Replacement cost definition
/What is Replacement Cost?
Replacement cost is the price that an entity would pay to replace an existing asset at current market prices with a similar asset. If the asset in question has been damaged, then the replacement cost relates to the pre-damaged condition of the asset. The replacement cost of an asset may vary from the market value of that specific asset, since the asset that would actually replace it may have a different cost; the replacement asset only has to perform the same functions as the original asset - it does not have to be an exact copy of the original asset. The concept is used in the areas noted below.
Replacement Cost in Insurance Policies
The replacement cost concept in insurance refers to the amount of money it would take to replace or repair a damaged, destroyed, or stolen asset with a new one of similar kind and quality, without accounting for depreciation. It is a critical factor in property and casualty insurance policies, particularly in homeowners' and business insurance. Key aspects of the replacement cost concept in this setting are as follows:
New-for-old principle. Replacement cost coverage ensures that the insured can replace the damaged item with a new one, regardless of the item's age or wear and tear. For example, if a five-year-old TV is destroyed in a covered event, the policy pays for a new TV of similar type and specifications, not the depreciated value of the old TV.
No deduction for depreciation. Unlike actual cash value (ACV) coverage, which subtracts depreciation from the reimbursement amount, replacement cost coverage focuses purely on the cost of a new equivalent item.
Scope of coverage. Home structure replacement cost often applies to rebuilding a home to its original specifications using current construction costs, materials, and standards. Personal property policies may offer replacement cost coverage for personal belongings, such as furniture, electronics, and clothing.
Conditions for full reimbursement. Insurers often require the policyholder to actually replace or repair the item to receive the full replacement cost. If the insured decides not to replace the item, the insurer may only pay the actual cash value.
Extended replacement cost. Some policies include extended replacement cost coverage, which goes beyond the policy's stated limit to account for unexpected increases in construction costs or materials, often capped at a percentage (e.g., 125% or 150% of the original coverage limit).
Guaranteed replacement cost. This coverage ensures that the insurer will pay the full cost to replace the property, regardless of policy limits, which can be especially useful in times of significant market inflation or post-disaster demand surges.
Replacement cost is a valuable feature of insurance policies that protects policyholders from financial losses by covering the expense of replacing assets with new ones. While it provides a higher level of protection than ACV coverage, the associated higher premiums and potential coverage gaps require careful consideration when selecting a policy.
Replacement Cost in Acquisitions
Replacement cost can also be used to estimate the amount of funding that might be required to duplicate another business. This concept can be used to establish one of several possible price points that can be used in the formulation of a proposed price to pay the shareholders of a target company as part of an acquisition.
Replacement Cost in Capital Budgeting
The concept is also used in capital budgeting, when formulating estimates of the funding needed to replace existing assets as they wear out. A business might even set aside cash for several years prior to actually replacing a major asset, based on the amount of its estimated replacement cost.
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Replacement Cost Budgeting
Businesses with a large asset base may engage in replacement cost budgeting. Under this approach, they anticipate when their key assets are going to require replacement, and then set up a plan to set aside the necessary funds for them, so that they can be replaced in an orderly fashion. For example, a manufacturer of precision widgets knows that a widget lathe will wear out in three years, and so develops a plan for how to come up with its $30,000 expected replacement cost. When the lathe wears out, the manufacturer will have the money to buy a new one.
Terms Similar to Replacement Cost
Replacement cost is also known as replacement value.