Activity Method Depreciation
Activity Method Depreciation, also known as a unit of activity depreciation or activity-based depreciation, is the depreciation method calculated base on the consumption of assets’ activity such as the number of running hours, unit produced rather than the time. Different from Straight-line depreciation, asset useful life will express as the expected units, and the expense charged to the income statement will depend on the number of units produce within the period. This depreciation method will rely on the actual usage of assets so it will be more accurate than other methods.
Depreciation expense is an accounting method used to allocate the cost of a long-term asset over its useful life. The total cost of the asset, including acquisition and installation costs, is divided into equal annual amounts and recorded as depreciation expense on the company’s income statement. Depreciation expense reduces the carrying amount of the asset on the balance sheet, but it does not reflect a cash outflow.
Depreciation is used to account for the wear and tear of a long-term asset such as a vehicle, building, machinery, and so on. The depreciation expense is matched with the revenue earned from using the asset, which provides a more accurate picture of the profitability of the business. In addition, depreciation expense can be used as a tax deduction, which reduces the amount of taxes owed by the company. For these reasons, depreciation expense is an important part of accounting for long-term assets.
Formula
We can calculate the activity method of deprecation by estimating the total output in the lifetime of the asset. And then calculate the cost per unit of output which is simply the purchase price less scrap value and divided by total output. Then we can get the depreciation expense per year by multiplying the output during the year with the cost per unit of output.
Process of Activity Method Depreciation
- Estimate the scrap value of an asset
- Estimate the total hour or units of production over the asset’s life
- Calculate the depreciation expense per unit or hour
- Calculate depreciation expenses per month by multiply the actual output (or hour) with the depreciation expense per unit.
Example
Company ABC purchases a new Excavator that cost $ 220,000 for a construction project. Based on the vendor, this truck expects to work for 5,000 hours. The scrap value is around $ 20,000.
In the first year of purchase, this Excavator has used for 1,500 hours. Please calculate the depreciation for the first year.
Depreciation expense per hour = ($220,000-$20,000)/5,000hours = $ 40 per hour
Depreciation expense for first year = $ 40 * 1,500 hours = $ 60,000 per year
Activity-Based Vs Other Depreciation Methods
Activities Based Depreciation will be calculated base on the production output of the machinery. So it depends on the actual use of the asset rather than the estimated useful life. The depreciation amount per month will depend on the actual output, so it will not be fixed from month to month. In the high season, the production increase as well as the depreciation expense. On the other hand, it will decrease in the low season as well.
Activities Based Depreciation allows the management to match between revenue and depreciation expense. It is easy to prepare a budget and project net profit during the period.
The other type of depreciation such as straight line and declining is depending on the time. They simply take the cost of assets and spread it over the estimated useful life. So the deprecation will be the same over month and year. Even the assets do not in use, they still charge the same depreciation. It is hard to evaluate the company’s performance when depreciation expenses are huge as it will impact the income statement. The result of the income statement will highly fluctuate due to the depreciation expense.
Why Should We Use Activity-Based Depreciation?
Activity-Based Depreciation expense is suitable for the assets which produce countable output. These assets must be linked with the unit of output. It is very popular for the plant and machinery in manufacturing as they are easily linked with production.
It would be hard to apply this method to depreciate office buildings or other assets that are not linked with the production unit.
The activity depreciation method is a cost accounting technique that changes the cost behavior with the fluctuating output. This means that the costs are assigned to the activities based on their usage or consumption. The activity depreciation method is used to allocate the depreciation expense base on the production activity. This method is designed to better match the costs with the revenue generated by the output. In other words, it ensures that the costs are properly assigned to the activity that caused them.
Feature of Activity-Based Depreciation
Activities Base Depreciation is suitable for the following condition:
| Feature of Activity-Based Depreciation Expense | |
|---|---|
| Assets link with output | There must be a connection between assets use and output. The output of assets must be measurable. |
| Matching Revenue and Expense | It will be great when the company wants to match revenue (production) with the depreciation expense. |
| Activity-Based Costing | This depreciation method is the best fit with activity-based costing. |
| Fluctuate production | If the production of the company highly fluctuates, it will help to match between production and depreciation. |
| Measurable total lifetime output | It can only use when the total output of the assets is measurable. Without measurable output, we will not be able to calculate the depreciation per unit. |
Limitation of Activity Method Depreciation
- Cannot apply for all assets
Not all assets are suitable with activity method depreciation as it is impossible to estimate the output over its life. So we have to depreciate based on the time rather than activity.
- Hard to estimate
In the straight-line method, we only estimate the useful life, but this method event requires us to estimate the total output that an asset produces over its lifetime. It is really hard to estimate, as we need to make assumptions over another assumption.
- Error
Due to the difficulties, the chance of error is very high. We may end up charging a significantly high amount in the first few years or the other way around.
Conclusion
The activity-based depreciation method is a depreciation method that links the costs of assets with their output levels over time. This method is useful for businesses with varying output levels, as it allows for more accurate cost matching.
It is not easy to measure the fixed assets’ activity output. This is due to the fact that output levels can vary significantly from year to year, making it difficult to create an accurate estimate.