Equipment Appraisal Blog | Understanding Machinery Appraisals

When appraising machinery and equipment, an important but often misunderstood component is obsolescence. Beyond normal physical wear and tear, obsolescence reflects the loss in value from economic or functional factors that affect an asset’s ability to perform its intended purpose efficiently and effectively. Here are some thoughts to consider when factoring obsolescence into your valuation.

Physical depreciation or deterioration is considered the most straightforward type of loss in value due to age, usage, and maintenance practices. While not technically “obsolescence”, it is considered one of the forms; however, the focus here is on the more abstract types, which are more difficult to measure.

Functional Obsolescence (Internal)

Functional obsolescence occurs when equipment is less efficient or less capable compared to newer alternatives, even if it’s still operational. Technological advancements are common with machinery that is reliant on high production capacity or lower energy consumption, such as computer equipment and CNC machine tools. Appraisers can try to estimate functional obsolescence by comparing operating costs or production capacity to new makes and models of similar specifications.

Economic Obsolescence (External)

Loss in value may also arise from factors outside the equipment itself, such as changes in market conditions, regulatory shifts, or industry demand declines. The oil and gas industry, for example, undergoes significant economic cycles, during which reduced output and changing environmental regulations affect value. These issues reflect current supply and demand. Measuring this may involve analyzing broad market data, profitability trends, or industry utilization rates.

It can be challenging to estimate obsolescence in these forms, given that appraisers may lack access to pertinent data and have difficulty determining how to calculate these percentages from information that is available. One efficient way to measure this is to work through market comparables and develop a trend or depreciation table by asset type that reflects the average annual loss in value over its useful life, while tracking new equipment pricing.

Used equipment market levels reflect all forms of depreciation and will allow you to recognize how obsolescence is factored into resale value from a buyer and seller’s perspective. If sufficient comparable sales data is unavailable, you should consider conducting interviews with business owners, maintenance managers, and equipment resellers and gathering opinions based on their hands-on experience.

In summary, estimating obsolescence requires both analytical discipline and industry insight. Combining quantitative analysis with practical experience is a balanced way to account for loss in value over time. A commonsense approach to measuring this comes with experience, as you track and develop a useful database that you can continue to update as new appraisal engagements take place.

We've all heard of problems businesses may have due to obsolete equipment. But what many companies don't realize is that there is a big difference between a piece of equipment being economically obsolescent and reaching functional obsolescence. But what's the overall difference between these two major types of obsolescence and what do you do when you have equipment that breaks down or wears out and becomes functionally obsolete? Here's a quick look at how it works out in equipment appraisal.

Used up and worn out: Dealing with functional obsolescence in equipment

Functional obsolescence is defined as the loss of value and usefulness of a piece of equipment which is caused by the machinery's lack of efficiency, inadequacies or high cost of maintenance and repair. In general, it's typically reached when a piece of equipment becomes more expensive to repair or maintain it than to replace it. But how does that work?

As a quick example, consider a vehicle. It's purchased with the understanding that at some point it will need to be replaced. As the years roll by, more repairs are required to keep the vehicle operating reliably. Eventually, the cost of these repairs will exceed the cost of purchasing a newer vehicle.  Another example could entail the need for a more fuel-efficient vehicle. If the current vehicle only gets five miles per gallon and a newer model would get 20 miles per gallon, the cost of operation is the key factor in terms of when to replace the equipment for a more efficient model. 

But what causes machinery to become functionally obsolete? Newer, more efficient technology may gain ground and come down in price, making the cost of acquisition much lower than in the past. This makes it possible to replace the equipment because of the reduced cost of waste. If it's caused by machinery breaking down, that can be caused by operating it in a state of over capacity, which wears the machinery at a faster pace than normal. In general, this is caused by purchasing machinery that is not suited to the task at hand or having to make increased demands on it after the initial investment. If innovations in the market provide new features that become necessary for modern operation practices, this can also make the machinery functionally obsolete.

Unfortunately, when you have a piece of equipment that has become functionally obsolete, it can create problems with your business' accounting and overall financial standing. If the machinery has not yet been fully depreciated, it may be showing a higher value than what it's actually worth at this point. If you have to deal with legal issues, the other side of the case may look at these values and claim that your company has a higher value than is reasonable. Having an equipment appraisal helps you document the machinery's actual value.

Though having equipment reaching functional obsolescence isn't a goal any business tends to make, it's one that many companies end up facing at some point or another. By taking the time to learn how to deal with the issue when it arises, you can make better decisions for your company and your remaining assets. Being able to document the final value of functionally obsolescent machinery can make a huge difference on your accounting and helps provide a more accurate overall picture of your business' financial health.