Factors That Affect the Equipment Rate

By Mike Vorster, Contributing Editor | September 28, 2010
The diagram shows how many areas can be used to focus on, calculate and calibrate the rate.

Mike Vorster
David H. Burrows Professor of Construction Engineering and Management at Virginia Tech. See ConstructionEquipment.com for full archives of “Equipment Executive.”

The equipment rate means many things to many people. People within the organization use it to estimate costs and measure performance, but they forget that the rate is nothing more than an interim estimate for the actual full lifecycle equipment cost the organization expects to experience if everything proceeds as planned.

The need to establish an hourly, weekly or monthly rate for a machine stems from the fact that most equipment costs occur in relatively large, discrete amounts spread at random times throughout the life of the machine. The rate averages out these large, infrequent expenditures and spreads them evenly over the life of the machine so that costs can be estimated and performance can be measured over shorter periods of time. The rate is, in fact, much like an insurance premium: You pay relatively small, regular amounts to cover the cost of the large transactions that you expect will, but hope will not, occur in the future. As with an insurance premium, the higher and more frequent the claims, the higher the payments.

Good, accurate and reasonable equipment rates play a critical part in three important aspects of construction management. First, they are used in estimating where they strongly influence the company's ability to competitively price work. Second, they are used in job costing to measure performance and profitability at an operational level. Third, they are used in equipment management to create benchmarks, standards and norms used for budgeting, cost control and a variety of other decisions. Setting the right rate for an item, category or class of equipment requires substantial thought, careful analysis, and good judgment.

The diagram shows how many areas can be used to focus on, calculate and calibrate the rate. The process starts at the bottom left of the diagram with a good theoretical calculation using a standard format such as that given in “How Estimates Affect Cost Calculations” or as described in many manufacturers' publications.

Theoretical calculations are usually based on a brand new machine, a competitive or commercial rate for the cost of money, the full lifecycle costs for repair parts and labor, and an assumed residual value. The resulting value provides a theoretical baseline for owning-and-operating costs under the assumed conditions and helps to show how internal policies for inputs to the calculation (such as depreciation, utilization and cost of capital) affect the rate.

The insights provided by a theoretical calculation are greatly enhanced if the calculation is repeated using a range of values for age and utilization so that both the magnitude and the timing of the minimum owning and operating cost point can be determined. This gives benchmark values for minimum cost as well as economic life and provides the information needed to set up a structured and quantitative approach to fleet-replacement planning. Theoretical calculations are also good for splitting the rate into its principal components such as depreciation, fuel, wear items and repair parts and labor.

Managers should test or calibrate the theoretical calculations using published standards and norms as shown in the bottom right of the diagram. Many agencies publish what they think the rate for a given class of machine should be under the conditions they assume. Every organization is different and individual experience can vary tremendously with time, location and economic factors. Great care should therefore be taken when using industry-wide published standards, and they must be constantly adjusted for changes in input costs such as labor and fuel. They do, however, provide a good starting point. You must be able to explain why your calculated rate for a 4-cubic-yard, 200-horsepower wheel loader comes to $95 per hour while the method proposed by the Army Corps of Engineers produces a result of $52 per hour for your local area.

The top row of the diagram shows a different process for setting equipment rates. It relies on the fact that the company has been in business for a while, that it keeps good cost records, and that it is able to use gains and losses relative to existing rates to set rates that reflect the current costs actually experienced.

Two different mindsets are found in practice. The first sees the rate as a “rental rate” and uses the product of the rate and the hours worked to generate a “revenue” that is offset against the actual costs to give a “profit or a loss” for each category of equipment. The other sees the rate as a “cost-recovery rate,” and users of this method believe that the product of the rate and the hours worked is a “costrecovery” that should equal the actual costs experienced as closely as possible. The former approach is in more common usage; the latter approach is more correct and helps drive home the fact that the rate is determined by the actual costs experienced.

The gold standard is using accurate equipment costs and a knowledge of gains and losses relative to current rates to set rates that enable each category of equipment to support itself and recover its actual costs. It is not easy to do, and it is not foolproof. The future does not necessarily reflect the past, and historical data cannot be used without care and judgment. This is particularly true when categories are relatively small and when the age of individual units in a category is not well distributed.

It also requires that cost data be collected and grouped by both cost type and equipment category. This makes it possible to establish an hourly cost recovery rate for undercarriages (the cost type) on crawler dozers less than 150 horsepower (the equipment category). Collecting costs into cost or category buckets that are too coarse can easily lead to a situation where “if you have enough things then, on the average, the average will be average” and produce meaningless results. As an absolute minimum, cost types should be segregated into ownership, operating, fuel and overhead; and equipment categories should be defined clearly by equipment type and size or power.

The two cells on the side of the diagram provide the ultimate way to calibrate either theoretical or cost-based rates. “What will the market bear?” and “How can the company be profitable at this rate?” These are real facts of life in a competitive world, and all aspects of company operations must be examined if calculations and available data produce rates that differ from like-for-like comparisons in the competitive arena.

Remember that the rate is the end result of all that has gone before. High rates are the symptom not the disease. They arise because there has been overapplication, under-utilization or bad preventive maintenance. Nothing is achieved by treating the symptoms and leaving the disease. Looking at all the factors shown in the diagram will give confidence in your rate structure and lead to appropriate action.