Cost Approach of Machinery and Equipment Valuation
Principle of Substitution
The general premise of the cost approach in machinery and equipment appraisals is the principle of substitution. The principle of substitution means that someone will not pay more for the asset being appraised than what the individual can purchase a substitute asset that performs the same function or service.
The cost approach to machinery and equipment appraisal involves the appraiser coming up with the replacement cost of the asset and then subtracting any value that has been lost due to economic obsolescence, functional obsolescence, or physical deterioration.
The best starting point of determining the cost approach value is to identify the replacement cost new.
Replacement Cost New
Replacement cost new is what it would cost to acquire a machine that performs the equivalent function of the piece of equipment being appraised. One way of calculating the replacement cost new of machinery and equipment is to gather the detail of the direct and indirect costs to having the machine running, assuming that this is how the machine is being requested to be analyzed for the appraisal. Direct costs include the cost of the equipment, direct labor for installation, freight, utility hook-ups, foundations, necessary sales tax, amongst other expenses. Indirect costs include engineering, administration, licenses, and other related set-up and typical acquisition expenses.
Economic obsolescence is the loss of value of an asset due to outside factors. These factors may include law or ordinance changes, increased cost of raw materials, labor, or utilities, financing ability, or changes in the industry. These economic obsolescence factors may affect the value of the machine or piece of equipment.
Functional obsolescence is the loss of value of machinery and equipment due to not meeting the standards of more efficient and less costly replacements. Equipment appraisers often see functional obsolescence when assets have seen technological advancements.
Physical deterioration is the loss of value due to wear and tear on machinery and equipment. Machinery and equipment are manufactured with a useful life in mind. As the machine is operated, the machine experiences physical stress and exposure to the elements of the environment. Over time, the performance of the machine may require additional maintenance expenditures to keep it running. Lack of maintaining equipment may lead to faster deterioration. It is usually estimated as a percentage with a brand new piece of equipment having 0% physical deterioration while a machine that has used up all of its life 100% physical deterioration. Measuring physical deterioration is often subjective and the appraiser will rely on similar assets and how they have performed in the past as the basis of calculating the percentage.