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Activity Method of Depreciation / Variable Charge Approach:

Learning objectives of this article:

  1. Define and explain the activity method of depreciation.
  2. In which situations this method is appropriate?
  3. What are the limitations of this method?

Contents:

Definition and Explanation:

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.

Formula:

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    

Example:

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    

Who Uses Activity Method of Depreciation:

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.

Limitations of Activity Method of Depreciation:

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.

 

More study material from this topic:

Definition, explanation and causes of depreciation
Depreciation is not a matter of valuation but a means of cost allocation
Activity method of depreciation
Straight line method of depreciation
Sum of the years' digits method of depreciation
Reducing balance method
Annuity method
Depreciation fund method or sinking fund method
Insurance policy method
Revaluation method
Depletion method
Machine hour rate, mileage, and global method
Methods of recording depreciation
Reserves
Difference between general reserve and specific reserve
Difference between capital reserve and general reserve
Difference between reserve and reserve fund
Difference between provision and reserve

 

 
 

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Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
----------------------------------------------------------------------------
  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
----------------------------------------------------------------------------
  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
----------------------------------------------------------------------------
  Standard Costing and Variance Analysis
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  Balanced Scorecard
----------------------------------------------------------------------------
  Capital Investment Analysis/Capital Budgeting
 
 

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