Replacement CostDefined along with Examples

Written By:
Adiste Mae

What is a Replacement Cost?

Replacement Cost is the amount a company is willing to spend to replace an existing asset, and the basis for the amount is the current market value of a similar item.

Examples of these assets are real estate property, investment securities, etc.

Factors affecting the value of replacement cost are the current market value of the similar item and the total cost of the asset in preparation for its intended use.

For example, insurance companies regularly use replacement costs to determine the insured item’s current value.

It is also widely used by accountants to account for the depreciation expense of the related asset.

Most of the time, replacing an asset can be a huge expense.

The management must consider the relative cost and future benefits from the said asset, like the Net Present Value (NPV) of future cash inflows and outflows.

The computation for the depreciation of the newly purchased and the replaced item is the same.

The purchase price, asset’s useful life, and salvage value are significant factors in the annual depreciation computation.

Understanding Replacement Costs

replacement cost

One of the primary indicators if an asset needs to be replaced or to determine its current market value is the Net Present Value (NPV).

The company must conduct a thorough analysis before purchasing an asset because some are relatively expensive.

The company must consider the future benefits of acquiring an asset.

For example, if the company acquires investment securities, the first thing to consider is the relative discount rate to compute the estimated rate of return on the possible investment.

With the provided accounting information, the company may perform a relative estimation of cash outflow and possible cash inflow and analyze other beneficial contributions of the newly acquired assets.

The discount rate is used to compute the present value of cash outflow and inflow of the purchased item in the current period.

The company will only buy the asset if the net present value of cash inflows is greater than the cash outflow.

Special Considerations

The asset’s depreciation cost is one of the top considerations in the replacement cost calculation.

The amount of a newly purchased asset is capitalized, and the same amount is depreciated over its intended useful life.

The purchased asset will be one of the company’s income-generating units, but at the same time, a relative expense is attached to the asset and is the depreciation expense.

The asset’s total costs include all related costs to prepare assets for their intended use like delivery, insurance, installation costs, etc.

There are different methods to account for asset depreciation, but the very popular and easy to use is the straight-line method.

The cost of the asset is divided by its useful life to determine the depreciation amount. Another method is the accelerated basis method, wherein during the asset’s early years, a higher amount of depreciation is recognized, and the amount decreases as time passes by.

Regardless of the depreciation method used, the total depreciation expense of the asset at the end of its useful life will all be similar.

Replacement Cost Budgeting

Since the cost of replacing an asset or even acquiring a brand new asset is costly, the management must plan the possible future expenditures related to the company’s operations.

As the company plans for the possible asset acquisition, a budget is set aside for the same asset.

The value of assets deteriorates over time, which is why it is vital to include them in the company’s plan and budget asset replacement.

For example, a manufacturing company budgets its machinery or equipment replacement when the same is all used up.

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  1. University of Mississippi "Replacement cost accounting: A Theoretical foundation " Page 4 - 23. October 21, 2022