УДК 33


Арыхов Орхан Алигусейн оглы
Финансовый Университет при Правительстве РФ

В статье рассматривается затратный подход к оценке бизнеса.


Arikhov Orkhan Aliguseyn ogly
Financial University under the Government of the Russian Federation

The Cost Approach to value is one of the three generally accepted approaches to estimate the fair value of an asset or physical property; its theoretical basis is reproduction cost. The cost approach is useful for recently built properties, because they have little depreciation and the reproduction cost is to be analogous to the actual expenditures; also it is suitable for older properties when reliable data is available for calculation of the depreciation. The cost approach is often referred to as the asset approach, and the terms are used interchangeably. In this paper we analyze the cost approach and highlight its advantages and disadvantages.

Keywords: asset approach, cost approach, reproduction cost, valuation approach


Библиографическая ссылка на статью:
Арыхов О.А.о. The Cost Approach to Business Valuation // Студенческие научные исследования. 2015. № 5 [Электронный ресурс]. URL: http://student.snauka.ru/2015/05/2522 (дата обращения: 03.06.2020).


The Cost Approach to value is one of the three generally accepted approaches to estimate the fair value of an asset or physical property; its theoretical basis is reproduction cost. The cost approach is useful for recently built properties, because they have little depreciation and the reproduction cost is to be analogous to the actual expenditures; also it is suitable for older properties when reliable data is available for calculation of the depreciation. The cost approach is often referred to as the asset approach, and the terms are used interchangeably[6].

American Society of Appraisers (ASA) states that “in business valuation, the asset-based approach may be consider as an analogue to the cost approach of other appraisal disciplines”.[3] However, the International Glossary of Business Valuation Terms divides these two approaches. The glossary defines the cost approach as “a general way of determining a value indication of an individual asset by quantifying the amount of money required to replace the future service capability of that asset” and asset-based approach as “a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities”[2].

The distinction between the cost approach and asset approach is that the cost approach is often the preferable approach when estimating the fair value of tangible personal property independently from going-concern value of the entity, whereas the asset-approach is used to estimate the fair value of a business unit, ownership interest and security. Under the definition of the cost approach, fair value is measured as the cost to replace the service capacity of the asset, while under the definition of the asset approach, fair value measurement of an entity is the summation of individual asset and liability values determined by various other valuation methods[3].

The ASA Business Valuation Standards’ interpretation of the cost approach is similar to Financial Accounting Standards Board’s (FASB) one. Fair Value Measurement and Disclosure (SFAS №157) describes the cost approach as the following:

The cost approach is based on the amount that currently would be required to replace the service 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 deterioration, functional (technological) obsolescence, and economic (external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (based on specified service lives)[4].

In this definition we can highlight three main ideas.

The first idea is the replacing concept; also could be treated as utility of an asset. Utility, in economics, means the satisfaction that is received from consuming goods and services. In addition, we can treat utility (or usefulness) as the “return” that investor is expected to receive on his/her investment. Therefore, if two different assets have the same return, then, other things being equal, these assets has the same utility for the investor.

The second idea is the principle of substitution. Since, fair value is an exit price to a market participants, we can interpret this concept as the following: a buyer will not pay more for one asset than for another with the same utility. The principle assumes rational market behaviour. Several similar or commensurate commodities, goods or services are available, the one with the lowest price attracts the greatest demand and widest distribution.

The third idea covers the adjustments for potential obsolescence. These adjustments are needed to equate the price of a substitute asset to the value of a subject asset. If a substitute asset has greater utility, then a buyer would pay more to acquire it. Therefore, the replacement cost of a subject asset would be equal to the price a buyer would pay for a better substitute minus an adjustment for obsolescence of the subject asset. The obsolescence factor would be equal to excess utility of the replacement plus any other obsolescence of the subject asset.

Reproduction Cost and Replacement Cost

The basis used normally in the Cost Approach is Current Cost New (CCN). While theoretically this should be reproduction costs, in practice, it may be either reproduction (duplicate) or replacement costs. Although the two are related, they represent different concepts and may be significantly different amounts. Understanding reproduction cost will provide a good foundation for understanding replacement cost. Reconciling reproduction cost to replacement cost will also provide a key to understanding and quantifying obsolescence[4].

