Depletion is computed using the units-of-production method, which ties the expense directly to how much of a natural resource is extracted during a given period. Unlike straight-line depreciation, which spreads cost evenly over time, the units-of-production approach matches expense to actual output, making it the standard for oil wells, mines, timber stands, and quarries. For tax purposes, a second method called percentage depletion also exists, and taxpayers must use whichever method produces the larger deduction.
How the Units-of-Production Method Works
The calculation follows two straightforward steps. First, you find the depletion cost per unit by dividing the total depletable cost by the estimated total recoverable units. Then you multiply that per-unit cost by the number of units actually extracted during the period.
Step 1: Depletion per unit = (Total depletable cost − Salvage value) ÷ Total estimated recoverable units
Step 2: Depletion expense = Units extracted this period × Depletion per unit
For example, if a mining company pays $5 million for a deposit estimated to contain 1 million tons of ore with no salvage value, the depletion rate is $5 per ton. If the company extracts 80,000 tons in a year, the depletion expense for that year is $400,000. In a slower year where only 50,000 tons come out, the expense drops to $250,000. The expense rises and falls with production rather than following a fixed schedule.
What Goes Into the Depletable Cost Base
The total cost you plug into the formula is not just the purchase price. The depletion base is made up of four components: acquisition costs, exploration costs, development costs, and restoration costs. Acquisition costs cover what you paid to buy or lease the land and mineral rights. Exploration costs include geological surveys, test drilling, and any other work done to locate and evaluate the resource. Development costs are the expenses of preparing the site for extraction, such as building access roads, sinking shafts, or installing drilling equipment. Restoration costs are the estimated future expense of returning the land to an acceptable condition after extraction is complete.
Adding all four together gives you the full depletable base. If the property has any residual salvage value after restoration, you subtract that before dividing by estimated units.
When Estimates Change
Geological estimates are rarely perfect. A mine originally expected to yield 2 million tons might turn out to hold 3 million, or only 1.5 million. When the estimate of total recoverable units changes, you recalculate the depletion rate going forward. You take the remaining undepleted cost (original base minus all depletion recorded so far) and divide it by the new estimate of remaining recoverable units. This revised rate applies to current and future periods only. You do not go back and restate prior years.
Cost Depletion vs. Percentage Depletion for Taxes
The IRS recognizes two methods for computing the depletion deduction on a tax return: cost depletion and percentage depletion. Cost depletion works exactly like the units-of-production method described above. Percentage depletion takes a fixed percentage of the gross income from the property, regardless of the actual cost basis.
The percentage rates vary by resource. Oil and gas wells carry a rate of 27.5%. Sulfur and uranium are set at 23%. Certain clay and metal mines use a 15% rate. These percentages apply to gross income from the property, so a highly productive well can generate percentage depletion deductions that eventually exceed the original cost of the property, something cost depletion can never do.
Not everyone qualifies for percentage depletion. For oil and gas, you must be an independent producer or royalty owner. Large integrated oil companies are generally limited to cost depletion. Timber owners can only use cost depletion, with no percentage option available. When both methods are available, the IRS requires you to calculate both and use whichever produces the larger deduction.
How Depletion Appears on Financial Statements
On the income statement, depletion shows up as an expense that reduces net income, similar to depreciation. On the balance sheet, the natural resource asset is reduced by an accumulated depletion account, which works the same way accumulated depreciation does for equipment or buildings. Over the life of the resource, accumulated depletion grows until the asset’s book value reaches its salvage value (or zero), at which point no further depletion is recorded.
If extracted resources are not immediately sold, the depletion cost attaches to inventory rather than flowing straight to the income statement. The expense only hits the income statement when that inventory is sold, following the same matching principle used for manufactured goods.
GAAP and IFRS Considerations
Under U.S. GAAP, companies typically treat a natural resource property as a single asset and apply one depletion rate to the whole thing. IFRS takes a stricter approach, requiring companies to separately depreciate (or deplete) significant components of an asset if those components have different useful lives or consumption patterns. In practice, this can mean an IFRS-reporting mining company breaks a single mine into multiple components, each with its own depletion schedule, while a U.S. GAAP reporter handles the same mine as one unit. The underlying units-of-production math stays the same either way; the difference is in how granularly you apply it.