Question

Describe what the graph would look like for the Units of Activity depreciation method. Explain why the graph would visually represent the Units of Activity depreciation method. (2 paragraphs)

Answer 1

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:

Depreciation = Number of Units Produced × (Cost ? Salvage Value)Life in Number of Units

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.

to illustrate the Units of Production amortization method, consider a similar scenario of BB company from the straight-line method. BB Company bought a high-end machine on January 1st, 2004 for $15,000 and used it throughout its predicted useful life of 5 years, through to December 31st, 2008; salvage value is $3000. The machine is expected to produce a total of 40,000 units of a particular beverage over its useful life. Here’s how the calculations would work out:

1) Amortization per Unit = (Total Cost – Estimated Salvage Value) / Total estimated units of production ($15,000 - $3000) / 40,000 units = $0.30/unit 2) Amortization Expense = Amortization per Unit x Units produced in period $0.30 / unit x 8,000 beverages = $2,400

Year	# of Units	Amortization per Unit	Amortization Expense	Accumulated Amortization	Net Book Value
					$15,000
2004	8,000	$0.30	$2,400	$2,400	$12,600
2005	12,000	$0.30	$3,600	$6,000	$9,000
2006	3,500	$0.30	$1,050	$7,050	$7,950
2007	14,500	$0.30	$4,350	$11,400	$3,600
2008	2,000	$0.30	$600	$12,000	$3,000
Total	40,000 **		$12,000 ***

** Notice the total # of units is 40,000 which equals to the total useful life of the machine.

*** Total amortization expense equals $12,000

This above graph shows the amortization expense incurred in each year using the units of production amortization method. Notice how the amortization expense fluctuates each year thanks to the # of units actually produced (output) for that year. For instance, the total # of units (output) in 2004 was 8000 units while that number increased to 12,000 in 2005. This means amortization expense in 2004 ($2,400) was lower than the amortization expense in 2005 ($3,600).