Inflation

In times of rapidly rising prices the calculation of how much cash to set aside for replacing capital assets is very difficult. If an asset has a projected life of, say, eight years, one's first thought would be that it should be sufficient to set aside each year one-eighth of its cost. This may prove to be insufficient for two main reasons: (a) that as the years pass the cost of repair and maintenance is likely to increase as the object is getting older; and (b) in eight years' time the price of a replacement may have about doubled. However, if in eight years it has doubled, it is likely that one's money income will also have doubled. In other words it would be reasonable to set aside each year rather more than one-eighth not of the original cost price, but of the rising replacement cost year by year. For a short-life asset a fraction with a denominator of 1 lower than the projected life will probably suffice. In this case that would make it one-seventh.

Example

An asset costs £400 today and has a projected life of five years. Inflation is expected to average 10% over the five years and it is assumed that both replacement cost and money income will rise by the same amount. The following action would spread the burden of provision evenly over the years:

Cost Year's provision (1/4)

£ £

1st year 400 100

2nd year 440 110

3rd year 484 121

4th year 532 133

5th year 585 146

610

Some slight over-provision will have been made, but this might just about balance the rising costs of repairs in the fifth year.

Nobody can forecast for longer than a few months what the rate of inflation is likely to be. So the above figures are intended only to illustrate that maintenance and replacement costs of wasting assets are likely to be a great deal higher than an unsophisticated appraisal might suggest, and to indicate one way in which they might be provided for.

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