There is a frequent diversion between value and cost when it comes to meaning in a business context and we need to understand how value relates to what an asset should cost. When is cost irrelevant and value more meaningful for use in a business decision? How do you use value as a concept for basing purchasing decisions on rather than the hard, accounting numbers which a set price or cost gives you?

Defining Cost

Cost is defined in numerous ways but, for practical decision making it typically is the price paid to acquire an asset. This is certainly what an accountant would consider to be cost, though we should note that cost is not just the price to buy an asset it is also the associated costs to put the asset into effective use within the business. In this case, cost includes the asset price, the cost of transportation and implementation along with costs of training how to use the item.

Defining Value

This is a difficult concept to define compared to cost. What should cost x may in fact be worth y and the two numbers are going to be very different. A way of defining value of an asset has been taken to be what someone is prepared to pay for the asset. Thus the market definition of cost and value are the same. However, rational decision making implies that a business does not simply buy an asset which will simply maintain its value, but that the business is using the asset to create something more valuable. In this instance, do you value the asset at what you paid for it, or do you value the asset at what it is worth to you?

This is the concept behind what economists term, “present value” – the actual economic benefit of an asset to your company.

Another way of looking at value and cost is to regard a transaction from the point of view of the seller – the seller has a price they are prepared to accept from you as the buyer. To the seller, the price they receive is the value they place on the asset being sold. The buyer will look to increase the value of that asset to realize further on in the process, and this brings time into the equation.

Net Present Value and Internal Rate of Return

Time passing impacts value – a dollar today is worth more than the promise of a dollar in a year’s time. The reason is because of the operation of risk – how certain are we that a dollar will be paid to us at a future date? Nothing is certain which is why the value of a dollar today has got to be worth more than the promise of a dollar paid to us at any future date. Inputting risk and time into the present value concept gives us Net Present Value (NPV) and Internal Rates of Return (IRR) techniques for evaluating asset purchases.

These techniques attempt to show the true value in today’s terms of what an asset purchase means to the business. In this respect, cost or price is not important as the determinant, but what value will be created by your use of the asset which is being bought. Negative NPV or below-threshold IRR mean the project should not be pursued, but more importantly, they give us a tool to compare multiple projects which are competing for the limited resources of our businesses.

Next time you look at a quote for work to be done, cost is going to be a headlining issue for you, but the real question you should be asking is not how much cost this will incur, but how much value will be created by acquiring the asset in question.

Author Bio: By Lawrence Reaves, a freelance writer for Galorath, Inc., a leading provider of cost estimation software. SEER by Galorath provides should cost modeling for software, hardware, electronics & systems, IT and manufacturing. Learn more at Galorath.com

Category: Business Management
Keywords: cost estimation software, understanding value, should cost modeling, SEER software, software