Principle of Substitution
The general premise of the cost approach in machinery and equipment valuations is the principle of substitution. The principle of substitution means that someone will not pay more for the asset being valued than what the individual can purchase a substitute asset that performs the same function or service.
The cost approach to machinery and equipment valuation involves determining the replacement cost of the asset and then subtracting any value that has been lost due to economic or functional obsolescence or physical deterioration.
The best starting point of determining the cost approach value is to identify the new replacement cost along with the ancillary expenses of a new acquisition.
New Replacement Cost
New replacement cost is what it would cost to acquire a new piece of equipment that performs the equivalent function of the piece of equipment being valued. This valuation is made by calculating the new replacement cost of a like machine and is to gather the direct and indirect costs acquiring the machine; including the cost of the equipment, direct labor for installation, freight, utility hook-ups, foundations, necessary sales tax and infrastructure modifications among other expenses. Indirect costs include engineering, administration costs, licenses and other related set-up and 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, utilities, financing ability or changes in the industry. These economic obsolescence factors may affect the value of the of the 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. Functional obsolescence occurs primarily when assets have become undesirable due to 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 expectancy. While the machine is used the physical stress and exposure to the elements of the environment cause deterioration. Over time the performance of the machine may require additional maintenance expenditures to keep it in operating condition. Lack of maintaining equipment caused faster deterioration. A percentage of deterioration is assigned to a piece of equipment; a brand new piece of equipment having 0% physical deterioration and a machine that has been used to or beyond the life expectancy having 100% physical deterioration. Measuring physical deterioration is somewhat subjective and it requires a knowledgeable valuator to accurately determine the value of an older piece of equipment. It may be necessary to rely on similar assets and how they have performed in the past as the basis of calculating the percentage.