Replacement Cost

Updated on January 12, 2024
Article bySourav Sinha
Edited bySusmita Pathak
Reviewed byDheeraj Vaidya, CFA, FRM

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 some time. The company involves the insurance company to do the needful. It is found out by calculating the present value followed by its useful life.

Replacement Cost

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The insurance company’s primary function is to evaluate whether the decision of replacement is better than repair and maintenance. 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 to continue the old asset or replace it 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.

Replacement Cost Explained

Replacement cost is the cost involved in replacing an existing item with another item having same or similar features. Businesses can assess the depreciation cost of the item against the market value of the same and then decide whether to replace it.

They compare the cash inflow and outflow in the future associated with the replaced items as well as the existing one. The firms consider the option of either continuing with the same item or the replacement based on the comparison. In this method, the items are replaced without any depreciation cost being deducted. This means the price of the new item replacing the used machines or accessories is equal or same to an extent.

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 uses this type of technique to find out the replacement cost of the asset, which is considered. The policy is designed so that the policyholder gets some benefit from the insurance companies. Still, sometimes the settlement of the claims is done with a lesser amount than the asset’s actual value.

The company should make a wise decision by carefully calculating this cost by comparing its repair and maintenance costs, which can be levied over the years if the asset is not replaced.

Insurance policies have a great role to play in the working of the replacement value. The coverage for replacement cost of contents offered by insurance companies include the schemes to allow owners of personal property owners to have a cover against damage and destruction. Such items that can be covered under this scheme include television, furniture, etc. When it comes to replacement cost for insurance, the schemes may not be available for a car insurance. However, for the rest, there is a possibility of protecting the items meant to be replaced in future against depreciation using a policy.

Many confuse replacement costs with reproduction costs. However, these are used in different contexts. While the former involves replacing an existing depreciated or damaged or stolen item with a new one offering same features and function but made up of more advanced and modern materials and designs, the latter involves cost of constructing a duplicate of what one already has made up of similar materials and designs.

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Examples

Let us consider the following instances to understand the replacement cost definition better and also see how it works:

Example #1

Suppose a company bought machinery for $ 2,500 ten years ago. The company has to decide whether it is good to replace the machinery and buy a new one or continue with the old one. The present value of the machinery is $1,000 after depreciation. Suppose the replacement cost for that machinery comes out to be $2,000.

In this case, the management should replace the machinery since it will add value to the business in the future.

A company has been using its machinery for several years, and theBook 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 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 two years now. If, after two 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. One fine day, the truck got heavily damaged while delivering the goods. The company claimed the insured amount from the insurance company since the truck was insured. 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 features, and the company is valued at $ 20,000 today.T

Therefore the replacement cost is $ 20,000. But there is a twist: if a similar truck in the market is valued at $13,000, the insurance company will only pay $ 13,000 and not the one 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.

Benefits

Replacement cost is the price involved in replacing an item with another one with identical features. It is not a complicated concept and hence, every businessperson can easily understand and assess whether replacement of an item is required. Let us check some of the benefits of such costs below:

Risks

Though these costs bring a lot of benefits to businesses, the challenges too require attention. Following are the demerits associated with the replacement cost value:

Replacement Cost vs Actual Cash Value

Replacement cost value and actual cost value (ACV) are two values of an item that differ in various aspects. The difference between the two have been discussed below in brief. Let us have a look:

  • Replacement value is the price that individuals and entities pay to replace an item for the same price without the deduction of the any depreciation cost. On the contrary, the ACV is the price at which the items are purchased after the de[recitation value of it is deducted from the actual price while making replacements.
  • Thus, replacement value is the total cost oone needs to pay for replacement, while ACV is the amount at which the items are currently available in their depreciated form.

This article has been a Guide to what is replacement cost. Here, we compare it with actual cash value (ACV), and explain its examples, benefits, and risks. You can learn more about investment from the following articles –