How to correctly apply and determine replacement values

26th of July 2022 by P. Merker

What is it about?

The replacement value is – in our opinion – one of the most interesting terms in valuation practice.

The crux is that – depending on the economic context – replacement values can be quite different.

Since it is generally always a good idea to clarify exactly what we are talking about (and in particular, of course, when preparing a valuation report), we would like to introduce the three most important concepts below.

These are

  • the current value, as you know it from motor vehicle insurance
  • the replacement cost, as used in business management
  • the replacement value as used in business property insurance

Furthermore, in our valuation practice we calculate current values and replacement values as a basis for determining fair market values, namely

  • to check the plausibility of comparative values and
  • if no comparative values exist, for example in the case of self-constructed machinery and equipment.

If you are interested in how we proceed with machinery valuation, we recommend our article “How to value machinery”.

What is the replacement value?

Basically, the replacement value includes all costs that have to be spent in order to be able to replace a similar and equivalent item (machine, plant, operating equipment, etc.) at a certain point in time.

Similar, equivalent

It is clear from the wording (“similar and equivalent”) that it does not have to be the value of the same asset. In many cases it may no longer be possible to procure the same plant or machinery, for example because it is technically obsolete.

All costs

In addition to the purchase price, the replacement value also includes the necessary incidental costs.

Time of replacement

Depending on the purpose for which the replacement value is determined, it may be in the present or in the future.

Replacement value vs. current value

Also depending on the purpose of the valuation, it can be the replacement of an item that is as good as new (replacement value) or an item that has a current value. We will now come to this.

The current value

Example of car insurance

You may be familiar with this value from your car insurance, because there it forms the basis for calculating the compensation you receive in the event of an accident, destruction or theft.

Here it includes the amount you would have to pay for a car that corresponds to yours in make, model, equipment, year of manufacture, mileage and condition, i.e. equivalent and similar to your car, on the day of the damage.

It is therefore not the value as new that matters, but the current value on the day of the damage, i.e. usually “as of today”.

Valuation of prototypes and self-constructed plants

The current value also plays a major role in our valuation practice, namely whenever we determine market values for machinery and equipment for which there is neither a second-hand market nor other comparative values.

This is always the case, for example, when prototypes or self-constructed plants are to be valued. In these cases, we usually only have information on the historical manufacturing costs.

These then serve as a basis for us to determine the replacement value (see below for how this is done).

In a next step, we assess the condition of the asset in order to be able to make appropriate deductions for use, if necessary. Then – depending on how long the plant has been in operation – the general depreciation is applied.

This allows us to calculate a value that tells us at what cost a machine of this age and condition could be replaced “as of today” (i.e. on the valuation date).

Incidentally, we often also determine this replacement time if there is a second-hand machinery market and corresponding comparative data in order to make the market values found in this way more plausible.

It is important to include ancillary costs, such as foundations, without which the machine could not be operated at all.

The replacement value as new value

For business property insurance

In contrast to motor vehicle insurance, the replacement value plays the decisive role in business property insurance.

This means that if you insure your company against fire, for example, you take out so-called replacement value insurance. For this, you need the replacement costs of your machinery and equipment at replacement value and “as of today”, i.e. at the current valuation date.

The replacement value includes the costs at which a machine or plant could be procured in a new and impeccable condition.

The sum insured is then formed from the values as new. For property insurance, the value as new therefore also includes freight, packaging and assembly, because the aim of property insurance is to have the equipment ready for operation as quickly as possible.

In certain cases, however, it is also possible and makes sense to insure machinery, plant or equipment at current value.

Ideally, the replacement value is adjusted annually so that the sum insured is always correct.

The correct determination of replacement values for property insurance is very important both for operational safety and for the operational wallet.

Read our article “The correct sum insured in business property insurance” and do the “Quickcheck sum insured”.

Excursus: Reconstruction costs for real estate

In the case of commercial buildings, especially if they have been in use for several years and the sum insured was determined at the time on the basis of the new construction costs, the sum insured should also be regularly adjusted. For this purpose, the “real estate equivalent” to the replacement values, the restoration costs, is determined.

The calculation is made on the basis of quality and cost ratios and takes into account the development of the construction price index.

