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 produce 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 method will rely on the actual usage of assets so it will be more accurate than other methods.

Formula

We can calculate the activity method of deprecation by estimate 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 multiply the output during the year with cost per unit of output.

Depreciation Expense = [(Cost – Scrap Value)*(Actual Activity in Period)]/[Total Estimate 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 = [($220,000-$20,000)*1,500hours]/5,000hours

= $ 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.

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 asset 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 asset

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 base 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 which an asset produces over its life. 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 other way around.