Financial constraints often force fleet managers to make tough equipment decisions, such as whether to repair a vehicle or replace it. And it doesn’t end there, if the fleet manager chooses to repair a vehicle, he must then decide whether to give it a complete overhaul or do just enough to get by. If the fleet manager chooses the other option, he also must decide whether to replace two low-cost units or one higher-cost unit.
In too many cases, the answers to these questions are based on educated guesses or driven by external decision-makers with their own agendas. One of the best financial analysis tools available to fleet managers for making these decisions is the net present value (NPV) life cycle cost analysis. Instead of relying on guesswork, a NPV life cycle cost analysis will illustrate the true total cost of each option.
Many fleet managers have used life cycle cost studies for years, but they usually only consider direct cash flows. Fleet managers may think that if they spend $1,000 today, they will save $250 a year, which means they will recoup their investment in four years. There are two faults with this type of analysis. First, it does not consider the time value of money. Second, decisions made by a fleet manager working for a taxpaying entity have a direct impact on the taxes the entity pays. An after-tax NPV life cycle cost analysis addresses both of these issues.
What Is the Difference?The time value of money is related directly to an entity’s cost of money. A taxpaying business’s cost normally is considered to be its minimum acceptable internal rate of return. For a government agency, it is typically the weighted cost of debt (direct loans, bonds, etc.). This cost of money, which normally is expressed as a percentage, means that one dollar at some point in the future is worth less than a dollar in hand today. For a given cost of money, the current value of a dollar at some point in the future is known as its present value. The total present values of a series of related expenditures spread over a period of time is referred to as the net present value.
If an entity pays taxes, the fleet manager must consider the true bottom line cost of an expenditure after taxes. Ordinary expenses reduce gross income, which in turn reduces tax liabilities. This effect is known as a tax shield. For example, if an entity has a total effective tax rate of 30 percent, a dollar of ordinary expenses only costs 70 cents after taxes. Capital expenditures, on the other hand, must be depreciated over a period of years, so the NPV of the series of depreciation allowances is less than the actual capital expenditure.
If a business has a tentative gross profit of $1,000 for a period, and the effective tax rate is 10 percent, the company will owe $100 in taxes for the period, leaving it with a net income of $900. If the company incurs an expenditure of $100, its gross profit will drop to $900 and its tax liability will drop to $90. That means the net income will be $810, so the additional $100 expenditure actually only costs $90 after taxes. Many businesses have total effective tax rates in excess of 40 percent to 50 percent, so the impact of a tax shield can be very significant to the bottom line.
Using an After-Tax NPV Life Cycle Cost Analysis
Admittedly, most fleet managers are not familiar with this type of financial analysis, but spreadsheet programs perform the calculations once the necessary information is input. The biggest issue fleet managers face with this type of analysis is it documents the total cost to the entity, as opposed to just the fleet budget. Work with the firm’s financial department to use this type of analysis to document stewardship of the entity’s budget and get additional funds when justified.
When developing an NPV analysis of a series of expense options, the NPVs of the various alternatives will be negative. The option with the least negative cost is the best alternative from a purely financial point of view. Some NPV life cycle cost spreadsheet programs also will show annualized cash flows. If the NPVs of two options are very close, these annualized cash flows may be more important than the total cost.
In the case of revenue-producing alternatives, the NPV will be positive if the alternative being considered is earning more than the established cost of money and negative if it is earning less. An alternative can be revenue generating even if there are no direct income flows associated with it. For example, a contractor may be considering upgrading a new truck to be more productive. If the operations associated with the existing truck incur a significant amount of labor overtime, the increased efficiency may eliminate that overtime. The loaded overtime rate ($50 per hour), times the total hours of overtime eliminated (one hour per day x 260 days per year), generates a direct labor savings for the company that can be treated as additional revenue. Using the hypothetical numbers stated, the annual savings (revenue) would be $13,000.
If the productivity of a new unit can be increased to the point that it will replace two existing units, the potential savings (revenue) may be even greater because the company will be eliminating the total labor costs of a driver (and possibly a helper), as well as the maintenance and operating costs of the second truck. The opposite of this scenario applies when the company wants to downsize a vehicle to reduce fuel costs. If downsizing increases overtime, or forces the addition of a second vehicle to get the work done, the fuel savings probably will be less than the other costs incurred.
Even replacing a high-cost unit with a new unit that has a lower life cycle cost can be considered revenue producing because it may reduce total life cycle expenditures. For example, if a contractor has a vehicle with a lifetime average operating cost of $1.50 per mile and the truck runs 15,000 miles per year, the annual costs will be $22,500. A new, more fuel-efficient vehicle may have a projected average annual operating cost of $1.10 per mile or $16,500 per year. Therefore, the cost reductions (revenues) associated with the new unit will be $7,000 per year.
Of course, the actual bottom line in these examples is not without some complexity. For tax-paying entities, the reduction in labor payments will eliminate a tax shield. In addition, the cost of the upgraded vehicle must be depreciated over time as opposed to being treated as a one-time expense. In all cases, the carrying costs (time value of money) must also be taken into account. A properly applied NPV life cycle cost analysis will take all of these factors into consideration.
Ranking Alternatives
If a company has a number of revenue-producing alternatives, and only enough money to fund part of them, it can perform an NPV analysis and determine the actual return for each alternative. The individual rates of return can be used to rank the alternatives.
For example: A contractors has five projects with a total cost of $450,000, but it only has been allocated $360,000. An NPV analysis provides the following information:
Project | Cost | Actual ROI | Target ROI |
| 1 | $150,000 | 18.2% | 15.4% |
| 2 | $100,000 | 20.3% | 15.4% |
| 3 | $75,000 | 12.9% | 15.4% |
| 4 | $25,000 | 14.6% | 15.4% |
| 5 | $100,000 | 15.1% | 15.4% |
| Total | $450,000 | | |
In this case, project 2 has the highest return on investment (20.3 percent) and should be funded first, followed by project 1 (18.2 percent). The remaining projects are returning less than the desired ROI, but may still be perfectly valid and necessary. Unless there are some overriding requirements, such as regulatory compliance, the next project funded should be number 5 (15.1 percent). Lacking an ROI analysis, the contractor may have been tempted to fund projects 3 and 4, which have the same total cost as project 5 but provide a lower ROI.
Although documentation of accurate NPV cost studies is not something finance people normally expect from the typical fleet manager, it is a means to maximize the utilization of a limited fleet budget and possibly obtain addition funding.