Use Life-Cycle Cost Analysis to Get the Most from Your Budget

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

In far too many cases, these decisions are based on educated guesses or are driven by external decision-makers with their own agendas. One of the best financial analysis tools available for making these types of decisions is the net present value (NPV) life-cycle cost analysis. Instead of relying on guesswork, a NPV life-cycle cost analysis determines the true total cost of each alternative.

Although fleet managers have used life-cycle cost studies for years, they often only consider direct cash flow. For example: If I spend $1,000 today, I will save $250 a year, which means I will recoup my investment in four years. However, there are two faults with this kind 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’s 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 $1 at some point in the future is worth less than $1 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 value of a series of related expenditures spread over a period of time is called 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 reduce tax liabilities — an effect known as a tax shield. For example, if your entity has a total effective tax rate of 30 percent, $1 of ordinary expenses only costs $0.70 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.

Here’s a very basic example of a tax shield. Let’s say that 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 that your net income will be $810, so the additional $100 expenditure actually only 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 very significant to the bottom line.

Using an after-tax NPV life-cycle cost analysis

Admittedly, most fleet managers are not familiar with this type of financial analysis, but available spreadsheet programs can perform the calculations. 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. However, your financial team is probably very familiar with the concept. If you are in a position to work with them, you may be able to use this analysis to justify additional funds when needed.

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 standpoint. Some NPV life-cycle cost spreadsheet programs, such as the NTEA’s Vehicle Life-cycle Cost Analysis Program will also show your annualized cash flows. If the NPVs of two options are very close, these annualized cash flows may 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. For example, you may be considering upgrading a new truck to make it more productive. If the operations associated with the existing truck incur a significant amount of labor overtime, the increased efficiency may eliminate that overtime. The loaded overtime rate (say $50 per hour), times the total hours of overtime eliminated (say one hour per day multiplied by 260 days per year), generates a direct labor savings for the company which can be treated as additional revenue. Using these numbers, the annual savings (revenue) would be $13,000.

If you can increase the productivity of a new unit to the point that it will replace two existing units, the potential savings (revenue) may be even greater because you will be eliminating the total labor costs of a driver (and possibly an assistant), as well as the maintenance and operating costs of the second truck. The opposite of this scenario applies when members of 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 when it reduces total life cycle expenditures. For example, 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, your 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. Therefore, the cost reductions (revenues) associated with the new unit will be $7,000 per year.

Of course, the actual bottom line in these examples is not always simple. 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. However, a properly applied NPV life-cycle cost analysis will take all of these factors into consideration to determine the true costs of each option.

Ranking alternatives

If you have a number of 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 rates of return can then be used to rank the alternatives. For example, let’s say 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:

Project       Cost        Actual ROI       Target ROI

1              $150,000       18.2%               15.4%

2              $100,000       20.3%               15.4%

3              $ 75,000        12.9%               15.4%

4              $ 25,000        14.6%               15.4%

5              $100,000       15.1%               15.4%

      Total: $450,000

In this case, Project 2 has the highest return on investment (ROI) at 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 perfectly valid, and necessary. Unless there are some overriding requirements, such as regulatory compliance, the next project funded should be Project 5, at 15.1 percent. Lacking an ROI analysis, you may 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 that finance teams normally expect from the typical fleet manager, it can be used to maximize your limited budget, increase your professionalism, and possibly obtain additional funding.

 

About the Author: 

Bob Johnson

Bob Johnson is a former fleet manager and currently serves as the director of fleet relations for the National Truck Equipment Association. To learn more about this topic, attend the “Making Vehicle Investment Decisions Using Life-cycle Cost Analysis” session on March 7 at The Work Truck Show 2012, March 6-8, 2012, in Indianapolis. Register at www.ntea.com. To order the NTEA Vehicle Life-cycle Cost Analysis Program (item #1226), click “Shop NTEA” at www.ntea.com.