What is Replacement Cost?

SARINYAPINNGAM/iStock/GettyImages

Most companies value business assets based on the item's acquisition cost, less any depreciation. This is known as the present book value. Replacement cost provides an alternative way of valuing a company's assets based on how much it would cost to replace the asset at today's prices. Replacement cost is typically higher than the item's book value since it doesn't take depreciation into account.

TL;DR (Too Long; Didn't Read)

Replacement cost is the amount you'd have to spend to replace an asset with another one of the same quality and functionality.

Replacement Cost Explained

Simply stated, replacement cost is the amount you would incur to replace an asset with another asset of comparable quality used for the same purpose – essentially swapping old for new. The replacement asset doesn't have to be an exact replica of the current asset as long as it performs the same function. If you're replacing a broken asset, the replacement cost refers to the asset in its pre-damaged condition. As an accounting methodology, replacement cost can be used to value just about any business asset from property and machinery to liens and unpaid invoices.

Why It Matters

Vehicles, machinery and even retail store designs are expensive assets that don't last forever. You'll need to replace assets at some point if you are to remain competitive. Most likely, the replacement will cost more than the price paid for the original – a truck that cost $20,000 a few years ago may cost $25,000 to buy today. When budgeting for future asset purchases, businesses must look carefully at the replacement cost to to figure out where the additional cash is coming from and to calculate the point at which it becomes cost effective to replace the item with a newer model.

Replacement Cost Versus Actual Cash Value

The insurance industry uses two primary methods of asset valuation: replacement cost and actual cash value. ACV is an item's fair market value – the dollar amount you would receive if you sold the asset in the marketplace. ACV is lower than replacement cost since the current market value takes account of depreciation. Suppose, for example, that your reception furniture is badly damaged. If the replacement cost were insured, you would receive a new model of the exact same furniture at a cost of $3,000. With ACV coverage, you would get the replacement cost minus depreciation. Since reception couches don't have much resale value, depreciation could be as much as 70 percent, reducing your payout to just $900.

Replacement Cost Estimator

When using the replacement method to value assets, a business estimates the replacement cost based on the current sale price of the asset. It then adds shipping costs and the cost of installation and configuration in the case of plant and equipment. The resulting value is then adjusted for depreciation. Some assets are depreciated on a straight-line basis by dividing the replacement value over the asset's useful life. Other assets are given greater deductions in the earlier years and less in later years. Whatever method is used, the total depreciation amount remains the same.

References

About the Author

Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a business writer. Her articles have appeared on numerous business sites including Typefinder, Women in Business, Startwire and Indeed.com. Find her at www.whiterosecopywriting.com.