Determining Life-cycle Costs

Determining whether or not it makes economic sense to buy one style of truck over another or even if it pays in the long term to upgrade a service truck’s transmission don’t have to be left to chance or gut instincts.

Using a technique called life-cycle analysis, a truck owner or fleet operator can plug relevant variables into a spreadsheet and compare the options side by side.

“I can even use this to actually come up with the optimum life cycle for a vehicle. That is a thoroughly complex process,” said Bob Johnson, then the director of fleet relations for the National Truck Equipment Association, during an educational session at the NTEA’s 2015 Work Truck Show last March in Indianapolis. (Johnson retired in October after 11 years with the association.)

Equipment manufacturers and distributors can also use life-cycle analysis to inform their purchasing decisions and even to “upsell” an accessory or alternative product that, for example, reduces maintenance costs, Johnson explained.

One way is to conduct that analysis is to use a spreadsheet program developed by the NTEA that looks at the time value of money, or what is known in financial analysis as “net present value.” The program employs a formula “which shows the return on investment associated with any given financial scenario.”

Because such a formula is often used in financial analysis, it generates numbers that a company’s budget people can understand, Johnson said. Manufacturers and distributors can also plug numbers into the program to show customers or potential customers that “If you do A, you can save B,” Johnson said.

Program helps identify strengths

It’s critical for a vendor or manufacturer to be able to identify the strengths of its products to a customer, Johnson said, noting that Lee Finley, founder of BrandFX Body Company, made a similar point in his earlier presentation at the session.

“There’s no ‘one size fits all’ format,” said Finley, whose company is based in Fort Worth, Texas. “You’re dealing with capital cost, operating expenses of all different types, capital costs of all different types of equipment, vehicle utilization situations, longevity of the product, disposal, recapture, how much you get for the vehicle when you sell it, and what’s the optimal period of time. There’s all kinds of issues, and cheap is not always the choice for initial cost.”

Finley said he had two major customers back in the 1980s that tried two different ways of lowering their life-cycle cost. One lowered his capital costs, the other raised them.

One company was willing spend more on a vehicle that could be remounted after seven years but the vehicle itself would last 21 to 25 years. The other company chose to downsize its chassis because it only wanted the chassis to last for 15 years.

“They both ended up achieving the same thing in different formats,” Finley said.

For fleets, the calculations are even more complicated because every fleet has different requirements, Finley said. For example, in one case, converting to gas from diesel reduced the capital cost of the chassis. In this day and age, Finley said, a company shouldn’t have to buy bigger vehicles than it needs.

“So, what’s the advantage of a diesel engine versus a gas engine? What’s the savings? What’s the lifetime maintenance of those types of engines?” Finley said.

Analysis takes cash flow into account

Johnson’s answer to that, when he stepped up to the podium later, is life-cycle cost analysis.

As defined by accountants, life-cycle analysis takes into account total cash flow as a critical component, Johnson said.

“Now, there are many of you sitting here saying, ‘How am I going to identify all these different numbers?’ The trick is to accurately identify the numbers that specifically apply in the situation you’re looking at. So you may only have to look at one or two numbers, as long as you pick out the right numbers,” Johnson said.

A common mistake, though, is that people “cherry pick” for only those numbers that support their program and preconceptions “and they tend to ignore others.”

Also, 99 percent of those who think they’re doing life-cycle cost analysis are actually calculating a simple return on investment. “It is a valid tool … but it’s not truly life cycle,” Johnson said.

For example, a simple return-on-investment calculation would be that a $5,000 expenditure saving $1,000 a year would be recouped in five years. But that doesn’t take into account that the value of the original $5,000 increases over that period. Money borrowed must be repaid to the bank with interest. Spending that $5,000 on a piece of equipment means it can’t be invested elsewhere to earn interest.

“You realistically have to assume that investment will earn a certain minimum rate of return,” Johnson said. “If I can’t earn that rate of return, I’m better off putting that money somewhere else.”

A key to the calculation is determining the net present value. Simply put, “a dollar in hand today is worth more than a dollar five years from now,” Johnson said. But it also requires knowing the minimum internal rate of return or IROR. That calculation differs between a business, which pays taxes, and a government agency, which doesn’t pay taxes.

“But the minimum acceptable rate of return for a business is typically equal to their weighted cost of long-term debt and equity,” Johnson said.

Cash worth more today than in future

At 10 percent interest or 10 percent internal rate of return, $1 five years in the future is worth about 27 cents today, Johnson said.

“If I take all the cash flows associated with the life cycle of a vehicle, calculate the present value from every expense at whatever point it occurs — one year, two years, three years, four years in the future, add all of this together and come back to Day 1, that is your net present value,” Johnson explained.

Almost any scenario can be made income-producing, he said, pointing out that in terms of cash flow, reducing the need to spend $1,000 is the same as creating $1,000 in income. The goal in any income-producing scenario, regardless of the rate of return, is to have a net present value of zero. For example, a rate of return of 10 percent with a net present value of $100 indicates that the rate of return can be bumped up, to say 11.5 percent, to produce a zero net present value, he said.

