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Cost based IP valuation is one of the easiest method from implementation point of view as the data
needed for doing the valuation are easily available. In our earlier post we have discussed how we do
Income based IP Valuation. In cost based IP valuation the value of the IP is equal to the cost one needs
to incur to develop the IP. The cost has two parts namely direct cost and indirect cost.

Direct cost involves

  • Cost of people fully involved in IP development
  • Cost of manufacturing to verify the IP in an application
  • Cost of dedicated tools, hardware infrastructure dedicated for the IP development

  • Management overhead for development of IP
  • Shared infrastructure overhead for IP development
  • Sales and marketing cost to launch the IP and in the market and realizing its sales across various customers

Now let’s see how we can calculate few of the above costs

Cost of people fully involved in IP development = (salary of the employees + overhead cost per
employee) x number of employees involved in IP development

Cost of dedicated tools = Tools license cost x license months used to develop the IP + cost of team
required to install and maintain those tools

Cost of shared infrastructure = Cost of tools or infrastructure x duration of the tools needed for IP

Once the total cost of the IP development is calculated that needs to be multiplied by opportunity cost
due to delayed and denied market entry for the IP. The effect of delayed market entry can be calculated
as a ratio between market share achievable today to the market share achievable once the IP has been
developed in-house. Denied market entry will come from the probability of coming a new standard or
new technology which will make the IP redundant

The valuation method is quite useful at the early stage of technology development when other
methods are not useful due to lack of data on market potential of the technology, average license price
customers would like to pay etc.

Also the method is suitable for valuing IP used for internal consumption as also in that situation the
other methods (like income based valuation/ option based valuation) is not applicable

Relief from Royalty:

Another key methods used by companies is relief from royalty method. In the relief from royalty method
the firms try to estimate the amount which they need to pay to the market if he does not hold the IP.
The amount payable in the market can be in the form of license fee as well as royalty.

The value of the IP = discounted present value of the forecasted license fee and royalty fee to be paid

License fee to be paid = license fee for each component of the IP x number of such components to be

Royalty fee to be paid = royalty rate x sales volume in a particular year

For example let us assume that the firm has to pay an amount of ‘x’ as license fee today to acquire
license right of an IP. It will take 2 years to make the product and launch the product in the market using
the IP. The product has lifetime of 3 years and the expected sales volume are V1, V2, V3. The royalty rate
is ‘y’ per product and needs to be paid at the end of the year. The opportunity cost of capital is ‘r’

Then using the relief for royalty method the IP value will be equal to

IP Valuation Cost Based Formula