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Replacement Cost

DEFINITION

When a company loses an asset of any kind, whether it’s a lien, an investment, a property, it must be replaced. This expense is referred to as replacement cost.

EXPLANATION

The value of the asset can change based on the market value, which is usually in flux. There may also be costs associated with preparations for the asset to be used. All of these costs are called the replacement cost. Accountants will calculate the cost of an asset of the course of its life through incorporating depreciation. Cover the cost of replacing an asset can be expensive, and most companies will analyze whether it’s worth doing so through figuring out the net present value, or NPV. The company will determine the most fiscally advantageous use of the property and then will offset the replacement cost through utilizing the asset to its highest extent.

Net Present Value

Companies will often decide on a discounted rate for purchase of an asset. A discounted rate is a price that’s below commercial prices. In real estate this translates into an prediction as to how much the smallest rate of return about any investment made by the organization. Then the company will analyze whether the potential purchase will bring in enough profit to offset the cost of buying it and whether it will increase productivity overall. The outflow and inflow of cash are calculated to current value with the discount rate. All the current values are added, and if the sum is positive, then the asset is purchased.

Depreciation

When a company purchases an asset, they add the cost of that purchase to an account dedicated to assets, and the account then depreciates over the course of the life of the asset. Deprecation basically factors in the profit that comes in from the asset against the cost of maintenance and use. This might include anything from insurance costs to the expense of the getting the asset ready for use. There are two different ways to calculate the rate of depreciation for an asset. The first is called a straight-line basis. In this way, the cost of the acquiring the asset is divided by the amount of time during which the asset is useful. This determines the depreciation amount. The other way that depreciation is calculated through an accelerated approach. With this way of calculating, depreciation is calculated by factoring in the notion that depreciation will happen more quickly while the asset is new, and more slowly in later years. The total of the expense of depreciation ends up being the same, no matter which method of calculation is used.

Budgets

Usually a company that’s managed well will have a separate budget for acquiring future assets. This account is called a capital expenditure budget. Each asset will have its own maintenance costs and this account allows for proper budgeting.

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