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 ddrews@ipmetrics.net.
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.
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