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 value of the asset followed by its useful life.
The insurance company’s main function is to evaluate whether the decision of replacement is better than repair and maintenance or not. It is also very important for a company to correctly calculate the depreciation since it will have a great 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 taking wrong decisions by the organization.
Examples of Replacement Cost
Lets discuss an examples of replacement cost.
- 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 is it 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 the book value of the asset is $ 5,000. The remaining useful life of the asset 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 of replacement cost related to insurance companies:
- 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 is $ 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 replacement cost 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 of Replacement Cost
Some of the advantages are as follows:
- 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.
- Replacement cost also helps in finding the labor-intensive replacements for the company. The hr policy of the organist ion also considers the replacement technique to arrive at a conclusion.
- One more advantage of replacement cost is that 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 the company may use the replacement cost to enhance the balance sheet figure of the asset.
Disadvantages of Replacement Cost
Some of the disadvantages are as follows:
- The premium which an insurance company demands is usually higher. Therefore it is very difficult 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 very difficult 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 settle 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.
- The replacement cost of an asset depends upon many factors like market condition, change in demand, asset useful lives, etc, therefore, these conditions should be there to get a 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 loss calculation after the close of the balance sheet.
The replacement cost technique is very helpful 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 replacement cost 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.
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The company should take a wise decision by carefully calculating the replacement cost of any asset by comparing its repair and maintenance cost which can be levied over the years if the asset is not replaced.
This has been a guide to what is replacement cost 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 –