BASIC COST APPROACH

PRESENTED TO:
Equipment Appraisers Association
Of America
January 24, 2014
 Presented By
Douglas R. Krieser, ASA FRICS
Valcon Partners, Ltd.
371 E. Prairie Street, Suite B
Crystal Lake, Illinois 60014

P: 815-477-1000
F: 815-477-1001

E-mail: dougk@valconpartners.com
Web Site: www.valconpartners.com
 Disclaimer
This is NOT a comprehensive review of the Cost
Approach Methodology.

The information presented cannot be taken as

“the definitive way” to perform a Cost
Approach.
 Review of Approaches to Value

There are 3 approaches to value:

Cost Approach
Market Approach
Income Approach
 Applicable Definitions
Replacement Cost New: The current cost
of a similar new property having the
nearest equivalent utility as the property
being appraised, as of a specific date.

Reproduction Cost New: The current cost

of producing a new replica of a property
with the same, or closely similar
materials, as of a specific date.
 Applicable Definitions
Actual Age/Chronological Age: The number of years
that have elapsed since the item or property was
originally built or placed in service for the first time.

Effective Age: The apparent age of a property in

comparison with a new property of like kind; that is,
the age indicated by the actual condition of the
property. The Effective Age varies with the amount of
use, regularity and extent of maintenance, wear and
tear, etc. For this reason, the Effective Age for a given
asset may be more than, less than, or equal to the
Actual Age.
 Applicable Definitions
Normal Useful Life (NUL):The physical life, usually in
terms of years, that a new property will actually be used
before it is retired from service. A property’s normal
useful life relates to how long similar properties actually
tend to be used (given minimal maintenance and no
rebuilds), as opposed to the more theoretical economic
life calculation of how long a property can profitably be
used. (NOTE: Parenthetical comment added)

Remaining Useful Life (RUL): The estimated period during

which a property of a certain effective age is expected to
actually be used before it is retired from service.
 Applicable Definitions
Depreciation: Mathematical formula measure of a
tangible asset’s loss of value over time to properly
match revenues against the appropriated asset’s
lost value (estimated expense). The actual loss in
value or worth of a property from all causes
including those resulting from physical
deterioration, functional obsolescence, and
economic obsolescence. Depreciation may be
curable or incurable. The estimated loss in value of
an asset.
 Applicable Definitions
Physical Depreciation: A form of depreciation where
the loss in value or usefulness of a property is due
to the using up or expiration of its useful life caused
by wear and tear, deterioration, exposure to various
elements, physical stresses, and similar factors.
Physical depreciation may be curable (or partially
curable), by replacement or rebuilding, to some
percentage of its full physical life. If curable, the
remaining life would go no lower than a core or re-
buildable life. Cure or partial cure may then change
the Effective Age of the property.
 Applicable Definitions
Functional Obsolescence: A form of depreciation in which
the loss in value or usefulness of a property is caused by
inefficiencies or inadequacies inherent in the property
itself, when compared to a more efficient or less costly
replacement property that new technology and changes
in design, materials, or process that result in inadequacy,
overcapacity, excess construction, lack of functional
utility, excess operating costs, etc. has developed.
Symptoms suggesting the presence of functional
obsolescence are excess operating cost, excess
construction (excess capital cost), over-capacity,
inadequacy, lack of utility, or similar conditions.
 Applicable Definitions
Economic Obsolescence: A form of depreciation
where the loss in value or usefulness of a property
is caused by factors external to the property. These
may include such things as the economics of the
industry; availability of financing; loss of material
and/or labor sources; passage of new legislation;
changes in ordinances; increased cost of raw
materials, labor or utilities (without an offsetting
increase in product price); reduced demand for the
product; increased competition; inflation or high
interest rates; or similar factors.
 Basic Cost Approach Formula
In its simplest form, the cost approach formula
is as follows:
REPLACEMENT COST NEW (Preferred RCN and NOT Repro
cost – custom equipment is an exception!)
LESS PHYSICAL DEPRECIATION
LESS FUNCTIONAL OBSOLESCENCE
LESS ECONOMIC OBSOLESCENCE
EQUALS FAIR MARKET VALUE (may be in use or in
exchange depending on costs associated with RCN)
 Cost Approach Components
REPLACEMENT OR REPRODUCTION COST
Data can be gathered from:
• Dealers or manufacturers (BEST) (have customer
contact them)
• Engineering studies/firms
• Engineers at plant (for custom equipment)
• Used equipment dealers
• Trending historic cost info
• Your Own Estimate (WORST – unless you KNOW the
equipment well!)
 Trending Discussion
You can ONLY trend HISTORIC COSTS NOT
ORIGINAL COSTS:

