A Factual Approach to
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DEPRECIATION
By Axel Mortensen
.M
. Y experience, 'acquired . during more than 20
years of selling•cOmmercial vehicles in Dena-wk and NorwaY,has taught me a few things about the importance to the customer . of operating-cost estimates, for Which -reasOn 1have had to •give 'the depreciation problem' a great deal of thought. It was of interest to me, therefore...to read that S.T.R. seems . to base his advice to operators on much the same theories as .I have adopted.. " , • . However, although .1 .like theWay • in 'which. S.T.R... deals directly with the piactieal problems, I believe that it would be. a good thing to-give an outline Of the underlying theories, and not just some 'examples of their practical application. " Much of the confusion prev.ailing among commercial-vehicle users on the subject . of depreciation might be cleared up by disseminating a better understanding of the theoretical. aspects.
As S.T.R. says, we are not concerned with the depre2eiation rates allowed by the income-tax authorities, who, of necessity,' must hasp their rates on general rules, instead of allowing for the special conditions peculiar to individual operation.' The operator who wishes to estimate beforehand his total costs for a specific contract, or for a certain period of time ahead, must base his depreciation rates on his own particular working conditions. TO me, it is somewhat misleading to see depreciation defined by S.T.R. as the rate at which a vehicle wears out.. S.T.R.'s idea is probably right; but the wording does not convey the real essence of the problem.
Defining Depreciation
Theoretically,•so long as replacement parts arc available, a vehicle need never wear out. During the war and the years which have followed it, operators in Britain as well as in this county have kept their vehicles running far beyond • the age at which they would normally have been.discarded. Therefore, it would be better to say that depreciation is the rate at which a vehicle loses its ability to make profit.
Any advance estimate of the operating costs per mile or per day will be lower for a new vehicle needing little or no repairs than for an old vehicle. An operator who bases his quotations on a figure which will hold true only so long as the vehicle is new, would find it impossible to lay aside enough money for a replacement during the short time in which his estimate held good. Therefore, his quotations must necessarily be based on the estimated average costs for the entire depreciation period, that is from the date of purchase of the vehicle to the time when it becomes unprofitable to operate. The length of this period, which it is extremely important to assess correctly in advance, depends primarily upon the inter-relation between cost of depreciation and Cost of repair and maintenance.
If the depreciation be based on too short a period, thevehiele will be written off before the heavy repair to arrive, and the repair cost per mile for the depreciation period will be small, but the depreciation c16 cost per mile will be unnecessarily.heavy. The opposite
• procedure leads to excessive repair costs per mile which cannot be offset by the restating small depreciation cost per mile. In either case, the operator's estimate of total operating costs per mile will be unnecessarily high, and may prevent him from quoting competitive rifles This. inteNrelatien 'of denieciation, and repair and maintenance' costs, can be illustrated by a hypothetical exaMple. Let us suppose that the operator has a vehicle costing £600 less tyres, and:that he has decided to write it oflover 100,000. miles. This gives a depreciation rate . per mile of 1.44d. Suppose that his total repair and
• maintenance expenses for the • depreciation period • amount to £300, making 0.72d. per mile. If he can run the vehicle for 20.00 more miles by spending a
• further £150 on repairs and maintenance, his depreciation per mile has been set unnecessarily high, because each of the additional 20,000 miles will cost him 1.80d. in repairs and maintenance and nothing in depreciation, whilst his depreciation, repairs and maintenance for the first. 100,000 miles, taken together, amounted to 1.44d. plus 0.72d., or 2.16d. per, Mile.
A Question of Mileage
Had it been possible to judge the expenses correctly beforehand, he would have needed to work on only 2.10d. per mile for 120,000 miles. the depreciation being £600 divided by 120,000 miles, which equals 1.200. per mile, and repairs and maintenance £450 divided by 120,000 miles, which works out at 0.900. per rriile.
If the operator had based his depreciation figure over, say, 130,000 miles, and his repair and maintenance expenses for the last 10,000 miles had been £100, his total cost of depreciation, repairs and maintenance would again prove higher than necessary. Depreciation would amount to £600 for 130,000 miles, which equals 1.11d. per mile, and the repairs and maintenance expenses £550 over the same mileage giving 1.02d. per mile, a total of 2.13d. per mile as against 2.10d, per mile for a depreciation period of 120,000 miles.
It can thus been seen that. in -this case, the "economical life of the vehicle should be set at 120,000 miles, and the depreciation worked out accordingly, because, after that mileage, a new vehicle of the same type can be operated cheaper than the old one. In other words, the economical age limit of a commercial 'vehicle is reached when repairs and maintenance alone begin to cost more per mile than the combined cost of depreciation, repairs. and maintenance for a new vehicle.
Obviously, this theoretical Statement requires some qualification. Repairs and maintenance are not the only expense items that tend to increase with the age orthe vehicle. Moreover, special conditions, such .as..-obso.lescence and general commercial risks, ha.±ie.t..ck-be, considered when setting the depreciation ratein: ac.1.1iiii practice. Still, this underlying theory..-or_eminiitercial vehicle depreciation must be nnderstood. by ail opera.. tors. .and lust form. the starting paint cif their. considerations, if their Cost estimates are to be well founded.
One reason why this theory should be understood is that it explains why the economical life of a vehicle depends not only on the repair and maintenance costs, but on the purchase price less tyres—not because a higher initial cost does necessarily imply better quality and fewer repairs, but simply because it means higher depreciation cost per mile.
