Replacement cost defines the present cost that would be incurred to replace an asset with another of similar function and capacity, considering current market conditions. This concept is essential in accounting and insurance to assess the fair value or coverage required for assets. Replacement cost is different from original purchase price, as it considers inflation, depreciation, and market conditions at the replacement time rather than the acquisition time.

For example, if a business bought machinery five years ago for $10,000, its replacement cost today might be $12,000 due to increased materials and labor costs needed to manufacture it presently. This valuation is crucial for accurately managing fixed assets or establishing insurance policies to recover asset value in case of loss.