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.
Hence, the activity method of depreciation is suitable for machines and vehicles that depreciate at a high rate during the productive year. But it is not ideal for assets that depreciate with the passage of time. Depreciation is the process of allocating a cost to an expense over an asset’s estimated useful life.
The output level from any asset directly relates to the expenses incurred in production. The profitability levels fluctuate with different levels of the activities too. As with activity-based costing, the depreciation method connects the profitability with asset activities. The yearly profits and costs can be really spread out based on the list of top 10 types of local businesses actual performance and utility of the underlying assets. 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 either case, the objective is to determine the correct measure for the asset’s useful life.
- Assume that a company acquires a robot that is expected to be useful for performing a simple operation on 100,000 units of product.
- As the name suggests, the main component in calculating depreciation under this method is the units of production.
- Depreciation expense is an accounting method used to allocate the cost of a long-term asset over its useful life.
- At the end of 10 years, the contra asset account Accumulated Depreciation will have a credit balance of $110,000.
The robot has a cost of $225,000 and is expected to have a salvage value of $25,000 at the end of the 100,000 operations. Under the units-of-activity method, the company will record $2 of depreciation for every robot operation. (Cost of $225,000 – $25,000 of expected salvage value divided by the expected 100,000 operations.) In an accounting year when 8,000 robot operations occur, the depreciation will be $16,000. In a year when 23,000 operations occur, the depreciation will be $46,000.
It mainly differs from other methods of depreciation on the very nature of the cost spreading method. Other depreciation methods consider time as the main cost spreading factor. The activity-based depreciation method considers the number of units or the output from the asset. The units of activity method of depreciation is a way to calculate how much of an asset’s value has been lost through use and age.
He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.
Activity-Based Vs Other Depreciation Methods
Therefore, the DDB depreciation calculation for an asset with a 10-year useful life will have a DDB depreciation rate of 20%. In the first accounting year that the asset is used, the 20% will be multiplied times the asset’s cost since there is no accumulated depreciation. In the following accounting years, the 20% is multiplied times the asset’s book value at the beginning of the accounting year. This differs from other depreciation methods where an asset’s depreciable cost is used. In conclusion, the units of activity method of depreciation is a way to calculate depreciation by estimating the number of units of output that a particular asset is expected to generate.
When Should We Use Activity-Based Depreciation Method?
The depreciation for the 2nd year will be 9/55 times the asset’s depreciable cost. This pattern will continue and the depreciation for the 10th year will be 1/55 times the asset’s depreciable cost. We can calculate the depreciation cost on the actual results of unit production. The MUP depreciation method involves selecting a measure for the asset’s use. In either case, the objective is to determine the correct measure for the asset’s useful life. Choosing the right measure can be difficult if the asset is used in many different production processes.
Methods of Depreciation
When this is combined with the debit balance of $115,000 in the asset account Fixtures, the book value of the fixtures will be $5,000 (which is equal to the estimated salvage value). As with other depreciation methods, this method also comes with certain limitations. It would be hard to apply this method to depreciate office buildings or other assets that are not linked with the production unit.
The robot depreciation will continue until a total of $200,000 of depreciation has been taken (and the book value will be $25,000). For some industries like manufacturing or transportation, the fluctuating levels of output incur different costs. Many industries such as real estate do not incur changing output levels over time. Hence the activity-based depreciation method cannot be uniformly applied across all industries.
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. Depreciation is based on the time the asset has been in service, not the date it was purchased. The double-declining-balance method accounts for the amount of time an asset has been in service. The first part of this method is the depreciation base, which is generally the asset’s net book value minus its salvage value.
This method assigns a depreciation expense to each unit of activity that the asset is used for. This expense is based on the amount of revenue that the asset helped generate and the amount of time it was used. This allows businesses to more accurately track the depreciation of their assets. Like the double declining balance method a declining balance depreciation schedule front-loads depreciation of an asset. Since new assets such as vehicles and machinery lose more value in the first few years of their life the declining balance method of depreciation is sometimes more realistic. The activity-based depreciation method takes a contradictory approach from other methods of depreciation.
This is due to the fact that output levels can vary significantly from year to year, making it difficult to create an accurate 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.
In the units-of-production method, the cost of an asset is depreciated according to its production and use. Under this method, the depreciable amount is determined by taking the asset’s cost less its salvage value. The value of the asset is deducted evenly over its estimated useful life. For example, a machine costing $25k produces four million units in its first year of activity.