OBSOLESCENCE

BY

SUNDEEP BIKHCHANDANI
B.E. (HONS), D.B.M., Master of Valuation (Plant & Machinery),
Master of Valuation (Real Estate) (Gold Medalist),
A.M.I.E., A.I.S.,MRICS

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 SYNOPSIS

The author has highlighted vital issues concerning the subject like :-

Limitation of market and income approaches

Causes of obsolescence

Importance for bankers, buyers and tax payers

Technological, Functional and Economic obsolescence

The paper is backed by case studies and judicial pronouncement.

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 OBSOLESCENCE
BY
SUNDEEP H. BIKHCHANDANI

1.0 Value of any asset can be numerically quantified with knowledge of law,
mathematics, economics and application of logic. This requires special skill
and abilities. It is also necessary that the result is tempered with judgment
and filtered with experience.

To forecast a capital sum, that is the anticipated price, to be paid, by a

purchaser and accepted by a vendor, is a matter of artistry, not exact
science.

When question is posed to an appraiser about most appropriate approach to

value, the answer would definitely be the Market Approach; however, if no
market data exist or if it is very rare for an exchange of ownership, one
cannot quantify the value of an asset by market approach, therefore it
becomes imperative to apply cost summation approach.

When it comes to the valuation of plant and machinery, the valuer is usually
faced with lack of evidence of market sales from which to decipher
comparable sales evidence. Moreover, it is not possible to quantify the
income from plant & machinery from total income. This eliminates the
possibility of applying either the sales comparison or income approaches to
value. Therefore the value is achieved by combining the skills of
engineering and valuation for cost approach.

While adopting cost approach due regard need to be given for obsolescence
alongwith other factors like age, conditions etc.

2.0 WHAT ARE THE CAUSES OF OBSOLESCENCE?

(a) Invention of new and better process / equipment
(b) Changes in Technology
(c) Changes in the demand for the product
(d) Legal implication
Note : Obsolescence does not include depreciation on account of wear
and tear.
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3.0 WHY IS IT NECESSARY TO ACCOUNT FOR OBSOLESCENCE?
(a) For bankers to lend appropriately
(b) To pay appropriate price at the time of purchase
(c) To pay appropriate tax by tax payers.

4.0 TYPES OF OBSOLESCENCE :

(a) Technological Obsolescence :
Technological obsolescence relates to the difference between the design
and materials of construction used in present-day machines compared
with the machine under appraisement. Size and overall floor space
requirements are other examples of technological obsolescence.

Examples :
1. Purchase of a Japanese Textile Printing machine for US
$250000/-. After three years it required replacement of IC.
The IC was no more manufactured and replacement of IC was
not available.

Thus in 3 years the machine became technically obsolete.

2. Other classic examples - Computer and IT related products and

electronics products.

(b) Functional Obsolescence :

Items of machinery and equipment are usually designed for or adapted
to a specific use. This can be defined as the highest and best use for the
subject item and the most profitable likely use to which property can be
put.

The opinion of such use may be based on the highest and most profitable
continuous use to which the property is adapted and needed or likely to
be in demand in the reasonably near future.

The ability of a property to be utilized at its highest and best use would
have some relationship to value.

Any utilization less than highest and best use would be a contributory
factor to depreciation because this represents a loss.

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 This limitation in use is functional obsolescence.

(c) Economic Obsolescence :

Economic obsolescence deals with influences external to the machine
itself. It is defined as the impairment of desirability or useful life arising
from economic forces, such as changes in optimum use, legislative
enactments which restrict or impair property rights, and changes in
supply-demand relationships. These factors, too, can be measured and
expressed in percentages of the subject machine’s productivity or
potential use.

It is possible for a machine to be 100 percent economically obsolete.

