How to Assess Interest
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WHENEVER a new edition of " ' The Commercial Motor' Tables of Operating Costs" appears, one or more readers raises the question of the item, "interest on first cost." There are some who refuse to include it as an item of operating cost; others query the percentage, and others again, insist that it ought to be assessed on a sliding scale. This year, following the publication of the 41st edition of the Tables, has proved no exception to the rule.
One operator writes to say: " It used to be our practice to charge 5 per cent, interest on the price of a new vehicle and the amount, in a particular case I have in mind, was 250d. per week.
"We have now adopted another method, which we think is the proper and legitimate one, namely, to charge interest at the rate of 5 per cent, only on the actual value of the lorry as it stands on our books after the periodical valuation. For interest, our average value at the present time is only a little over £100. and this makes a difference of almost :El per week in the all-in costs. Perhaps you will favour me with your views on this point?"
I replied: " It is, in my opinion, wrong to calculate the interest on the first cost of a motor vehicle on a sliding scale, as you suggest. The expenditure involved on this particular item of operating cost may be described as the investment value of the money laid out on the vehicle in the first ease. It is not'in any way concerned with the actual value of the vehicle itself and does not depreciate in any way.
"To appreciate this point, consider what would have been the annual return if the money spent on the vehicle had been suitably invested or put to some reasonably profitable use in any way. Only some serious error in selecting the investment, or some misfortune or mismanagement would have the effect of depreciating the capital sum involved and, on the other hand, a little good fortune attending either the investment 01. speculation would be as likely to appreciate the sum concerned.
"In view of these facts it is clearly wrong to vary the item ' interest on first cost' in any way pro rata to the age of the vehicle."
My correspondent, however, was insistent. He wrote again: It does not appear to me that there is an analogy between an investment giving a diAdend return and money laid out in the purchase of a motor vehicle. In the former ease, when compiling a half-yearly or yearly balance sheet, one does not charge anything against the investment, whereas in the case of the motor vehicle we have been charging ourselves with one-eighth of the value. I am therefore of the opinion that our method is correct."
My reply: "1 am afraid my previous answer has been misunderstood. There was no attempt to draw an analogy between an investment and money paid out on the purchase of a motor vehicle. The two are quite different things. The item 'interest on first cost' is a definite yearly expenditure, negative if you like; it is the amount which the money invested in the motor vehicle would have earned if it had been put to some other use, and you are quite wrong to depreciate that amount in any way according to the life of the vehicle."
That was not all the correspondence; Others joined in the fray. There was an insistence that the item should diminish as time goes on. It may therefore be useful if I go into the matter in greater detail. I think it might be a good thing too, if I compromise, and endeavour to meet these fellows half way. I admit that they are correct in the results they achieve by their methods and only wrong in the interpretation of their accounts.
They are right in the belief that the incidence of the interest on first cost diminishes as the vehicle depreciates, but they are wrong, in giving the credit to that item alone.
The incidence, but not the amount, of the interest
• diminishes. The effect—the incidence of the interest on capital outlay—may become less if, during the life of the vehicle, a sinking fund is established, a fund growing exactly in proportion to the falling value of the vehicle. If that money is invested, at a rate of interest corresponding to that at which the interest on capital expenditure is calculated, then, as the fund grows, the interest on k, set against the interest on first cost, has the effect of diminishing the total liability and the result is the same as if we were to take it that the latter item automatically diminished, taking no consideration of the interest on the sinking fund.
That procedure is fairly easy to understand and may be illustrated by a simple example. Assume a vehicle costing £1,000 depreciated in such a manner as to lead the user to the conclusion that its life was going to be 160,000 miles. Let us take it that the machine covers 20,000 miles per year, on the average. That means that it will depreciate at the rate of 12+ per cent, per annum.
At the present time, interest is calculated at the rate of 3 per cent. On the sum of £1,000, that is equivalent to £30 per annum. It persists at that figure throughout the life of the vehicle and, if not extinguished in any way, extends beyond that period.
If a sinking fund is established, at the end of the first year the fund will stand at £125 which, during the ensuing year, will earn interest at the rate of 3 per cent. The return from that investment will be £3 15s., and that sum may be set against the £30 interest 'on first cost, so that the latter will be reduced, to all intents and purposes, to a total of £26 5s.
More in Sinking Fund
At the end of the second year the sinking fund will have risen to 1.250, and during the third year the interest on the fund will be £7 10s, and the effect of the interest on first cost will accordingly be diminished to £22 10s., and so on, year by year.
The result of this method of operation is shown in the accompanying graph. Where the procedure of establishing a sinking fund in this manner is followed, and if it is desired, for accountancy purposes, to write down the interest on first cost in proportion as the interest on the sinking fund grows, it is better to establish an average figure for the interest on first cost based on that policy rather than to attempt to depreciate the amount year by year.
