As seen in Accounting Today
Physical depreciation is the normal wear and tear that diminishes the value of assets over time. Economic depreciation (or obsolescence) is the loss in value resulting from factors external to the asset (or group of assets) such as changes in supply of raw materials or demand for products. Let’s consider in more detail the third form of depreciation, functional obsolescence.
The ebook “Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets,” from the American Society of Appraisers, defines functional obsolescence as:
“a form of depreciation in which the loss in value or usefulness of a property is caused by inefficiencies or inadequacies inherent in the property itself, when compared to a more efficient or less costly replacement property that new technology and changes in design, materials, or process that result in inadequacy, overcapacity, excess construction, lack of functional utility, or excess operating costs in the property. Symptoms suggesting the presence of functional obsolescence are excess operating cost, excess capital cost, over-capacity, inadequacy, and lack of utility.”
A few examples will help illustrate the elements of this definition.
Curable functional obsolescence: This form of FO is present in an asset when, with the expense of replacing necessary components, the asset can be brought up to current operating standards. For example, a milling machine may have its capacity limited by out-of-date computer numeric controls, or CNC. By upgrading the CNC, the machine’s capacity is increased. This is the easiest form of FO to quantify if the cost of the necessary upgrade can be identified.
Functional obsolescence from excess capital cost: Equipment appraisers differentiate between reproduction cost (the cost to reproduce the exact same asset) and replacement cost (the cost to replace an asset with an asset providing the same utility). When the replacement cost for an asset is less than the reproduction cost, the difference is an indication of FO. For example, not too long ago, surveying equipment cost thousands of dollars.
Today one can find laser-based equipment offering the same (or better) utility in a big box hardware store for several hundred dollars. The value of the older equipment has suffered a loss in value due to FO from excess capital cost.
Functional obsolescence from excess operating cost: As a result of new technology or superior design, it may not only be cheaper to acquire a modern asset, it may also be cheaper to operate it. In one engagement, we valued a number of paper mills. Some of the mills were 100 years old. The inefficient design (the older mills had been reconfigured and added on to over the decades) and technological deficiencies of the older mills were indicators of FO. A comparison of production cost per ton for the older mills with that of newer mills producing similar products confirmed this assumption. The calculation of the amount of FO was based on the amount of the increased operating expenses.
Functional obsolescence from excess capacity: The loss in value due to excess capacity of a product plant as a whole is most often due to economic obsolescence—factors external to the assets such as changing demand or industry economics.
However, excess capacity of a single asset within a production plant is an indicator of FO resulting in the loss in value of that particular asset. For example, a brewery production line might have a filling machine with the capacity to fill 1000 bottles per minute.
If that same line should have a bottle-capping machine with a capacity to cap 2,000 bottles per minute, the capping machine suffers from a loss in value due to FO. This component of the production line is not used to its full capacity, and therefore no prudent investor would pay for its rated capacity.
Functional obsolescence and economic obsolescence interrelationship: In a recent engagement, we had to deal with both FO and EO.
(The calculations below are simplified for the sake of clarity. The actual analysis included exponential adjustments and annual inflation adjustments.)
The chemical plant, built at a cost of $200 million, was designed to produce 100,000 metric tons (MT) of product per year (MT/Y). Because of changing environmental regulations, the facility has never produced more than 50,000MT/Y (50 percent of rated capacity), resulting in an EO penalty caused by external factors.
The company decided to replace certain components of the plant at a cost of $20 million to raise permitted production capacity to 80,000MT/Y. After the new equipment is installed, the facility will have an FO penalty.
The FO on the upgraded plant is measured by the reduction in utilization of most of the plant equipment from its rated 100,000MT/Y to 80,000MT/Y. (This is properly regarded as FO because utilization is limited by the new components installed.)
There are at least two reasons why the consideration of functional obsolescence is important. First, it ensures that the valuation is correct. A prudent investor will either implicitly or explicitly consider FO in the determination of a purchase price for the entire business.
The valuation of the individual assets should correlate with these considerations. Second, a failure to consider all forms of depreciation in an initial valuation may result in an impairment charge to the value of the asset or asset group later.