Defer Equipment Replacement Plans?

Pat Crail, CEM | September 28, 2010

There are those who would argue that we cannot afford to deviate from established fleet replacement plans in lean times; that by doing so, we delay the inevitable and, in the meantime, increase repair and maintenance expense while decreasing reliability. Another argument against deferring replacement is that once your plan gets off-track, it will take years to get it back on the rails. These are valid arguments, and in normal times, it’s tough to argue with the assertion that the prudent decision is to stick to your established replacement plan through the normal peaks and troughs of the business cycle.

However, these are anything but normal times, particularly for construction and related industries. For many contractors and materials producers, business is off 20%, 30%, 40% and the near-term future is uncertain, at best. Many firms have worked through the backlogs that prevented a complete disaster in 2009 and see little work in the pipeline for 2010. Will we have a nice “V”-shaped recovery, with a quick return to the "good times?" Will we see a “U”-shaped recovery, slowly turning positive over the next couple of years? Or will we see the feared “W,” with a quick bounce up and another precipitous drop? 

No one knows for certain, yet we still must plan for the year ahead.

Will the plan work today?

One school of thought is that the shape of the recovery should not influence your fleet replacement plan: stick with it and manage fleet average age. But is this approach really a prudent use of capital in today’s economic climate? Does it make sense to invest scarce capital in assets that may not earn a return over the next 12 to 24 months? Mind you, I’m not advocating abandoning your fleet replacement plan altogether but, rather, adopting a flexible approach based on your firm’s circumstances. There is no right or wrong way, but a series of informed decisions: the appropriate decisions will depend on your organization’s strategy, ownership, capital structure, financial strength, and the relative certainty of your workload in the near future.

After careful analysis, and in alignment with the strategy and goals of the organization, a fleet’s management team may reach the conclusion that the prudent choice is to delay part or all of its planned equipment replacement until such time as those machines will be able to work productively and earn a return on the investment. After all, machines are assets. They are a use of the firm’s capital and are expected to earn a return at least equal to the opportunity cost of that capital. Perhaps that capital can be put to better use until the future is more certain. I would suggest that this isn’t turning away from your replacement plan, but adjusting the plan to maximize the organization’s return on invested capital.

An example to consider

Suppose you are a medium-sized asphalt and aggregate producer with a fleet of 100 wheel loaders. You have a replacement plan in place based on your typical business cycle, and average 2,000 hours per year on each machine. You have calculated 20,000 hours as the ideal economic life of the machine, the point at which total hourly owning and operating are at a minimum. As such, you replace 10 machines per year, maintaining an average age of approximately 5.5 years for your fleet of wheel loaders.

Your materials business is off 30% for 2009. You’ve built up inventories and gotten ahead of plant maintenance during the slack season while keeping your workforce employed. However, 2010 is looming: The construction firms who are your customers are burning through their backlogs, Congress hasn’t addressed highway funding, and stimulus jobs are letting slowly. Your internal forecasts are pointing to a slow 2010, and it’s time to place your equipment replacement orders. This is one of the series of informed decisions you’ll have to make: Do you forge ahead with your replacement plan or adjust to the economic climate and delay the replacement until the machines can work productively and at capacity?

Do you invest $3.4 million of your firm’s capital in 10 wheel loaders for the sake of maintaining fleet average age, or do you conserve capital and put it to work where it can earn a return? The opportunity cost of that $3.4 million will vary depending on your organization and its alternative uses for that capital, but any positive return has to look attractive when compared with the alternative. Capital invested in idle machines earns a negative return, as opportunity cost and depreciation expense take their toll. Capital invested in underutilized machines fails to earn the organization’s required rate of return and results in increased hourly ownership cost.

Playing the risks

Granted, there is some risk involved in delaying replacement. Machines that should have been retired may break down while you try to get that extra year out of them. You may have to replace some failed engines and transmissions that you would otherwise have avoided, increasing repair and maintenance cost. Reliability will likely suffer. However, if your forecasts are correct, you’ll have plenty of excess machine capacity to pick up any slack caused by breakdowns, and the use of the additional capital may well justify any extra repair expense. There is also a risk that your forecasts are wrong, and that you’ll end up with plenty of work. If that happens, you’ll be asking these machines that should have been replaced to work a full year at capacity, and the downtime could be costly.

There are sound arguments for maintaining fleet average age through a rigid fleet replacement plan. However, all plans should be subject to periodic review and revision as circumstances change. This is often called the control function of management: reviewing plans, making sure they are effective and appropriate in light of changing internal and external environments, and adjusting those plans as appropriate. We must also remember that the fleet is a collection of assets, and its purpose, just like the other assets of the firm, is to earn a return. There are times where the capital we would normally invest in the fleet could be put to better use elsewhere until things return to normal.