What it means
An asset's original purchase price can be very different from what it would cost today. Construction prices, materials and labour rates move over time, so a building bought for $1,500,000 years ago may cost far more to replace now.
Replacement Cost New updates the figure to current conditions. The estimate includes all the costs of getting the replacement into use, such as materials, labour, design fees, permits and installation.
It describes a new asset with the same function, not necessarily an exact copy, because an exact copy using obsolete methods might not be sensible to build today. Valuers normally use cost indexes, builder quotations or published cost guides to arrive at the figure.
RCN is then adjusted to reflect the asset's age and condition. Subtracting physical deterioration, functional obsolescence and economic obsolescence gives the depreciated replacement cost, which is a fair estimate of the value of the used asset.
This is widely used in property valuation, insurance and accounting for specialist assets with no active market. For insurance, RCN sets the maximum amount needed to rebuild.
If a property is insured for less than its replacement cost, the owner may be underinsured and receive less than needed after a loss. Many policies include conditions that reduce a claim in proportion if cover is too low.
The nuance is that RCN is not the same as market value. A building may have a high RCN but sell for much less if the location is poor or demand is weak.
Conversely, a well-located site can sell for more than its RCN because of the value of the land. Accountants meet the concept in several places.
It supports impairment testing, where an asset's carrying value is compared with what it is worth, and it features in business combinations when assets are valued at the time of purchase. Lenders also use it to check that the security for a loan would be enough to rebuild the property.
In practice
Real-world examples.
Example
A factory owner reviews her insurance and asks a surveyor for the RCN of the building. The surveyor finds that rebuilding would cost 40% more than the policy sum insured. She raises the cover to avoid being underinsured, even though the premium rises by a modest amount.
Example
A utility company values a specialised pipeline for its regulator. There is no market for second-hand pipelines, so the valuer estimates the RCN and deducts depreciation. The result forms part of the asset base.
Example
An accountant in a hospital group estimates the value of an old surgical suite for a financial statement. She uses the RCN of equivalent modern equipment, adjusted for the age of the existing items. The figure supports the carrying value in the accounts, and the auditor accepts the method after reviewing the cost guides used.
Formula
Calculation
Depreciated replacement cost = RCN - physical depreciation - functional obsolescence - economic obsolescence
A valuer estimates that a warehouse would cost $2,000,000 to rebuild new today. Physical depreciation of 30% is 2,000,000 x 0.30 = $600,000, and functional obsolescence from an outdated layout is estimated at $100,000, with no economic obsolescence. The depreciated replacement cost is 2,000,000 - 600,000 - 100,000 = $1,300,000.Case study
Seen in the real world.
Stonefield Manufacturing is an illustrative, fictional company that insured its main plant for $4,000,000, the figure from the original construction twelve years earlier. A new insurance broker asked for a valuation.
The surveyor estimated the RCN at $6,500,000 after rises in building costs. The plant was therefore insured at 4,000,000 / 6,500,000 = about 61.5% of its replacement cost.
After a small fire causing $200,000 of damage, the insurer applied the underinsurance condition and paid only about 61.5% of the loss, around $123,000, leaving the company to find the remaining $77,000. The broker raised the sum insured to $6,500,000 and set a reminder to revalue the plant every two years. The illustrative lesson is that RCN should be reviewed regularly, because an out-of-date sum insured can leave a large gap at the worst moment.
Watch out
Common mistakes.
- Using the original purchase price as the replacement cost, which ignores changes in building and equipment prices.
- Confusing RCN with market value, even though location and demand can make them very different.
- Forgetting to include fees, permits and installation, which can make the estimate too low.
Questions
People also ask.
What is the difference between replacement cost and reproduction cost?
Replacement cost is the cost of a modern equivalent with the same function, while reproduction cost is the cost of building an exact replica, including outdated features.
How often should RCN be updated?
Many insurers and valuers recommend a review at least every few years, or sooner when construction prices move sharply.
Why subtract depreciation from RCN?
Because a used asset is worth less than a new one, and the deduction shows how much value has been used up.
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