Replacement cost is a term referring to the amount of money a business must currently spend to replace an essential asset like a real estate property, an investment security, a lien, or another item, with one of the same or higher value. Sometimes referred to as a “replacement value,” a replacement cost may fluctuate, depending on factors such as the market value of components used to reconstruct or repurchase the asset and the expenses involved in preparing assets for use. Insurance companies routinely use replacement costs to determine the value of an insured item. Replacement costs are likewise ritually used by accountants, who rely on depreciation to expense the cost of an asset over its useful life. The practice of calculating a replacement cost is known as “replacement valuation.”
Replacement cost is the price that an entity would pay to replace an existing asset at current market prices with a similar asset. If the asset in question has been damaged, then the replacement cost relates to the pre-damaged condition of the asset. The replacement cost of an asset may vary from the market value of that specific asset, since the asset that would actually replace it may have a different cost; the replacement asset only has to perform the same functions as the original asset – it does not have to be an exact copy of the original asset.
Reproduction cost looks at the cost of creating an exact replica, and should not be confused with replacement cost, which looks at the cost of replacing an insured property with one of similar functionality.
Reproduction costs estimate how much it would cost to exactly reproduce an asset or property to exact specifications if damaged or lost, for insurance purposes. Reproduction cost is not the same concept as replacement cost, which is the cost of replacing an asset or property and not reproducing it.
Different insurance contracts will insure for a different cost. While some insurers will pay out an amount to purchase a similar asset of the same functionality; others will pay out an amount to purchase an identical property. Because these amounts can differ greatly, it is important to know the terms in your own insurance contracts.
The reinstatement cost of a property is the amount it would cost to totally rebuild the property in the event that it was totally destroyed. So for example if a fire burned your property down, or if it was left in such a state of disrepair that it had to be completely knocked down and rebuilt, the reinstatement cost is the sum of money it would take to reinstate it to how it was previously.
The reinstatement cost takes into consideration clearing the land of debris, labour, building materials, as well as reinstalling facilities such as double glazing and central heating. It allows for the same materials to be used as in the original property, as well as similar or the same construction processes.
As such, the reinstatement value of your property is different to the market value. Just because your property is worth £1 million, it does not mean that it would cost £1 million to rebuild the property from scratch.
In insurance sector If an insured person fails to pay the premium due to various circumstances and as a result the insurance policy gets terminated, then the insurance coverage can be renewed. This process of putting the insurance policy back after a lapse is known as reinstatement.