Financial constraints often force fleet and vehicle maintenance managers to make tough equipment decisions. Should a vehicle be repaired or replaced. If a vehicle should be repaired, how much work should be done to it? Is it better to replace two low-cost units or one higher-cost unit?
In far too many cases, the answers to these questions are based on educated guesses, or are driven by external decision-makers with their own agendas.
One of the best financial analysis tools available for making decisions of this nature is the net present value (NPV) lifecycle cost analysis. Instead of relying on guesswork, and not being able to fully defend your position, a NPV lifecycle cost analysis will show you the true total cost of each alternative.
DIRECT CASH FLOW
Many fleet and maintenance managers have used lifecycle cost studies for years. Unfortunately, the usual study only considers direct cash flows.
A typical logic thread might be something like: If I spend $1,000 today, I will save $250 a year, which means I will recoup my investment in four years.
There are two faults with this type of analysis. First, it does not consider the time value of money. Secondly, decisions made by a manager working for a tax-paying entity have a direct impact on the taxes the entity pays.
An after-tax NPV lifecycle cost analysis addresses both of these issues.
VALUE OF MONEY
The time value of money is directly related to an entity’s cost of money. A tax-paying business’ cost is normally 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 is normally 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/maintenance manager must also 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.
The following is a very basic example of a tax shield. Let’s say that a business has a tentative gross profit of $1,000 for a period, and the effective tax rate is 10 percent. That means 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, the gross profit will drop to $900 and the tax liability will drop to $90. That means that 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.
Admittedly, most fleet/maintenance managers are not familiar with this type of financial analysis, but available spreadsheet programs perform the calculations for you once you input the necessary information.
The biggest single issue managers face with this type of analysis is that it documents the total cost to the entity as opposed to just the manager’s budget. However, a company’s financial people are probably very familiar with the concept, so if you are in a position to work with them, you may be able to use this type of analysis to document your stewardship of the entity’s budget and get additional funds when justified by your analysis.