Replacement Cost – Correct method of replacing an existing asset


Replacement of old assets is one of the most common and critical decisions that have to be made by an organization dealing with goods or services. Many organizations do not know the correct method of replacing an existing asset and face huge losses later when the asset stops working altogether.

There are some considerations that need to be addressed while taking a replacement decision. Here are some of the most needed ones.

Do not let the machine decide

Many organizations follow a very simple policy for the replacement of existing assets.

  • Instead of trying to decide for the time of replacement, they let the assets do the task. That is, they do not make the decision themselves but let the asset tell them when they need replacement.

  • For example, an asset would become dysfunctional at a time in the future and that would be the ideal time for replacement of the asset. This is a completely wrong assumption and policy. If we leave the decision to be made by the assets, they may go defunct at a very needy moment, costing a lot of money and loss of revenues.

  • Companies should have economic policies to decide the total useful life of machinery or an asset. For example, if an asset has 5 years of average life, it should be replaced at the end of 5 years without waiting for it to go defunct. This would not only save money but will also keep the production process running when there is an utmost need for its use.

Arranging the costs early

It is also of very high importance to arrange the cost of assets before they become unusable. If the management waits for the machine to become unusable and then arrange the costs, it may be too late to evade the losses. As explained above, the economic policy should tell the business owners when to replace the old assets and that should be the time to make a new investment to get a new or improved asset.

Conclusion

Following the Annual Equivalent Value (AEV) method that takes into consideration both the above-mentioned qualities is the best bet for companies looking for the replacement of an asset.

Calculating the AEV would tell us whether the asset needs to be sold in the given year or not.

It is a cost-based calculation that shows the ultimate life of an asset. Following the AEV, one can realize whether the costs of replacement at any given moment would save costs or not and so they can invest money for the replacement depending on the outcome.

Updated on: 03-Dec-2021

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