Historical Cost: The initial capitalized cost of an

asset at the time it was first put into service

Original Cost: The initial capitalized cost of the

asset in the hands of its present owner.
 Trending Discussion
Trending may be the easiest method to use, BUT it has the most
limitations, some of which are as follows:

• Only “Historic” costs can be trended and asset records often include
used costs, discounts, allocated costs, “ghost assets” (which can
skew the values up or down significantly)

• The data included on most fixed asset records is vague at best and
may or may not provide enough information on the assets (to do a
proper trend analysis)

• The results can vary significantly depending on the source of, make
up of specificity, and reliability of the trends utilized
 Trending Discussion
Trending may be the easiest method to use, BUT it has the most
limitations, some of which are as follows:

• Trending MAY be good in aggregate but may or may not arrive at a

reasonable result for any individual item

• Trending an entire fixed asset listing will not typically provide

enough reliable data to allow the values to be segregated by
building or area (which is critical depending on the PURPOSE of the
appraisal).

• (Typically) The older the asset being trended, the bigger the
probability that the resulting trended cost will be either much
higher or much lower than the “true” RCN today.
Trending Discussion
 When is Trending a Reasonable Tool?
• Trending CAN BE a reasonable tool for:

• Trending the historic costs of “newer” equipment

(depending on the source of the trends etc.).

• Estimating the Reproduction Costs for customized

equipment when there is no other way to estimate the
cost to replace the item.

• Where practical, use independent, verifiable sources

(i.e. manufacturers, dealers, engineers, etc.).
 Custom or Specialized Equipment
• Make sure you are accounting for ALL material and
labor costs

• Estimate costs as if SOMEONE ELSE builds the unit

• Typically exclude excessive engineering and/or

prototype costs
 Custom or Specialized Equipment
One form of functional obsolescence is EXCESS CAPITAL
COST (Repro Cost – RCN)…it may cost MORE to build a
unit “as is” today than to replace its operational
capacity.

Reproduction Costs “best used” for unique or

customized equipment.
 Cost Approach Components
PHYSICAL DETERIORATION/DEPRECIATION
• Physical deterioration
• Observation based on experience
• Age/Life Analysis
• Cost to cure analysis

NOTE: is NOT the same as accounting

depreciation!
 Cost Approach Components
Cost to Cure: The cost to fix physical
deterioration or obsolescence. NOTE: Any
depreciable factor cannot exceed the cost to
remediate the problem.

Curable depreciation: Any form of depreciation

that is economically feasible to remedy. The
resulting increases in utility and value are equal
to, or greater than the expenditure to cure.
 Age-Life Analysis
An easy formula to use is:

% Depreciation = (Effective Age/Normal useful Life) = EA/NUL

OR

% Good = (Remaining Useful Life/ Normal useful Life) = RUL/NUL

NUL = EA + RUL
 Effective Age Notes
EA may be equal to, less than or greater than
actual age depending on:

• Atmosphere/surroundings/conditions it exists
in

• Maintenance (or lack thereof)

• Use (or lack thereof)

 How Can You Estimate NUL?
• Dealers or manufacturers
• Engineering studies/firms
• Articles on various industries/equipment
• Engineers at plant
• Used equipment dealers
• Marshall and Swift
• ASA NUL study
• Specialty guides
• Your Own Estimate
 Cost Approach Components
FUNCTIONAL OBSOLESCENCE
This is typically due to technological change WITHIN the
asset or product itself.

