Inventory | Replacement Cost

CFA Level I FRA
#1

Can someone please explain what is the “replacement cost” with examples, and why it isn’t equal to fair market value?

Thanks

#2

We can think of replacement cost as the cost of buying or manufacturing a similar product to replace a lost or destroyed item.

Fair market value of an item is always changing and is determined by interations between buyers and sellers in the marketplace.

Suppose you have an icecream machine that was used for three years which broke down for good. And instead of buying a new machine in the market, you decide to buy a similar machine at a second hand sale. So the value of this purchase is the cost of replacing the existing asset.

Now this replacement cost could equal the fair market value at the time, but it doesn’t necessarily have to. For example, the seller could have offered you a discount to fair market value in order to clear stock.