The Replacement Cost Method is the main technique under the Cost Approach. It values an asset at the current cost of obtaining a modern equivalent asset with the same utility, less deductions for physical deterioration and for functional and economic obsolescence. The result is often called depreciated replacement cost (DRC).
When to Use the Replacement Cost Method
- Specialised property, plant and machinery with few market transactions, such as factories, power plants and process equipment
- Purchase price allocation: fair value of PPE and some internally developed intangibles, such as software and assembled workforce
- Impairment testing and revaluation under IAS 16 and IAS 36
- Insurance: setting adequate sums insured
- Public sector and infrastructure assets
How the Method Works
- Identify and inspect the assets and their current use.
- Estimate the gross replacement cost of a modern equivalent, using supplier quotes, cost databases, construction cost guides or indexed historical costs.
- Deduct physical deterioration, based on age, condition and remaining useful life.
- Deduct functional obsolescence: excess capacity, inefficiency or outdated technology compared with the modern equivalent.
- Deduct economic obsolescence: external factors such as weak demand, regulation or under-utilisation, which are often tested against the business's earning capacity.
- Conclude the depreciated replacement cost and reconcile it with income and market evidence where available.
Replacement vs Reproduction Cost
Replacement cost prices a modern asset with the same utility. Reproduction cost prices an exact replica. Replacement cost is generally preferred because it automatically removes much of the functional obsolescence.
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