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G. Lifecycle Cost Analysis

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NAFA’s Fleet Acquisition and Disposal Guide

G. Lifecycle Cost Analysis

Who Provides? Employer Provided How Acquire? What Acquire? How Reimburse ? Employee

Provided Own Lease Rent

1. Introduction

Two of the most important tasks any fleet manager must undertake are deciding which vehicles to obtain or when to replace them. Many subjective factors contribute to this decision, such as corporate culture, funding availability and organizational image. One factor contributes to this decision by using quantitative data: the lifecycle cost analysis (LCA).

The LCA is a mathematical model that is used when making a financially based decision between two or more competing options. When done properly, it forces one to consider all the relevant costs incurred over the lifetime of a vehicle or operation. By doing so, the LCA often contradicts conventional acquisition policies that select lowest initial cost choices even when competing choices may be far superior over the long run. LCA is one of the most important steps of the vehicle selection and disposal process as it assists not only in pinpointing optimum replacement points, but also contributes to making decisions regarding alternative fuel or hybrid candidate vehicles, lease versus buy versus reimbursement decisions, outsourcing/out-tasking all or some of the fleet repair and maintenance functions and other items where costs are a primary concern. There are five elements to a LCA. They are net acquisition cost, fixed costs, operating costs, personal use costs, and total lifecycle cost. Each element has its own particular set or sets of data that need to be gathered. Also, each of these elements depends on a certain set of variables that need to be considered before any analysis can take place. Each of these elements, plus the original variables needed is covered in the following sections.

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2. Set of Variables

Each organization has its own parameters for how long a vehicle or piece of equipment should be kept in service. Many times, an organization wants to keep vehicles for a number of years in order to move capital dollars into operating accounts to be used elsewhere. Other organizations may elect to keep vehicles only a year or two as they are concerned about corporate image. Whatever the reasoning behind it, a fleet manager needs to know the timeframe they plan on keeping a vehicle. This is called “Target Months in Service.”

At the same time, companies also want to have parameters in place to indicate at what mileage a vehicle should be replaced. This is called “Target Replacement Mileage.” “Target Months in Service” and “Target Replacement Mileage” are not mutually exclusive. If a vehicle hits its replacement mileage mark before its months in service mark, the vehicle may be replaced earlier. Consequently, if the vehicle will hit its mileage mark after its months in service mark, it may either be sold with lower mileage than anticipated or a decision to retain the vehicle may be made. Either way, both targets need to be known as they will help to pinpoint through later analysis if those targets are correct or need to be modified.

There are many instances where an organization may expect an employee to cover a certain amount of territory or miles in a given month. An “Expected Mileage Per Month” variable needs to be determined as it also affects the “Target Months in Service” and “Target Replacement Mileage.” If the “Expected Mileage Per Month” multiplied by the “Target Months in Service” is greater than the “Target Replacement Mileage”, adjustments will need to be made before any other analysis can be completed. An example of this is below:

Expected Mileage Per Month = 1,900

Target Replacement Mileage = 85,000

Target Months in Service = 48 months 85,000 divided by 1,900 = 44.7 months (round to 45) Adjusted Months in Service = 45 months

If an organization knows the “Expected Mileage Per Month,” daily mileage can be calculated as follows:

(Mileage Per Month x 12) divided by 365 = Daily Mileage

However, this calculation can only be done if there is personal use on a vehicle. If an organization does not allow any type of personal use (either after hours or on weekends), then the daily mileage can be calculated as:

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(Mileage Per Month x 12) divided by 261 = Daily Mileage

The figure of 261 is obtained by subtracting two days out of every seven and multiplying by 52 weeks (2 x 52 = 104, 365 – 104 = 261).

If an organization leases a vehicle, the annual interest rate for the lease needs to be known. Dividing the annual interest rate by 12 months gives a monthly interest rate. However, if an organization buys all vehicles outright, then a cost of money figure needs to be calculated. The cost of money is the rate of return on investment had the money not been used to purchase a vehicle. If an organization earns 3% on their money if it is invested, then the cost of money is 3%.

This “opportunity cost” of money can sometimes be substantial to an organization. The financial policy may dictate that a “return on investment (ROI)” value far in excess of current interest rates should be used in all financial calculations. For example, a manufacturing company may determine that every dollar they invest in expanding capacity yields a return of $1.60 in net profits from sales of goods produced. They would, therefore establish 60% as the ROI. In the same way, government entities must consider the financial impact of debt to asset ratios on their bond ratings and therefore its cost to borrow money for major public projects.

