Historical and Replacement Cost

The historical cost of an asset refers to the actual cost incurred at the time the asset was acquired. In contrast, the replacement cost stands for the cost which must be incurred if the asset is to be purchased today. The two concepts differ due to price variations over time. During inflationary conditions, as witnessed today, the replacement cost exceeds the corresponding historical costs, and quite the opposite holds good during deflationary situations.

Conventionally, balance sheets are cast on the basis of historical costs. Also, while calculating costs for use in completing a firm’s income tax returns, accountants are required by law to list the actual rupee amounts spent to purchase the labor, raw material, capital equipment etc used in production. For managerial decisions, however, historical costs may not be appropriate. Instead, replacement costs are relevant for these purposes. For example, suppose an oil mill has an inventory of 10 tons of groundnut purchased at a price of Rs. 8,000 per ton. Groundnut price now increases to Rs. 12,000 a ton if this firm is asked to bid a price for its ground oil , what cost should it assign to the ground nut to be used in the deal – the historical cost of Rs. 8.000 a ton or replacement (current) cost of Rs. 12,000 a ton? Obviously, the latter, for it must buy groundnut at the new price to replace the old stock, alternatively, it could sell the groundnut at the new price if it elects not to use it on the proposed project. Thus, Rs. 12,000 is the relevant cost of groundnut per ton for purposes of bidding on the job. However, the cost of groundnut for tax purposes is still Rs.8,000 per ton.

Note that while historical cost of an assets is known as it is actually incurred, replacement cost may not be known unless proper enquires are made in the market. Further, for fairly old plants/machines, exact replacement costs may not be known at all, for they may no longer be available in the market. In such circumstances, the management will have to be content with their approximate values.

Incremental costs are the costs which vary with the decision. In contrast, sunk costs are the costs which are invariance with the decision. Suppose a firm hires a consultant at a fee of Rs. 10,000 to advise on the economies of fish farming on an erstwhile agricultural land. The consultant recommends that by switching over to fish farming, the firm would make a profit of Rs. 5,000 over and above what it could make in agriculture. For sake of argument, assume that the extra profit of Rs. 5,000 is over the life time due care of time value of money. Should the firm switch over to fish farming? The answer is yes, for the consultant fee of Rs. 10,000 is a sunk cost, which has been incurred irrespective of the decision. If sunk cost is added to the cost of fish farming, fish farming would turn out to be less profitable than agriculture. But this would be a wrong calculation. Consider another example. Suppose there is a university which runs all its activities during the day time. It is considering starting an evening program on commercial basis. The evening program is intended to use faculty time, administrator’s time and some time of the clerk-cum peon, for whom extra payments would have to be made for their services. In addition, there will be some cost on electricity, chalk etc. Besides, the class room of the university would be utilized for the purpose. What are the incremental and sunk costs of said program? The answer is simple. The cost of the time of faculty, administrator, clerk-cum-peon, and the amount spent on electricity bill, chalk etc. will be the incremental costs and the cost of the use of class room and blackboard would be the sunk cost.

Quite often, management gets mixed up between these two types of costs and, of so, they might err in decision making. The costs relevant for decision making are incremental costs only. Since sunk costs do not depend on the decision, they are irrelevant for decision making.

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