Functional and external (economic) obsolescence are two of the most important factors when estimating an asset's value using the cost approach to value.
Functional obsolescence is defined as the impairment of functional capacity or efficiency that reflects the loss in value brought about by such factors as overcapacity, inadequacy, excess operating costs, and changes in the art. The functional utility and level of technology of the equipment will have a direct effect on the value received when an asset is sold on a piecemeal basis and in the manner in which knowledgeable buyers view the in-place value as compared to new capacity.
Functional obsolescence can be further broken down into curable and incurable obsolescence. Curable obsolescence is a deficiency of an asset that can be remedied through addition or modernization. An example of this would be the replacement and update of a machine's computer numeric control (CNC). By updating the machine's CNC control, the productivity of the equipment can be improved, sometimes to a level that is comparable to a new replacement machine. Incurable functional obsolescence is an inadequacy identified in a machine that cannot be remedied. A machine utilized to produce cans is a good example. These machines are rated by productivity (cans produced per minute), and the productivity is directly dependent on the number of stations with which the machine is equipped. Older machines were equipped with a maximum of 10 stations and an operating capacity of approximately 2,000 cans per minute. Modern machines have as many as 14 stations that produce approximately 3,500 cans per minute. Since stations cannot be added to older machines, the productivity will always be constrained which will limit their value and marketability as a result of this incurable functional obsolescence. Appraisers utilize this information in order to make quantifiable deductions in the cost approach calculation.
External (economic) obsolescence is defined as the impairment of desirability or useful life arising from factors external to the asset, such as economic forces or environmental changes that affect the supply-demand relationship in the market. The current housing crisis provides an excellent example of the effects of external obsolescence. New homes and condominiums in distressed markets throughout the U.S. are being heavily discounted in an attempt to attract buyers. These homes are new so there is no physical deterioration; they incorporate the latest designs and technologies so there is no functional obsolescence. Therefore, all of the value loss is due to factors external to the properties themselves, or external obsolescence. Estimating a loss in value due to outside forces is a very difficult process for appraisers and typically is more subjective than the other deductions taken in the cost approach calculation.
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