A big crux here is the distinction between buildings and furnishings, because very specific rules apply here for the insurance.

For example: passenger lifts are part of the building, goods lifts are part of the operating equipment.

This is why we prepare insurance appraisals for companies on request for buildings and facilities “from a single source” together with our colleagues from Wagner und Partner Immobilienbewertung, because this way we can ensure that nothing is recorded twice or forgotten.

Determining fair market values on the basis of replacement values

We have already explained above that in certain cases we derive market values on the basis of current values.

To determine the current values, we in turn need the replacement values. We derive these (if we have nothing else) from the historical acquisition and production costs.

We use this procedure in particular for the valuation of prototypes and self-constructed plant and machinery. We proceed as follows:

  • All cost blocks for the creation of the machine are clustered according to the applicable index series and according to the time of their contribution. These are, for example, the personnel costs, machine hours and material costs. Depending on the machine, this can be several dozen clusters!
  • Then, in a first step, we extrapolate the values to the time when the machine was first put into operation and, in a second step, to the valuation date. This gives us the replacement value. From this we then calculate – as already described – the current value.

The following chart illustrates the entire way we use replacement values to arrive at fair market values for such specialities as self-constructed machinery and equipment.

Replacement value and fair value

Replacement costs

In business administration, replacement costs are determined in order to enable the so-called “output-equivalent” replacement of an asset at a later date.

In this case, replacement values are determined that lie in the future.

The following considerations play a role:

Price increases:

In your company balance sheet you will usually find the acquisition and production costs at historical prices. However, price increases and inflation will lead to the fact (probably no one needs to convince us of this at present) that a higher amount of money will have to be spent at the time of replacement.

Technological progress:

At the time of the replacement investment, you will probably use equipment of the then current state of technology in order to remain competitive. However, next generation equipment may be more expensive – but it may also be cheaper. So you may consider an innovation factor in the replacement.

Economic life:

Legally permissible depreciation methods and useful lives are often not identical with the actual wear and tear of machinery and equipment – neither in terms of amount nor over time. This means that in order to ensure the substance of a business, calculate the depreciation of the projected replacement costs according to the actual circumstances.

To determine the replacement costs for the purpose of preserving the substance of an enterprise, you therefore proceed as follows:

  • you determine the time of the replacement investment.
  • you forecast the price increase (probably currently one of the greatest challenges) and the influence of technological progress on the price.

These replacement values also take into account the necessary ancillary costs.

The relationship can be well illustrated by the following graph:

Replacement value

All theory is grey – the replacement value in a practical test

Why we are dealing with replacement value now of all times has a bit of a back story.

When we recently moved our office from the Colonnaden to Mönckebergstraße, I was packing boxes when I came across the beautiful, old, robust industrial stapler for round wire staples, model Elastic No. 53 by Schlemming.

My grandfather, who founded our surveyor’s office in the 1950s, had bought this in the early 1960s.

I thought of my grandfather and how great he thought it was that the office was now in its third generation. And then I thought (occupational disease!) how this super stapler would be valued today…

Praxibeispiel Wiederbeschaffungswerte

This is the industrial plier stapler for round wire staples, model Elastic No. 53 from around 1960. I haven’t the faintest idea what the historical acquisition costs were.

A little research: The unit is still being manufactured and sold for €387.52. This gives us an impressive replacement value.

Praxibeispiel Wiederbeschaffungswerte

You can get a Simplex A stapling plier for less than 100 € per piece, i.e. for just under a quarter. You can also use them to staple size 53 staples in your documents. On the other hand, we have the task of assessing similarity and equivalence.

Praxibeispiel Wiederbeschaffungswerte

This Ebay offer for 17 € (the year of the offer is unknown) could be used as a basis for a current value. However, the device has probably not found a buyer for this price. Therefore, we would be very cautious in deriving a fair market value.

Praxibeispiel Wiederbeschaffungswerte

Which ultimately brings us to the most beautiful of all values, which defies all reason:  The value of love, for things that are irreplaceable and priceless.

Philip Merker Expert for the appraisal of machinery and technical equipment

Philip Merker, MBA

Certified expert for the evaluation of machinery and technical equipment (DIN EN ISO / IEC 17024)

Telephon +49 40 602 13 33
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