5.0 ACCOUNTING FOR OBSOLESCENCE :

If a person contemplating purchase of an existing improvement is not
concerned with the original cost or the current cost to create a replica of
the existing, but is only interested in the comparison between the subject
property and a new, state of the art, property of equal end utility, then to
make this comparison, the following information is required:
1. The cost of new plant of equal utility but with the latest in cost
saving technology, from a capital cost, as well as a production cost
basis.
2. The length of time it will take to create the new plant.
3. The anticipated life of the new plant and the existing plant.
4. The capital amount that will have to be deducted from the cost of
the new to equalize the investment in terms of anticipated life,
production costs, and costs of acquisition and holding.

6.0 CASE STUDIES :

6.1 CASE STUDY – I :
1 Bank requires valuation of Spinning Mill having:

Plant and machinery of a spinning mill established 5 years back for

spinning of the superfine yarn of 100s count as per demand prevailing
then.

Machines required to make 100s count installed in the plant, along

with Replacement Cost New are as under:

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 Name of machine Quantity Replacement Cost New
(US $ In million)
Blow room & mixing 1 0.24
Cards (high production) 4 0.19
Draw frame 2 0.04
Comber preparation 1 0.04
Comber 2 0.08
Speed frame 2 0.07
Ring frame 24 0.54
Winding 2 0.53
--------
1.73
--------

Above machines are five year old. Economic life of these machines
is considered to be 20 years; depreciated replacement cost works
out to –

1.73 x (15 / 20) = US $ 1.29 millions.

Market survey revealed that yarn of superfine counts of 100 are not
in demand but of 30s count are in demand

Banks advance to projects which are capable of repaying loan with

interest. In otherwords security offered must be capable of
generating income by which installment of principal amount and
interest can be paid.

In this case, it is worth while to note that plant is neither suffering

from technological nor functional obsolescence. But suffers from
economic obsolescence as the product is not in demand.

Since DRC of US $ 1.29 millions is not the value, then what is the
value? In order to answer this question we need to find out what
investment is required to make the plant suitable for manufacturing
yarn of 30s count.

For manufacture yarns of 30s count, the following additional

machines are required :

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 Name of machine Quantity Replacement Cost Price of second
of New Machine hand (12 years
(US $ In Million) old) machine
(US $. In millions)
Cards 4 0.19 0.10
(high production)
Draw frame 2 0.04 0.02
Comber 5 0.21 0.08
Speed frame 2 0.07 0.02
Winding 2 0.53 0.15
Miscellaneous
expenses for
conversion 0.04 0.03
------- -------
1.07 0.39
===== =====

In view of the facts mentioned above, a prudent buyer will not pay
US $ 1.29 millions (depreciated replacement cost) as it is not
capable of generating economic return.

In order to generate economic return, it is necessary to incur an

expense of installing additional machines. These expenses are
liability and need to be deducted from depreciated replacement
cost of US $ 1.29 millions.

In order to calculate deduction, the following fact needs to be

taken into consideration.

Proper deduction will depend on future market of yarn of 30s

count. If market is estimated to be of 5 years, and second-hand
machines in good condition are available which are capable of
working for the next five years without heavy cost of repairs, then
deduction of US $ 0.39 millions from depreciated replacement cost
of US $ 1.29 millions will be appropriate. If new machines are
required, the liability would be US $ 1.07 millions.

It is observed from above that, consideration of obsolescence is

very important from Banker’s point of view.
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6.2 CASE STUDY – II :
Let us consider an example of calendaring machines which were
purchased by a company in 1985, the description of the machine is given
below. The said machine is still operational but no longer manufactured
by the manufacturer. The latest model is available with better features.

Furnished below is the table showing specifications of Calendar Machines

under consideration and the latest calendar machine available in the
market.

It will be observed on comparison of the machines installed in the plant

and latest machine, that one latest machine replaces both the old
machines installed in the plant.

