Cost Depletion

What Is Cost Depletion?

Cost depletion is one of two accounting methods used to allocate the costs of extracting natural resources, such as timber, minerals, and oil, and to record those costs as operating expenses to reduce pretax income. It’s a method for allocating extraction costs, charged as an expense. The yearly depletion cost is based on the units extracted or used for a given time period.

The Formula for Cost Depletion Is:

Cost of depletion = A P V T R × U where: A P V = adjusted property value T R = total reserves U = units extracted in a given period \begin{aligned} &\text{Cost of depletion} = \frac{APV}{TR} \times U\\ &\textbf{where:}\\ &APV=\text{adjusted property value}\\ &TR=\text{total reserves}\\ &U=\text{units extracted in a given period}\\ \end{aligned} Cost of depletion=TRAPV×Uwhere:APV=adjusted property valueTR=total reservesU=units extracted in a given period

To calculate the adjusted value of the property, note that:

A P V = I C + D C − S V where: I C = investment cost of a property or asset D C = development or exploration costs S V = salvage value \begin{aligned} &APV = IC + DC - SV\\ &\textbf{where:}\\ &IC=\text{investment cost of a property or asset}\\ &DC=\text{development or exploration costs}\\ &SV=\text{salvage value}\\ \end{aligned} APV=IC+DC−SVwhere:IC=investment cost of a property or assetDC=development or exploration costsSV=salvage value

What Does Cost Depletion Tell You?

Cost depletion is typically part of the "DD&A" (depletion, depreciation, and amortization) line of a natural resource company's income statement. Depletion is similar to depreciation, which is used to allocate the cost of tangible assets like factories and equipment over their useful lives. Depletion is used for natural resources, which can include minerals, ore, oil, gas, and timber. In particular, a company that extracts resources will use depletion to account for the use of these assets.

Example of How to Use Cost Depletion

The investment cost of a natural resource asset is $2 billion and development costs during a period were $40 million. The salvage value is $200 million. If the estimated number of resource units on this property is 600 million and the company extracts and sells 10 million units, depletion expense under the cost depletion accounting method would be:

[ ( $ 2 billion + $ 4 0 million − $ 2 0 0 million ) 6 0 0 million ] × 1 0 million = $ 3 0 . 6 7 million [\frac{(\$2 \text{billion} + \$40 \text{million} - \$200 \text{million})}{600 \text{million}}] \times 10 \text{million} = \$30.67 \text{million} [600million($2billion+$40million−$200million)]×10million=$30.67million

Companies engaged in mining or extracting identify their depletion expense methods and comment on period expenses in the management discussion and analysis (MD&A) sections of their quarterly and annual filings.

Pioneer Natural Resources Company states that it uses the cost depletion method and provided the following explanation for a 19% decrease in depletion expense for its fiscal year 2017: "The decrease is primarily due to (i) additions to proved reserves attributable to the Company's successful Spraberry/Wolfcamp horizontal drilling program and (ii) commodity price increases and cost reduction initiatives, both of which had the effect of adding proved reserves by lengthening the economic lives of the Company's producing wells."

The Difference Between Cost Depletion and Percentage Depletion

The other method of depletion is percentage depletion, which is calculated by multiplying the gross income received in the tax year from extracting a resource by an IRS-determined percentage established for each resource. For example, if the percentage were 22%, depletion expense would be gross income times 22%. However, in some cases, cost depletion must be used over percentage depletion, such as the case with standing timber.

Limitations of Using Cost Depletion

Depletion can only be used for natural resources, while depreciation is allowed for all tangible assets. Unlike depreciation, cost depletion is based on usage and must be calculated every period.

For related information, read about how to account for depletion and other non-cash charges.