Finance⏱ 5 min read
How to Calculate Depreciation: Three Methods Explained
Depreciation spreads the cost of an asset over its useful life. Here are the three main methods — straight-line, reducing balance, and units of production — with worked examples for each.
Depreciation is how businesses (and HMRC for tax purposes) account for the gradual wearing out of physical assets. Understanding it matters for business owners, sole traders, and anyone buying a depreciating asset like a car.
Why Depreciation Exists
If you buy a machine for £50,000 and it lasts 10 years, recording the full £50,000 as an expense in year one would distort your profit figures. Depreciation spreads the cost across the years the asset is used — matching the expense to the revenue it helps generate.
Method 1: Straight-Line Depreciation
Annual depreciation = (Cost - Residual value) / Useful life
Residual value: estimated sale value at end of life
Example: Machine costs £50,000, useful life 10 years,
residual value £5,000
Annual depreciation = (50,000 - 5,000) / 10 = £4,500/year
Year 1: Book value = 50,000 - 4,500 = £45,500
Year 2: Book value = 45,500 - 4,500 = £41,000
...
Year 10: Book value = £5,000 (residual value)
Method 2: Reducing Balance (Declining Balance)
Annual depreciation = Book value x Depreciation rate %
Higher expense early, lower later. Better for assets that
lose value faster when new (cars, technology).
Example: Vehicle costs £25,000, depreciation rate 25%
Year 1: 25,000 x 25% = £6,250 depreciation. Book value: £18,750
Year 2: 18,750 x 25% = £4,688. Book value: £14,063
Year 3: 14,063 x 25% = £3,516. Book value: £10,547
Year 4: 10,547 x 25% = £2,637. Book value: £7,910
Asset never technically reaches £0 under this method.
Choosing the Right Rate for Reducing Balance
To find rate that reduces asset to residual value in n years:
Rate = 1 - (Residual value / Cost)^(1/n)
Machine: £40,000 cost, £4,000 residual, 8-year life
Rate = 1 - (4,000/40,000)^(1/8)
= 1 - (0.10)^0.125
= 1 - 0.7499
= 25.0% per year
Method 3: Units of Production
Depreciation per unit = (Cost - Residual) / Total expected units
Annual depreciation = Depreciation per unit x Units produced
Example: Industrial printer costs £80,000, residual £8,000,
expected to print 1,000,000 pages total
Depreciation per page = (80,000 - 8,000) / 1,000,000 = £0.072/page
Year 1 produces 180,000 pages: depreciation = 0.072 x 180,000 = £12,960
Year 2 produces 120,000 pages: depreciation = 0.072 x 120,000 = £8,640
HMRC Capital Allowances (UK Tax Depreciation)
For tax purposes, HMRC uses its own depreciation system (capital allowances) which may differ from your accounting depreciation:
Asset TypeAllowanceRate
Annual Investment Allowance100% in year of purchaseUp to £1m/year
Main rate pool (plant, machinery)Reducing balance18%/year
Special rate pool (integral features)Reducing balance6%/year
Cars (low emission, under 50g CO2)First year allowance100%
Cars (over 50g CO2)Reducing balance6%/year