To that end the following formula may be used:— where L is the assumed life of the vehicle in years, P is the capital sum invested, C is the rate of interest. The solution of the formula is the average amount of the interest on first cost calculated according to this scheme.
Those who proceed according to this plan may think my attitude pedantic and my explanation unnecessary. Let me disabuse them. The foregoing result is not achieved and the method is not applicable unless a sinking fund is established in the way I have laid down.
The fact is that few users of commercial motors establish such a fund. Everyone should do so, but the majority do not. Therefore, in any schedule of operating costs designed to meet the needs• of the average user it is, unfortunately, necessary to assume conditions which are known to prevail amongst the majority, and to take it that there is no sinking fund.
Reduction in Cost
In those eases where there is such a fund the net result of following the lead set by the Tahles is a slight reduction in actual cost, as compared with the figures given in the Tables for the cost of operation, the difference being no more than a few pounds per year. On the other hand, if the interest were to be reckoned on a sliding scale the result, in the majority of cases, would be that the actual cost would be more than is laid down in the Tables.
It has always been my policy to overestimate the probable cost of operation of motor vehicles rather than to underestimate that expense, and the interpretation of the item "interest on first cost" as a fixed charge is in due consonance with the application of that principle.
It should be borne in mind, moreover, that one of the main functions of the Tables is to give guidance to smaller operators when they are assessing rates for the job. It would be wrong, therefore, to assess the item of interest on a shifting basis, varying from year to year, for in that case the operator would be called upon to vary the rates he charges according to the age of his vehicle, which is obviously absurd.
Another hoary old annual has cropped up again, namely, the placing of the item "hire-purchase payments" in any scheme of costing the operating motor vehicles. A corre spondent writes complaining that there is no provision in the Tables for the entry of that expense. He has recently purchased a used vehicle costing in all £625. Of that stint. £300 has been paid in cash and the balance in instalments of £20 per month.
He asks, how to provide for that in his operating costs. I have replied to that question, not less than 100 times, that hire-purchase instalments are not operating costs. How can they be? In this case the inquirer has a fleet of five vehicles of which four, I gather, have been paid for, the fifth being the subject -of this inquiry. If the cost data relating to one of them is made to bear the instalments on hire-purchase then it will apparently, be £4 per week more than the others, which will upset any scheme of reckoning rates on the basis of cost plus profit.
It is true that the inquirer asks if he should spread these payments evenly over the five machines, which would answer my query on that point. It still remains, however, that hire-purchase instalments are in no way to be regarded as operating costs.
The proper place for them is amongst the establishment costs. To put it another way: instalments must be paid out of profits. It is true that, in that way, the ultimate result is the same; the instalments have to be paid for out of the earnings and the rates to be charged will be increased if the operator desires to earn the same net profit as before the h.p. contract was entered into. If, however, the haulier is in such a position that he cannot increase his rates, he will have to make those payments out of his own pocket.
Could Not Pay
What may happen is strikingly made clear in a case which was reported on page 514 of the issue of The Commercial Motor for November 19. An applicant for a B licence had already a contract-A licence. An ownerdriver, he had secured a contract to carry lime. "Although he was guaranteed a certain minimum payment per month in respect of lime haulage, it was not sufficient to enable him to make a living or to pay off hire-purchase instalments on his lorry," said the report.
According to my interpretation of the situation, it just could not be done, as the margin of profit was so small that it could not cover the payments, let alone enable the operator to earn a living for himself.
Let me try to put the matter into figures. Assume that his vehicle is a 6-tonner and that the lime contract takes up only 30 hours per week, during which the. vehicle runs 300 miles. According to the Tables his total of operatingcosts is £23 14s. With the optimism typical of the ownerdriver he decides to accept an offer of £28 per week forrn the contract, so that, his margin for gross profit is only £46s.
Not until he has held the job for some months does he recall that his payments are more than enough to swallow, any profit he -may make. In desperation he tries to get a B. licence to. enable him to remedy that state of affairs, Only to be disappointed by the refusal of the Licensing Authority to grant him that licence, "Glowing Promises"
The representative of the objectors stated: "This is not an isolated case. There are far too many advertisements appearing today, inducing these men to throw over steady jobs with promise of. a better living. Glowing promises are made and it is very unfortunate that a man like this should find himself in this position."
An operator buying under hire-purchase might find that he cannot exist on the rates he is getting, whereupon he ' shortly fails to meet his liabilities, has to give up his vehicle and is thus thrown back to a point farther back 'than whence he was started in this quick-profit scheme, inasmuch as he has lost all his savings and is in debt all round. There was a tremendous incidence of this kind of occurrence before nationalization, and the way is now open for the same situation to arise again. Indeed, there is plenty of it about now. What can be done to stop it I don't know.