If a vehicle is leased, the leasing company usually charges a lease management fee per month, either a percentage amount (for example, 0.05% per vehicle per month) or a flat rate per month (for example, $10 per month per vehicle). For companies that own their fleet, this translates into the administrative overhead per vehicle per month and can be either a flat rate or a percentage.

Every vehicle placed into a fleet depreciates over time. Depreciation is defined as lowering the estimated value of something over a period of time as use accumulates. Depreciation rates are usually agreed to with the leasing company when the vehicle is placed on the lease. For companies that buy their vehicles, they set a book depreciation rate internally in their organization. As an example, an organization may decide to depreciate the value of a vehicle over a period of five years (60 months). Dividing 100% by 60 months gives the organization a depreciation rate of 1.67% per month. The value of the vehicle is decreased by 1.67% per month so that at the end of 60 months, the book value of the vehicle is zero.

Other set variables that need to be known before a lifecycle can be calculated are the cost of fuel per gallon, the estimated personal use that will be accrued (for example, 15% of all use is personal), and the cost to provide a loaner vehicle, either by renting or providing one from an in-house motor pool.

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For most fleets, knowing insurance costs per vehicle are not applicable for a lifecycle analysis as insurance costs are quoted on the fleet as a whole under a blanket policy and not per vehicle. However, if the fleet is small (25 vehicles or less), insurance costs may be quoted per vehicle and will need to be factored in as insurance rates differ from one model to another.

To recap, the set of variables needed before lifecycle costs can be calculated are: 1. Target Months in Services

2. Target Replacement Mileage 3. Expected Mileage Per Month 4. Adjusted Months in Service 5. Daily Mileage

6. Annual Interest Rate, or Cost of Money

7. Monthly Interest Rate, or Monthly Cost of Money

8. Lease Management Fee per Month, or Administrative Overhead per Month 9. Depreciation Rate, both Annual and Monthly

10. Fuel Cost per Gallon 11. Estimated Personal Use

12. Cost to Provide Loaner Vehicle, either per day or per mile 13. Insurance Cost per Vehicle (if applicable)

3. Net Acquisition Cost

After selecting the types of vehicles for a lifecycle analysis, one should obtain the dealer invoice price (if available). If the new models have already been announced, it is relatively easy to obtain this information from sales representatives, dealers, the manufacturer or a leasing company. Invoice costs can also be obtained by reading bid award announcements or by published pricing guides. Sometimes, pricing may not be available if manufacturers are in the middle of a redesign of a model or are retooling for a new unit altogether. In cases like this, it is acceptable to estimate the “dealer invoice”, basing it on the previous years’ model with an acceptable inflation rate figure such as the Consumer Price Index (CPI) or appropriate Producer Price Index (PPI). Factory sales representatives, leasing companies and local dealerships can also provide estimates.

Dealer invoices may not reflect any type of incentives or special offers that may be available to fleets or to a specific industry segment or a specific organization. Some of these may include:

1. “Fast Start” monetary incentives (often appearing as an invoice credit) for ordering early in a new model year.

2. Regular incentives available for a full model year. These incentives may be a cash invoice credit, options at no charge, special equipment package discounts and upgrade credits.

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3. “Special Programs” negotiated with a manufacturer on an individual basis (may also be called “Manufacturer’s Additional Incentives”).

4. Dealer holdback adjustment (the incentive portion normally given to a dealer). 5. “Guaranteed Market Value” plans which assure that a vehicle’s depreciation

will be at least as good as a competitive vehicle’s depreciation, based on a published source. However, these types of plans may require a minimum quantity order and a specified service life.

6. AFV incentives or credit given to an organization for ordering specific types of alternatively-fueled vehicles. These incentives can only be considered if the credit actually appears on the invoice. Other AFV tax credits are discussed under “Fixed Costs”.

7. “Price Protection” guarantee against an increase in vehicle cost. This is usually available only before the introduction of a new model year, with order and delivery before specified deadlines.

8. “Rebate Programs” which offer credit after delivery.

9. “Late Model Programs” which offer a credit for brand new late model vehicles. 10. “Sole Source” programs which offer credits on the invoice for a fleet that buys

all vehicles only from a specific manufacturer.

The list above of credits or incentives can only be deducted from the acquisition cost if they appear on the invoice. Once the incentives or credits have been deducted from an invoice, dealer or leasing company charges or deductions need to be added in or subtracted out.

Expenditures for up-fitting the vehicle with specialized equipment, bodies, and accessories must be added to the net cost of the vehicle.

