What is Replacement Cost?
Replacement cost is a cost that is required to replace any existing asset having similar characteristics. An organization often chooses to replace its assets when the repair and maintenance costs increase beyond an acceptable level over a period of time. The company involves the insurance company to do the needful. It is found out by calculating the present valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read more of the asset, followed by its useful life.
The insurance company’s primary function is to evaluate whether the decision of replacement is better than repair and maintenance or not. It is also vital for a company to correctly calculate the depreciationCalculate The DepreciationThe Depreciation Expense Formula computes how much of the asset's value can be deducted as an expense on the income statement. Formula for Straight-line depreciation method= Cost of an asset - Residual value/useful life of an asset.read more since it will have a significant impact on the decision of the continuation of the old asset or replacement with a new one. Sometimes it becomes a challenge to estimate the correct market value of the asset, and hence it may lead to making wrong decisions by the organization.
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Source: Replacement Cost (wallstreetmojo.com)
Examples
Example #1
- Suppose a company bought machinery for $ 2,500 ten years ago. The present value of the machinery is $1,000 after depreciation. Suppose, the replacement cost for that machinery comes out to be $2,000. Now the company has to decide that it is a good idea to replace the machinery and buy a new one or to continue with the old one.
- In this case, the management should replace the machinery since it will add value to the business in the future.
- A company is using its machinery for several years, and the book value of the assetBook Value Of The AssetBook Value of Assets is the asset's value in the books of records of a company or an institution at any given instance. Assets Book Value Formula = Total Value of an Asset – Depreciation – Other Expenses Directly Related to it read more is $ 5,000. The remaining useful life of the assetRemaining Useful Life Of The AssetUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets.read more is 2 years now if, after 2 years, the asset value becomes $ 8,000, and the discount rate is 5%, the present value of the replacement cost will be $ 8,000 / (1.05)*(1.05) = $ 7,256.
Example #2
- A company is in the transport business. They own several trucks and vans. On one fate day, while delivering the goods, the truck got heavily damaged. The company claimed the insured amount from the insurance company since the truck was insured with them. The insurance company after an investigation found that the truck was $ 15,000 2 years ago, now the same truck in the market with the same feature, and the company is valued for $ 20,000 today.
- Therefore the replacement cost is $ 20,000. But there is a twist if a similar truck in the market is valued for $13,000; the insurance company will only pay $ 13,000 and not the one as decided by the company. Therefore for the insurance company, the replacement cost will be the lowest cost possible for any asset available in the market with similar features and utility.
Advantages
- It is a very simple technique and can be adopted by anyone with little knowledge of profit and loss.
- The company can estimate the present value and depreciation and then can decide whether the asset needs replacement or not.
- They also help the organization in cost budgeting and hence maintain a healthy financial practice to plan the finances in advance so that the company can get benefit from the same.
- It helps the insurance company to settle for the claims. The coverage of the replacement cost is made in such a way that the policyholder will not be at a loss, and the assured sum will be equivalent to the asset, which is to be replaced.
- It also helps in finding the labor-intensiveLabor-intensiveLabor intensive implies those tasks which require a heavy workforce for accomplishment. In the production of goods and services, the industry is considered labour intensive if the manufacturing process relies more on human resource than machinery.read more replacements for the company. The hr policy of the organist ion also considers the replacement technique to arrive at a conclusion.
- The company may use the replacement cost to increase its valuation. The historical cost if calculating any tangible asset will also be less than its replacement cost, so the company may use it to enhance the balance sheet figure of the asset.
Disadvantages
- The premium which an insurance company demands is usually higher. Therefore it is challenging for the policyholder to pay such premiums to get their assets insured.
- The replacement cost for the insured assets if the damage is determined with the lowest price possible; therefore, sometimes it is challenging for the company to cope up with the loss.
- If any company is following replacement cost basis to get their claims settled from the insurance company, then they may have to settle for the loss as well because the lesser amount of the asset is usually settled, but if the company intends to follow the actual cash value of the asset then the company will be in a neutral position.
- It is not at all helpful in valuing certain items like antiques, etc., for that some special treatment is required.
- This cost depends on many factors. E.g., market condition, change in demand, asset’s useful lives, etc.. Therefore, these conditions should be there to get correct replacement value, and all these factors are not always available with the organization.
- The current market value of inventories is not available for any organization. Therefore, the replacement valuation does not help here. The inventories valuation keeps the unrealized profits and lossUnrealized Profits And LossUnrealized Gains or Losses refer to the increase or decrease respectively in the paper value of the company's different assets, even when these assets are not yet sold. Once the assets are sold, the company realizes the gains or losses resulting from such disposal.read more calculation after the close of the balance sheet.
Conclusion
The replacement cost technique is beneficial for those who can take advantage of the same. This method is not helpful for those businesses where the current market price is not available. The insurance company makes use of this type of technique to find out the replacement cost of the asset, which is considered. The policy is designed in such a way that the policyholder gets some kind of benefit from the insurance companies, but sometimes the settlement of the claims is done with a lesser amount than the actual value of the asset.
The company should make a wise decision by carefully calculating this cost by comparing its repair and maintenance cost, which can be levied over the years if the asset is not replaced.
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