
Each year, depreciation is recorded as follows:
Journal Entry:
Debit: Depreciation Expense
Credit: Accumulated Depreciation
Example (Year 1):
Debit: Depreciation Expense $8,000
Credit: Accumulated Depreciation $8,000
5. Impact on Financial Statements
A. Income Statement
- Depreciation expense is deducted from revenue, reducing net profit.
B. Balance Sheet
- The asset’s book value decreases annually.
C. Cash Flow Statement
- Since depreciation is a non-cash expense, it is added back to net income in operating activities.
6. Advantages of the Machine Hour Method
- More Accurate Expense Allocation: Depreciation reflects actual usage.
- Better for Production-Based Assets: Ideal for machines with variable workloads.
- Fair Cost Distribution: Years with higher usage show higher depreciation expenses.
7. Disadvantages of the Machine Hour Method
- Requires Detailed Record-Keeping: Businesses must track machine hours accurately.
- Not Suitable for All Assets: Only useful for machinery and equipment.
- Variable Depreciation Expense: Difficult to predict future costs.
8. Comparison with Other Depreciation Methods
| Depreciation Method | Basis of Calculation | Best Used For |
|---|---|---|
| Machine Hour Method | Depreciation based on actual hours used. | Machinery and production equipment. |
| Straight-Line Method | Equal depreciation each year. | Office buildings, furniture, equipment. |
| Reducing Balance Method | Higher depreciation in early years. | Computers, vehicles, technology. |
Practical Application of the Machine Hour Method
The Machine Hour Method is highly effective for businesses that rely on heavy machinery, ensuring that depreciation reflects actual wear and tear. This method aligns depreciation expenses with asset usage, making it a more accurate approach to cost allocation. However, businesses must maintain detailed records of machine hours to implement this method successfully.