Last, but not least, charges for making ready a vehicle for service need to be added. These charges may include installing shelving, cargo screens, radios, phones, lights, sirens, computer docking stations, GPS units or adding special markings or striping. Since many fleets are geographically dispersed, adding sales tax, registration fees, license fees or other local rate charges may not be practical since these costs vary by location. However, if the fleet is located in one geographic region (state, county, city) and the costs are not equal for each vehicle, then these costs should be included because they may impact the outcome of the LCA.

After all credits and charges have been added or deducted from the invoice, the net acquisition cost is known. This can also be referred to as the “Capitalized Cost/Cap Cost” or “Stipulated Cost” particularly within the leasing industry.

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4. Fixed Costs

Fixed costs are all those expenses incurred just from having a vehicle in a fleet. These costs occur even if the vehicle is never driven. Depreciation, which represents the value of the vehicle consumed between acquisition and disposal, is the largest of these costs.

To calculate depreciation, a projected resale price of a vehicle needs to be determined, based on the “Target Months in Service” and “Target Replacement Mileage”. The resale price is an important factor in determining lifecycle costs because better resale performance for certain vehicles or options may more than offset a higher initial cost. Resale values can be estimated by checking the current resale prices on similar vehicles at auction. A number of published guides offer this type of information. Leasing companies can also provide resale price projections based on past experience. Also, companies that use a specific auction for vehicles that are owned may have data on previous selling experiences that can be used.

When a resale price has been estimated, subtract any costs related to sales fees, detailing a vehicle for sale, removing special equipment or markings, and administrative costs related to processing paperwork. This will determine the net resale price. Subtract the net resale price from the net acquisition cost for the actual depreciation.

Net Acquisition Cost – Net Resale Price = Actual Depreciation

When buying or leasing vehicles there is a cost for using the money to obtain the vehicles. If an organization leases a vehicle, the interest paid in the lease represents a direct cost of money. If an organization buys a vehicle outright, there is a loss of interest income, which could have been realized if the organization invested the money instead of buying an asset that will depreciate in value. For analyses to determine acquisition funding options, it is also appropriate to consider opportunity costs or an organization’s ROI targets.

To be as accurate as possible, cost of money should be calculated on the remaining book value each month and for the entire period the vehicle is expected to remain in service. However, applying cost of money to the average book value each year gives an acceptable general estimate and is much easier to calculate and budget. The most common calculation to use for finding a relatively accurate annual cost of money rate on remaining book value is the Step Rate Formula. An example of how to calculate the Step Rate Formula is located in the appendix to this section.

When calculating the cost of money for a LCA, a fixed rate is typically used. However, many organizations chose to finance using a variable rate. An organization’s finance department or budget office can help determine an optimum fixed rate for a LCA based on variable rate history.

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Once depreciation and total interest costs are calculated, there are several other fixed costs that need to be determined. For fleets that are leased, the leasing company charges a management fee to the lessee for each vehicle in the fleet. This charge is either a flat fee per month per vehicle or a percentage per month per vehicle based on the net acquisition cost. For fleets that are owned, the cost of managing the fleet can be considered a fixed cost. This can also be a flat fee or a percentage per vehicle per month. Either way, there is a cost for managing a fleet of vehicles, whether there is one or a thousand. Since this cost occurs even if the vehicle is never driven, it is a fixed cost.

Insurance costs are also a fixed cost. However, insurance costs may not be a factor in a LCA in some cases. If an organization is large enough and can obtain a blanket insurance policy to cover all vehicles, the cost of the policy is usually spread equally over every vehicle in the fleet. Therefore, if the insurance cost is equal no matter which vehicle is being considered, the insurance cost will not be a deciding factor in a LCA and can be left out. But, if a fleet is small and insurance is obtained on each vehicle separately, then the cost of insurance will factor in and should be included. Also, if overall costs, including insurance, need to be calculated to obtain budgetary figures, then insurance should be factored in, even if the cost is the same for all vehicles being considered.

When comparing vehicles using a LCA, it is important to remember that the delivery of the new vehicle will affect fixed costs. For example, if one vehicle can be delivered in thirty days while another vehicle is delivered in sixty days, those thirty days without the second vehicle have a cost associated with non-use. To accommodate for this delay, figuring a build-time delay cost is necessary. Using the shortest delivery time as a starting point, all vehicles delivered over the shortest delay have a cost associated with either supplying a rental vehicle, reimbursing an employee for personal use on their own vehicle, or higher maintenance costs on the vehicle being replaced. The build-time delay cost should be figured for each day over the shortest delivery time and added to each vehicle.

