What is Cost Approach?
IFRS 13.B8 defines the cost approach as a technique that reflects the amount required to replace the service capacity of an asset (often referred to as current replacement cost). The buyer in an orderly transaction would not pay more for an asset than the cost to acquire or construct a substitute of comparable utility. That ceiling is the logic behind the method.
The gross replacement cost is only the starting point. IFRS 13.B9 requires the entity to adjust for physical deterioration (wear and tear), functional obsolescence (the asset's design is outdated relative to modern equivalents), and economic obsolescence (external factors that reduce demand for the asset's output). The three adjustments convert gross replacement cost into a measure that reflects what a market participant would pay for the asset in its current condition, location, and economic context. ISA 540.13(a) requires the auditor to evaluate whether the estimation method is appropriate for the item being measured. Where a quoted price or active market exists, the cost approach is rarely the best technique. It comes into its own for specialised assets (custom-built plant, purpose-designed production lines) where neither comparable transactions nor reliable cash flow projections exist.
Key Points
- The cost approach answers one question: what would it cost today to replace the asset's remaining service capacity from scratch?
- Replacement cost must be reduced for physical deterioration, functional obsolescence, and economic obsolescence before it qualifies as a fair value measure.
- IFRS 13.62 permits the cost approach alongside the market approach and the income approach; the entity selects whichever technique maximises the use of relevant observable inputs.
- Inspectors most often flag insufficient documentation of the obsolescence adjustments, not the gross replacement cost itself.
Worked example: Dupont Ingénierie S.A.S.
Client: French engineering services firm, FY2025, revenue €92M, IFRS reporter. Dupont acquired a competitor in 2023 under IFRS 3, and the purchase price allocation identified a specialised calibration facility in Lyon. No comparable market transactions exist for calibration facilities of this specification. The income approach is unsuitable because the facility does not generate cash flows independent of Dupont's broader operations. Management applies the cost approach to measure the facility's fair value at acquisition date.
Step 1 — Estimate gross replacement cost
Dupont obtains a quantity surveyor's report. Constructing an equivalent facility at current material and labour rates in the Lyon metropolitan area would cost €4,800,000, including site preparation, structural work, HVAC, and specialised clean-room installations.
Documentation note: record the surveyor's name, report date, and scope of the estimate. Reference IFRS 13.B8 for selection of the cost approach. Attach the surveyor's report as supporting evidence per ISA 500.6.
Step 2 — Adjust for physical deterioration
The facility was built in 2016. Based on a 30-year structural life, 9 years of physical wear have elapsed. The surveyor estimates physical deterioration at 22% of gross replacement cost (factoring in a 2021 roof replacement that extended certain components). The deduction is €1,056,000.
Documentation note: record the useful-life assumption, the basis for 22% rather than a straight 30% (9/30), and the effect of the 2021 refurbishment. Cross-reference to the asset register for the refurbishment capitalisation.
Step 3 — Adjust for functional obsolescence
Current building standards require higher-grade insulation and energy recovery systems that the existing facility lacks. Retrofitting would cost €180,000. A market participant would pay less for the facility because it does not meet the current specification. Functional obsolescence deduction: €180,000.
Documentation note: record the nature of the functional shortfall, the retrofit cost estimate (sourced from the surveyor), and the rationale for treating the full retrofit cost as the measure of functional obsolescence per IFRS 13.B9.
Step 4 — Assess economic obsolescence
Dupont's finance team evaluates external factors. Demand for third-party calibration services in France grew 4% in 2025, and no regulatory changes threaten the facility's permitted use. Management concludes that no economic obsolescence adjustment is warranted.
Documentation note: record the market data supporting the nil adjustment. Where the auditor disagrees, ISA 540.18 requires documentation of the alternative assumption and its effect on the fair value estimate.
Conclusion: the fair value of the Lyon calibration facility under the cost approach is €4,800,000 less €1,056,000 (physical) less €180,000 (functional) less €0 (economic), producing €3,564,000. The measurement is defensible because the gross replacement cost rests on an independent surveyor's report, each obsolescence adjustment is separately quantified and sourced, and the absence of comparable transactions or independent cash flows justifies the selection of the cost approach.
Why it matters in practice
Teams apply a single blanket depreciation percentage to gross replacement cost without distinguishing between physical deterioration, functional obsolescence, and economic obsolescence. IFRS 13.B9 treats these as separate adjustments because they originate from different causes and require different evidence. Collapsing them into one figure obscures the analysis and makes it harder for the auditor to test each component under ISA 540.13(b).
Entities select the cost approach for assets that do have observable market transactions, then fail to explain why the cost approach is more representative than the market approach. IFRS 13.61 requires the entity to use valuation techniques that maximise the use of relevant observable inputs. Choosing cost over market when comparable data exists inverts that hierarchy and draws scrutiny from reviewers.
Cost approach vs. [income approach](/glossary/income-approach)
| Dimension | Cost approach | Income approach |
|---|---|---|
| Core question | What would it cost to replace this asset's service capacity today? | What is the present value of the cash flows this asset will generate? |
| Best fit | Specialised physical assets with no active market and no separable cash flows | Income-producing assets with identifiable, projectable cash flows |
| Primary inputs | Current construction or acquisition costs, surveyor reports, obsolescence estimates | Cash flow forecasts, discount rates, growth assumptions |
| Key audit risk | Obsolescence adjustments are subjective and often underdocumented | Discount rate selection and terminal value dominate the output |
| Observable-input level | Typically Level 3 (gross cost may be Level 2, but obsolescence adjustments are unobservable) | Typically Level 3 (management cash flow projections are entity-specific) |
The distinction matters on purchase price allocations. When IFRS 3 requires the acquirer to measure identifiable assets at fair value, teams default to the income approach for everything. For specialised property or plant with no independent revenue stream, the cost approach produces a more supportable result because it avoids forcing a cash flow allocation that the asset's economics do not support.
Related terms
Frequently asked questions
When should I use the cost approach instead of the income approach?
The cost approach fits assets whose value comes from their physical service capacity rather than from the cash flows they generate independently. Specialised plant, purpose-built facilities, and infrastructure assets with no separable revenue stream are typical candidates. IFRS 13.B9 directs the entity to the cost approach when replacement cost best represents the amount a market participant would demand to acquire a substitute asset of comparable utility.
Does the cost approach apply to intangible assets?
Rarely in practice. IFRS 13.B8 does not exclude intangibles, and the cost approach can theoretically measure assembled workforce or proprietary software by estimating recreation cost. ISA 540.13(a) requires the auditor to evaluate whether the method is appropriate, and for most intangibles the income approach better captures the asset's value because the cost to recreate a brand or customer list bears little relation to its market worth.
How do I document obsolescence adjustments in the audit file?
Record each adjustment category (physical, functional, economic) as a separate line with its own evidence trail. For physical deterioration, link to the asset's age, condition report, and any capital maintenance that extended its life. For functional obsolescence, attach the retrofit or redesign cost estimate. IFRS 13.91 requires disclosure of the valuation technique used and the significant inputs, so the working paper should mirror those disclosure categories.