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.

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 depreciation 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 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.

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 the book value of the asset is $ 5,000. The remaining useful life of the asset 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.

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:

• It is a very simple technique that anyone with little knowledge of profit and loss can adopt.
• 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 so that the company can benefit from the same.
• It helps the insurance company to settle the claims. The replacement cost coverage is made so that the policyholder will not be at a loss, and the assured sum will be equivalent to the asset to be replaced.
• It also helps in finding labor-intensive replacements for the company. The HR policy of the organisation also considers the replacement technique to conclude.
• The company may use the replacement cost to increase its valuation. The historical cost of 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.

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:

• The premium that 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 with the loss.
• Suppose any company follows a replacement cost basis to get their claims settled from the insurance company. In that case, they may have to settle for the loss because the lesser amount of the asset is usually settled. Still, if the company intends to follow the actual cash value of the asset, then the company will be in a neutral position.
• It does not help certain value items like antiques, etc. 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 the correct replacement value, and all these factors are not always available to the organization.
• The current market value of inventories is not available for any organization. Therefore, the replacement valuation does not help here. The inventory valuation keeps the unrealized profits and loss calculation after the close of the balance sheet.

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 –

• Coinsurance
• Contra Asset Account
• Wasting Asset
• Wash Sale Rule