Updated July 24, 2023

Introduction to Replacement Cost

Replacement cost is the cost to build the same building or replace a machine with the same capacity as a new one. For a manufacturing unit to run its daily operation, it needs machinery. The output of the machinery decides the overall production of the firm. It is crucial for a firm to estimate the cost of producing the same units with a recent machinery cost.

Explanation: The most practical or theoretically correct cost to estimate the business’s smooth running is the replacement cost. This cost tells you the exact cost you will need if you want to maintain the same production capacity. The case of Real Estates helps you gauge the exact cost needed to build up the same building today. The Replacement cost estimate for the property assumes that the building is new and has no obsolescence. It is helpful when you are selling an old building that needs a few repairs. So the person who will be buying it will calculate the replacement cost first. So he got the new building’s value, now he will deduct the charges of repair that the old building needs and will finally come to a value that he will be ready to pay for the old building.

How to Calculate the Replacement Cost of a Firm?

Suppose there is a small manufacturing firm situated in a remote area within one building. How will you calculate the replacement cost?

Say the building from where the firm operates is 50 years old. The firm repurchased the building then by paying $5,000. So to make the exact same building now the cost will be $15,000. So $15,000 is the replacement cost of the building.

Similarly, the replacement cost of all the machinery is $6,000. So to replace the firm today you will be needing ($15,000 + $6,000 = $21,000)

Examples of Replacement Cost

Here we discuss some examples are:

Example #1

A plastic bottle manufacturing firm produces 1,000,000 units of bottles each year. It has 10 machines running in shifts. Each machine has the capacity to produce 100,000 units each year. Machines have a life span of 10 years. Say the cost of each machine is $1,000.

So for the business’s smooth running, a firm will have to replace the machines after 10 years with the same capacity. Say the cost of new machines with the exact same capacity now is $1500. So the cost has risen in 10 years. Now, the firm will have to spend ($1,500 * 10 = $15,000) to replace the old machines. So $15,000 is the replacement cost of the machines that the firm will have to spend for the business’s smooth functioning.

Now the firm will also have to calculate whether it is economical to replace the buildings. Earlier the cost was less, now it has increased, and the firm will have to inject fresh capital of $15,000. So the firm will have to calculate the Net Present Value of the project with new machinery. If the present value of future revenue that will be generated from the sale of bottles is more than the cost incurred now, then the firm should replace the machines. If not, then the firm should look for different capacities of machines or a different business altogether.

Example #2

It is also used in the Real estate business. Say an old building is put up for sale. It is difficult to determine the value of old buildings as there are no comparable buildings sold recently, which will help you gauge the price. New buildings have similar products to be compared and can be priced easily.

So when an Old building is put up on sale, the buyer will have to calculate the building’s replacement cost. Replacement cost will consider the cost incurred to erect an exact same building with all the features inexact. One thing that should be considered here is that the cost will portray the cost of a new building with exact features. So the Old building will have occurred some depreciation in terms of physical damage and also constructional drawbacks. It may be that the height of the old building is so high that it will require an extra heating capacity fireplace to heat it up. So this is a drawback, and the price will be adjusted from the new building.

So the replacement cost acts as a base, and the new price is adjusted on that.

Replacement Cost vs Market Value

Market value is the price that is determined in the market, considering the demand and supply. If there is a machine whose cost was $500 and is used for 5 years and has 3 years remaining, it may have a market value of $200. So it means the market is ready to pay $200 for an old machine that is being used for 3 years.

The replacement cost is entirely different. It will be the cost of another new machine that will have the same capacity as the old machine. Obviously, the cost will be more than $500 because $500 was charged 5 years back. Now, the prices may have gone up. So market value is the value of the asset in the market, and replacement cost is the cost that will be incurred to replace the old asset with a new one now.

Benefits of Replacement Cost

Some of the benefits are given below:

It helps in the Real estate market by giving a base in the valuation of Old buildings, which are really difficult to value otherwise.
It helps in capital budgeting, where the cost and benefit analysis is done based on the replacement cost of machines for continuation or expansion of projects.

Drawbacks of Replacement Cost

Some of the drawbacks are given below:

It gives the value of the new building. It doesn’t consider depreciation cost and other damages that the building has undergone.
It gives a picture considering the current economic condition. If due for some reason, the economy is going through a high inflation phase, which will recover in a few months, then replacement cost will not provide a proper picture, and a project may be rejected considering high replacement cost.

Conclusion

Replacement Cost is an important way by which we get a picture of what should be the cost involved in the case a firm is thinking of expansion or someone is planning to buy the Real estate. It is easy to calculate as it considers the current pricing that is in the market.