Sr. Description of machine Make Year of

No. (Technical Specifications) Supplier Manufacture

1 2 3 4

PLANT & MACHINERY

1. Calendar Line No. 1 Berstoff / 1985

Cap. : 450 Kgs. / Hr. Klockner Pentaplast
Speed : 30 Mts. / Min. Germany
comprising of
a) Weighing & Dosing Equipment Steimd, Germany
Cap. : 600 - 700 Kgs. / Hr.
b) Kneader Buss
Cap. : 500 Kgs. / Hr. Switzerland
Screw Dia. : 140 mm.
L/D : 11
c) Control Panel Obdenoff
d) Mixer with 3 HP Drive Motor Mixaco
e) Width : 1 Mtr. Germany

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 2. Calendar Line No. 2 Berstoff / 1985
Cap. : 1,000 Kgs. / Hr. Germany
Speed : 40 Mts. / Min. Tirupati
comprising of Vinyl
a) Weighing & Dosing Equipment Schenik &
Cap. : 2,000 Kgs. / Hr. Jension
b) Mixer Unit with 60 HP drive Neoplast Engg.
motor
Ahmedabad
c) Kneader Buss
Cap. : 1000 Kgs. / Hr. Switzerland
Screw Dia. : 140 mm.
L/D : 11
d) Control Panel Obdenoff
e) Width : 1.2 Mtr.

3 Calendar Line No. 3 (New) Berstoff / 1985

Cap. : 1,500 Kgs. / Hr. Klockner Pentaplast
Speed : 90 Mts. / Min. Germany
comprising of
a) Weighing & Dosing Equipment Steimd, Germany
Cap. : 3000 Kgs. / Hr.
b) Kneader Buss
Cap. : 1500 Kgs. / Hr. Switzerland
c) Control Panel Obdenoff
d) Mixer with 60 HP Drive Motor Mixaco
e) Width : 2.1 Mtr.

The Gross current replacement cost the latest machine (inclusive of all
direct and indirect cost) is US $ 17.5 million.

In order to compute obsolescence it is necessary to compare machines

under consideration with latest machine with regard to following;
a) Direct Wages
b) Fixed cost
c) Stores
d) Energy
e) Space
f) Down time

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6.2.1 Comparison of the Machines :
a) Comparison of Direct wages (No of Workers):
Name of the Machine Old New
Calendar Line No.1 5 --
Calendar Line No. 2 5 --
Calendar Line No.3 (New) -- 5

Note : The comparison of Direct wages shows that the latest technology
is cheaper by about 50% and hence the old machine has been
rendered obsolete from the view point of the wages.

b) Comparison of Consumption of Stores (figures in US $):

Name of the Machine Old New
Calendar Line No.1 5000 (per month) --
Calendar Line No. 2 7500 (per month) --
Calendar Line No. 3 (New) -- 1250 (per month)

Note: The comparison of stores shows that the latest technology is

cheaper by about 90% and hence the old machine has been
rendered obsolete from the view point of the stores.

c) Comparison of Energy (figures in units):

Name of the Machine Old New
Calendar Line No.1
Calendar Line No. 2 0.75 Units/ Kg. --
Calendar Line No.3 (New) -- 0.50 Units / kg.

Note : The comparison of Energy shows percentage difference of 33% &

technically much better, hence the old machine has been
rendered obsolete from the point of view of energy.

d) Comparison of space required :

Name of the Machine Old New
Calendar Line No.1
Calendar Line No. 2 16,000 sq. mtrs. --
Calendar Line No. 3 (New) -- 12,000 sq. mtrs.

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 Note : This comparison shows that the latest technology is cheaper by
about 25% and hence the old machine has been rendered obsolete
from the point of view of space requirement.

e) Down time (Calculating on per month basis):

Name of the Machine Old New
Calendar Line No.1 57.6 Hrs. per month
Calendar Line No. 2 --
Calendar Line No. 3 (New) -- 7.2 Hrs. per month

Note : This comparison shows that the latest technology is cheaper by

about 87.5% and hence the old machine has been rendered
obsolete from the point of view of Down time.

