Life-Cycle Cost Analysis: Getting the Most from Your Limited Budget

Article excerpt

Financial constraints often force fleet managers to make tough equipment decisions-Should I repair a vehicle or replace it? If I do repair it, how much work should I do: just enough to get by, or a complete overhaul? 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 to fleet managers for making decisions of this nature is the net present value (NPV) life-cycle cost analysis. Instead of relying on guesswork, and not being able to fully defend your position, an NPV life-cycle cost analysis will show you the true total cost of each alternative.

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Many fleet managers have used life-cycle 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. Second, decisions made by a fleet manager working for a tax-paying 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 directly related to an entity's cost of money A tax-paying businesses 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 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 your 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 your business has a tentative gross profit of $1,000 for a period, and the effective tax rate is 10 percent. That means that you will owe $100 in taxes for the period, leaving you with a net income of $900. If you incur an expenditure of $100, your gross profit will drop to $900 and your tax liability will drop to $90. That means that your net income will be $810, so the additional $100 expenditure actually only costs you $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 available spreadsheet programs perform the calculations for you once you input the necessary information. The biggest single issue the fleet manager faces with this type of analysis is that it documents the total cost to the entity, as opposed to just the fleet manager's budget. However, your 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 ad ditional funds when justified by your analysis. …