Replacement Cost

Although it is typical for current costs to exceed historical costs, this is not always the case. Computers and many types of electronic equipment cost much less today than they did just a few years ago. In many high-tech industries, the rapid advance of technology has overcome the general rate of inflation. As a result, current costs are falling. Current costs for computers and electronic equipment are determined by what is referred to as replacement cost, or the cost of duplicating productive capability using current technology. For example, the value of used personal computers tends to fall by 30 to 40 percent per year. In valuing such assets, the appropriate measure is the much lower replacement cost—not the historical cost. Similarly, if a company holds electronic components in inventory, the relevant cost for pricing purposes is replacement costs.

In a more typical example, consider a construction company that has an inventory of 1,000,000 board feet of lumber, purchased at a historical cost of $200,000, or $200 per 1,000 board feet (a board foot of lumber is 1 square foot of lumber, 1 inch thick). Assume that lumber prices rise by 50 percent, and the company is asked to bid on a construction project that would require lumber. What cost should the construction company assign to the lumber—the $200,000 historical cost or the $300,000 replacement cost? The answer is the replacement cost of $300,000. The company will have to pay $300,000 to replace the lumber it uses on the new construction project. In fact, the construction company could sell its current inventory of lumber to others for the replacement cost

The cost of duplicating productive capability using current technology

2 This statement involves a slight oversimplification. The economic cost of using a machine for 1 year is its current market value minus the discounted present value of its worth 1 year from now. This adjustment is necessary to account for the fact that future dollars have a lower present value than dollars received today.

prevailing market price of $300,000. Under current market conditions, the lumber has a worth of $300,000. The amount of $300,000 is the relevant economic cost for purposes of bidding on the new construction project. For income tax purposes, however, the appropriate cost basis for the lumber inventory is still the $200,000 historical cost.

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