Replacement Cost

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.

Replacement Cost

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Examples

Example #1

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

Disadvantages

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.

This article has been a guide to what replacement cost is and its definition. Here we discuss examples of replacement costs related to insurance companies along with advantages and disadvantages. You can learn more about investment from the following articles –