If you’ve ever had a vehicle lease agreement, chances are you’ve heard the term residual value. However, this term is used for much more than determining the value of a vehicle after a multiyear lease.
Business owners can use residual value calculations to determine future equipment replacement costs, competitive pricing models, and an optimized understanding of the cash flows within their companies.
What Is Residual Value?
The residual value meaning is simple. It points to the value of an asset after a lease period or after its useful life has expired. For example, if you lease a car, the residual value of the car is what it’s worth at the end of the lease. Banks calculate this based on several factors. They then use this value to determine a fair monthly lease payment and residual value guarantee you agree to when you enter the lease.
However, in business, residual value may have nothing to do with a lease period. It may refer to the useful period.
For example, say you purchase new computers for your office. You predict that those computers will be effective tools in your office for three years. After this period, you expect to replace your computers again. As a wise business owner, you want to know the residual value of those computers — the fair market value you can expect to sell them for after their useful life.
With this information, you can make informed budgeting decisions and ensure that you have the money you need to replace your computers again when the time comes.
Sure, that sounds like resale value. However, resale value is based on factors like market conditions, while residual value is based on the useful life of a product and its MSRP.
Factors That Affect Residuals
When you calculate residual value, it’s important that you consider the asset’s useful life, the asset’s salvage value, the asset’s resale value, and the asset’s disposal cost.
The Asset’s Useful Life
All assets have a useful life. In business, this can mean a couple of things:
- The Lifespan of the Asset: Consider the average lifespan of an asset. For example, the average computer lasts between three and eight years. You don’t want your business to run into computer issues, so you determine that the useful life span of your computers is three years.
- The Amount of Time You Can Generate Predictable Gains: It's crucial for companies to accurately anticipate the returns they'll generate from investments. For example, when a gym invests in new machines, they need to predict the gains that will be generated over time. As equipment ages, its reliability decreases, which impacts the returns. Therefore, the useful life of the equipment may not match the duration it remains useful. Instead, it should align with the period of time where predictable returns can be expected.
In most cases, an asset with a longer useful life has a lower residual value when residual value is expressed as a percentage. This is because the majority of the asset’s value was depleted during its useful life.
The Asset’s Salvage
You can use the terms residual value and salvage value interchangeably. These terms refer to the asset’s resale value after its useful life. In most cases, salvage values are expressed as a percentage of its purchase price or MSRP. For example, the salvage value of a server used to fulfill online subscription services might be 50%. That means that at the end of its useful life, you’ll be able to sell the server for about half of what you paid for it.
The Asset’s Resale Value
Although banks use MRSP to determine the residual value of an asset they lease to a customer, business owners may prefer to use the resale value of that asset. For example, if you purchase a server to fulfill your online subscription business, the server’s MSRP probably won’t make much of a difference in the end.
Instead, you’ll need to determine what the server’s resale value will be after its useful value. This will give you a more accurate depiction of your asset’s residual value. However, it may be more difficult to determine using this method.
Several factors play into the resale value of an asset. At any time, market conditions can change, and the resale value of your assets will do the same. If you calculate the residual value of an asset this way, update it regularly to account for changing market conditions.
The Asset’s Disposal Cost
An asset’s disposal cost is the last thing to consider. In some cases, the cost of asset disposal will lead to a negative residual value. That means your company will have to pay to get rid of an asset at the end of its useful life.
This is often the case if the disposal of the asset is regulated. Improper disposal of some assets, such as a solar battery bank, can lead to contamination. You’ll likely have to pay a service provider to take the battery bank off your hands. In this case, the residual value of the battery bank will be negative.
Nonetheless, it’s important to consider the asset’s residual value even if high disposal costs are a concern. After all, you don’t want to get to the end of the battery bank’s life and not have the financial capability to dispose of it properly.
What Is the Residual Value Formula?
There’s no way to determine the true residual value of an asset in advance. At best, you’re estimating the residual value of assets. You can do so by using the residual value depreciation formula:
Residual Value = Estimated Salvage Price - Estimated Disposal Costs
For example, say you have a piece of equipment. You estimate that at the end of its value, you can sell some of its parts for a total of $5,000. You also estimate that getting rid of the rest of the pieces of the equipment will cost you about $2,000. In this case, the residual value calculation is as simple as $5,000 minus $2,000. That means the residual value of this example equipment is about $3,000.
