Replacement Cost

Replacement cost focuses on current prices, not on what was originally paid. Because of inflation, technological change and wear and tear, the replacement cost of an asset can differ significantly from its original cost or its value on the balance sheet.

Replacement cost is used in several areas. In insurance, many property policies pay out the cost of replacing damaged items or rebuilding a property, rather than their depreciated value. For example, a house insurance policy may cover the cost of rebuilding the home at current construction prices, which may be very different from its market value.

In valuation, replacement cost helps set a reference point for what a business or asset is worth. If a company's market value is far below the cost of building its assets from scratch, it might be undervalued, or it might reflect poor returns on those assets. The ratio of market value to replacement cost of assets, known as Tobin's q, is sometimes used to study this.

In accounting, replacement cost is one possible basis for measuring assets and calculating the true cost of goods sold during periods of inflation.