What is Capitalized Cost?
Capitalized cost is a financial concept used to evaluate the total cost of an asset or project over its lifetime. It combines the initial purchase or construction cost with the present value of all future maintenance and operating costs. This approach is particularly useful in engineering economics and capital budgeting, where decision-makers need to compare different investment options on an equal footing.
By converting recurring maintenance costs into a single lump-sum value using a discount rate (interest rate), capitalized cost provides a comprehensive view of what an asset will truly cost over the long term.
How to Calculate Capitalized Cost
The formula for capitalized cost is:
$$\text{Capitalized Cost} = \text{Initial Cost} + \frac{\text{Maintenance Cost}}{\text{Interest Rate}}$$
Where:
- Capitalized Cost is the total present value cost
- Initial Cost is the upfront investment ($)
- Maintenance Cost is the annual maintenance expense ($)
- Interest Rate is the discount rate (expressed as a decimal)
To use this formula, divide the annual maintenance cost by the interest rate (as a decimal), then add this value to the initial cost. This gives you the equivalent present value of all costs over the asset's lifetime.
Calculation Example
Let's walk through a practical example to see how this works.
Example Problem:
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Step 1: Determine Initial Cost
- Suppose you're purchasing equipment with an initial cost of $150,000.
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Step 2: Determine Maintenance Cost
- The annual maintenance cost is $30,000.
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Step 3: Determine Interest Rate
- The interest rate used for discounting is 12% (or 0.12 as a decimal).
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Step 4: Calculate Capitalized Cost
- Using our formula:
$$\text{Capitalized Cost} = 150{,}000 + \frac{30{,}000}{0.12}$$
- Calculating the maintenance component:
$$\frac{30{,}000}{0.12} = 250{,}000$$
- Adding the initial cost:
$$\text{Capitalized Cost} = 150{,}000 + 250{,}000 = 400{,}000$$
The capitalized cost of this equipment is $400,000, representing the total present value of acquiring and maintaining it indefinitely.
This calculation helps you understand the true long-term financial commitment and makes it easier to compare different investment options with varying initial costs and maintenance requirements.