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# Activity Method of Depreciation / Variable Charge Approach:

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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