What is depreciated replacement cost?
Depreciated replacement cost (DRC) is the current cost of replacing an asset with a modern equivalent asset, less deductions for physical deterioration and all relevant forms of obsolescence. It is a method within the cost approach, one of the three valuation approaches recognised by the International Valuation Standards (IVS) and by IFRS 13 Fair Value Measurement.
The cost approach rests on a simple economic principle: a buyer will pay no more for an asset than it would cost to obtain one of equal utility, whether by purchase or by construction. IFRS 13 describes the result as the amount that would be required currently to replace the service capacity of an asset — often called current replacement cost.
When is DRC used?
DRC is used where there is little or no market evidence for the asset as it stands. Typical examples:
- Installed processing lines and fixed plant
- Infrastructure networks: roads, water, sewer, stormwater and energy
- Purpose-built or specialised equipment that rarely sells as-is
- Public sector assets held for service delivery rather than profit
Where an active second-hand market exists — mobile plant, vehicles, standard machine tools — the market approach usually gives better evidence, and DRC becomes a cross-check.
The DRC formula
DRC = gross current replacement cost
− physical deterioration
− functional (technological) obsolescence
− economic (external) obsolescence
Gross current replacement cost is the cost of a modern equivalent asset with the same service capacity, including installation, freight, transport and commissioning where they would be incurred.
- Physical deterioration — loss in value from age, wear and tear.
- Functional obsolescence — loss from inefficiency compared with a modern equivalent, such as higher running costs or excess capacity.
- Economic obsolescence — loss from factors outside the asset, such as reduced demand, lower utilisation or regulatory change.
Step by step
- Identify the asset and its service capacity from the register and a physical inspection, recording make, model, capacity, year and condition.
- Price a modern equivalent asset and add installation, freight, transport and commissioning costs where appropriate.
- Establish lives and residual value — total useful life, remaining useful life and residual value for the asset type.
- Deduct physical deterioration, usually based on age and remaining life and adjusted for the condition observed.
- Deduct functional and economic obsolescence where the evidence supports it.
- Test the result against any market evidence and the purpose of the valuation, then report the value and the assumptions behind it.
Worked example
A food-processing line installed eight years ago. The figures are illustrative only; a real valuation uses researched costs, inspected condition and evidence-based obsolescence.
| Step | Working | Amount |
|---|---|---|
| Modern equivalent line (supply) | Current supplier pricing | $1,200,000 |
| Installation, freight & commissioning | On-costs for the replacement | $180,000 |
| Gross current replacement cost | $1,200,000 + $180,000 | $1,380,000 |
| Residual value | 5% of gross cost | $69,000 |
| Physical deterioration | ($1,380,000 − $69,000) × 8 ÷ 20 years | −$524,400 |
| After physical deterioration | $1,380,000 − $524,400 | $855,600 |
| Functional obsolescence | 10% of $855,600 — higher energy use than a modern line | −$85,560 |
| After functional obsolescence | $855,600 − $85,560 | $770,040 |
| Economic obsolescence | 5% of $770,040 — running at reduced capacity because of lower demand | −$38,502 |
| Depreciated replacement cost | $770,040 − $38,502 = $731,538, rounded | $730,000 |
Replacement cost vs reproduction cost
Replacement cost prices an asset of like utility and function — a modern equivalent. Reproduction cost prices an exact replica, of like kind and materials. Reproduction cost is appropriate only when a modern equivalent would cost more than a replica, or when only a replica could provide the asset’s utility, such as some heritage assets.
Common mistakes
- Indexing historical cost instead of pricing a genuine modern equivalent.
- Leaving out installation, freight and commissioning costs.
- Using accounting depreciation rates instead of researched economic lives.
- Ignoring economic obsolescence for plant that is underused.
- Counting the same inefficiency as both functional and economic obsolescence.