“What you can do is calculate the actual rate of return from all multiple investments, and the one that has the highest rate of return is the one that represents your best investment of funds, assuming you’re not otherwise constrained by things like regulatory requirements and needs of the business, things of that nature,” Johnson said.

A slide in his PowerPoint presentation gave the calculation for present value as follows: PV=Fn/(1+r)n where F is future value, n is number of years, and r is the rate of return.

It’s not necessary to remember this “critical” formula because it’s built into every spreadsheet program as well as the NTEA’s program, he said.

The NTEA spreadsheet has two versions: one for vehicles, and the other for property, plants, and equipment. Each of the two versions will value three scenarios.

In one example during his Work Truck Show presentation, Johnson compared the life-cycle cost of upgrading the transmission on a truck that the owner planned to keep for seven years with the life-cycle cost of replacing the transmission, which usually lasts five years.

“So the question is: Is it worth paying $1,100 up front to save $2,500 five years from now?” Johnson put it.

His answer took into account the $220 in annual straight-line depreciation, that the $2,500 includes 34 percent in taxes, and that the internal rate of return is 10.5 percent on the $1,100 for the transmission upgrade. As it turned out, the analysis showed that the upgrade would add $875 to after-tax cash flow and produce a net-present value of $278.90, ensuring an internal rate of return of at least 10.5 percent.

Because this analysis was just looking at the transmission, it didn’t include variables like fuel costs or the costs of the truck itself because they’re the same whether the upgrade takes place or not. (The analysis did include an extra $25 every two years to maintain the upgraded transmission for a bigger filter kit and extra fluid, for example.)

“That’s the entire analysis,” Johnson said. “I don’t need to worry about anything else. So you see, it can be quite simple.”

If, however, the analysis was looking at the impact of weight reduction, for example, the analysis would have to look at fuel and maintenance.

Analysis can compare different trucks

In another example, Johnson compared two options for purchasing a new truck. One is a low-cost truck (light duty cube body), the other a higher-cost option (plate aluminum body) but one that has double the life expectancy.

“So I’m going to run two cycles of the low cost option versus one cycle of the high cost option.”

Again he plugged in his assumptions, ignoring factors that won’t affect the analysis, such as the engine, chassis and transmissions — which are the same in both vehicles.

The first option (plate aluminum body) had an NPV of -$23,645.82, whereas the (light duty cube body, which needed two cycles) had an NPV of -$26,422.70.

“So the scenario with the least negative net present value is my best investment,” he said. It’s also important to compare the cash flows. In this example, the truck with the better net present value also has the smaller negative cash flow, both before and after tax, than the other option. (For the plate aluminum body, the pre-tax cash flow was -$35,969 and -$23,020 for after tax, and for the light duty cube body, those figures were -$48,105 and -$30,787 respectively).

But Johnson said he has also seen cases where cash flows were within a couple of hundred dollars but the NVPs were “significantly” different.

Income taxes also have a big impact on the cash-flow calculations — but only for businesses, Johnson noted.

For example, a dollar spent doesn’t actually cost a dollar because the amount is reduced by the tax paid, what Johnson called a tax shield. “That’s why an investment that makes sense for a government agency may not make sense for a private agency, and vice-versa,” Johnson said.

Resale value diminishes as trucks age

For that reason, manufacturers and distributors need to take into consideration whether the customer is a private or government entity when undertaking such an analysis to upsell a product.

Another difference is that government agencies don’t have depreciation, although they do have amortization, to write off assets as they age. At present, the Internal Revenue Service “is being nice to us” by allowing accelerated depreciation, sometimes in as little as one year. “That’s not going to last,” Johnson said. “We all know that. It’s going to go back to the old days when we had to depreciate over five, six, seven years.”

Another variable that Finley mentioned is that a truck of less than 33,000 pounds gross vehicle weight isn’t subject to federal excise tax. And a truck of less than 26,000 GVW doesn’t require a commercial driver’s licence.

“So there’s lots of reasons for buying the right size truck and the smallest truck that you need for the job it does,” Finley said.

He cited an example where his company put together a 10,000 GVW package that would normally require a 14,000 GVW truck. “Not only did we do that, we gave him the payload they required, we saved a dramatic amount of money on the chassis, a dramatic amount of money on the operating expense, and increased the vehicle utilization, which was the most important to him, dramatically,” Finley said.

Johnson and Finley also agreed that the resale value of truck is highest when it’s still relatively new as opposed to when it’s old, although Johnson used the term “salvage value” while Finley referenced the “dispostion” value.

“Operating vehicles beyond their optimal life cycle, which happens a lot in the industry, reduces the disposition value,” Finley said. “And a lot of people don’t care. They just run them until they drop, and then tow them in. So that’s a part of their particular formulas; it’s not the one that we recommend.”

Johnson said that while salvage value is “hugely critical” for a truck of about three years old, after 15 years it becomes of minimal impact.

“So if I want to keep it for three years, and get rid of it, I’m going to buy the truck for a higher resale value,” Johnson said. “I’m going to put options on it I don’t even need for my fleet, if I know it’s going to add to the resale value.”