The cost of build time delay is particularly pronounced if vehicles are replaced in five or fewer years. The difference between selling the old vehicle at wholesale auction in October versus selling it in December can be significant because many used vehicle markets saturate quickly and dealers are reticent to build stock before the beginning of a calendar year for tax purposes.

Two other items may also impact fixed costs. If a fleet buys a hybrid or alternatively fueled vehicle, the IRS offers a tax credit that can be taken on an organization’s tax return. Since this credit is given whether or not the vehicle is actually driven, it is appropriate to deduct the credit from fixed costs. Also, if a manufacturer has made arrangements with an organization to pay an additional rebate at the end of a model

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year in the form of a check, it is appropriate to credit fixed costs with this rebate amount per vehicle since the rebate is paid whether the vehicle is driven or not.

5. Operating Costs

Operating costs are those that will be incurred once the vehicle is being used. Common items associated with operating costs include fuel, tires, oil, regular maintenance and any other repair necessary that is performed on the vehicle. Basically, anything consumed during the operation of the vehicle is considered an operating cost.

Fuel costs on a vehicle can be hard to accurately predict as various factors cannot be controlled. The Organization of Petroleum Exporting Countries (OPEC) cartel practices world crude oil market price setting by adjusting its production. However, other supply and demand variables including political strife, storms, terrorism, government regulation changes, and refinery problems coupled with market speculation still make fuel prices volatile. This makes setting a reasonable price for fuel over the life of the vehicle hard to determine. Unless there is valid reason to anticipate a significant change in fuel prices, using the most recent annual average cost is a reasonable approach.

Fuel costs also depend heavily on the types of vehicles being selected for comparison. A vehicle with a low miles-per-gallon (MPG) estimate will naturally consume more fuel over its life than one with a higher MPG rating. MPG estimates in the United States are established by the U.S. Environmental Protection Agency (EPA) and are available from their web site at www.epa.gov or can be obtained from dealers, manufacturers, or lessors. In Canada, use Environment Canada at www.ec.gc.ca. If historical data supports that a fleet gets predictably lower fuel economy than the EPA estimates because of loads carried, terrain driven or driver habits then the MPG estimates may be reduced uniformly to obtain more realistic cost results.

Fuel costs also depend on the “Expected Mileage per Month” variable. Multiplying the “Expected Mileage per Month” by the “Target Months in Service” determines the estimated mileage on the vehicle at the time of sale. Using an estimated fuel cost per gallon and the MPG of the vehicle determines the total cost of fuel over the vehicle’s life.

Maintenance and repair costs for a vehicle need to be estimated for a LCA. Many fleets rely on previous maintenance history and experience from in-house maintenance operations. Private sector fleets that lease can obtain the same information from a fleet management company or from other private fleets with the same vehicles being considered. Industry publications such as Automotive Fleet or Fleet Financials regularly publish averaged estimated fleet maintenance costs for common light-duty vehicle manufacturers and models, plus list actual maintenance cost experience by several large fleets.

Normal maintenance costs include the number of oil changes and tune-ups over the life of the vehicle, brake repairs and replacements, tire changes, and other routine

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replacement items. Some fleets prefer to add collision repairs and windshield replacement costs while others estimate these items in a separate line item in an analysis for further model consideration. Either way is appropriate and only needs to be accounted for separately if collision damage costs for like repairs between the vehicles considered are large.

Fleets that obtain a regular, inclusive maintenance program through a manufacturer as part of a lease or as a separate product should factor it in either as a flat fee per year or as a cost per mile figure.

6. Personal Use

If an organization allows an employee to use their employer-provided vehicle for personal use, there is a cost associated with that personal use. These costs are portions of the fixed and operating costs. By way of a simple example, if an employee uses a vehicle for personal use ten percent (10%) of the time it is driven, then theoretically ten percent (10%) of the fixed and operating costs can be attributed to personal use.

Organizations are required to recognize and recoup costs for the personal use of a vehicle in one of two ways:

1. Have the employee reimburse the organization for personal use.

2. Assess the employee for personal use (usually as “additional income” on the employee’s W-2) and collect taxes on this amount by payroll deduction.

If an organization does not require an employee to reimburse for personal use, including it in a LCA is not necessary. However, many fleet managers do include it to illustrate to upper management how much personal use will cost on vehicles being considered. Fleet managers may also use this cost to propose new policy changes to collect personal use expenses if the costs of assessment and taxation to the organization are greater than the processing of a check from the employee.

If a LCA is used to compare an employer-provided vehicle program to an employee-provided vehicle program, it is essential to remember to back out personal use expenses from the employer-provided assessment or the cost comparison will not be accurate.