Reproduction cost is an estimated cost of creating a similar or duplicate subject asset at a valuation date. Thus, the cost of reproduction should represent all functional deficiencies and obsolescence of the subject asset; commonly, the reproduction cost is referred to as “Cost of Reproduction New” (CRN). The Cost of Replacement (CoR) is the estimated cost to create very similar substitute with equivalent utility at a valuation date. Thus, the CoR does not embody all functional deficiencies and many types of obsolescence[7].

An important point to emphasize is that both reproduction and replacement cost are current costs, not historic. The difference between the current cost to reproduce a replica and the current cost to replace it with a better substitute relates to obsolescence present in the original. Replacement cost is generally considered the most meaningful basis of value for fair value measurement under the cost approach. However, whether the starting point of a valuation analysis is from the cost of reproduction or from the cost of replacement, properly considering obsolescence will lead to the same value conclusion. The relationship can be summarized in the formula[1]:

Both CRN and COR represent new property without any physical deterioration. Therefore, an amount for this deterioration commensurate with the effective age (physical condition) of the subject has to be deducted from either to determine fair value. Generally the choice of which current cost new to adopt is based in the availability of reliable data on which the cost and depreciation estimates will be made.


Obsolescence is significant decline in the competitiveness, usefulness, or value of an article or property. Obsolescence occurs generally due to the availability of alternatives that perform better or are cheaper or both, or due to changes in user preferences, requirements, or styles. It is distinct from fall in value (depreciation) due to physical deterioration or normal wear and tear, because obsolescence does not directly impact the utilization or useful life of the assets.

Obsolescence could also be treated as the reason a subject asset costs less than the cost of a modern replacement. Thus, obsolescence is equal to excess utility of the modern replacement; in other words, obsolescence is the difference between the cost of reproduce a duplicate and the cost of modern replacement[6].

From an economic perspective obsolescence could be curable and incurable. If the benefit that a company gains on improvements are more than the cost of improvements, then obsolescence is said to be curable. And vice versa, obsolescence is to be incurable, if the resulting increase in asset’s value is less than the cost of cure. The following formula more precisely describes about the types of obsolescence that distinguish the reproduction and replacement costs:

To identify fair value the following formula should be used:

It does not matter what starting point to choose: reproduction cost or replacement cost – at result we will received the same fair value, when all types of obsolescence are properly considered and assessed[1].

Physical deterioration

Physical deterioration is the loss in value of an asset due to exposure to the elements; causes include: wear and tear, usage (fatigue), deterioration with age and exposure, accidental or chance destruction, and/or lack of maintenance[9].

Physical deterioration can be estimated by determining the cost to cure the deficiency or based on observed depreciation. Another common method to quantify physical deterioration is to calculate the percent of physical deterioration (%PD) based on the age and life expectancy of the asset, as follows:

Effective Age (EA) the age of the asset relative to a new asset of like kind, considering rebuilding and maintenance that will extend its service life

Remaining Useful Life (RUL) the estimated period during which an asset is expected to be profitably used for its intended purpose

Economic Life (EL) the estimated total life of the asset[5]

Due to fact that intangible assets do not have a physical form it is impossible for them to have a physical deterioration.

Functional (Technological) Obsolescence

Functional obsolescence is a loss in value of an asset due to its inability to perform the function for which it was designed. There are no changes in intended function, rather the asset’s ability to perform the functions declined. Functional obsolescence include also technological obsolescence – the function of an asset has become obsolete. Though the function of an asset is obsolete, the asset is still able to perform the function[9].

Physical inspection is one of methods to identify functional obsolescence. It is mostly effective for tangible assets.

Comparative analysis is the other methods and can be applied to both functional and technological obsolescence. To identifying functional obsolescence a subject asset is compared to a new version of itself. To identifying technological obsolescence a subject asset is compared to a new, ideal replacement.

To measure functional or technological obsolescence can be used a number of methods. The cost-to-cure method is often used to measure functional or technological obsolescence from physical structure or capacity lack. If there is excess capacity, then it is needed to calculate the pro rata portion of capital cost attributable to the excess capacity. In this case a measure of obsolescence could be the pro rata excess capital cost. The last method is to quantify excess operating costs attributable to a subject asset over its remaining useful life. This can be accomplished by using a one-period capitalization model or a multi period discounted cash flow model. Capitalized or discounted excess costs would be a measure of the amount of obsolescence and these models are applicable for both tangible and intangible assets[6].

