What Is Replacement Cost and How Does It Work?

What Is a Replacement Cost?

Replacement cost is a term referring to the amount of money a business must currently spend to replace an asset like a fixture, a machine, a vehicle, or an equipment, at current market prices. Sometimes referred to as a "replacement value," a replacement cost may fluctuate, depending on factors such as the market value of components used to reconstruct or repurchase the asset and the expenses involved in preparing assets for use.

Insurance companies routinely use replacement costs to determine the value of an insured item. The practice of calculating a replacement cost is known as "replacement valuation."

Replacing an asset can be an expensive decision, and companies analyze the net present value (NPV) of the future cash inflows and outflows to make purchasing decisions. Once an asset is purchased, the company determines a useful life for the asset and depreciates the asset's cost over the useful life.

Understanding Replacement Costs

As part of the process of determining what asset is in need of replacement and what the value of the asset is, companies use a process called net present value. To make a decision about an expensive asset purchase, companies first decide on a discount rate, which is an assumption about a minimum rate of return on any company investment.

A business then considers the cash outflow for the purchase and the cash inflows generated based on the increased productivity of using a new and more productive asset. The cash inflows and outflow are adjusted to present value using the discount rate, and if the net total of all present values is a positive amount, the company makes the purchase.

Special Considerations

When calculating the replacement cost of an asset, a company must account for depreciation costs. A business capitalizes an asset purchase by posting the cost of a new asset to an asset account, and the asset account is depreciated over the asset’s useful life. The cost of the asset includes all costs to prepare the asset for use, such as insurance costs and the cost of setup.

Some assets are depreciated on a straight-line basis, meaning the cost of the asset is divided by the useful life to determine the annual depreciation amount. Other assets are depreciated on an accelerated basis so more depreciation is recognized in the early years and less in later years. The total depreciation expense recognized over the asset’s useful life is the same, regardless of which method is used.

Replacement Cost Budgeting

Given the cost of replacing expensive assets, well-managed firms create a capital expenditure budget to plan for both future asset purchases and for how the firm will generate cash inflows to pay for the new assets. Budgeting for asset purchases is critical because replacing assets is required to operate the business. A manufacturer, for example, budgets for equipment and machine replacement, and a retailer budgets to update the look of each store.

The Bottom Line

In business, a replacement cost is the cost of restoring or replacing an asset that has been sold or damaged. This may be different from the cash value of that asset, due to factors like depreciation and market fluctuations.