Examples include:
• Lack of utility
• Excess capacity
• Excess construction
• Change in design, materials or process
• Efficiency
• Technological change
• Excess operating costs
 Cost Approach Components
How can you compensate for Functional Obsolescence?

• Reduce RUL

• Ask dealers/manufacturers how much more efficient (as a

percentage or production, energy usage etc.) the newer model is
and use that as an estimate (as a percentage)

• Estimate excess operating costs over the RUL (beyond scope of

presentation)

• Inutility calculation (can be used for functional OR Economic

depending on reason for reduced utility) – BEYOND SCOPE OF THIS
PRESENTATION.
 Cost Approach Components
ECONOMIC OBSOLESCENCE
This is typically due to technological change EXTERNAL to the
asset or product itself.

Examples include:
• Management concepts or ability
• Availability of raw materials
• Availability of labor supply
• Market accessibility or acceptability
• Governmental regulations
• Earning power
• Competition
 Cost Approach Components
Notes on Economic Obsolescence:
• Typically NOT Curable!

• CAN be VERY volatile.

• Can change over time (up or down). VERY dependent on

what is going on SPECIFICALLY on the valuation date.

• May make an asset TOTALLY obsolete (to current or future

potential owner)

• May cause a value of an asset to be negative

 Cost Approach Components
How can you compensate for Economic Obsolescence?

• Reduce RUL

• Estimate excess penalty costs over the RUL (BEYOND

THE SCOPE OF THIS PRESENTATION)

• Inutility calculation (can be used for functional OR

Economic depending on reason for reduced utility)
Cost Approach Components
Market Based Obsolescence Factor
• There is a method to estimate obsolescence (typically Economic or a
combo Functional/Economic factor) which utilizes known market data to
estimate the obsolescence for items which do not have market data
available.

• This method utilizes comparing the results of the cost approach and
market approach for a known series of assets and utilizing that
relationship to estimate the obsolescence for an item where no market
data exists.

• A remaining obsolescence factor (ROF) or an aggregate obsolescence

factor can be quantified by a comparison between the results obtained
through the use of a cost indicator of value prior to the deduction for
obsolescence and results obtained through the use of the sales
comparison approach. This is a market-derived obsolescence analysis.
Market Based Obsolescence Factor
• In order for this methodology to be used effectively, replacement cost
new/reproduction cost new data and fair market value data for a sample of assets
similar to the subject assets must be gathered or otherwise calculated (i.e., by
trending). Such a comparison is necessary to reconcile any potential differences
between the cost approach and actual market data obtained from comparable
sales transactions.

• The most accurate and supportable results of this process will be realized if the
analysis breaks the assets down into various asset-specific categories (i.e.,
production equipment, packaging equipment, conveyors, maintenance equipment,
etc.) and develops remaining obsolescence factors for each of the various
categories. However, it is also possible to use this technique to develop plant-wide
or process-wide factors, as long as the sample used is significant and contains a
relevant sample of assets used in the process or plant. The former method is
preferred and is necessary for facilities that have a variety of different types of
equipment, while the latter can be used when the process or facility has assets
that are similar in nature or when the assets are all part of a continuous process.
Market Based Obsolescence Factor

EXAMPLE:
• Subject: ABC Company can seamer, model
100, which was built in 1990 and is in good
condition
• Physical Deterioration Est: 70%

• RCN (Per MFG): $400,000

Market Based Obsolescence Factor

EXAMPLE:
• Market Indication of Value: $66,000

• Functional Obsolescence: NA per MFG

• Economic Obsolescence: ???????

Market Based Obsolescence Factor

EXAMPLE:
Using the cost approach, we have the following result:
Market Based Obsolescence Factor

EXAMPLE:
In order quantify the remaining obsolescence, use the following
formula:

RCNLD − FMV
ROF =
RCNLD
Market Based Obsolescence Factor
RCNLD − FMV
ROF =
RCNLD

Where: ROF = Remaining Obsolescence Factor

FMV = Fair Market Value
RCNLD = Replacement Cost New Less
known or estimated Depreciation
Market Based Obsolescence Factor
EXAMPLE:
Using the formula in the current example gives us the following:

$120,000 − $66,000
ROF =
$120,000

$54,000
ROF =
$120,000

ROF = 45%
 How Is This Data Useful?

