Cost Approach

• Author: Russell L. Parr
• Profession: President of Intellectual Property Research Associates
• Pages: 75-86

CHAPTER 6

COST APPROACH

The cost approach determines the value of a property by considering the costs required to

replace the subject property. It is very useful for valuing specialty equipment, assembled

workforces, customized software, and internally developed practices and procedures but

not very helpful for most types of intellectual property. That said, concepts associated with

this valuation approach are important.

The Financial Accounting Standards Board provides the following denition for the cost

approach:

The cost approach is based on the amount that currently would be required to replace the ser-

vice capacity of an asset (often referred to as current replacement cost). From the perspective

of a market participant (seller), the price that would be received for the asset is determined

based on the cost to a market participant (buyer) to acquire or construct a substitute asset of

comparable utility, adjusted for obsolescence. Obsolescence encompasses physical deterio-

ration, functional (technological) obsolescence, and economic (external) obsolescence and is

broader than depreciation for nancial reporting purposes (an allocation of historical cost) or

tax purposes (based on specied service lives).1

The cost approach seeks to measure the future benets of ownership by quantifying the

amount of money that would be required to replace the future service capability of a subject

property. The assumption underlying this approach is that the cost to purchase or develop

new property is commensurate with the economic value of the service that the property

can provide during its life. The cost approach does not directly consider the amount of eco-

nomic benets that can be achieved or the time period over which theymight continue. This

approach is often employed together with the assumption that economic benets indeed

exist and are of sufcient amount and duration to justify the developmental expenditures.

Using a cost approach to develop an indication of market value, however, requires a consid-

eration of economic obsolescence, and to what extent future economic benets will support

an investment at the indicated value.

General concepts of the cost approach will rst be discussed as they typically apply to

the valuation of xed assets. This includes production equipment, ofce furnishings, truck

eets, and many of the tangible items that are used in a business enterprise. Then application

of the cost approach for intangible assets will be discussed.

GENERAL COST APPROACH PRINCIPLES

If the price of a new computer-controlled machine tool were set at a level exceeding the

present value of the future economic benets of owning the machine, none would be sold.

1Accounting Standards Codication (ASC) 820.

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