One of the most common subjects frequently discussed whenever there is a need to value or appraise the cost of a piece of machinery price is the concept of the principle of substitution.
For this reason, it is important to understand what the concept of the principle of substation means, especially when there is a need for equipment appraisers to value some machines or a piece of equipment.
With this basic knowledge of the principle of substitution, both buyers and sellers of a piece of equipment will know and understand what will be the fate of the machine in question during valuation.
Definition of Cost Approach
The cost approach method of machinery appraisal is also referred to as the principle of substitution. In the cost approach of machinery prices, it is assumed that, for a buyer of any piece of equipment, they won’t pay more for equipment than the equivalent cost that would be used in manufacturing similar equipment with the same functionalities and components.
Take, for instance, if a piece of an industrial machine is eight years old, and it is priced at $10,000. If a buyer can purchase a similar piece of industrial equipment that is still eight years old at the cost of about $8,000, then it makes no sense paying the extra $2,000 for the first piece of the industrial machine since they both share the same functionality and years of use.
So, in the cost approach or principle of substitution method of machinery appraisal, the maximum amount a buyer can pay for the industrial machine will be $8,000.
When taking a critical consideration of the cost approach, it can be deduced that an informed buyer of a piece of equipment, will only accord a certain maximum value to a piece of equipment based on the current amount it will cost to manufacture or construct the same type of equipment with the same utility as the piece of equipment under evaluation or appraisal.
As a result of the implication the cost approach of machinery prices, it is safe to say that; when a piece of equipment is not in its original or new state, the current cost of the machine has to be adjusted to reflect all forms of depreciating such as wear and tear, age, and other variables that can be visibly attributed to the machine as at the exact date when the valuation is taking place.
With that, it then follows that in the next time when the valuation of a piece of equipment is to be carried out, the price is likely to be reduced since some additional form of depreciation must have set in after the last time of its valuation.
Nevertheless, the current market demand is also another core fact affecting the principle of substitution. Take, for instance, if fifty used industrial machines are readily available for sale near a buyer, to quickly sell off their used equipment, sellers will have no choice than to slash the price of their used equipment as a way of attracting prospective buyers.
In the same vein, it then follows that if used industrial equipment is scared in the marketplace, sellers are likely to increase the prices of their used equipment above the true value of the equipment, especially when demand from buyers for such piece of equipment is soaring.
In the simplest form, cost approach or the principle of substation of a piece of machinery can be expressed mathematically as follows;
Cost of a new machine – Depreciation = Current value
For instance, if the cost of a new machine is $25,000, and after ten years of use, the level of depreciation in the machine is calculated to be $10,000, the current value of the machine based on the cost approach or the principle of substitution technique can be calculated thus;
Cost of new machine – Depreciation = Current value
$25,000 – $10,000 = $15,000
Speaking from the formula or equation above, we can say that the basis for the principle of substitution or cost approach is the cost it will take to reproduce a new machine, the cost it will take to replace the machine or a summation of both factors/criteria.
Other Reasons for the Principle of Substitution in Machinery Valuation
Besides the valuation of a piece of equipment to ascertain its current selling value, the principle of substitution or cost approach can also be applied when insuring a piece of equipment.
Take, for instance, if a piece of equipment that is insured with an insurance company happens to be damaged or stolen, the insurance company will not pay more to replace or repair the piece of equipment than its current worth as at the time of damage or theft.
With this, the insurance agent will fall back to the principle of substitution to have a good understanding of the amount to which you will be entitled to in the case of a machine loss or damage.