EXAMPLE:
• Subject: ABC Company can seamer, model
120, which was built in 1993 and is in good
condition
• Physical Deterioration Est: 65%

• RCN (Per MFG): $420,000

 How Is This Data Useful?

EXAMPLE:
Using the cost approach, we have the following result:

Replacement Cost New $420,000

Less Phys ical Deterioration @ 65% -$273,000

Replacement Cost New Less Phys ical Deterioration $147,000

Less Functional Obsoles cence –$0

Replacement Cost New Less Phys ical Deterioration $147,000
and Functional Obsolescence

Less Assumed Economic Obsolescence (45%) -$66,150

Replacement Cost New Less All Depreciation and

Specific Obsolescence Using the Cost Approach
("RCNLD") $80,850
 Another Example
Your job is to appraise the FMV a 2013 caterpillar
324E L Crawler Excavator. Your client tells you he
paid $350K.

You search the market and cannot find any comps

due to the unit being relatively new, so you have to
perform a cost approach.

Assuming you use a 20 year NUL, the total

depreciation in year one would be 5% of $350K or
$17,500.
 Another Example
As such, your initial cost approach results would
be:
$350,000 (RCN)
Minus $ 17,500 (1 year depreciation)
$332,500
Another Example
 Another Example
Assuming the $215,000 unit is essentially the
same as your subject (just older) you can
estimate the FMV of the comparable (using the
cost approach) as follows:
$350,000 (RCN)
Minus $ 52,500 (3 years depreciation)
$297,500
 Another Example
The difference (Obsolescence) can be calculated
as follows:
$297,500 − $215,000
𝑅𝑂𝐹 =
$297,500
$82,500
𝑅𝑂𝐹 =
$297,500
ROF = 28%
 Another Example
This can be used to value our Subject as follows:

$350,000 (RCN)
Minus $ 17,500 (1 year depreciation)
$332,500
Minus $ 92,200 (28% Econ Obs.)
$240,300
CONCLUDED FMV
 Bringing It All Together
Assignment: To appraise a production line that
produces products for the automotive industry.

Within this line there is a custom built machine.

Premise of value: Fair Market Value Installed (as

part of the entire production line)
 Bringing It All Together
Custom Machine Cost: $250,000 (installed –
5 years ago)

Trending this cost using accepted trends arrives

at REPRODUCTION COST of $275,000 (installed)

Discussions with Engineer at client indicate

engineering and design costs: $50,000
 Bringing It All Together
RCN today (discussed with Engineer and machine
builder): $210,000 (installed)

New Unit would be 10% more energy efficient

(discussed with Engineer and machine builder).

Salvage Value (discussed with Engineer and

machine builder): $15,000

Physical Useful Life: 15 years

 Bringing It All Together

Using the data, physical deterioration is 5/15 =

33% (67% “good”)

Engineering and Company Management indicate

that the product line in which the machine is
used will be discontinued in 3 years.
 Bringing It All Together
Since the product line will be discontinued in 3
years, the ACTUAL percent good is either:

3/15 = 20% (RUL/NUL)

OR

3/(3+5) = 38% (RUL/( EA + RUL))

Remember NUL = EA + RUL (stated previously)?

 Bringing It All Together
Based upon this, we get the following:

$210,000
X 38%
$ 79,800
 Bringing It All Together
Based upon our discussions, there is also a 10%
Functional Obsolescence so:

$210,000
X 38%
$ 79,800
X 90%
$ 71,820
 Bringing It All Together
Based upon our discussions, there is also a 10%
Functional Obsolescence so:
$ 210,000
X 38%
$ 79,800
X 90%
$ 71,820
X 75%
$ 53,865
 Disclaimer
This is NOT a comprehensive review of the Cost
Approach Methodology.

However, hopefully this will give you some tools

that will assist you if you find yourself needing
to perform a cost approach
QUESTIONS?