Economic obsolescence

Economic obsolescence is defined as "the decrease in the value of an assets due to influences that are external to the subjects asset"(M.L. Zyla 2010, p. 125) or "loos in value of a property caused by factors external to the property"(G.R. Trugman 2017, p. 457).

The Economic obsolescence occurs when the asset cannot generate a sufficiently high rate of return over the potentially remaining useful life based on a given value. The Economic Obsolescence is considered by all economists as incurable and cannot be eliminated. It usually cannot be determined by physical control and is essentially the same for tangible and intangible assets (M.L. Zyla 2010, p. 125).

According to Gary's R. Trugman book, the external factors that causes decrease in property value are for example economic factors related to industry, such as the availability of financing, loss of required materials or loss of sources of work, increased cost of raw materials needed, increased competition or increased inflation. In his work he says that in order to check whether economic obsolescence occurs "a review must be made of the economics of the subject property and the industry in which it competes, as of the valuation date. The review can be made by examining the earnings history of the subject property and any local or other influences that may affect the economic perfomance the subject and its assets" (G.R. Trugman 2017, p. 457).

Causes of economic obsolescence

"The American Society of Appraisers lists common external causes of economic obsolescence as (M.L. Zyla 2010, p. 126):

• A declining industry
• Inability to get financing
• Loss of material or labor sources
• New legislation or ordinances Increases in the price of inputs without the ability to increase product prices
• Reduced demand for the product
• Increased competition
• Inflation or high interest rates".

Trugman says, that the factors determining the occurrence of Economic Obsolescence are (G.R. Trugman 2017, p. 458):

• "Reduced demand for the company's products;
• Overcapacity in the industry;
• Dislocation of raw material, supplies;
• Increasing cost of raw materials, labor, utilities, or transportation, while the selling price of the product remains fixed or increases at a much lower rate;
• Government regulations that require capital expenditures to be made with little or no return on the new investment raw material supplies;
• Environmental considerations that require capital expenditures to be made with little or no return on investment".

Types of Economic Obsolescence

There are 3 types of Economic Obsolescence (G.R. Trugman 2017, p. 458):

1. Item specific economic obsolescence-is defined as customer responses after subtracting physical and functional depreciation factors. It is measured on the market as items similar to those currently being sold;
2. Industry specific economic obsolescence-is associated with the industry in which the equipment operates. If the machine was operating in an industry where economics is good, an appraiser might conclude that the industry is standard and has no economic obsolescence. On the other hand, if the industry is in a bad economic situation it would be considered smaller than standard. In this case, there may be an economic penalty that is estimated in relation to other market companies that must compete for similar products or operations.
3. Business specific economic obsolescence-this is the factor in which the entity is measured by the analyst as an enterprise in order to demonstrate whether the profit can be in line with the values provided by the property appraiser and other property appraisers, assuming that the profit can be in line with the values given. If a company demonstrates that its earnings are not in line with the figures given, this factor of economic obsolescence as a percentage of this difference is the specific economic obsolescence. It is only important because it relates to continuous use consistent with market value for current operations.

Examples of Economic obsolescence

• Economic obsolescence can occur when technological advancements render an existing asset obsolete and unable to compete in the market. For example, the introduction of digital cameras has made traditional film cameras increasingly obsolete.
• Economic obsolescence can also occur when changes in consumer preferences render an asset less desirable or out of fashion. For example, the popularity of SUVs has led to a decrease in the demand for sedans, resulting in economic obsolescence for many car models.
• Economic obsolescence can be caused by changes in the macroeconomic environment, such as an increase in interest rates that makes borrowing to finance a purchase less attractive. For example, an increase in interest rates could lead to a decrease in demand for luxury cars, resulting in economic obsolescence for certain car models.
• Economic obsolescence can also be caused by changes in government policies, such as a new tax policy that affects the value of an asset. For example, a new tax policy that increases the cost of owning a certain type of property could lead to a decrease in demand for that type of property and result in economic obsolescence.

Advantages of Economic obsolescence

Economic obsolescence can have the following advantages:

• It can provide an opportunity to purchase assets at a discounted price, thus providing a potential for a higher return on investment.
• It can provide an opportunity to acquire a unique asset that may not be available through other means.
• It can provide an opportunity to acquire a technologically advanced asset that may have a longer useful life than other comparable assets.
• It can provide an incentive to businesses to innovate and develop new products or services that can replace an obsolete asset.
• It can drive competition in the market, as businesses strive to create better products or services that can replace obsolete assets.

Limitations of Economic obsolescence

Economic obsolescence can be a major limitation to any business or organization. The following are some of the limitations of economic obsolescence:

• Inability to predict future trends: One of the main limitations of economic obsolescence is the inability to accurately predict future trends. As technology and consumer preferences can change rapidly, it can be difficult to accurately anticipate how the value of an asset will be affected in the future.
• Lack of control: Economic obsolescence can be difficult to control as it is often out of the organization's hands. Factors such as changes in technology, consumer preferences, or market conditions can all lead to economic obsolescence.
• Financial consequences: Economic obsolescence can have serious financial consequences for a business. As an asset loses its value, the business can suffer from financial losses as the asset can no longer be sold for its original value.
• Increased competition: As technology advances, competition can increase. This can create additional pressure on businesses to remain competitive and can lead to economic obsolescence in some cases.
• Difficulty in assessing value: Economic obsolescence can be difficult to assess and quantify. Factors like technological advancements, consumer preferences, and market conditions can all impact the value of an asset, making it difficult to accurately assess the value of the asset.

Other approaches related to Economic obsolescence

The other approaches related to economic obsolescence include:

• Technological obsolescence - when technology advances, making the subject asset obsolete or inefficient.
• Market obsolescence - when the market for the asset changes due to changes in consumer preferences, competition, or industry dynamics.
• Physical obsolescence - when the physical condition of the asset deteriorates over time and becomes outdated.
• Functional obsolescence - when the subject asset fails to meet the needs of the current market.

In sum, economic obsolescence is a decrease in the value of an asset due to external factors, such as technological advancements, market changes, physical deterioration, and functional inadequacy.

Economic obsolescence — recommended articles

External obsolescence — Factor of production — Commercial facility — Factors affecting pricing — Barriers to exit — Goodwill — Price taker — Economic shock — Functional obsolescence

References

• Mettling S., Cusic D. (2019), Principles of Real Estate Practice: 6th Edition, Performance Programs Company, Tampa, p. 232
• Trugman G.R. (2017), Understanding Business Valuation: A Practical Guide To Valuing Small To Medium Sized Businesses, American Institute of Certified Public Accountants Inc., New York, p. 457-460
• Zyla M.L. (2010), Fair Value Measurements: Practical Guidance and Implementation, John Wiley & Sons Inc., Hoboken, p. 125-127

Author: Patrycja Czerwiec