What Is A Replacement Cost?
Replacement cost refers to the amount an entity must spend at current market prices to replace an asset with a similar one. The amount of money an entity must pay to replace an old asset may change after some time due to various market conditions.
Replacement cost is what an entity pays to replace an old asset with a new one of equal or higher value. An insurance company may use replacement costs to determine the value of an insured item if it were to be damaged.
Replacing an asset, more often than not, can be a costly decision. That is because market prices tend to fluctuate over time. In replacing an asset, emphasis is on the similarities between the functions an old and new asset can perform. The emphasis on functions entails that an entity may not get the exact copy of the original asset being replaced.
In companies, replacement cost is used when creating budgets for the procurement of worn-out assets that are essential for operation. For example, a construction company may budget to replace equipment and machines used for day-to-day activities as they wear out.
When deciding whether an asset is worth replacing, companies use the net present value (NPV). The concept of NPV involves analyzing the cash outflows of the asset, as well as the inflows generated by the asset. The difference between both values helps companies decide whether to go ahead and replace an asset or not. A positive result means the asset is valuable and should be replaced. A negative one means the asset is not adding any value to the company, and it does not need replacing.
Replacement Costs Example
A fabric company, with a running capacity of 20 machines, produces 2,000,000 units of fabrics yearly. Each machine costs $1,000, produces 100,000 units each year, and has a life span of 5 years.
After five years, the company would need to replace the machines for smooth running. Assuming the cost of acquiring a new machine with similar capabilities is now $1300. The company would spend $26,000 to purchase 20 new machines. So $26,000 is the replacement cost to replace the old machines.« Back to Glossary Index