What Makes Up a Rate ?
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Calculating Interest on Capital Outlay, with Special Reference to Operating Costs and their Application to a Rates Schedule
IHAVE found from experience, that it is never wise to be too dogmatic when dealing with inquiries on costing. I have many times said that I am not so much concerned with the method of cost recording, as I am in ensuring that all the items of cost are properly entered in some way or other.
What I am alWays concerned about is that nothing should be omitted, as any omission obviously tends to give the operator the idea that his costs are less than they really arc. If he makes that mistake, he is the more likely to underquote for a particular job. Many operators are charged with the crime of rate cutting, whereas they may he innocent of the charge. As I pointed out in my article in last week's issue of "The Commercial Motor," if there be no agreed rate, there can be no charge of rate-cutting. In those circumstances, all that a haulier is expected to do is to quote a rate which is profitable to him.
That is only reasonable, for if a man, by the exercise of efficiency and economy in the administration of his business, can reduce his overall costs to something less than average, he is surely entitled to. make use of that advantage when quoting for any work in competition with other hauliers. Although I have, in the general interest, given my support to schemes of rates standardization, there has always been some little doubt in my mind as to whether the idea of standard rates is so good as some people would appear to think.
. No Provision for Interest
This somewhat long preamble arises from some correspondence which I have had recently with a north-country haulier, who makes a good living out of his business. The inference that can be drawn from this is that he is not rate cutting in so far as the term would imply that he is working at a loss, or for insufficient profit. When he gave me details of his operating costs, I noted that no provision was made for interest on capital outlay on his vehicles. In reply to my inquiry as to his usual practice in regard to this matter he advised me that he kept his vehicles for five years. and depreciated them evenly over that period, so that at the end of the fifth year they, were written off. He then sold them and set the sum acquired from the sale against whatever he might have lost by not keeping an account of the interest on the capital outlay.
He felt, he said, that he was the more justified in taking this attitude, because he was acquiring his vehicles by hirepurchase. That meant that the initial outlay was comparatively small. He quoted an example of a vehicle costing. on a cash basis, £701. The period of the hire-purchase was one year, and the initial outlay about £240. At the end of five years, even if used-vehicle prices had gone back to normal, he reckoned he would get about £50 for the machine. and he thought that it was reasonable to set that sum against the interest on £240 for five years.
The two points which arise are, first, the importance of being reasonably accurate in costing, and, secondly, that the item interest on capital outlay," to be inserted in the
records of operating costs, is entirely distinct from the interest involved in hire-purchase transactions. and should be recorded quite differently.
Before I can properly discuss these points, I must first of all establish once more what is meant by interest on first cost, and how, according to circumstances, it should be calculated.
Interest on first cost 's the annual amount that would be earned by the money spent upon the vehicle had such money been invested in some trustee stock. I have had many arguments with operators as to the percentage to be charged. Nowadays, 3 per cent. is generally agreed as being fair. To put this in simple terms: interest, regarded as an item of operating cost. is calculated on the assumption that if the operator had not spent the money on a vehicle, hut had invested it elsewhere, it. would have earned him 3 per cent. per annum without the haulier himself doing any work, or taking any risk.
Take as an example a vehicle costing £1,000. The interest on that at 3 per cent 'per annum is £30. The point to note is that, until the operation of that vehicle has returned that £30 pei annum, it does not show a real net profit to its owner.
I have stated that the method of calculating this interest depends upon the circumstances. There are two ways in which the calculation may be tnadc, according to Wiether or not the operator establishes a sinking fund for the purchase of a new vehicle when the old one is completely depreciated. If, for example, a vehicle costs £1,000 and is to be depreciated over five years, and the operator puts £200 per annum into a sinking fund, then at the end of five years he will have sufficient to purchase a new machine.
Sinking Fund Bears Interest
If he does that the sinking fund itself will return interest to the operator and, to be strictly correct, that amount should be set against the original £30 per annum which has been shown to be the proper sum to be debited as interest on first cost.
At the end of the first year the sinking fund will be £200, which, during the ensuing year, that is the second year, will earn interest at the rate of 3 per cent. The return from that investment will be £6, which may be offset against the £30 interest on first cost.
At the end of the second year, the sinking fund will have risen to' £400, and during the third year the interest will be £12, reducing the interest on first cost to £18, and so on, year by year. Where this procedure is followed, and if it be desired, for accountancy purposes, to write down the interest on first cost as it will be as diminished by the interest of the sinkingfund cost. it is better to establish an average figure.for.the interest on first cost rather than to attempt to depreciate
the amount year by year. To that end the following formula should be used:—
Where L is the assumed life of the vehicle in years. , P. the capital sum invested. and C the rate of interest.'
Taking the same vehicle costing £1,000, having a life of five years, with 3 per cent. as the rate of interest, the formula gives the average amount per annum to be debited on account of interest as £18 instead of £30.
If the operator does not establish a sinking fund, and few do. then the full amount of £30 per annum must be debited each year.
Except for the need of accuracy in schedules of operating coSts, it might be politic to ignore the amount. In the case of a £1,000 vehicle, for example, the amount is approximately 12s. per week. The full operating costs for such a vehicle, running 500 miles per week, might amount to £25, and 12s, is not a very considerable margin. As a matter of principle, however, it should definitely be entered.
