Vehicle Depreciation Analysed Simply
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Misunderstanding of the Importance of Setting up a Fund to Pay for New Vehicles is One of the Reasons for Post-war Rate Cutting
IT is advisable, in beginning this article, briefly to recapitulate the main points of the previous one, to which this is a sequel. It is apparent that the pre-war lessons on costs and rates, intended as a deterrent to rate cutting, are almost entirely forgotten, and thus, after a lapse of a dozen years or so, it seems necessary to deal with the subject again and in just the same way. Small hauliers are lacking in knowledge of vehicle-operating costs and are cutting rates right and left. That has come about largely as the result of wartime experience, when rates were fixed and the operator ceased to worry about costs and certainly ceased to make any records of them.
I am hoping to repair that war-damaged fabric, and as a preliminary I am explaining the first principles of cost estimating, as distinct from cost recording, so that ultimately I may be able to persuade the operator to apply these principles, so that he can assess the margin of profit in the rates he is thinking of charging. I want to warn him, even, that those rates may not show a profit at all.
Ten Inescapable Items
In the previous article I referred to the 10 headings under which vehicle-operating costs fall, and emphasized that no operator can escape some expenditure undgr every one of those headings. I described the five standing charges and the five running costs, and dealt at some length with eight of them—with four of the standing charges, that is to say, Road Fund licence, garage rent, vehicle insurance and interest on capital outlay, and with four of the running costs, i.e., fuel, lubricants, tyres and maintenance.
There remain depreciation and wages; and of these depreciation is the more important. It is an item concerning which there are many different ideas, nearly all of which are wrong.
The unfortunate thing is that there are so many ways of dealing with the item. There is one, for example, which none of us can escape, although it is-ore which, unfortunately, is not of any real practical use for our purpose, which is the assessment of cost as a basis for calculating rates. I refer to the method we must use in making our income tax returns, and perhaps the best thing I can do just now is to deal with that method at once and show why it is not satisfactory for our purpose.
For simplicity, I will take the case of a vehicle costing £1,000 new and bought comparatively recently, so that the Income Tax Act of 1945 applies in respect of this calculation of depreciation or, as the income tax authorities call it, wear and tear.
In the first year the income tax allows an initial amount of ore-fifth, or 20 per cent., of the value, plus 25 per cent. wear and tear, a total of 45 per cent, altogether, and that, on £1,000, is £450. That is to say, the depreciation allowance on this vehicle in the first year is £450, and its value at the end of that year is therefore assumed to be £550.
For each subsequent year the income tax allowance is 25 per cent. of the reducing value of the vehicle, so that in the second year, taking that reduced value of £550, the allowance on account of wear and tear will be £138, leaving the vehicle with a value of £412 at the end of the second year. In the third year the initial value is £412. the wear and tear allowance £103; the value at the end £309. In the fourth year the figures are £309, £77, £232. And so on to the sixth year. when the wear and tear allowance is £44, leaving the vehicle still with a value of £130.
Now let us assume, for the moment, that an operator proposes to use these depreciation figures as a basis far assessing his vehicle operating costs and thence the rates he must charge. Let us assume also that his average mileage per annum is 24,000.
In the first year the depreciation is £450, and if we divide that by 24,000 miles we get a depreciation allowance of 4,1-d. per mile. During the sixth year, however, the wear and tear allowance is only £44 but the mileage is still 24,04V, and if £44 be divided by 24,000 mites we get only 0.44d., which is less than id.
Assume -that the rest of the operating costs total 7id. per mile, then during the first year the total. cost, including depreciation at 44,c1 per mile, is Is., but in the sixth year the amount is less than 8d.
No operator can one year base his rates on a cost of Is. and another year on 8d., especially if, in the seventh year, he buys another vehicle at the same price and has to start all over again. A depreciation figure which is going to be of any value must be the same throughout.
Now let me explain the orthodox method of assessing depreciation. The first thing to do is to deduct from the first cast the price of a set of tyres. I have found that many operators fail to appreciate the need for this, and before going further I propose to explain it.