Economic (External) Obsolescence

Economic obsolescence, also referred to as external obsolescence, is the loss in value resulting from influences external to an asset itself, generally incurable[1]. Economic obsolescence exists when the subject asset is unable to generate a sufficient rate of return over its expected remaining life based on its indicated value. The American Society of Appraisers highlight common external causes of economic obsolescence as:

A declining industry;

Inability to get financing;

Loss of material or labor sources;

New legislation or ordinances;

Increases in the price of inputs without the ability to increase product prices;

Reduced demand for the product;

Increased competition;

Inflation or high interest rates[3].

To identify the existence of economic obsolescence it is helpful to perform a comparative analysis. Economic performance of a subject asset is compared to its historical performance, to its budgeted performance, to a similar asset, or to an industry average. Main indicators of the comparison analysis are profit margin, ROI, unit selling price, unit COGS, and unit sales volume. The comparative analysis would show whether there are any economic deficiencies related to a subject asset. Once identified, the economic deficiency is projected over the subject asset’s remaining useful life and discounted to the present value. The discounted amount (present value) of economic deficiency is equal to economic obsolescence.

Another method of identifying economic obsolescence is to compare enterprise value of a company to the total fair value of its assets less liabilities. If the enterprise value of the total fair value is less than the sum of working capital, tangible and intangible assets, and other assets at fair value, the difference is equal to economic obsolescence[3].

Advantages and Disadvantage of the Approach

As a conclusion we discuss pros and cons of the cost approach.

Disadvantages of the Cost Approach

Every method has its own drawbacks and the cost approach is not an exception. The main shortcoming of this approach to measuring fair value is that it does not often include entrepreneurial profit and opportunity costs. Reason for this is that appraisers do not adjust historic cost to include profit and incentive on which the cost approach is based.

The solution for this problem is to adjust replacement costs by adding entrepreneur’s profit and opportunity cost. If the cost to create and asset includes the entrepreneur’s profit and incentive, then the historic cost would be approximately equal to historic market cost and would be a better base from which to measure fair value under this approach. As a result, the fair value assessing would be close to fair value measurement under the income and market approaches[6].

Other disadvantages of the cost approach are:

If inadequate data is available, it may be impossible to apply.

Adjustments must be made – no two properties are ever identical.

Sales are always historical.

Accuracy of the method depends upon the appraiser’s ability to recognize differences, and to make the proper adjustments for those differences.

It is sometimes difficult to ascertain circumstances surrounding a sale.

Advantages of the Cost Approach

The main pros of this methods are:

It reflects market behaviour.

It is widely used and understood.

It is accorded greatest weight by the courts.

It requires least adjustment if sufficient data is available[8].

  1. Agiato, Joseph A. Jr., and Michael J. Mard, Valuing Intellectual Property and Calculating Infringement Damages, American Institute of Certified Public Accountants Consulting Services Practice Aid 99-2, 2012, 38–39.
  2. American Institute of Certified Public Accountants, American Society of Appraisers, Canadian Institute of Chartered Business Valuators, National Association of Certified Valuation Analysts, and the Institute of Business Appraisers, International Glossary of Business Valuation Terms, 2011, pages 2 and 4.
  3. American Society of Appraisers, “ASA Business Valuation Standards,” 2008, 9.
  4. Financial Accounting Standards Board (FASB) Statement of Financial Standards (SFAS) No. 157, Fair Value Measurements, FAS157-10.
  5. Hitchner, James R., Financial Valuation Application and Models, Second Edition (Hoboken, NJ: John Wiley & Sons, 2006), 365.
  6. Mark L. Zyla, “Fair Value Measurements Practical Guidance and Implementation”, 2010.
  7. Reilly, Robert F., and Robert S. Schweihs, Valuing Intangible Assets (New York: McGraw-Hill, 2012), 122.
  8. The Canadian Real Estate Association, 2010.
  9. Willamette Management Associates, Property Tax Valuation White Papers: Economic Obsolescence Is an Essential Procedure of a Cost Approach to Valuation of Industrial or Commercial Properties, http://www.propertytaxvaluation.com/economic obsolescence essential procedure.html (accessed 4/16/2009), 4–5.

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