10.1 Cost Sources and Cost Components

Why the Cost Approach Earns Its Own ECO Area

AQB Content Area V — Cost Approach (ECO effective April 1, 2026) is a substantial scored block: about 12 items (10.9%) at Certified General, 15 items (13.6%) at Certified Residential, and 10 items (9.1%) at Licensed Residential. The approach is not a backup only for new construction. It is required thinking whenever you need to separate land from improvements, measure depreciation, support insurance or special-purpose problems, or test whether improvements contribute what they cost.

Core idea: A buyer will not rationally pay more for an existing property than the cost of acquiring an equivalent site and constructing equivalent improvements, less any loss in value the existing improvements already suffer (depreciation), subject to market timing, entrepreneurial reward, and the principle of substitution.

Formula Overview (Memorize the Structure)

The classic classroom and exam form:

Value (cost-approach indication) = Land (site) value + (Cost new of improvements − Accrued depreciation)

Equivalently:

Value = Land + Depreciated cost of improvements

Worked skeleton:

• Site value (sales comparison of lots): $100,000
• Replacement cost new of house + site improvements: $350,000
• Accrued depreciation (all causes): $70,000
• Depreciated improvements: $350,000 − $70,000 = $280,000
• Cost-approach indication: $100,000 + $280,000 = $380,000

If the stem omits land or forgets depreciation, the answer that adds only raw cost new to land (or ignores land) is usually wrong.

When the Cost Approach Is Strong vs Weak

Exam tip: Strength of the approach depends on reliability of cost new and depreciation, not on whether you “like” cost theory. A brand-new home with solid contractor costs can support a tight indication; a 90-year-old mixed-use building with unknown functional issues may not.

ECO V.a — Sources of Cost Information

The ECO lists three primary sources. You must know what each is, when it is preferred, and how it fails.

1. Cost Manuals

Cost manuals (and related software/services—historically Marshall & Swift and similar residential/commercial cost services) provide unit costs, component costs, and multipliers based on surveys of construction costs, adjusted by location, quality, and time.

Typical use:

• Select a building class / quality / style that matches the subject
• Apply base cost × floor area (or other unit)
• Add or adjust for features (HVAC type, elevators, basements, garages)
• Apply local and current-date multipliers so the manual reflects the subject’s market and effective date

Exam vignette pattern: An appraiser uses a national base cost without a local multiplier in a high-cost metro—critique is failure to reflect local cost levels.

2. Actual Costs

Actual costs are documented expenditures for the subject (or a highly similar project): contractor contracts, change orders, invoices, builder’s cost breakdown, or developer’s construction budget.

When actual costs help:

• Subject was recently built; books are complete
• Assignment needs support for a specific quality level the manual under- or over-states
• Specialty construction with thin manual coverage

When actual costs mislead:

• Owner was a builder who omitted profit and some overhead
• Owner performed sweat equity (labor not on books)
• Luxury upgrades or waste that the market will not pay for (cost ≠ value)
• Costs from three years ago without time adjustment to the effective date
• Costs include personal property, FF&E, or non-realty items

Exam rule: Actual cost is evidence of cost new, not automatic proof of market value. Superadequacies still need depreciation (functional) even if the owner paid for them yesterday.

3. Market-Extracted Costs

Market-extracted cost estimates cost new by analyzing what the market implies from recent construction and sales—often rearranging the cost-approach identity when land and sale price are known and depreciation is negligible (new homes).

Simplified extraction when depreciation ≈ 0:

Implied cost of improvements ≈ Sale price − Land value

Example: New house sells for $520,000; finished site value $120,000; minimal depreciation (days old).
Implied improvement cost (including entrepreneurial reward embedded in the sale) ≈ $520,000 − $120,000 = $400,000.

If GLA is 2,000 sq ft, unit cost ≈ $200/SF all-in. That unit can support costing similar new homes in the same market—often more persuasive than a distant manual figure when local builders are active.

When extraction is weak: Older sales with unknown depreciation, land value guesswork, or sales that include atypical concessions. You cannot “extract” a clean cost if half the price gap is obsolescence you have not measured.

Choosing Among Sources

ECO V.b — Cost Components

Cost new is not only lumber and nails. ECO expects direct, indirect, and entrepreneurial incentive, and (in the outline under cost components) recognition of reproduction vs replacement cost bases—those bases get full treatment in Section 10.2; here, build the dollar stack correctly.

