When a business purchases an asset like equipment, machinery, or a vehicle, that asset has a cost that must be recovered over time. The concept of cost recovery refers to accounting for and recapturing the cost of acquiring that asset through revenues earned from using it in business operations. There are a few key questions around cost recovery:
- What is the initial cost of the asset?
- Over what time period will the asset’s cost be recovered?
- What depreciation method will be used to allocate the cost over the recovery period?
- How will the asset’s use contribute to revenues and cash flows?
Understanding cost recovery is important for financial planning, setting prices and rates charged to customers, managing taxes, and making replacement decisions when assets near the end of their useful lives.
What is the Initial Cost of an Asset?
The first step in cost recovery is determining the initial cost of the asset. This includes the purchase price paid plus any other costs incurred to acquire the asset and prepare it for use. Initial costs may include:
- Purchase price
- Delivery and freight charges
- Installation charges
- Testing and configuration costs
- Legal fees, title, and licensing costs
- Professional fees like architects or consultants
For example, if a company purchases a new piece of equipment for $100,000, pays $5,000 for delivery, and spends $10,000 installing and getting it ready to use, the initial cost would be $115,000. This is the total amount that must eventually be recovered through the asset’s use in operations.
Over What Time Period is the Cost Recovered?
Companies do not attempt to recover the full cost of an asset in the first year it is placed in service. Instead, the cost is allocated over the asset’s estimated useful life. This represents the number of years or production units over which the company expects to use the asset. Estimating an asset’s useful life requires judgement and depends on factors like:
- The asset type and durability characteristics
- Expected physical wear and tear from use
- Technical obsolescence risks
- Maintenance policies and quality of care
- Industry standards and practices
For the equipment example above, the company determines the useful life is 10 years based on the physical wear and tear expected from operating the equipment 12 hours a day, 6 days a week in their manufacturing facility.
Ideally, the time period over which the cost of the $115,000 equipment will be recovered is 10 years. This matches the useful lifespan rather than attempting full recovery too quickly or dragging it out longer than necessary.
What Depreciation Method is Used?
Once a company knows the initial cost and useful life, it can allocate portions of the cost to each year of use. This allocation process is called depreciation. There are several standard depreciation methods, with the most common being:
- Straight-line depreciation – Cost is allocated evenly across each year of the asset’s useful life.
- Declining balance depreciation – Larger portions of cost are allocated to early years with the portion declining each year.
- Sum-of-the-years’-digits depreciation – Allocates decreasing portions, but on an accelerated scale compared to straight line.
- Units-of-production depreciation – Allocates cost based on actual units produced each year.
For the equipment example, let’s assume straight-line depreciation is used. With a $115,000 initial cost and 10 year useful life, $11,500 of the cost would be allocated to each year (= $115,000 / 10 years).
The depreciation method impacts the timing of cost recovery and when expenses are recognized on financial statements. It can also impact taxes. Selecting the method requires balancing different financial reporting and tax objectives.
How Does the Asset Contribute to Revenues?
The fundamental goal of cost recovery is for the revenues earned from using the asset to recapture the allocated portion of its cost each year. This requires considering how the asset will be used in operations and its role in generating revenues.
For tangible assets like equipment, this often involves estimating:
- Units to be produced with the equipment each year
- Price per unit that can be charged to customers
- Annual revenues at the expected production volumes and unit prices
Let’s assume the equipment will be used to manufacture 20,000 units per year. The company has determined it can sell each unit for $50 based on market research and demand forecasts.
At 20,000 units with $50 price, annual revenues are expected to be $1,000,000 (= 20,000 units x $50 price).
Comparing the expected $1,000,000 in annual revenues to the $11,500 portion of the asset cost allocated each year, the revenues are sufficient to recover the allocated cost.
What Happens After the Cost is Fully Recovered?
Once an asset reaches the end of its useful life, the full initial cost will have been allocated and recovered through depreciation expenses recognized on the income statement. At this point, cost recovery is complete.
The company can choose to replace the fully depreciated asset with a new one, which restarts the cost recovery process. Or, in some cases, the asset may still be usable for additional years. It has been fully expensed for accounting purposes but could continue generating revenues.
Many companies establish minimum levels of cash flows an asset must produce annually to remain in use, even after being fully depreciated. As long as the asset meets those targets, cost recovery is viewed as complete and any further cash flows generated are bonus.
There are also tax considerations once assets become fully depreciated. The company no longer receives tax deductions for depreciation expenses on the income statement. This can motivate replacing assets to restart tax-deductible depreciation.
What is the Impact of Maintenance and Repairs?
Routine maintenance and minor repairs required to keep an asset operating are typically expensed as incurred rather than treated as additional costs to recover. These are not considered to extend the asset’s useful life.
However, major upgrades or component replacements that do extend the asset’s original useful life are capitalized. The costs of those upgrades would be added to the asset’s net book value and recovered through additional depreciation expense over the revised remaining useful life.
For example, halfway through the equipment’s 10-year life, a major upgrade costing $40,000 extends its useful life by 4 years. The $40,000 would be added to the equipment’s net book value and depreciated over the remaining 6 year (4 year extension + 2 years remaining from original life).
Are There Alternatives to Purchasing Assets?
Upfront cash outlays to purchase assets can be challenging, especially for small businesses or startups. Some alternatives that allow using assets without purchasing them include:
Leasing – The company makes monthly lease payments to use the asset but does not own it. Lease expense is deductible on the income statement.
Renting – Similar to leasing but typically more flexible terms and does not include a purchase option. The rental expense is deductible.
Sharing – Arrange to share use of assets owned by other businesses. For example, sharing warehouse space and material handling equipment. The sharing fee is deductible.
These options can facilitate getting access to productive assets without major capital investments. However, they also result in ongoing required payments as long as the arrangement continues. The company never fully recovers the “cost” on its own books.
Conclusion
Recovering the cost of purchasing productive assets is fundamental in business accounting and financial management. Careful consideration of the initial cost, useful life, depreciation method, and expected revenues is required for assets to pay for themselves over time.
While some companies aim to minimize assets and associated cost recovery obligations on their books, access to certain assets remains essential for most operations. Understanding asset cost recovery helps managers determine if the long-term cash flow potential justifies the upfront capital investment.