How Does An Appraiser Determine Functional
Or External Obsolescence?

Functional and external (economic) obsolescence are two of the most important factors when estimating an asset's value using the cost approach to value.

About Functional Obsolescence

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.

Types Of Functional Obsolescence

Functional obsolescence can be further broken down into Curable and Incurable Obsolescence.

Curable Functional 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

Incurable Functional Obsolescence is an inadequacy identified in a machine that cannot be remedied. A machine utilized to wind bobbins is a good example. These machines are rated by productivity (bobbins per hour), and the productivity is directly dependent on the number of stations with which the machine is equipped. Our sample machine is equipped with a maximum of 22 stations and an operating capacity of approximately 1,200 bobbins per hour.

Newer and more modern machines are offered with a greater number of stations. In our case above, the newer machines now have 38 stations with a machine that is comparable in physical foot print. The newer machines offer the buyer and increase of over 50% capacity but also produce 66% more bobbins than the original machines. Because additional stations cannot be added to our existing machines, the productivity of the original machines will always be constrained. This constrain will limit their value and marketability as a result of this Incurable Functional Obsolescence.

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Appraisers utilize this information in order to make quantifiable deductions in the cost approach calculation.

About External (Economic) Obsolescence

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.

How Does External Obsolescence Affect Value?

The current over supply of large SUV's (poor gas mileage) is an excellent example of the effects of external obsolescence.

New large SUV's are distressed in almost all markets throughout the U.S. and are being heavily discounted in an attempt to attract buyers and reduce inventories. These vehicles are new (most un-used) so there is no physical deterioration; they incorporate the latest designs and technologies; no functional obsolescence. Therefore, all of the value loss is due to factors external to the vehicles themselves; external obsolescence.

Estimating a loss in value due to outside forces is a very difficult process, typically an appraisers opinion is more subjective than other deductions taken in the cost approach.

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