Probably one of the most important roles of any senior manager is to closely watch capital budgets. Inevitably, once the budgets are submitted for a fiscal period, management is committed to �stay the course� on capital expenditures and reduce them whenever possible. This is usually thought of as being fiscally prudent.
However, saving money by cutting back on capital expenditures can actually be detrimental to a company�s fiscal health. It is important to consider the true cost of equipment usage over a period of time. What may look good on paper actually could be substantially increasing a company�s overhead without knowing it. Most companies do not keep accurate records of all maintenance costs, downtime and cost of lost productivity as a result of downtime.
Let�s compare the story of two companies � we�ll call them A Corp. and B Corp. These two companies each decide to acquire Model J forklift at the beginning of the fiscal year. A Corp. believes it will save money by buying the forklift and depreciating the cost over five years. The reasoning is that the forklift will have a long economic useful life after it is depreciated.
On the other hand, B Corp. simply takes a five-year lease on the equipment. After five years, it leases new replacement equipment. Table 1 illustrates how these decisions look on paper.
At the end of the five-year term, decisions should be made. A Corp. must either keep the forklift or trade it in for a new unit or keep it as a spare and get a new unit. B Corp. has a few more options to choose from. It can return the equipment to the lessor or it may decide to get a new unit. It can also renew its lease at lower rental rates or buy the equipment from the lessor for its then-current market value. There are some questions that need to be discussed to make the determination as to which of the above options make the most sense:
1. Are maintenance costs remaining relatively constant or are maintenance costs beginning to escalate?
2. Has equipment downtime been increasing?
3. If there has been downtime, has it disrupted production?
4. If downtime exists, are you keeping spare equipment to fill in or renting units short term while other units get repaired?
5. Do you have lost productivity from workers because of downtime?
6. Would new equipment cost less to maintain?
7. Would new equipment reduce downtime?
8. Do you need this piece of equipment, or is it now surplus?
9. What has been the utilization rate of this piece of equipment compared to similar pieces of equipment in your fleet?
10. How do all of these issues affect the total cost of ownership?
11. Would a new piece of equipment offer better safety features?
Unfortunately, unless you keep accurate records for all maintenance costs, downtime and lost productivity, it will be very difficult to make a proper assessment of which decision would be the most cost effective. It may be easy to think if the forklift is still operational after five years and has been fully depreciated, then you should keep the unit rather than spend money for a new unit. But let�s analyze probable costs after the first five years. The estimated total cost of ownership for a forklift is as follows:
Acquisition Cost 10%
Operator Cost (labor and benefit) 60%
Fuel & Insurance 5%
Maintenance Cost 25%
If a unit has increasing downtime, the cost of your operator waiting for the forklift to get repaired can be costly. It can also affect productivity. If your solution is to have spare units available, these can become costly to maintain and inefficient to operate. When analyzing maintenance costs, there is generally a warranty covering the first year with new equipment. Maintenance may run approximately 60� per hour for year two, increase to $1.54 per hour by year five and further escalate to $3.85 by year 10.
If you originally purchased then traded in your original unit after five years and got a new unit, maintenance savings would be the same as listed above in Table 2.
Estimated maintenance costs per hour:
Year 1 Warranty Year 6 $2.00
Year 2 60� Year 7 $2.45
Year 3 90� Year 8 $2.90
Year 4 $1.20 Year 9 $3.35
Year 5 $1.50 Year 10 $3.85
Costs could get up to $ 7.00 per hour for units over seven years old if they have had heavy usage. Often, when an older unit breaks down, short-term rental units are brought in to do the work. These units can cost an additional $1,200 per month on top of costly repair bills.
There are other costs to consider. Five-year-old forklifts do not burn fuel as efficiently as new ones, thereby increasing the costs for fuel. Moreover, there are often costs stemming from idling a $45,000-salaried driver while an older machine is in the shop for more frequent repairs. A Corp. has neglected to figure in the loss of productivity for the department while its drivers and units are not being used. Older units are also more expensive to maintain when it comes to replacement parts for equipment that breaks down. Even finding replacement parts for older units sometimes becomes a problem.
Another cost stems from operator preferences. For example, when a plant has multiple units, an operator might prefer using one unit to another. This would cause one unit to be over utilized and another unit to be underutilized, creating more costs to one unit and fewer costs to the other unit. There should be a mechanism in place to ensure the appropriate utilization of each unit.
On closer inspection, it becomes evident that the expense of keeping old forklifts may be more than just the increased cost of maintenance. In fact, it makes little economic sense to keep a $25,000 piece of equipment in operation after it reaches its economic breakeven point, which is defined as the point at which it becomes more expensive to keep a lift truck than to replace it with a new unit. Owning allows equipment to languish unchecked for economic efficiency.
Now, let�s go back to B Corp. As you remember, B Corp. leased its forklifts for five years. At the end of five years, it returned the Model J to the leasing company and leased a new forklift. No B Corp. drivers were idled. Work schedules continued on time. There were no costly repair bills. The new machines are state-of-the-art, safer, more productive and more fuel-efficient. The same benefits would hold true if A Corp. established a replacement program for all of its units once they reach the determined economic breakeven point.
Life Cycle Replacement
Leasing can be an excellent tool to manage life cycle replacement. Leasing is simple and time-disciplined, creating a decision point for all units that are leased. Rather than deal with capital budget processes and attempt to justify replacing older equipment, a lease has a defined maturity date. It is an easy choice to replace the unit with another unit when the lease matures or renew the lease if it makes sense to keep the unit longer.
The key to a successful leasing program is to select lease periods of time that will match the optimal economic life cycle of the equipment, triggering a replacement decision that results in reduced total operating costs. Do not choose a term such as five years if in fact your equipment will receive heavy usage and will need to be replaced in less than five years. On the other hand, perhaps a term longer than five years makes sense for units that will receive light usage.
Does leasing make sense for all equipment? Of course not. Some units have a nominal use and will have a very long useful life. As a rule of thumb, units that reach their economic breakeven point in less than seven years probably should be leased, but units that receive little use should most likely be purchased.
Since 1990, Robert H. Rowland has served as senior vice president and sales manager with ICX Corporation. He can be contacted by e-mail at bobr@icxcorp.com or by phone at 216-328-8747.