Interest on capital outlay is an item of operating cost; interest on hire purchase is not. The point is that the amount of interest involved in hirepurchase transactions is invariably much more than would be debited in the ordinary way as interest on first cost. If, therefore, an operator enters hire-purchase interest as a vehicleoperating cost, and assesses his rates accordingly, he is, in effect, expecting the customer to pay h(!m more for his work just because he, the operator, has purchased his vehicle in this way. The extra cost involved in purchasing a vehicle by hire-purchase must come out of the operator's profit; he cannot reasonably debit the customer with it.
Approximate figures relating to the hire-purchase of a vehicle costing 11,000, based on a one-year agreement, are a; folloWs: Cash payment, £350; balance, £700, to be paid in 12 monthly instalments of £58 8s. The total amount of hire-purchase interest, therefore, is £50, which, in effect, is on a loan of £700, the rate of interest being approximately per cent.
To deal with the problem of separating interest on capital outlay and hire-purchase interest, the operator should, 1 think, still debit the full 3 per cent. on £1,000, that is £30 per annum as interest on capital outlay, and make no reference to the hire-purchase interest in his vehicle operatingcost record. The £50 interest which he actually pays, he nhould set against his profit during the year in which he pays it.
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Returning to my correspondent's method of dealing with interest, he says that he buys a £700 vehicle for which he pays £240 down. In five years he sells the vehicle for £100. and he thinks in that way he has reasonably disposed of the item interest," because 3 per cent. on £240 per annum is only £7 4s. which, in five years, would amount to £36. Realizing that. according to his method of calculation, he was covering his costs, I did not attempt to confuse him by telling him that his method did not help accountancy.
In an inquiry recently received assistance was sought in making quotations for the haulage of material, not described, over distances varying from 1 to 25 miles. The operator was putting two vehicles on to the work, one a 3-tonner, the other a 5-tonner.
• I was informed that it took 2 hours to load the 3-tonner, and 11 hours to unload. Corresponding fillies for tit:: 5-tonner were 3 hours, and 2 hours. He wanted to know what he should charge per ton for each vehicle over distances from one mile to 25 miles, mile by mile.
There are three ways of assessing the cost. One is to take the number of journeys which the vehicle can be expected. to cover each week, ascertain the total Cost of running the vehicle for that number of journeys and to divide by the number of tons actually carried.
The difficulty about that is, first, it involves a large number of calculations, hut, more particularly, that there are so many journeys the number of which per week is not an integer; the vehicle can, for instance, make six-and-a-half or six-and-three-quarter journeys, or something like that.
The second method is very similar. It involves the calculation of the number of journeys which can be covered in a week, and from that the number of miles run per week. The cost per mile can be taken from "The Commercial Motor" Tables of Operating Costs, and the rate calculated by using the figure for cost per mile. This is even more complicated than the first method, and is no more accurate.
The procedure which I recommend is illustrated in the accompanying three tables. In Table "I, appears only the essential basic data, namely, the distance travelled for each lead distance, the travelling time, and the time spent at terminals. The rates quoted in Tables II and III are calculated from the data given in Table I.
Table II gives rates for three-ton loads. This assumes that the rate to be charged per hour for the use of the vehicle is 5s., and that the amount to be added for each mile is 5d. Taking as an example a 10-mile lead, the total time given in Table I is 4.:? houts. That is made up of 31 hours loading and unloading., and 1.1 hours for travelling the 20 miles out and home.
The rate is made up of a time charge and mileage charge, I he time charge is for 4:1 hours at 5s. per hour, which is it 3s. 9d., and the mileage charge, 20 miles at 5d. per mile, which is 8s. 4d. The total charge is thus fl 12s. Id. The rate per ton is therefore Ll 12s. Id. divided by three, and that, to the nearest Id., is 10s. 8d. per tort. Similarly, in the case of the -tortner figures, which are given in Table 111; the total time needed for a 10-mile lead is given as N, hours, made up of 3 hours for loading, 2 hours unloading" and' 11 hours travelling time for the 20 miles. The rates to be charged for the live-ronner are 5s. 60. per hour; and W. rlitile. For this 10rritle lead, therefore, the' time charge as 6i hours at 5s. 6d. (fl 155. 9d.) and mileage charge 20 times qd. (10s. 10d.). The total is, therefore, k.2 6s. 7d. and, as the load carried is five tons, the rate per ton works out at 9s. 4d.
One difficulty which is common to all three methods is that time may be wasted because, near the end of the day, the driver cannot get in another journey within the 11 hours working time. As a rule, however, it is possible to get round that difficulty by mixing long and short journeys in such a Way as to give the vehicle and the driver the opportunity td do a lull ..day's work with or without overtime, so that the difficulty is actually more imaginary than real.
One final point., which has, in the past, given rise to a good deal of heart burning amongst small operators, concerns rate-cutting. la.,An operator, using afive-ton lorry and carrying live-ton loads, quotes 9s. 4d per-ton, whereas a competitor, working his charges out in the same way, would -come to the cOnclusion that lOs 8d was the minimum rate If he did not Itiow that his comj etitor was using a five-tOnner, but was told that the traffic was being carried at, 9s. 4d., he would proMptly accuse that competitor of cutting the rate. Actually, he would be doing nothing of the kind as 1 think will be
clear from the foregoing. • • S-. T. R.