So you’ve started a business, great. If you’ve started a business that depends heavily on an asset for producing your output you should understand the concept of asset replacement planning. This could be a web or graphic designers computer, a delivery business vehicle, a baker’s oven or any other asset that is integral to the running of the business or the production process. Let’s have a discussion about asset replacement planning and what it means for you.
I have seen discussions rage on about what an asset is. For business purposes, we should use the International Financial Reporting Standards definition which is a resource owned or controlled by the business due to past economic events which is expected to bring future economic flows into the business. The important words have been bolded to make sense of things. In this case, we are talking about fixed, tangible assets used primarily in production processes. You can read this article on assets to get crystal clear about exactly what we are talking about.
An asset of course has a useful life and there are a few ways that accounting looks at this to quantify the usefulness of an asset. Of course, in reality, an asset works until it does not but for accounting purposes, we need a measure of this we can use to help with asset management. There are 3 ways of assessing the useful life of an asset namely years of life, hours of production and units of output. Bear in mind these are estimates of useful life.
Years of life
This simply looks at the assets life in terms of years of operation based on normal usage levels. This also ties into support for the product. Mobile phones are the best way to make the case here. Say you buy two phones, an iPhone on one hand and an Android model on the other. The useful lives of the two phones would be limited by the provision of up to date software for the phones as this impacts the ability to work with the newest applications. It is well known Apple provides software updates for as much as 5 years while most Android models lose support after 2 years. Just trying to point out that useful life is not just a hardware issue.
Hours of production
This isn’t very different from years of life but it is a bit more scientific and accurate. This simply says an asset will be able to work for 15000 hours. While this not usually a hard and fast measure you will find the asset usually lasts about that long. It trumps years of life because it is matched to your real usage patter rather than an estimated usage pattern. A real-world example of assets that work like this are projectors, where the projector bulb will have a number of hours it is expected to last.
Units of production
This method is just like hours of production but looks at the units of output. The hours method is better suited to processes in the provision of services while the units method is better suited to the production of physical goods. The methodology is the same, the asset will give you 20000 units before you should expect trouble.
Many people start and run businesses with second-hand assets. The problem here is of course estimating the useful life without full knowledge of how it was used before you acquired it. The same problem is experienced by those who bring in assets they own into the business, though to a lesser extent. Also, consider the graphic or web designer who uses their computer for non-work related things or the delivery vehicle that is also a personal vehicle. These matters all have an impact on the estimated useful life and asset replacement planning.
Depreciation is an accounting measure that attempts to estimate the reduction in the value of an asset due to its usage and operation. Depreciation is important to asset replacement planning because it gives us a measure of the reduction in the value of the asset. Depreciation takes into mind the useful life of an asset and spreads the purchase price of an asset over its useful life. So if we buy an asset for $1000 and expect to use it for 5 years and it to zero value thereafter it depreciates at $200 a year.
Depreciation can get complicated so there’s another way to look at it, as expensing (amortisation) the asset. When you buy the $1000 asset you have $1000 of value on the books. As you use the asset some of this value is lost, at the rate of $200 a year until it reaches zero value at the end of year 5.
Asset replacement fund
If your business is reliant on an asset for the fulfilment of customer orders then you need an asset replacement plan. One of my mantra-like statements that I often give to those who listen is to prepare before you need something. That is in essence what asset replacement planning involves. If you look at our aforementioned $1000 asset, you would consider saving $200 a year from the proceeds of the business to replace the asset if and when its useful life is up. This is of course assuming all goes to plan. Life rarely goes to plan and those who have second hand, repurposed or multiple-use assets are at risk of the asset not living up to its full estimated useful life. When things go out of control you would rather have half the money for the asset replacement than nothing at all.
Not a Substitute for insurance
Asset replacement funds and planning are not a substitute for insurance. Insurance is cover for the unexpected while asset replacement planning is all about preparing for the expected if not eventual.
You will find yourself better if you start an asset replacement fund. It doesn’t have to be a full asset replacement fund though this is preferred.