Cost depletion is a method for allocating the cost of natural resource extraction to the units produced. The concept is used to determine the amount of extraction cost that can be charged to expense.
Cost depletion involves the following steps:
- Determine the total investment in the resource (such as buying a coal mine).
- Determine the total amount of extractable resource (such as tons of available coal).
- Assign costs to each consumed unit of the resource, based on the proportion of the total available amount that has been used.
An alternative to cost depletion is percentage depletion, where a mineral-specific percentage is multiplied by the gross income generated by a property during the tax year. There are restrictions on the use of this method. For example, cost depletion must be used for standing timber.
Cost depletion is similar to depreciation, where the cost of a tangible asset is ratably charged to expense over a period of time. There are two key differences between cost depletion and depreciation, which are:
- Cost depletion can only be used for natural resources, whereas depreciation can be used for all tangible assets
- Cost depletion varies based on usage levels, while depreciation is a fixed periodic charge