For more information on personal use issues, please consult NAFA’s educational Info kit: Driver Reimbursement Options. For more information on lease versus buy versus reimbursement decisions, please consult NAFA’s Lifecycle Cost Analysis for Fleets and the NAFA Foundation’s Vehicle Lease vs. Buy vs. Reimbursement Model.

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7. Analysis Result

Once the fixed, operating and personal use costs have been calculated, a LCA can be determined by the following equation:

Fixed Costs + Operating Costs – Personal Use Costs = Total Lifecycle Cost Remember that personal use costs can be deducted only if an organization collects the money from an employee. If the costs are assessed to the employee and taxed, they must be included as they are costs incurred but not reimbursed.

8. Additional Discussion

Many fleet managers perform a LCA when considering replacement vehicles or when expanding the fleet. While this analysis does help determine which vehicle may be the best choice as a fleet addition, it truly does not take into account those items that are intangible, like organization image. Keeping this in mind when completing an analysis may help to further refine potential choices for vehicles.

It is wise to remember that a LCA and the subsequent choice of vehicle do not end the financial picture. Completing a LCA each year the vehicle is in service will give a fleet manager a good overall picture of how accurate the projections were versus actual costs. Police fleets are good candidates for such yearly review and analysis as police fleet units typically generate more mileage per year and more engine hours than traditional fleet units. Larger pieces of construction equipment and dump trucks are also good candidates for multi-year analysis as usage may vary by project and time of year.

As a final note, remember that a LCA is only as accurate as the data gathered for the analysis. If there are data flaws or gaps, the analysis will not give as accurate a financial picture. All assumptions must be annotated as part of the analysis for testing and refinement purposes later.

9. Determining Optimum Replacement Point

Different fleet managers have different ideas when it comes to determining optimum replacement points for units in their fleet. Some fleet managers, dealing with a budget crunch, elect to delay replacing units until additional funding is found. Other fleet managers may elect to replace units after one or two years because of corporate image. While these strategies deal with factors typically outside of a fleet manager’s control, there are ways to determine when the optimal time is to replace a vehicle.

As a general rule, depreciation per period declines faster than maintenance costs increase. Because depreciation depends on remaining book value, the higher the book value, the higher the depreciation. Maintenance costs, on the other hand, are relatively small during the first few years of a vehicle’s life because of regular preventive

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maintenance and warranty coverage on a vehicle. Therefore, depreciation is the biggest expense in the early years of a vehicle’s life.

Completing a LCA for each year over the life of a vehicle can pinpoint when a vehicle should be replaced. Again, as a general rule, when a vehicle’s annual lifecycle cost increases compared to the previous year, it is time to replace a vehicle. The reason is that while annual depreciation has decreased each year, the maintenance cost has increased enough so that the two items combined have exceeded the previous year’s total.

The cost of downtime as determined by the customers using the vehicles are most often the deciding factor in replacing a vehicle before it becomes so old that it is economically non-repairable (i.e., mechanically totaled). Assessing the financial impact of vehicle downtime on customers is a critical task in the LCA process. Reducing that impact may lead to keeping spare vehicles in a pool, using rental units, or performing maintenance during off-use hours. The cost of using any of these strategies in lieu of replacing vehicles sooner before major breakdowns predictably occur must be factored into the LCA as part of the cost of downtime for the analysis to be accurate.

10. Extended Replacement Benefits

There are benefits to keeping a vehicle in a fleet longer than originally anticipated. If the vehicle has been fully depreciated by an organization, there are minimal fixed costs contributing to its lifecycle. Or, if the vehicle is not fully depreciated but kept longer, depreciation costs can be spread out over a longer period of time, again contributing to lower fixed costs.

If a vehicle is kept longer, there is no capital expenditure made to replace it. This may be important when money is not available for capital acquisitions and must be used for operating purposes or be redirected into other more critical capital projects.

For vehicles that are kept longer and are in good operating condition, they can be redeployed in a fleet to cover an area of need. As an example, if a vehicle is needed in a localized pool, having a well maintained older vehicle serve this function may be more cost effective than buying a new vehicle.

11. Extended Replacement Drawbacks

Keeping a vehicle in a fleet longer than it should be may result in higher maintenance costs than necessary. Maintaining a 10-year-old vehicle with 150,000 miles on it will cost more per year to maintain than a brand new vehicle. Plus, added to the higher maintenance cost will be higher downtime due to major parts failure and the inability to find replacement parts. Older vehicles in a fleet do not have new automotive

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technologies (resulting in more fuel-efficient vehicles) and they may not have new safety features.

Keeping an older vehicle also may contribute to lower driver morale and may not be conducive to organizational image.

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