Summarized statement of overall comparison:

Sr. Description Old (%) New (%)
No.
1 Direct Wages 100 50
2 Fixed Cost 100 80
3 Store 100 10
4 Energy 100 66
5 Space 100 75
6 Down Time 100 12.5
------ ------
100 48.91
===== ====

The old machine suffers from a obsolescence factor of

(100 - 48.91) = 51.08

Price for the new machine is US $ 17.5 millions

.
. . Obsolescence = Replacement cost of x Obsolescence
New machine factor

= US $ 17.5 millions x 51.08 %

= US $ 8.939 millions
================

And machines are 22 years old. Total life is considered to be 30 years.

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 .
. . Depreciation = Replacement x Depreciation
Cost factor

= 8.939 x 22
----
30
= 8.939 x 0.7333
= 6.552
=====

.
. . Price at which = Obsolescence – Depreciation
Calendar lines No.1
& 2 can be purchased = US $ 8.939 millions Less US $ 6.552 millions

= US. $ 2.387 millions

=================

7.0 CASE LAW

In this case primarily involving the 1987 valuation for machinery and
equipment used for the production of tyres, it was undisputed that the
taxpayers’ plant was at all relevant times, continuously employed in
production of tyres at a maximum practical rate of production.

Following relevant facts were found by the Commission :

 The plant where the personal property under appeal was
originally located, designed and constructed as a bias tyre
manufacturing facility. The plant was converted to radial tyres in
1980. As of the valuation date 1st January, 1987 the plant was
exclusively used for production of radial tyres for passenger cars.
 The highest and best use of the machinery and equipment forming
the vast majority of the property under appeal was its continued
use in place for the production of radial tyres. Breaking up this
machinery and selling it off would yield only a fraction of its value
in use to the owner.
 The property at all relevant times, was in operation essentially 24
hours per day, 7 days per week producing radial passenger car
tyres.
 The tyres produced by the plant were of very high quality. Many
of these tyres were used as original equipment tyres on luxury
automobiles.
 The property suffered from no abnormal physical depreciation,
however, the taxpayer’s expenditures for repair, replacement,
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 and maintenance of the production machinery were abnormally
high.
 Of the three generally accepted approaches to value, the market
approach was not appropriate for the valuation of production
machinery, because the market for used equipment of this type
was primarily in third world countries. The Commission noted that
when such machinery is uprooted from the location where it has
been installed, the value of wiring, piping, plant layout and
design, and many other elements of value in use are lost. The
third world purchaser, who has pay to move the machinery, will
pay a price much lower than the value in use.
 The income approach was also inappropriate for this property,
though for different reasons. The Commission observed that such
machinery is generally not leased, but is owned by the user, who
purchases or constructs it and employs it to produce a product. An
income approach would be required to extensive use of the
owner’s internal cost accounting information, and a comparison of
this information with similar information from the owner’s
competitors. Such information is considered confidential by the
owners and is not readily available.
 The Country employing the cost approach had correctly
determined the replacement cost new of the property and made
an appropriate reduction to reflect physical depreciation. The
Country had erred, however in failing to further reduce the value
of the property to reflect Incurable Functional Obsolescence
affecting the production machinery and equipment.

The Commission noted that the plant where property was located
was constructed in 1966-67 and was originally designed as a bias
tyre plant. The capacity of the plant was expanded in 1970 and
again in 1972. In 1980 the plant was converted to the production
of radial tyres. Because of its history, the production of tyres at
this plant required substantially more labor than would be needed
at a modern ‘state of the art’ facility. While the machinery was
physically sound and operated at or near capacity, producing a
quality product, the Commission found that the high level of
output was achieved through use of a high level of labour input. In
addition, the Commission found that expenditures for repair,
replacement and maintenance were much higher than would be
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 found in a modern facility capable of achieving the same level of
output.

The Commission found that the obsolescence was clearly present.

8.0 CONCLUSION :
Consideration of obsolescence is very vital for bankers, purchasers,
taxpayers for their economic activity, and is also important for
insurance.

By
Sundeep Bikhchandani

References:-
(a) Economic obsolescence by Tom Johnstone
(b) Valuing plant and machinery by ASA
(c) Valuation of plant & machinery (Theory & Practice)
– K. P. Budhbhatti

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