Cost Approach Criteria explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
What something cost to build says nothing about what it earns — which is why the Standard fences this approach in with three conditions before it may be used.
The three cost approach criteria
The Cost Approach should be used to value the intangible assets only if the following criteria are met:
- It would be possible for market participants to recreate an intangible asset of similar utility to the subject asset;
- There are no legal restrictions or other types of barriers to entry preventing market participants from recreating an asset of similar utility to the subject asset; and
- The intangible asset can be recreated quickly enough that a market participant will not be willing to pay a significant premium for the ability to use the subject asset immediately.
Read the three tests as three different ways cost stops being a proxy for value.
Test (i) fails where the asset simply cannot be rebuilt. A brand with fifty years of consumer trust is not recreatable by spending money on advertising; the outcome depends on time and market response, not on outlay.
Test (ii) fails where the law blocks recreation. A patent, a broadcast licence, a spectrum allocation — these exist precisely to prevent market participants from replicating them. Their value is the exclusion, and the exclusion has no cost.
Test (iii) fails where recreation is possible but slow. If rebuilding takes three years, a buyer who needs the asset today will pay a premium for immediacy, and the build cost understates what they would pay.
Together the cost approach criteria explain the placement the Standard gives the approach: it is normally used to value intangible assets that are not primary or significant in nature from market participants' point of view, and it works for replicable assets, such as software and assembled workforce.
A recruitment cost fairly represents an assembled workforce because a buyer really could hire the same people; an advertising budget does not represent a brand.
The four inputs the cost approach criteria sit alongside
While applying the cost approach, the valuer should consider few points, such as:
- direct costs needed in replacing the asset, such as number of employees and their salaries, total time required to replace the asset etc.;
- profit margin on the expenses incurred, if applicable. As assets acquired from a third party would normally include the total costs along with a profit margin on those costs, it may be appropriate to include a profit margin on the costs incurred;
- opportunity cost, if applicable. The opportunity cost considers the economic cost of deploying resources in replacing the subject intangible asset; and
- obsolescence factors (economic or technological obsolescence) if any.
Opportunity cost is the input most often forgotten. Rebuilding an asset consumes people and management attention that would otherwise have produced something else, and a market participant weighing build against buy prices that in.
The candid limitations
The Cost Approach, though effective for some replicable assets, such as software and assembled workforce, is not always a useful indication of value for other intangibles. It tends to look backwards in time, which is not the way most buyers and sellers view assets or transactions.
Even a relatively simple piece of software, if it provides a competitive advantage that generates incremental profits, may have a value significantly different than its cost. Further, not all costs are incurred wisely, efficiently, or successfully. Many research projects that entail significant outlays of funds do not result in the creation of any asset value. Application of this approach to such assets may produce misleading result.
The counterweight: because the cost of an item is an indication of what one investor is willing to invest in the hoped-for creation of an asset, the Cost Approach is not without merit.
When nothing else is available
The Cost Approach may also be used when no other approach can be applied, however, a valuer should analyse all alternative methods in such cases. For example, brands are not normally valued under this approach; however, the valuer has to use his professional judgement at all times.
Note the sequence — analyse the alternatives first, then fall back, and record why the income and market approaches were rejected. That reasoning belongs in the report.
Common mistakes
- Valuing a brand or a patent on what it cost to create.
- Ignoring the recreation-speed test among the cost approach criteria where the asset takes years to rebuild.
- Treating unsuccessful research spend as asset value.
- Falling back on cost without documenting why the other approaches failed.