Replacement cost means the cost of any asset if we buy same at current price from market. This cost will change if market value will change.If market price of same asset will be increasing, our replacement cost will become higher due to inflation effect. If market price of same asset will be decreasing, our replacement cost will become lower. So, we take historical cost for making our financial statements. It is different from replacement cost. It will be same whether market prices increase or decrease.
Effect of Replacement Cost on Company's profit
Suppose, market prices are increasing and any company is using LIFO for inventory evaluation. Company is also using replacement cost method. With this, profit of company will less than historical cost. We can take the different of the profit with replacement cost method and historical cost method. It is called illusory profits.
Example :
1. Product's Replacement Cost
When we produce the product, we have to pay its material cost, labor cost and overhead cost. All these replacement cost will be changing due to changing market price. Suppose, petrol prices has increased. It means, raw material cost will increase. Laborers wants to increase their labor cost due to high inflation of consumable goods. When all these things cost will increase, our replacement cost will increase. For example ZY company sells his product of winter clothes. When it started its production in June, per unit cost of sale was $ 10. Company is selling it at $ 16 per unit in Dec. In December, prices of raw material has increased upto double and labor cost has also increased. Due to this, same cost of sales has reached $ 14. So, $ 14 per unit will be the replacement cost of same winter cost
2. Replacement Cost of Insured Asset
If insurance company has done the insurance through replacement cost value policy. It will be more costly in case of inflation because the client will get its replacement cost not actual paid money for buying that asset in past.
Effect of Replacement Cost on Company's profit
Suppose, market prices are increasing and any company is using LIFO for inventory evaluation. Company is also using replacement cost method. With this, profit of company will less than historical cost. We can take the different of the profit with replacement cost method and historical cost method. It is called illusory profits.
Example :
1. Product's Replacement Cost
When we produce the product, we have to pay its material cost, labor cost and overhead cost. All these replacement cost will be changing due to changing market price. Suppose, petrol prices has increased. It means, raw material cost will increase. Laborers wants to increase their labor cost due to high inflation of consumable goods. When all these things cost will increase, our replacement cost will increase. For example ZY company sells his product of winter clothes. When it started its production in June, per unit cost of sale was $ 10. Company is selling it at $ 16 per unit in Dec. In December, prices of raw material has increased upto double and labor cost has also increased. Due to this, same cost of sales has reached $ 14. So, $ 14 per unit will be the replacement cost of same winter cost
2. Replacement Cost of Insured Asset
If insurance company has done the insurance through replacement cost value policy. It will be more costly in case of inflation because the client will get its replacement cost not actual paid money for buying that asset in past.
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