Getting the Most from Your Limited Budget Through Life-cycle Cost Analysis

Financial constraints often force fleet managers to make tough equipment decisions. Should I repair a vehicle or replace it? If I do repair it, how much work should I do: just enough to get by or a complete overhaul? Is it better to replace two low-cost units or one higher-cost unit?

Ntea

By Robert Johnson

Financial constraints often force fleet managers to make tough equipment decisions. Should I repair a vehicle or replace it? If I do repair it, how much work should I do: just enough to get by or a complete overhaul? Is it better to replace two low-cost units or one higher-cost unit?

In too many cases, the answers to these questions are based on educated guesses or are driven by external decision-makers with their own agendas. One of the best financial analysis tools available to fleet managers for making decisions of this nature is the net present value (NPV) life cycle cost analysis. Instead of relying on guesswork, and not being able to fully defend your position, a NPV life-cycle cost analysis will show you the true total cost of each alternative.

Many fleet managers have used life-cycle cost studies for years. Unfortunately, the usual study only considers direct cash flows. A typical logic thread might be something such as: If I spend $1,000 today, I will save $250 a year, which means I will recoup my investment in four years. There are two faults with this type of analysis. First, it does not consider the time value of money. Second, decisions made by a fleet manager working for a tax-paying entity have a direct impact on the taxes the entity pays. An after-tax NPV life-cycle cost analysis addresses both of these issues.

What is the Difference?

The time value of money is directly related to an entity's cost of money. A tax-paying business' cost is normally considered to be its minimum acceptable internal rate of return. For a government agency, it is typically the weighted cost of debt-direct loans, bonds, etc. This cost of money, which is normally expressed as a percentage, means that one dollar at some point in the future is worth less than a dollar in hand today. For a given cost of money, the current value of a dollar at some point in the future is known as its present value. The total present values of a series of related expenditures, spread over a period of time, is referred to as the net present value.

If an entity pays taxes, the fleet manager must also consider the true bottom-line cost of an expenditure after taxes. Ordinary expenses reduce gross income, which in turn reduces tax liabilities. This effect is known as a tax shield. If your entity has a total effective tax rate of 30 percent, for example, a dollar of ordinary expenses costs 70 cents after taxes. Capital expenditures, on the other hand, must be depreciated over a period of years, so the NPV of the series of depreciation allowances is less than the actual capital expenditure.

The following is a basic example of a tax shield. Assume your business has a tentative gross profit of $1,000 for a period, and the effective tax rate is 10 percent. That means that you will owe $100 in taxes for the period, leaving you with a net income of $900. If you incur an expenditure of $100, your gross profit will drop to $900 and your tax liability will drop to $90. That means your net income will be $810, so the additional $100 expenditure actually costs you $90 after taxes. Many businesses have total effective tax rates in excess of 40 percent to 50 percent, so the impact of a tax shield can be significant to the bottom line.

Using an After-tax, Net Present Value, Life-cycle Cost Analysis

Most fleet managers are not familiar with this type of financial analysis, but available spreadsheet programs perform the calculations once the necessary information is entered. The biggest issue the fleet manager faces with this type of analysis is that it documents the total cost to the entity, as opposed to just the fleet manager's budget. Your financial department is probably familiar with the concept, so, if you are in a position to work with them, you might be able to use this type of analysis to document your stewardship of the entity's budget and get additional funds when justified by your analysis.

When you make an NPV analysis of a series of expense options, the NPVs of the various alternatives will be negative. The option with the least negative cost is the best alternative from a purely financial point of view. Some NPV life-cycle cost spreadsheet programs, such as the National Truck Equipment Association's (NTEA's) Vehicle Life-cycle Cost Analysis Program, will also show your annualized cash flows. If the NPVs of two options are close, these annualized cash flows might be more important than the total cost.

In the case of revenue-producing alternatives, the NPV will be positive if the alternative being considered is earning more than the established cost of money and negative if it is earning less. An alternative can be revenue-generating even if there are no direct income flows associated with it. You may, for example, be considering upgrading a new truck in such a way that it will be more productive. If the operations associated with the existing truck incur a significant amount of labor overtime, the increased efficiency might eliminate that overtime. The loaded overtime rate ($50 per hour, for example), times the total hours of overtime eliminated (one hour per day x 260 days per year, for example), generates a direct labor savings for the company that can be treated as additional revenue. Using the hypothetical numbers stated, the annual savings (revenue) would be $13,000.

If the productivity of a new unit is increased to the point it will replace two existing units, the potential savings (revenue) may be greater since you will eliminate the total labor costs of a driver and possibly a helper, as well as the maintenance and operating costs of the second truck. The opposite of this scenario applies when people in your entity want to downsize a vehicle to reduce fuel costs. If this downsizing increases overtime or forces the addition of a second vehicle to get the work done, the fuel savings will probably be less than the other costs incurred.

Even replacing a high-cost unit with a new unit that has a lower life-cycle cost can be considered revenue-producing, since it may reduce total life cycle expenditures. If you have a vehicle with a lifetime average operating cost of $1.50 per mile and the truck runs 15,000 miles per year, for example, annual costs will be $22,500. A new, more fuel-efficient vehicle may have a projected average annual operating cost of $1.10 per mile, or $16,500 per year. The cost reductions (revenues) associated with the new unit, therefore, will be $7,000 per year.

As we have seen, the actual bottom line in these examples is not without some complexity. If you work for a tax-paying entity, the reduction in labor payments will eliminate a tax shield. In addition, the cost of the upgraded vehicle must be depreciated over time as opposed to being treated as a one-time expense. In all cases, the carrying costs-time value of money-must also be taken into account. A properly applied NPV life-cycle cost analysis, however, will take all these factors into consideration and the true costs of each option.

Ranking Alternatives

If you have many revenue-producing alternatives and only enough money to fund part of them, you can perform an NPV analysis and determine the actual return for each alternative. The individual return rates can then be used to rank the alternatives. Assume, for example, that you have five projects with a total cost of $450,000, but you have only been allocated $360,000. An NPV analysis provides the following information:

In this case, Project 2 has the highest return on investment (ROI) (20.3 percent) and should be funded first. Next would be Project 1 at 18.2 percent. The remaining projects are returning less than the desired ROI, but may still be valid and necessary. Unless there are overriding requirements, such as regulatory compliance, the next project funded should be Project 5, at 15.1 percent. Lacking an ROI analysis, you might have been tempted to fund Projects 3 and 4, which have the same total cost as project 5, but provide a lower ROI.

Learning More

Although documentation of your operations with accurate NPV cost studies is not something finance people normally expect from the typical fleet manager, it is a means to:

• Maximize the utilization of your limited budget,
• Increase your professionalism, and
• Possibly obtain additional funding.


About the author: Robert Johnson is a former fleet manager and currently serves as director of fleet relations for the NTEA, the Association for the Work Truck Industry.

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