If the hypothetical vehicle in the foregoing examples had cost £1,000 instead of £600,•we would have found that, witl( the same repair and maintenance expenses, its economical life would be longer than 120,000 miles. With a total repair and maintenance expense of £450 for 120,000 miles, we would have: depreciation— £1,000 divided by 120,000 equals 2.00d, per mile; repairs and maintenance—£450 divided by 120,000 miles equals 0.90d. per mile; giving a figure of 2.90d. per mile. With repair and maintenance expenses of £550 for 130,000 miles, the respective figures would be 1.85d., 1.01d. and 2.86d. per mile. In the latter case it would be too early to replace the vehicle after 120,000 miles of service.
Therefore, tables of recommended depreciation rates must be arranged according to the initial cost of the vehicle. Furthermore, they must take into account the varying wear-and-tear conditions, by classifying the types of operation in at least three ea tegories—severe, normal and easy.
Mileage and Running Costs Estimates
The foregoing examples show that a misjudgment o1 the economical mileage life by 10,000 or 20,000 miles will al-ter the estimated average running costs per mile by only a fraction of a penny, which will hardly affect an operator's position when, for example, he is bidding for a competitive contract. Therefore, tables of recommended depreciation rates prepared by people with a thorough practical knowledge of repair costs, can be followed without hesitation, provided they take into account both the Initial cost of the vehicle and the type of operating conditions.
Before the war, it was frequently said that the rapid improvement in commercial vehicle design was the main reason why depreciation periods should be limited to a certain maximum number of years regardless of mileage, for the reason that the introduction of better and more economical types of vehicle could, otherwise, make the use of old models unprofitable before they were written off. I do not, by any means, think that commercial vehicle design has reached perfection, although do maintain that we shall not live to see another period of such rapid progress as was witnessed in the twenties and early thirties.
Still, there are other reasons why . no commercial vehicle should be depreciated over an unreasonably long period of time. Although the profitable life of a vehicle is expressed in miles, and depreciation should normally be figured on a mileage basis, it is, therefore, desirable to set a suitable time limit in cases where the yearly mileage is relatively small. Just where this time limit should be set under British operating conditions, I do not pretend to know. In practice, it is sufficient to call the operator's attention to this point and leave it to him to decide on the time limit.
Whenever specially constructed or equipped vehicles are bought to perform a special type of work which may not last indefinitely, the answer is quite obvious. However, even if the vehicle be of a normal type suitable for general purposes, it is reasonable to say that the investment is not sound unless the operator can insure that he can earn and set aside a sum equal to the initial outlay within a given number of years, and to set the depreciation rate accordingly. Generally speaking, the question of desirability of a time limit must he decided by the operator according to the peculiarities of his business and the competition he is facing.
Similar viewpoints apply to the depreciation of trailers and articulated six-wheelers. Technically speaking, a trailer or semi-trailer can outlast its tractive unit, or perhaps even several of them. As the repair costs of a trailer or semi-trailer are usually small compared to those of a truck, their economical mileage life can often be set at a high figure. However, for the reasons just stated, it is usually advisable not to go to the full mileage limit when deciding on the depreciation rate.
Besides the usual obsolescence risks, there may be an additional point to consider in the case of articulated six-wheelers, inasmuch as some semi-trailers cannot be adapted to a tractive unit of a design different to the original one without incurring expense, so that it may he wise to write off the truck and the trailer over the same number of miles or years.
In the foregoing I have dealt with depreciation, only as a rate that has to be set beforehand in order to arrive at an estimate of future operating costs on which to base the rates charged to customers, or the transport expense to be included in the price of one's goods. After operation has actually begun, certain precautions can sometimes be taken as an insurance against unforeseen developments and re-sale losses.
• As I have said already, it is not practicable in the advance estimate of future operating costs to figure on anything but a uniform, average expense per mile for the entire economic life of the vehicle, and this, of course, applies equally to depreciation. It is true that the market value of a used vehicle does not drop uniformly, but this does not matter at this stage of the calculation, which is concerned only with the utility value of the vehicle to the present owner.
Actual and Estimated Expenses
With the depreciation shown in his books after operation has begun, the matter is different. This "actual " depreciation should, as nearly as possible, take into account the drop in market value, and this can be achieved by various kinds of " bookkeeper's acrobatics." If a sound estimate has been made, it is most likely that the actual running costs for the first year or years will be lower than estimated. In that case, if it be practicable for income tax reasons, the operator may set aside in his books the difference between actual and estimated expenses as an "extra depreciation reserve,"
Such a practice may be most desirable, because it allows the total operating expenses in the books to stay fairly uniform throughout the life of the vehicle, although, in the beginning, depreciation will represent a comparatively large percentage of total expenses. whilst later on depreciation will decrease and an increasing percentage of the total expenses will be taken up by the growing repair and maintenance costs If all goes well, the vehicle will be completely written off long before it becomes unprofitable, allowing the operator to dispose of it at any time without showing a book loss.
Owners of large fleets have other means for regulating their operating expenses, including depreciation. By switching the oldest vehicles to the easiest routes, vehicle life can be prolonged, and the risk of rapidly increasing repair costs, or re-sale losses, diminished. During a visit to the United States before the war, I was told that a large dairy concern there, operating many hundreds of vehicles, had found a way of avoiding such losses by writing off one-third of the purchase price, less tyres, in the first year, one-third of the remaining balance in the second year, and so on, at the same time systematically shifting the vehicles to easier routes as they grew older. r It was claimed that the combination of these methods had given excellent results.