In our 10 items of operating cost we already have a heading for tyres, as well as this heading for depreciation, and it is customary, when estimating the tyre cost, to take the cost of a set and divide it by the mileage which a set is expected to give. Thus in this case a set of 35-in. by 11-in. tyres will cost £108, and reckoning a life of 24,000
miles, that is roughly Id. per mile for tyres. That will already have been entered in our schedule of operating costs and we must not, therefore, duplicate it; we must take it away from the vehicle cost, so that we do not charge twice for tyres. It is as well to bear that Id. per mile for tyres in mind, as I shall refer to it again in a moment.
Cost of Tyres to be Deducted
In estimating the amount we must charge for the depreciation of this vehicle, therefore, the first thing to do is to subtract £108, the cost of a set of tyres, from the amount of £1,000. That leaves £892. Now we have to appreciate that when the vehicle has run its allotted span it is usually sold for whatever it will fetch, and before we can calculate depreciation we must form some idea as to what that sum of money is likely to be.
To-day, of course, that is extremely difficult because sometimes a used vehicle fetches nearly as much as a new one, but in normal times—and we all hope times will be normal six years from now!—the amount likely to be obtained for a six-year-old vehicle which has been well used will not be great. For convenience, I am going to assume that it is £92, and I deduct that from the £892 which we already have, leaving £800.
Now, if' the operator estimates that he is going to run that vehicle for six years, then he should divide £800 by six, which should give him £133 as the depreciation per annum: He is running 24,000 miles per annum, so that he must now divide £133 by 24,000. and the answer is 1.33d. That is his depreciation, expressed as a cost per mile.
Sometimes it is preferable to calculate the depreciation as a cost per mile direct, without letting the number of years the vehicle will live enter into it. The vehicle is likely tohave a life of approximately 180,000 miles. Divide that into the £800 value of the vehicle and the answer is Depreciation per mile, calculated that way, is thus less than when worked out on a time basis.
Now, that is one of the difficulties of reconciling different views on depreciation. According to one method, we have a figure of 1.33d.; according to the other, a figure of 1.00d. Which is right? Generally speaking the first is iight, hut it all depends upon the work which the vehicle is doing. That difference between the 1.33d. and the 1.00d. represents what is called obsolescence. In other words, it is the loss in value which the vehicle suffers by going out of date.
In this case, the vehicle running 24,000 miles per annum covered only 144,000 miles in six years. According to the other method it lasts for 180,000 miles, so there are still 36,000 miles of life left in it. It is not worn out, It has become so much out of date that in many classes of work it may not be worth while to run it for those remaining 36,000 miles.
The operator may wish to run it for that distance but dare not do so because it is out of date, and for a variety of reasons it may not pay him to keep it in commission. He must get rid of it at the best figure he can. That figure will be low, because it can be paid only by someone who is willing to put up with an out-of-date machine.
In "The Commercial Motor "'Tables of Operating Costs. depreciation is always given directly as a running cost, a cost per mile, but in assessing it care is taken to make provision for this obsolescence, for this tendency for vehicles to go out of date.
In the above example, the Id. per mile calculated directly by dividing the vehicle life of 180,000 miles into its value when new, less tyres and less residual or used value, is taken. That Id. per mile is the basic figure for depreciation, but it assumes that the vehicle is going to run not less than 36,000 miles per annum. In other words, it must run that mileage, otherwise it will begin to get out of date before it has run its allotted span of 180,000 miles.
To correct the figure, 5 per cent. is added to the basic Id. per mite for every 1,500 miles by which the annual mileage fails to reach 36,000.
Extra Depreciation on Low Mileages
In the above case, the annual mileage is only 24,006 and falls short of the limiting minimum by 12,000 miles per annum, which is eight times 1,500 miles. The basic depreciation figure of Id. must therefore be increased by eight times 5 per cent., which is 40 per cent., and according to that method the depreciation allowance is 1.40d.
This may seem somewhat complicated to the operator for whom I am writing this article, the man who is not too good at figures and has not the time to be bothered with them. He is recommended to take the figures direct from "The Commercial Motor" Tables of Operating Costs and apply them to his own purposes.
Another problem which often arises in connection with depreciation, and is as often put to me in the form of an inquiry, is how 1 reckon depreciation on a used vehicle, Suppose a man has bought for £400 a vehicle which originally cost £1,000. How does he assess depreciation? The answer is that the amount to be set aside for depreciation should be at least the same as that which applies in the case of the new vehicle.
