Replacement Cost

Replacement cost is the price a business would have to pay, at current prices, to replace an existing asset with one that provides the same service capacity. For inventory it is the current cost of buying or producing the same goods. For equipment or buildings it is usually the cost of a new equivalent asset, adjusted for the age and wear of the one being replaced, a figure often called depreciated replacement cost.

Replacement cost is an entry value: it looks at what it would cost to acquire an asset. It differs from historical cost, which is what was actually paid in the past, and from exit values such as net realizable value or fair market value, which look at what the asset could be sold for. It is unrelated to replacement cost risk, a term used in derivatives and settlement for the risk of having to replace a failed trade at a worse price.

Under the cost principle, most assets in US GAAP financial statements are recorded at historical cost less depreciation. In periods of inflation, that figure can fall far below what it would cost to replace the asset. A factory bought for $10 million 20 years ago and depreciated to $3 million might cost $25 million to build today. Profit measured with historical cost depreciation can then look high, while the business is not setting aside enough to replace its assets when they wear out.

Current cost accounting, which was required as supplementary disclosure for large US public companies under FASB Statement No. 33 from 1979 until it was made voluntary in 1986, tried to address this by measuring assets and expenses at replacement cost. The difference between the replacement cost and historical cost of assets held is a holding gain.

• Inventory valuation: before 2017, the US GAAP lower of cost or market rule defined market mainly as replacement cost, within a ceiling and a floor. Since ASU 2015-11, most inventory is measured at the lower of cost and net realizable value instead, although the market test with replacement cost still applies to inventory measured under LIFO or the retail method.
• Fair value measurement: the cost approach, one of three valuation approaches in US GAAP and IFRS, estimates fair value as current replacement cost adjusted for obsolescence. It is often used for specialized equipment.
• Insurance: property policies may pay replacement cost, the full cost of repairing or replacing damaged property, or actual cash value, which deducts depreciation. Replacement cost cover costs more in premiums but avoids a shortfall.
• Decision making: when deciding whether to use materials in stock for a job, the relevant cost is usually their replacement cost, because using them means buying more.
• Investment analysis: Tobin's q compares a company's market value with the replacement cost of its assets.

A printing business owns a press bought six years ago for $400,000, with a useful life of ten years and no salvage value. Its carrying amount is $160,000. An equivalent new press now costs $520,000. Depreciated replacement cost is:

Here the current cost of a new equivalent is $520,000, the remaining life is 4 years and the total life is 10 years, giving $208,000. That is $48,000 more than the carrying amount. Annual depreciation on a replacement cost basis would be $52,000 rather than $40,000, so profit measured on that basis would be $12,000 lower each year, a better guide to the cost of sustaining the business.

Replacement cost can be hard to measure when technology changes and no identical asset is available, so estimates rely on price indexes or engineering judgment. It is less verifiable than historical cost, which is one reason standard setters have generally kept it as a disclosure or a test rather than the main basis of inventory valuation and asset measurement.