Again, there is no guarantee that you’ll be able to generate $5,000 in sales of spare parts or that the cost of disposal will stay stagnant at $2,000. So, it’s best to consider this as an estimated residual value rather than a number set in stone.
Benefits of Knowing the Salvage Value of Assets
Knowing the estimated salvage value of assets your company owns comes with several benefits. It helps you understand the depreciation of your assets and plan for disposal. Keeping track of salvage value also allows you to set fair prices on your assets when it’s time to offload them.
Calculates the Annual Depreciation Expense of an Asset
When you understand an asset’s salvage value, you’ll better understand how much that asset costs your company annually. You can determine the annual depreciation expense of your assets by subtracting their salvage value from their purchase price and dividing the total by the number of years you expect the asset to be effective.
For example, say you purchased a piece of equipment for $25,000, and you’re calculating depreciation expenses for your investors. You expect to get seven useful years out of the equipment. You also expect its selling price to be $9,000 after its useful life.
In this case, you can calculate depreciation by subtracting the $9,000 residual value from the $25,000 purchase price. Now, divide the $14,000 that is the result by seven useful years. This gives you an annual depreciation cost of $2,000.
Helps Plan for the Disposal or Replacement of an Asset
Whether you’re considering the end of a lease term or the useful life of equipment your business uses, disposal and replacements are always a consideration. If you want your business to run efficiently, you need your equipment to work properly. So, you’ll need to replace things from time to time.
If you don’t consider the residual value of your assets, their life span, and the cost of replacing them, your company may struggle when their useful life expires. But if you calculate their residual value and disposal costs, you’ll have a better idea of future expenses. Paying attention to residual values makes it easier to plan for the disposal and replacement costs of key assets.
Estimates the Fair Value of an Asset or a Business as a Whole
When you calculate the residual value of an asset, you’re determining quite a bit. You’ll be able to estimate the fair value of the following:
- Each Individual Asset Your Business Owns: It’s important to understand how much your assets are worth for financial reporting purposes. Residual value calculations give you an idea of how much your assets are worth now and in the future.
- Your Business’s Value: The value of the assets your business owns plays a major role in the overall value of your company. When you keep track of the residual value of your assets, you can better determine how much money your company is worth.
Contributes to Tax Deductions for Asset Depreciation
You can take advantage of various tax deductions to reduce your company’s overall tax burden. Depreciation is a key tax deduction to consider. However, it’s important that you report an accurate cost of depreciation to the IRS.
Use the example in the “Calculates the Annual Depreciation Expense of an Asset” section above to determine the annual depreciation cost of your assets. This will give you an accurate deduction when it’s time to write off your depreciation expenses.
Guides the Optimization of Pricing Strategies
Competitive prices are vital, whether you’re selling a product at the end of its useful life span, selling a new product, or leasing a product to consumers. Here’s how residual value helps in each of these situations:
- Selling a Product at the End of Its Useful Life: The residual value of an asset is the fair market price you can expect to generate from the asset after its useful life. By determining the asset’s residual value, you’ll know how much money to list it for at the end of its life span.
- Setting a Retail Price: If you’re setting a retail price for a new product, understanding that product’s residual value can help inform your pricing decisions. After all, consumers are likely to pay a higher price for products they can sell for a reasonable amount of money on the secondhand market.
- Monthly Lease Payments: If you’re leasing an asset to consumers, the residual value of that asset can help inform your monthly payment pricing. Since you know the residual value of the asset, you know how much money you’ll lose through the life of the lease. From there, you simply need to determine your markup on the loss, interest, and other fees you might wrap into the monthly payment.
How the Right Partner Can Help You Optimize Revenue and Cost
Optimizing revenue and costs and keeping track of residual value can be a headache. That is unless you have the right partner to help with these tasks. That’s where partners like Revolv3 come in.
Revolv3 is a payments platform with state-of-the-art features to help you optimize your company’s revenue and plan for future expenses. Enjoy higher approval rates, lower fees, and more insights at your fingertips. Find out how Revolv3 can help your company thrive today.