Replacement cost is a term used in cost accounting. However, finance or investing prefer the world replacement value. No matter the term used, evaluating this cost is important for acquiring another asset needed to get things done in an organization. In this article, let’s discuss the meaning and explain this word.
Definition of Replacement Cost (Value)
1. In costing, replacement cost is the estimated cost at which an identical item can be acquired or produced.
2. In finance, replacement value is the amount an entity will spend to replace its existing asset in its current condition.
Estimated Cost. In costing, an estimate is made to know the expenditure involved in replacing the identical item. For example, if an inventory got damaged before delivery to the client, the company will quickly estimate the expenses involved to make that inventory available to its client so that the deal will be completed. In most cases, the replacement cost is what will bring the inventory to the condition before it was damaged. The part damaged can either be purchased or made in-house.
Identical item. These expenses are made on identical items. Whatever item is acquired or produced to replace the previous item must perform a similar function. For example, if a major part of an office building got damaged, the amount spent to put that deteriorated part in good condition is the replacement cost.
Use of Net Present Value. In finance, the net present value (NPV) of the asset to be replaced must be evaluated before a decision is made. Here the cash outflow is compared with the expected discounted cash inflow at present value is calculated to decide if the investment is worth it. An entity will pursue a replacement value with a positive NPV. The reason is that a positive NPV means that the asset is profitable.
Other things you should know about Replacement Value
Replacement value or cost arises when an item is damaged. These damages may be due to changes in technology so that the asset can no longer perform its usual task in ways that will benefit the company’s clients. It may also be as a result of flooding in the location the asset resides or damaged cost by a thief, crime scene, or war.
When this occurs the replacement cost will be considered along with the market price for a new item. The business may choose the pricing that is more cost-effective and efficient.
In the insurance business, the insured will only get the amount of the part of an insured item that was damaged. And this is subject to the amount he or she has contributed as a premium. An insurance company that notices an item insured under a policy was damaged will first ensure that the type of damages is under the policy’s clause. Any item damaged by fire but was insured for thief will not be replaced by the insurance firm.
If the item is under the policy, the insurance firm will evaluate the replacement cost of the item. That is the amount required to put the asset in the position it was before it was damaged. The insurer will only pay the amount in full if the premium paid by the insured is equal to or higher than the expenses incurred to replace the item insured.
Replacement cost or value is a term used in costing products or assets. It is also used in finance, to determine if the item is worth replacing. Only expenditure with positive NPV is replaced by the entity. This term applied to damaged items caused by several factors like fire, thief, flood, and more. Also, when this item is insured, the insurance company will only pay the amount spent to put it in the pre-damaged condition.