Capitalized Cost
Assets may have different original and/or maintenance costs, different useful lifetimes, different salvage values or produce revenue at different rates. All these differences make it very hard to choose between alternatives.
Typical situations are:
- you're considering whether to put aluminium siding on your house or to continue to have it painted every three years...
- you need to choose between two machines, but find it very hard to choose between them because machine ABC lasts 8 years and produces 1,000 units per year, while the cheaper machine XYZ lasts only 5 years, produces less units and has a higher maintenance cost...
You could ask yourself the following question:
How much money would I need now, to be able to purchase the asset, pay for annual maintenance, and replace it at the end of its useful lifetime by another one, forever?
An asset's capitalized cost is the original cost of the asset, plus the present value of an infinite number of replacements, plus the present value of maintenance costs in perpetuity.
The Capitalized Cost calculation enables you to choose rationally between alternatives. All you need to do is compare their capitalized costs: they represent the present value of all costs involved with purchasing, maintaining and replacing the assets.
Input
| • nominal annual rate (compounding frequency is assumed to be annually) | |
| • cost | |
| • useful life in years | |
| • salvage value | |
| • annual maintenance cost | |
| • units produced per year |
Results
| • capitalized cost |
| • capitalized cost per unit |
Examples
| • | Bart has to decide whether to install aluminium or wooden windows. Aluminium
windows cost $5.000, have no maintenance cost and last
50 years. What should he do when his savings earn interest at 6 % annually? Step 1: Calculate the capitalized cost for aluminium windows.
Step 2: Calculate the capitalized cost for wooden windows.
Answer: Bart should install aluminium windows. |
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| • | Machine A costs $30,000, lasts 15 years, and will have a salvage value of $4,500. Its annual maintenance cost is $3.500. Machine B costs $40,000, will last 20 years, and will have a salvage value of $2,000 after 20 years. The annual maintenance cost for this machine is $3.000. Both machines produce 10,000 units per year. If money is worth 10 % annually, which machine should be purchased? Step 1: Calculate the capitalized cost for machine A.
Step 2: Calculate the capitalized cost for machine B.
Answer: Machine A should be preferred because it has a lower capitalized cost. |
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| • | What if, in the above example, machine B produces 11.000 units per year?
Answer: Machine B should be preferred because it has a lower capitalized cost per unit. |
Related topics
| Equipment lease |
| Compounding and payment frequencies |