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Cost approach 2010


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Cost approach 2010

  1. 1. The Cost Approach to IP Valuation: Its Uses and Limitations By David Drews* – IPmetrics LLC To gain a better understanding of the concepts and issues that this column will address each month, it is important to have a basic understanding of the tools, procedures, and methods used in valuing intellectual property. In previous columns I have discussed the “what” and “why” of IP valuation. It is now time to entertain the question of “how.” One of the least understood methods of IP valuation is the cost approach. This is one of the three main methods used to determine the value of intellectual property, the others being the market approach and the income approach. The discussion that follows will address the usefulness of this approach, various factors that can impact its application, and some of the constraints you may encounter either during the analysis or when considering any conclusions you have reached. The cost approach seeks to determine the value of IP by aggregating the costs involved in its development. Without knowing anything about the details of the process, this may seem fairly simple. However, there is more to it than merely adding up all of the receipts for expenditures associated with the R&D. As with all IP valuation, the first step is to understand the context in which the asset is being analyzed. This will include such parameters as the assets you’re analyzing, the date as of which your attempting to determine value, and the purpose for the valuation. The answers to these questions will determine which of two cost approach methods is more appropriate: reproduction or replacement. “Reproduction cost” is the cost necessary to reproduce the exact same asset and is appropriate in situations such as litigation involving the specific intangibles in question or when attempting to measure return on investment. The “replacement cost” method measures the cost to develop an asset with similar utility and is appropriate in situations such as determining a target price prior to negotiations or calculating a basis for a fair rate of return from which suitable royalty rates or transfer pricing can be determined. An important requirement for both methods is that the measurement of the costs be performed as of the valuation date, as opposed to when the historical expenditures actually took place. Understanding this distinction is crucial if a valid conclusion is to be reached. In practice, this means that only the expenditures necessary to reproduce or replace the intangibles in the environment in existence on that date should be included. For the * David Drews is president of IPmetrics LLC, an intellectual property consulting firm. You can reach him at 858-538-1533, or
  2. 2. The Cost Approach to IP Valuation purposes of this discussion, I will assume that the valuation date coincides with the current date, although that is by no means a necessity when using the cost approach. The impact of this requirement is twofold. If the cost of any of the relevant components has changed since the initial expenditure, whether upward or downward, the current cost level needs to be incorporated into the calculations. Any developments taking place in the interim that would materially impact the development process need to be factored in as well. An example of this would be the utilization of software applets in writing code. Software code developed prior to the widespread use of this technique could conceivably be developed in a far shorter time and at far less cost now than in the past situation of having to write each piece of code from scratch. COSTS INCLUDED Not all costs encountered during the time period an intangible was developed should be included, only those that would be required to duplicate the asset or an asset of similar utility. These will consist of both direct expenditures and opportunity costs. The direct expenditures will comprise items such as materials needed in the development process, labor costs, and some overhead items. Again, these costs should be considered as of the date of valuation looking forward, not in their historical terms. If, in the interim, the relevant literature has progressed to the point where, say, a developmental process for a patented technology that took seven researchers two years to develop could now be accomplished by three researchers working for 18 months, the latter structure is the template to use when estimating research labor costs. Also, make sure that the salaries, benefits, and other employment costs being attributed to those hypothetical researchers are based on current practices, not on the specifics in place historically. Overhead and management costs, such as project supervision, utilities, and administrative costs, should be pro-rated to reflect their true involvement with the direct development process. Some administrative costs should be disregarded altogether. Also, when projecting the timetable needed to develop the IP in question based on the current environment of prices, knowledge, and available inputs, consideration must be given to the probability of success. Including this will act as a discounting factor, similar to performing present-value calculations on projected revenue or income, which will be the subject of a future column. The opportunity costs mentioned above assume that other courses of action and investment opportunities have been passed on in order to pursue the development of this intangible. If structured properly, this element should take into account the required return on the investment being made by the asset’s owner. Other opportunity costs are the lost profits that result from any delay in getting to market. In other words, if instead of taking the time to develop the new asset, an investor were to purchase an asset of similar utility and begin using it immediately, the profit earned between the purchase date and the date that the newly developed asset would be available for use is a cost that needs to be included. Page 2
  3. 3. The Cost Approach to IP Valuation Another major concern when using the cost approach is that all aspects of obsolescence be addressed. If there is a better mousetrap, it may not matter what the magnitude of the other factors is. If the objective of your analysis is to determine the value of the IP in the marketplace, whether via the reproduction method or the replacement method, the process needs to recognize any elements of the IP that are obsolete in the current environment. Obsolescence can take many forms. It may be that the asset simply does not perform as well as it once did (e.g., a tired customer list), or there may be a new technology or process that provides the same or better utility for less cost (technological improvement). Whatever form the obsolescence takes, it will have a direct impact on the value of the intellectual property. USES AND LIMITATIONS This cost approach is useful in cases where there is no economic activity to review, such as early-stage technology. It also is effective at establishing a maximum price for the asset if the context is a proposed transaction. This situation exists when there are many candidates for substitution available. The theory here is that an investor will pay no more for an asset than the cost to develop or obtain an asset of similar utility. The main drawback associated with the cost approach is that it does not recognize the economic benefit provided to the owner of the IP through its use. There is no mechanism to incorporate revenue or profit data, and therefore it ignores an important standard of value by which many assets are measured. In summary, be careful before concluding that the calculated amount of costs determined by your analysis is indeed the value of the assets in question. This is only the case when all relevant costs, including opportunity costs, have been factored into the analysis; that they have all been treated appropriately; that probability of success has been taken into account; and that the issue obsolescence has been addressed. This article was originally posted on on 01-12-2001. * David Drews is president of IPmetrics LLC, an intellectual property consulting firm. You can reach him at 858-538-1533, or © 2010 IPMETRICS LLC. All rights reserved. Page 3