Depreciation is the systematic allocation of the cost of a long-term asset over its useful life. Whether you're a small business owner, an accountant, or a sole trader trying to reduce your tax bill, understanding how to calculate depreciation correctly can save you money and keep your accounts compliant. This guide explains the three main methods with clear worked examples and practical guidance on when to use each.
Why Depreciation Matters
When a business buys an asset — a van, a laptop, a machine — it doesn't expense the full cost in year one. Instead, the cost is spread across the asset's useful life. This:
- Matches expenses to the periods the asset generates revenue (matching principle)
- Reduces taxable profit each year rather than all in year one
- Accurately reflects the asset's declining value on the balance sheet
- Helps plan for asset replacement (accumulated depreciation shows the "used up" portion)
Note: For UK tax purposes, HMRC uses its own system called Capital Allowances, not accounting depreciation. The two can differ. This guide covers accounting/financial reporting depreciation.
Key Terms
- Cost: Purchase price + any costs to put the asset into use (delivery, installation)
- Residual (salvage) value: Estimated value at end of useful life
- Depreciable amount: Cost − Residual value
- Useful life: Expected period of use (can be years or units of output)
- Net book value (NBV): Cost − Accumulated depreciation
Method 1: Straight-Line Depreciation
The simplest and most widely used method. The same amount is charged each year.
Annual depreciation = (Cost − Residual value) ÷ Useful life (years)
Depreciation rate = 1 ÷ Useful life × 100%
Example: Commercial van
Cost: £22,000 | Residual value: £4,000 | Useful life: 5 years
Annual depreciation = (£22,000 − £4,000) ÷ 5 = £3,600/year
| Year | Depreciation | Accumulated Dep'n | Net Book Value |
|---|---|---|---|
| 1 | £3,600 | £3,600 | £18,400 |
| 2 | £3,600 | £7,200 | £14,800 |
| 3 | £3,600 | £10,800 | £11,200 |
| 4 | £3,600 | £14,400 | £7,600 |
| 5 | £3,600 | £18,000 | £4,000 |
When to use: Assets with consistent usage and value decline (office furniture, buildings, software licences).
Method 2: Declining Balance Depreciation
Applies a fixed percentage rate to the net book value each year, producing higher depreciation in early years that falls over time. Better matches assets that lose most value early (cars, technology).
Annual depreciation = Net book value × Depreciation rate
To find the rate that reduces cost to residual value over n years:
Rate = 1 − (Residual ÷ Cost)1/n
Example: Same van at 25% declining balance
Cost: £22,000 | Rate: 25%/year
| Year | Opening NBV | Depreciation (25%) | Closing NBV |
|---|---|---|---|
| 1 | £22,000 | £5,500 | £16,500 |
| 2 | £16,500 | £4,125 | £12,375 |
| 3 | £12,375 | £3,094 | £9,281 |
| 4 | £9,281 | £2,320 | £6,961 |
| 5 | £6,961 | £1,740 | £5,221 |
Note: With this method, the asset rarely reaches exactly zero/residual value — many companies switch to straight-line in the final year to ensure the NBV matches residual value exactly.
When to use: Vehicles, computers, machinery — assets with high early-year usage and rapid obsolescence.
Method 3: Units of Production
Depreciation is based on actual use (units produced, hours run, miles driven) rather than time. Ideal when usage varies significantly year to year.
Rate per unit = (Cost − Residual value) ÷ Total estimated units
Annual depreciation = Units used in period × Rate per unit
Example: Industrial printer
Cost: £15,000 | Residual: £1,500 | Expected total output: 500,000 pages
Rate = (£15,000 − £1,500) ÷ 500,000 = £0.027 per page
If 120,000 pages printed in Year 1: depreciation = 120,000 × £0.027 = £3,240
If only 60,000 pages in Year 2: depreciation = £1,620 (half as much)
When to use: Mining equipment, vehicles (by mileage), manufacturing machinery where output directly causes wear.
Choosing the Right Method
| Asset Type | Recommended Method | Reason |
|---|---|---|
| Buildings, furniture | Straight-line | Even wear over long life |
| Cars, vans | Declining balance | Heavy early depreciation matches market value fall |
| Computers, phones | Declining balance | Technology obsolescence front-loaded |
| Machinery, equipment | Units of production | Wear directly tied to usage |
| Leasehold improvements | Straight-line over lease term | Fixed period of benefit |
Summary
Straight-line: equal amounts each year — simple, predictable, suits most assets. Declining balance: higher depreciation early, falling each year — matches vehicles and technology. Units of production: tied to actual use — perfect for equipment with variable output. Use our depreciation calculator to model any asset across all three methods and compare the P&L impact year by year.