For an understanding of this seeming anomaly, it should be explained that the purpose of allowing depreciation as a cost is to provide a fund out of which a new vehicle may be purchased when that becomes necessary or advisable, If the proprietor of the above vehicle puts aside Id. per mile, then, when the vehicle has run 180,000 miles, he has £800 available. If he gets £92 for the sale of the used machine he has £892 and he is short only by the cost of a set of tyres of the purchase price of a new vehicle. The man with a used machine should therefore really put a bigger amount aside for depreciation if he is going to be able to buy a new vehicle when the used one is worn out, for he has a much shorter period in which to amass the essential capital, That is rarely practical and all that he can do, therefore, is to put aside the same amount as he would if it were a new vehicle and make up the difference by providing additiOnal capital. Alternatively, he may do as he did before, that is to say, buy another used vehicle. If any reader doubts the wisdom of this view of depreciation—that, so far as he is concerned, it is to gre regarded as a means for providing the purchase of a new vehicle—he should take a lesson from what is happening to-day as -regards compensation which is being awarded in respect of compulsory acquisition of hauliers' businesses. The method employed shows that even the British TransportCommission appreciates that it is what has to be laid out on a new vehicle, and not what was laid out on the old one, that is the criterion.
Examine the procedure which is to be applied in assessing the compensation to be paid for any vehicle which is taken over. Suppose a used vehicle was purchased in January, 1946. for £1,350 and assume that the operator's business is taken over in December of this year. The cost of a new vehicle of the same type, if bought next December, would be £2,600.
What the B.T.C. Pays
The British Transport Commission, in assessing the value of that vehicle for the purposes of take-over, does not take into consideration what the operator paid for it, but what he would have to pay for a new one. In other words, it assesses depreciation on the price of a new machine. The figures would work out as follow:— The compensation would be assessed at /1,331, which is almost what the operator paid for the vehicle in the first place.
This point arose quite recently. I was asked by an operetor to support his plea for an increased charge for the conveyance of miners between their homes and the pits. He was admittedly using a very old vehicle for the job and the authorities, in assessing his costs, were allowing a negligible amount for depreciation. That, I pointed out, was wrong. The amount per mile 'or the amount per annum which he should allow for depreciation, in assessing costs as the basis for rates—I must emphasize that—should be based on what he would have to pay for a new machine.
The assessors were taking 25 per cent. of £280, which was probably all the vehicle was worth. That is to say, they were allowing him 157 per annum for depreciation. Now that is perfectly correct from the point of view of income tax or the method of an ordinary auditor, but it is no use to a man who is using it as a means for earning a living. A new vehicle would probably cost him £3,500 and his depreciation should be at the rate of £600 per annum.
Finally, and in conclusion, I should like to quote Sir Geoffrey Heyworth, chairman of the Lever Bros. and Unilever combine, when he addressed the stockholders of the company at the last genera! meeting.
Support from Lever Bros. Chairman
He was explaining a large allocation. £7.800,000, to maintain the company's assets and he quoted this example to simplify his justification of that allocation. He said: "Take the case of a road-transport company having fixed assets of four trucks costing £500 each. Suppose these trucks were worn out after five years and had to be replaced by new ones, which, owing to the rise in prices, cost £1,000 each. The money accumulated in the depreciation fund" (mark that) "would buy only two trucks instead of the previous four, and the operations of the company would be reduced by half."
That is precisely the point I always. try to make, in reckoning depreciation. it is a provision for a fund to buy new vehicles when the old ones are done and; year by year, it must be calculated on the price of vehicles during that year, not on what the operator's own vehicles cost him.
In a subsequent article I will deal with the remaining item, wages, and I shall also get down to figures and show how, in a simple way, an operator commencing with a few vehicles—say, up to four—can, without keeping detailed cost records, nevertheless arrive at figures for cost sufficiently accurate to enable him to know, from week to week, exactly how he stands and whether the rates he is charging and the money he is earning are sufficient to cover his costs and provide a reasonable margin of profit. S.T.R.