Fleet Management Conference

22nd September 1972, Page 182

22nd September 1972

Page 182

Page 182, 22nd September 1972 — Fleet Management Conference

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ally and otherwise acceptable. If, as is often the case, sufficient capital is not available or the consequential effects are not acceptable, a compromise life has to be found in which the direct effects on profit are other than ideal but the other two tests are, more or less, satisfied.

A compromise judgment of this sort cannot itself be made by means of research and calculation. It is a value judgment, cutting across many aspects of company policy. Where research and calculation can and should help is in providing for the decisiontakers the best possible assessment of the effects on profits and on capital employed that can be expected to result from specific changes in life policy. More specifically, the decision-taker needs to know:—

a) What is the life span that produces the lowest costs and the amount of additional capital, if any, that will be needed in order to adopt that life span, and b) the penalty, in terms of reduced profit, that will result from adopting, for whatever reason, shorter or longer lives and the corresponding changes in capital requirements.

There should be adz difficulty in assessing the capital requirements of various policies. This is simply a matter of consulting manufacturers' price lists. The remainder of this paper is devoted to a method of determining the least-cost life and the penalties for departing from it.

The method may be summarized as follows: 1. Collect basic data on maintenance, loss of use costs and resale values.

2. Apply inflation factors to the data.

3. Tabulate the cash flows year by year for each life separately.

4. Determine the net present values of the cash flows and hence the average annual discounted cost for each life.

5. By inspection, select the lowest and then tabulate the excesses on the other years. Each of these steps is now dealt with in more detail.

1. Collection of basic data

a) Maintenance costs are required for each year of life at today's prices up to the longest life considered practicable. Historical data, adjusted to today's prices, may be used for this purpose. Where maintenance is carried out by an outside contractor, garage overheads will of course be included in the cost records. Where the operator does his own maintenance it is, in my view, permissible to ignore workshop overheads and use the cost of parts and labour only. Where very large changes in policy are contemplated, however, workshop overheads may vny significantly and should, perhaps, be included. Since the purpose of collecting this data is to predict future costs, every effort should be made to detect and eliminate data obtained in non-typical circumstances.

b) Loss of use costs are collected and tabulated in a form similar to that for maintenance costs. What is required is the ratio of spare vehicles to active vehicles necessary at each age. The cost to be tabulated is the corresponding proportion of the standing costs of the spare vehicle.

c) Resale values as at the end of each year of life, at today's prices, are required.

2. Inflation An estimate has to be made of the rate of inflation likely to obtain over the life of the vehicle. It is simplest to settle upon one single rate to apply equally to maintenance, loss of use, and resale values. The use of differential rates introduces considerable complication. In any event, over a period the rates will tend to equalize. The chosen rate is applied year by year, compounded, to the maintenance, loss of use, resale values and cost of the new replacement.

3. Tabulation of cash flows The cash flows, adjusted for inflation as above, are then tabulated year by year separately for each life. This task requires the greatest care as it is very easy inadvertently to place cash flows in the wrong year. Counting the date of purchase of the new vehicle as the end of

year 0. the cash flows to be tabulated are:—

a) In Year 0. The payment of the purchase price.

b) In Year 1. The sum of the inflated maintenance and loss o use costs for year 1, less 40 per cent (if that is the appropriati rate of Corporation Tax) of the first year writingrdowi allowance.

c) In Year 2. The sum of the inflated maintenance and loss o use costs for year 2, less 40 per cent of the second year writing. down allowance.

. . .and so on, until the year of replacement.

d) In Replacement Year. The sum of the inflated maintenance and loss of use costs for that year. less 40 per cent of the inflated maintenance and loss of use costs for the previous year, less 40 per cent of that year's writing-down allowance, less the proceeds of sale (i.e. the inflated resale value) plus the additional cost of the replacement (i.e. the difference between the original purchase price and the inflated replacement cost.) e) In the Year after Replacement. 40 per cent of the balancing charge (i.e. the difference between the actual inflated resale value and the tax written-down value) less 40 per cent of the inflated maintenance and loss of use costs in the year of replacement.

After tabulation, the cash flows for each year are totalled, taking very careful note that some cash flows are "outwards" (such as the purchase) whilst others are "inwards" (such as tax allowances). This process is repeated for each life to be considered.

4. Determining the average annual discounted cost

In order to compare the cash flows of the one life with those of another so as to decide which represents the lesser cost, it is necessary to take into account the cost of capital. The rising and falling patterns of the cash flows over the life of the vehicle will have a similarly rising and falling effect upon the operator's finances. A pattern of cash flows in which the major outlays are late Li the sequence is clearly preferable, from this point of view, to one in which the major outlays are concentrated at the beginning, since interest charges will be less. This aspect of the method is dealt with by means of the technique known as discounted cash flow. At this stage, unfortunately, a certain amount of mathematics is unavoidable. The procedure is as follows:—

a) For each life in turn, find the net present value of the net cash flow in each year at the chosen rate of interest by using a set of discount tables.

b) Add the results together to find the total net present value of all the net cash flows tabulated for that life.

c) Divide the result by a factor F from the following formula:— n is the year in question, i is the rate of inflation and R is the discount rate.

The result is the average annual discounted cost of the life. The significance of this figure is that it represents the value of the cost pattern expressed in terms of a constant annual payment, and this may be compared directly with the corresponding result for other lives. The least-cost life can now be found simply by inspection and the penalties for other lives are the differences between the annual discounted cost of the life in question and that of the leastcost life.

Larger operators may be able to entrust the more technical parts of these procedures to their own specialist departments; others may use outside consultants. Reliable guidance can now also be obtained from published tables which set out the leastcost lives and penalties for various types of vehicle with assumed basic data on maintenance, loss of use costs and resale values.

In conclusion, I would, ask delegates to bear in mind the point made earlier in this paper. The not inconsiderable complexity of the method described above may lend it, in the mind of the reader, an importance that is not wholly justified. Least-cost lives and penalties are only one aspect of the factors which should affect vehicle replacement policy. They are important, but in practice often no more important than the amount of capital available or the consequential effects, such as frequency of breakdown.