Equipment Appraisal Blog | Understanding Machinery Appraisals

What is the principle of substitution in machinery appraisal?

Posted by Equipment Appraisal Services on Tue, Feb 09, 2016 @ 07:30 AM


The concept of the principle of substitution comes up any time that machinery and equipment appraisal is discussed. It is important that you understand what this concept means if you are seeking equipment appraisers for a machinery valuation. Learn what is the principle of substitution and what it means for both buyers and sellers of machinery and equipment. 

What is the principle of substitution?

In equipment value terms, the principle of substitution means that a party will not pay more for the piece of equipment in question than the cost they would pay for an equivalent piece of equipment with the same purpose.

For example, consider a tractor that is 10 years old and has an asking price of $5,000. If you can purchase a comparable tractor that is also 10 years old, yet costs just $4,000, why would you pay the extra $1,000 for the first tractor? Under the principle of substitution, the maximum acceptable buyer's out of pocket cost for the tractor would thus be $4,000. 

The principle of substitution is also affected by market demand. If hundreds of used tractors become available near you, sellers will have to lower their prices to attract buyers. If used tractors are scarce, sellers can raise prices above the equipment value if there is demand from buyers for the piece of machinery. 

The principle of substitution is a fundamental basis of the cost approach to machinery valuation. In the cost approach, an equipment appraiser usually determines the replacement cost of a new item (i.e., a new tractor) and then factors in lost value from age, wear and tear, and other variables to arrive at the equipment value in real terms. 

Why the principle of substitution matters in a machinery valuation

If you are in the market for a new piece of equipment, it is only natural that you would want the highest value for your budget, whether buying a used tractor or a new piece of factory machinery. Knowing the cost value of a piece of machinery can help you determine whether it is a good use of your funds. 

Even after the sale, the principle of substitution can be used to help insure the piece of equipment. Were your asset to be stolen or damaged, an insurer would not pay you more to replace the item than it was worth. Insurance agents will thus use the principle of substitution to calculate the amount to which you would be entitled in case of loss. In some cases, an insurer might send a machine appraiser to estimate your equipment's value before issuing an insurance policy. 

Likewise, businesses often need the appraised equipment values for tax purposes. Investing in something as important as a tractor is certainly a business write-off; to claim that it is worth the stated amount, you may need an equipment appraisal that is accurate and irrefutable in case of audit. 

Whether you are buying a piece of equipment or selling one, knowing the equipment value ahead of time can help you determine a fair price for the item. This can help equipment buyers move forward with the deal with confidence and assist sellers in pricing the item fairly enough to move it quickly. Equipment Appraisal Services offers machinery and equipment appraisals nationwide. Get peace of mind before you buy or sell your next asset by seeking an independent machinery valuation from our certified appraisers.

Tags: replacement cost new, principle of substitution, cost approach