The cost method is based on the licensor’s investment in the technology. The cost approach is based on the economic principle of substitution. An investor will pay no more for an asset than the cost to develop or obtain another asset of similar utility. The value of the intellectual property is equal to the cost to replace or re-create the intellectual property. The theory behind this approach is that the licensee avoids these costs by licensing the IP from others. It is represented by those costs associated with developing, protecting and commercializing the technology. These expenditures are known to the licensor and can be reasonably estimated by the potential licensee. They represent the base, or minimum that the licensor would want to recover, with interest. The relevant costs and the opportunity cost associated with the technology have to be considered. Examples of such costs may include: R&D (labor and overhead), testing and regulatory approval costs, patent prosecution costs, equipment and other capital investments, and opportunity cost of diverted resources.
Sometimes a cost approaches used to estimate all the costs that would be incurred if the licensee were to obtain, from their own internal development or a different outside source, technology that could deliver an identical product or process. This might be through a third party with competing but non-infringing technology. The cost approach is used to establish costs that would be involved in the creation of a similar technology that takes into account the prices and rates of payment on the date of the valuation. In these and other appropriate situations, the licensee would estimate the time and the cost of acquiring or developing alternative technology. The licensee is effectively determining the cost of the next best alternative, and this, where possible, can be a useful measure of the importance and value of the licensor’s source technology to the licensee.
One final comment about the Cost Method regarding the concept of obsolescence; all forms of obsolescence have to be identified, quantified, and subtracted from the cost of the asset in order to estimate its value. Common forms include (1) Physical deterioration (not usually applicable for intangible assets), (2) Functional obsolescence that doesn’t provide the same benefits for external or internal reasons as it did at origin (3) Technological obsolescence which occurs when the original intended function is no longer needed or wanted by the marketplace, and (4) Economic obsolescence (sometimes location-related or economic price/cost-related obsolescence)