Reviewed by Jan 05, 2021| Updated on
Replacement costs are the cash outlay that the business has to pay to replace an old asset at the existing market price. The price charged to replace the old asset with the new one having the same value is the replacement cost.
Replacing an asset can be a costly decision, and companies are analysing the net present value (NPV) of future cash inflows and outflows to make buying decisions. The company determines a useful life for the asset and depreciates the cost of the asset over the useful life.
The replacement cost is used while making the company renovation business decisions. The replacement costs are always higher than the book value of the asset to be substituted and thus often called the replacement value. The companies estimate the funding requirements for the replacement well in advance, to locate all possible price points from which the replacement costs or value can be paid off.
If the asset prices are stable over time, then the cost of replacement and the historical cost is equal to each other, i.e. both are identical. However, the costs vary if the rates differ.
A business must calculate for the depreciation costs when determining the replacement cost of an asset. The asset cost covers all costs associated with preparing the asset for use, such as insurance costs and setup costs.
While arriving at the replacement cost of expensive assets, well-managed firms create a capital expenditure budget to plan for both future acquisitions of assets and how the firm will generate cash inflows to pay for the new assets.
Budgeting on the purchase of assets is vital as it needs replacing assets to run the company. For example, a manufacturer has budgeted for equipment and machine replacement, and retailer budgets that update each store look.