Cost Approach Valuation Methods
The cost approach is based on the following economic principles:

• Substitution - Affirms that a prudent buyer would pay no more for an intellectual property than the cost to construct or develop an asset of equal desirability and utility.
  
  
• Supply and Demand - Shifts in supply and demand cause costs to increase and decrease and cause changes in the need for supply of different types of intellectual properties.
  
  
• Externalities - Gains or losses from external factors may accrue to intellectual properties. External conditions may cause a newly constructed intellectual property to be worth more or less than its original cost.
  
  
• Functional Obsolescence - The reduction in the value of an intellectual property due to its inability to perform the function or yield the utility for which it was originally designed.
  
  
• Technological Obsolescence - A decrease in the value of an intellectual property due to improvements in technology that make an intellectual property less than the ideal replacement for itself. Technological obsolescence occurs when, due to improvements in design or engineering technology, a new replacement intellectual property is judged more productive than the intellectual property being appraised. Technological obsolescence is often considered a specific form of functional obsolescence.
  
  
• Economic Obsolescence - A specific form of external obsolescence, economic obsolescence reflected in a reduction in the value of the subject intellectual property due to conditions external to and not controlled by the current use or condition of the intellectual property. The impact of economic obsolescence is usually beyond the control of the intellectual property owner and is, thus, generally considered incurable.

There are several related valuation methods within the cost approach. Each uses a similar definition of the type of cost that is relevant to the valuation analysis. The most common types of cost or definitions of cost, include reproduction cost and replacement cost.

There are subtle but important differences in the definitions of these types of cost. Reproduction cost contemplates the construction of an exact replica of the subject intellectual property. Replacement cost contemplates the cost to recreate the functionality or utility of the subject intellectual property, but in a form or appearance that may be quite different from the actual intellectual property subject to appraisal.

The valuer must also consider the concepts of functionality and utility. Functionality is an engineering concept that means the ability of the subject intellectual property to perform the task for which it was designed. Utility is an economic concept that has to do with the ability of the subject intellectual property to provide an equivalent amount of satisfaction.

Although the replacement intellectual property performs the same task as the subject intellectual property, the replacement asset is often better in some way than the subject asset. If so, the replacement property may yield more satisfaction than the subject property. The valuer must be careful to adjust for this factor in his estimate of obsolescence.

The cost approach also encompasses several other definitions of cost. First is a measure of cost avoidance, which quantifies either historical or prospective costs that are not incurred by the intellectual property owner due to the ownership of the subject intellectual property. Next is trending historical costs where actual historical asset development costs are identified and quantified and then "trended" to the valuation data by an appropriate inflation-based index factor.

All cost approach methods include a comprehensive and all-inclusive definition of cost. It is important to recognize that the cost (whether replacement cost or reproduction cost) includes not only hard costs (e.g., materials) and soft costs (e.g., engineering, design, labor, and overhead), but also the intellectual property developer's profit on both the hard and soft cost investment. It sometimes also includes an entrepreneurial incentive to economically motivate the intellectual property development process.

The replacement cost of an intellectual property is the total cost to create, at current prices, an asset having equal utility to the intellectual property subject to appraisal. However, the replacement intellectual property would be created with modern methods and developed according to current standards, state-of-the-art design and layout, and the highest possible quality. Accordingly, the replacement intellectual property may have greater utility than the subject property.

In contrast, reproduction cost is the total cost, at current prices, to develop an exact duplicate or replica of the subject intellectual property. This duplicate asset would be created using the same materials, standards, design, layout, and quality used to create the original intellectual property.

Replacement cost typically establishes the maximum amount that a prudent investor would pay for an intellectual property. To the extent that an intellectual property is less useful than an ideal replacement asset, the value of the subject intellectual property must be adjusted accordingly.

The replacement cost for the subject intellectual property should be adjusted for losses in economic value due to:

• Functional obsolescence;
• Technological obsolescence (often considered a specific form of functional obsolescence); and
• Economic obsolescence (often considered a specific form of external obsolescence).

In estimating the amounts, if any, of functional obsolescence, technological obsolescence and economic obsolescence related to the subject intellectual property, the consideration of: (1) the subject property's actual age and, (2) its expected remaining useful life are essential to the proper application of the cost approach.

Under the cost approach, a common formula for quantifying an intellectual property's replacement cost is:

Replacement cost new

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Curable functional and technological obsolescence

=

Reproduction cost new

An intellectual property's deficiencies are considered curable when the prospective economic benefit of enhancing, or modifying the intellectual property, exceeds the current cost of the material, labor and time needed to change it. Next, to estimate the intellectual property's value, the following formula may be used:

Replacement cost new

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Economic obsolescence

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Incurable functional and technological obsolescence

=

Value

An intellectual property's deficiencies are considered incurable when the current cost of enhancing or modifying the asset (in terms of materials, labor and time) exceed the expected future economic benefits of improving it.