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How to Determine the Replacement Cost of Equipment

A Step by Step Guide

How to Determine the Replacement Cost of Equipment

The decision to replace a piece of equipment should be based on facts and figures. The judgment which the owner-manager of a small company makes should be the result of weighing the costs of keeping the old equipment against the cost of its replacement.

This guide discusses the elements involved in making such a cost comparison. Examples are used to illustrate the gathering and use of the appropriate cost figures.

Sooner or later, you must decide whether you should keep an existing unit of equipment or replace it with a new unit. As time goes by, equipment deteriorates and becomes obsolete. Frequent breakdowns occur, defective output increases, unit labor costs rise, and production schedules cannot be met. At some point, these occurrences become serious enough to cause you to wonder whether or not you should replace the equipment.

The problem is that the new equipment costs money, and the question that comes to you is: Will the advantages of the new equipment be great enough to justify the investment it requires? you answer this question by making a cost comparison.

Table of Contents

1. Introduction
2. Depreciation
3. Interest
4. Operating Costs
5. Revenues
6. An Annual Average Cost
7. The Old Equipment
8. The New Equipment
9. The Comparison
10 Irreducible Factors

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Sample Content

The decision to replace a piece of equipment should be based on facts and figures. The judgment which the owner-manager of a small company makes should be the result of weighing the costs of keeping the old equipment against the cost of its replacement.
This guide discusses the elements involved in making such a cost comparison. Examples are used to il­lustrate the gathering and use of the appropriate cost figures.
Sooner or later, you must decide whether you should keep an existing unit of equipment or replace it with a new unit. As time goes by, equipment deteriorates and becomes obsolete. Frequent breakdowns occur, defective output increases, unit labor costs rise, and production schedules cannot be met. At some point, these occur­rences become serious enough to cause you to wonder whether or not you should replace the equipment.
The problem is that the new equipment costs money, and the question that comes to you is: Will the advan­tages of the new equipment be great enough to justify the investment it requires?
You answer this question by making a cost comparison.
To recognize the better alternative you need to know the total cost of each alternative - keeping the old equipment or buying a replacement. Once these costs are determin­ed, you can compare them and identify the more economical equipment. The paragraphs that follow discuss the individual costs which you must consider when computing the total cost of the old and new equip­ment.

Depreciation

One of the costs connected with any type of equipment is depreciation. For cost comparison purposes, deprecia­tion is simply the amount by which an asset decreases in value over some period of time. For example, if you bought a piece of equipment for $20,000 and sold it for $6,000 after seven years of service, you would say that the depreciation during the seven-year period was $20,000 minus $6,000, or $14,000. This $14,000 was one of your costs of owning the equipment for that period.
From this, it follows that when considering equipment replacement, you must calculate the future depreciation expense that you will experience with both the old and the new equipment.
Insofar as the new equipment is concerned, this calls for knowing certain things about the equipment. You need to know (1) its first cost, (2) its estimated service life, and (3) its expected salvage value. The difference between the first cost and the salvage value will represent the amount by which the equipment will depreciate during its life - that is, during the time you expect to use it.
You determine the depreciation expense for the old equipment in the same general way but for one impor­t difference. The difference is that no expenditure is required to procure the equipment because you already own it. However, a decision to keep it does require an investment at the present time. This investment is equal to the asset's market value - that is, to the amount of money the asset would bring in if it were replaced and sold. If this amount is not equal to the equipment's book value. the depreciation expense that was shown for accounting purposes is in error because it did not reflect the actual depreciation.

So to determine the actual future depreciation expense that will be experienced with the old equipment, you must know (1) its present market value, (2) its estimated remaining service life, and (3) its expected salvage value at the end of that life. The difference between the pre­sent market value and the future salvage value represents the amount by which the equipment will depreciate during its remaining life in your business.
To sum up, you must begin your cost comparison by determining the first cost of the new equipment and estimating its service life and salvage value. Also, you must determine the market value of the old equipment and estimate its remaining service life and future salvage value.

Interest
In addition to depreciation, every piece of equipment generates an interest expense. This expense occurs because owning an asset ties up some of your capital. If you had to borrow this capital you would have to pay for the use of the money. This "out-of-pocket" cost is one of the costs of owning the equipment.
The story is the same even when you use your own money. In this case, the amount involved is no longer available for other investments which could bring you a return. This "opportunity cost" is one of the costs of  owning the equipment.
To cite an example, suppose that the market value of an asset during a given year is $10,000. Suppose also that at the same time, you are getting capital at a cost of 15 percent per year. On the other hand, suppose that if you converted the asset into cash, you could invest the money and realize a rate of return of 15 percent per year. In either case, a decision to own that asset during that year would be costing you 15 percent of $10,000, or $1,500 in interest.
Thus, in any comparison of equipment alternatives, you must take the cost of money into account. So, when determining whether or not existing equipment should be replaced, you must estimate what money is costing you in terms of a percent per year.

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