Learning objectives of this
article:
-
Define and explain the activity
method of depreciation.
-
In which situations this method
is appropriate?
-
What are the limitations of this
method?
Contents:
The activity method of
depreciation (also called the variable charge
approach) assumes that depreciation is a
function of use or productivity instead of the
passage of time. The life of the asset is considered
in terms of either the output it provides (units of
produces), or an input measure such as the number of
hours it works. Conceptually, the proper cost
association is established in terms of output
instead of hours used, but often the output is not
easily measurable. In such cases, an output
measure such as machine hours is a more appropriate
method of measuring the dollar amount of
depreciation charges for a given accounting period.
The following formula is used for
the calculation of depreciation charge under
activity method:
(Cost less
salvage value)
×
Hours this year |
|
|
|
= |
Depreciation charge |
Total estimated hours |
|
|
|
Assume that a company purchased a
crane for digging purposes. Pertinently data
concerning the purchase of the crane are:
Cost of crane |
$500,000 |
Estimated useful life |
5 years |
Estimated salvage value |
$50,000 |
Productive life in hours |
30,000 hours |
|
If the crane is used 4,000 hours the first year,
the depreciation charge is:
(Cost less
salvage value)
×
Hours this year |
|
|
|
= |
Depreciation charge |
Total estimated hours |
|
|
|
|
|
($500,000 -
$50,000)
×
4,000 |
|
|
|
= |
$60,000 |
30,000 |
|
|
|
Real Business Example |
Inland Steel switched to units of production
depreciation (variable charge approach) at one time and reduced its
losses by $43 million or $1.20 per share |
Where losses of services is a result of activity
or productivity, the activity method will best match
costs with revenues. Companies that desire low
depreciation during periods of low productivity and
high depreciation during high productivity either
adopt or switch to an activity method of
depreciation. In this way plant running at 40
percent of capacity generates 60 percent lower
depreciation charges.
The major limitation of activity method is that
it is not appropriate in situations in which
depreciation is a function of time instead of
activity. For example, a building is subject to a
great deal of steady deterioration from the elements
(time) regardless of its use. In addition, where an
asset is subject to economic or functional factors,
independent of its use, the activity method loses
much of its significance. For example, if a company
is expanding rapidly, a particular building may soon
become obsolete for its intended purposes. In both
cases activity is irrelevant. Another problem in
using this method is that an estimate of units of
output or service hours received is often difficult
to determine.
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