Loading the player...

What is a 'Replacement Cost'

A replacement cost is the cost to replace an asset of a company at the same or equal value, and the asset to be replaced could be a building, investment securities, accounts receivable or liens. The replacement cost can change, depending on changes in market value of the asset and any other costs required to prepare the asset for use. Accountants use depreciation to expense the cost of the asset over its useful life.

BREAKING DOWN 'Replacement Cost'

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.

How Net Present Value Is Used

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.

Factoring in Depreciation

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. Depreciation matches the revenue earned by using the asset with the expense of using the asset over time. 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 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.

Examples of Budgeting for Asset Purchases

Given the cost of replacing expensive assets, well-managed firms create a capital expenditure budget to plan future asset purchases and how the firm generates 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.

RELATED TERMS
  1. Accumulated Depreciation

    The cumulative depreciation of an asset up to a single point ...
  2. Depreciation

    1. A method of allocating the cost of a tangible asset over its ...
  3. Betterment

    A type of action or cost expenditure that contributes towards ...
  4. Declining Balance Method

    A common depreciation-calculation system that involves applying ...
  5. Business Asset

    A piece of property or equipment purchased exclusively or primarily ...
  6. Economic Life

    The expected period of time during which an asset is useful to ...
Related Articles
  1. Investing

    Understanding Capital Assets

    A capital asset is one that a company plans on owning for more than one year, and uses in the production of revenue.
  2. Investing

    Explaining Replacement Cost

    The replacement cost is the cost you’d have to pay to replace an asset with a similar asset at the present time and value.
  3. Investing

    Explaining Capitalized Cost

    A capitalized cost is an expense associated with a fixed asset that is added to the basis of that asset and expensed over its depreciable life.
  4. Investing

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  5. Investing

    Understanding Carrying Value

    Carrying value is the value of an asset as listed on a company’s balance sheet. Carrying value is the same as book value.
  6. Managing Wealth

    What's an Asset?

    An asset is a resource with economic value.
  7. Investing

    Explaining the Declining Balance Method

    The declining balance method is a system for calculating an asset’s rate of depreciation against its non-depreciated balance.
  8. Investing

    Assessing Bank Assets: Are Your Savings Safe?

    Learn how to determine if your assets are safe or if your bank has spread itself too thin.
  9. Investing

    What is a Real Asset?

    A real asset is a physical asset that has value.
  10. Investing

    Understanding Historical Cost

    Historical cost equals the original purchase price of an asset recorded on a company’s balance sheet.
RELATED FAQS
  1. Why do companies often treat events such as the purchase of an asset or construction ...

    Understand the capitalized costs of fixed assets and learn how they are reflected on a company's balance sheet and income ... Read Answer >>
  2. What happens to accumulated depreciation when you sell an asset?

    Learn what happens to a company's accumulated depreciation when it sells an asset. Understand why accumulated depreciation ... Read Answer >>
  3. Is depreciation only used for tangible assets?

    Learn if tangible assets can be depreciated, as well as what other assets are eligible for depreciation so you can account ... Read Answer >>
  4. What would cause a decrease in accumulated depreciation?

    Understand what causes a decrease in a company's accumulated depreciation. Learn why a company's accumulated depreciation ... Read Answer >>
  5. What is the difference between carrying value and market value?

    Understand the difference between carrying value and market value. Learn when a company uses carrying value to value an asset ... Read Answer >>
  6. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ... Read Answer >>
Hot Definitions
  1. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  2. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  3. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  4. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  5. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  6. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
Trading Center