Direct (Hard) Costs

Direct costs (hard costs) are expenditures for labor and materials used in the physical construction of the improvements—work and materials that become part of the building or site improvements.

Examples:

• Foundation, framing, roofing, exterior finishes
• Plumbing, electrical, HVAC installed in the building
• Interior finishes, millwork, built-in appliances that are real property
• On-site concrete flatwork, attached garage structure
• Contractor’s on-site supervision often treated within the construction contract (classification can vary by source—follow the stem)

Indirect (Soft) Costs

Indirect costs (soft costs) are expenditures necessary to the project that are not the physical building materials/labor themselves.

Examples:

• Architectural and engineering fees
• Building permits, impact fees, inspection fees
• Appraisal, legal, and accounting fees during development
• Construction loan interest and fees during the construction period
• Property taxes and insurance during construction
• Marketing / leasing costs to achieve occupancy (when part of creating the real property product—context matters)
• Overhead not embedded in the hard-cost contract

Worked split:

Builder’s construction contract (labor/materials): $280,000 → largely direct.
Architect/engineer: $18,000; permits/fees: $12,000; construction-period interest and taxes: $15,000; other soft: $5,000 → indirect = $50,000.
Subtotal hard + soft = $330,000 before entrepreneurial incentive.

Entrepreneurial Incentive vs Entrepreneurial Profit

Exam distinction (high yield): Incentive is what the market requires going in; profit is what the developer got coming out. Cost-approach cost new typically includes a market-supported incentive percentage or amount so “cost” reflects a complete development outcome, not a nonprofit build.

Worked incentive:

Hard + soft costs = $330,000.
Market entrepreneurial incentive for this product type = 10% of hard + soft (some markets apply incentive to total project including land—read the stem).
Incentive = $330,000 × 0.10 = $33,000.
Cost new of improvements = $363,000.

If the project later sells and residual profit is only $10,000, that ex post profit does not rewrite the cost approach unless you are analyzing a completed sale’s residual; for prospective cost new, use incentive, not last year’s lucky or unlucky profit.

Full Cost-New Stack (Teaching Model)

1. Direct (hard) costs
2. • Indirect (soft) costs
3. • Entrepreneurial incentive
4. = Cost new of improvements (reproduction or replacement basis—Section 10.2)
5. − Accrued depreciation (physical + functional + external)
6. • Site value
7. = Cost-approach value indication

Some models show site value first; order of presentation varies. Algebra is the same.

Worked Full Example

Subject: One-year-old ranch; site value $90,000.
Direct costs (current): $240,000
Indirect costs: $35,000
Entrepreneurial incentive: 12% of (direct + indirect) = 0.12 × $275,000 = $33,000
Cost new: $240,000 + $35,000 + $33,000 = $308,000
Accrued depreciation (minor physical + negligible other): $8,000
Depreciated improvements: $300,000
Indication: $90,000 + $300,000 = $390,000

Cost New vs Price vs Value (Link to Earlier Chapters)

• Cost is the dollar outlay (or market-required outlay) to create improvements.
• Price is what was paid in a transaction.
• Value is the opinion of worth under a defined type of value (usually market value).

The cost approach uses cost as an input to indicate value. It does not claim that historical cost equals value. Over-improvement (superadequacy) can have high cost and low contribution—functional obsolescence handles that in later sections.

Site Improvements vs Building

Do not bury everything in one lump if the stem separates them:

Common Exam Traps

• Using only hard costs as cost new (omitting soft costs and incentive).
• Treating assessed improvement value as cost new.
• Equating actual cost paid by an owner-builder with complete market cost new.
• Adding land cost basis (what the owner paid years ago) instead of current site value.
• Forgetting that cost manuals need local and time adjustments.
• Calling entrepreneurial profit the same as incentive without reading the stem’s definitions.
• Reporting cost new as the value opinion without subtracting depreciation or adding land.

Process Checklist (ECO V.a–b)

1. Confirm the cost approach is applicable and define the improvement being costed.
2. Select cost source(s)—manual, actual, market-extracted—and support them.
3. Build direct costs completely.
4. Add indirect costs the market would incur.
5. Add entrepreneurial incentive on a market-supported base.
6. State whether cost is reproduction or replacement (next section).
7. Measure depreciation, add site value, reconcile to an indication.

Master the formula and the cost stack first. Section 10.2 decides which cost new you are measuring—exact replica or modern equivalent—and Sections 10.3–10.4 start subtracting what the market will not pay for.