Protect Profit by Counting Interest and Depreciation

By Larry Stewart, Executive Editor | September 28, 2010

Quick Tip

Even if you own a machine outright, you're paying interest on the capital tied up in it. If you borrow operating capital, the rate may be equal to the percentage on your line of credit (which you would not have to borrow if your capital wasn't tied up in the machine). If you're completely debt free, your capital should probably return a percentage equal to alternate investments as risky as construction—certainly higher than the prime lending rate.

Small Change Hits Hard

How important is interest? If you decide to earn just 8 percent on your money invested in this tractor, but you borrow operating capital at 12 percent, in 7 years you will pay nearly $22,000 more in finance charges than the machine will recoup even if it earns your rate for the projected 7,700 hours.

Owning Costs
  1. Delivered price (including attachments) $135,000
  2. Residual value at replacement (35%) $47,250
  3. a. Value to be recovered through work (subtract line 2 from line 1) $87,750
    b. Depreciation Per Hour: Value (from 3a.)/Life in Hours = $87,750/7,700 = $11.40
  4. Hourly Interest Cost:
    N = life in years
    N = 7 years
    Interest rate = 10%
  5. Hourly Insurance Cost: $693 per year/1,100 hours per year = $0.63
  6. Hourly Property Tax: $852 per year/1,100 hours per year = $0.77
  7. Total Hourly Owning Cost (add lines 3b, 4, 5, and 6) $19.81
  • Fuel Cost ($1.25 per gallon × 5 gallons per hour) = $6.25

    Lubes, Filters, Grease = $1.20

    Undercarriage Cost = $3.61

    Repair and Labor Cost = $3.06

    Ground Engaging Tool Cost = $1.32

    Total Hourly Operating Cost = $15.44

    Total Hourly Owning and Operating Cost $35.25

    A simplified estimate of hourly ownership costs for a $135,000 crawler dozer expected to work 1,100 hours per year for 7 years is $19.81 per hour. Note none of the operating costs equals the magnitude of depreciation (3b) and interest (4).

  • Quick Tip

    You're trying to figure out how much a new machine will cost to own and operate—a number to use in estimates. If you don't recover some loss in value, or depreciation, over the life of the machine you will be giving a little of the machine away every hour it works. Before subtracting market resale value for similar machines from the sale price, though, remember those dollars will buy less when you sell the machine than they do today. If you don't adjust the resale value down for inflation, you'll recover less than your actual loss in value.

    Inflation Squeezes Residual Values

    Don't think inflation is a big deal? If you don't adjust expected residual value on this machine before calculating its rental rate, after 7 years, 3 percent inflation will rob you of $8,855 of the machine's value.

    Suppose 8 percent return on capital is good enough for some hypothetical manager, and his dream banker lends operating capital at 10 percent. He pays $10,780 more in finance charges than his rate recoups. If he figures that 3 percent inflation is too low to hassle with, in 7 years he's lost a total of $19,635 in profits on this one machine. That's $2,805 per year.

    Some folks are so caught up with the daily demands of keeping machines deployed, fueled and maintained, they only include cash costs like taxes and insurance in their machine rates. They count on their fee, or profit margin, to cover the biggest elements of ownership cost—interest and depreciation. Unfortunately, failing to include the fully loaded ownership cost in an estimate hides the true cost to run machines, and the true profit made on the job.

    The good news is that calculating interest and depreciation on machines is fairly simple (these formulas will get you started). And if you make sure they're recouped somehow in company cash flows, you can save yourself a trip to bankruptcy court.

    The problem with these costs is that they're not cash costs. You don't get a bill for interest or depreciation, but you make installments on the two costs every day. The key to managing them is making sure they're covered. Leaving interest and depreciation to be picked up like a general and administrative cost out of the project fee not only makes it difficult to tell how much your machines actually cost to own, but it confuses the profit picture. The fee on a labor-intensive job may cover machine-ownership costs without squeezing the profit margin. But depreciation and interest costs on several machines working an equipment-intensive job will eat up a much larger portion of the profit. Without these non-cash costs in the rates, you can only guess at how much money you made.

    Set your rate

    It's easy to include interest in your ownership-cost calculations when you're paying off a banknote on a piece of machinery. It's tempting to drop interest from the cost figures after the note is retired, but even then equipment users are not finished paying interest.

    The owner, or whomever supplies capital to fund the company, has to earn a return on the money committed to machines in order to maintain the value of capital invested in the operation. If interest is part of the machine's rate, you're motivated to keep money invested in machinery. If it's not in the rate, when you pay finance charges for any loan you're spending profits. Think about it this way: You wouldn't have to borrow as much money if you had the capital that is tied up in equipment.

    Financial officers see the cost of capital every day. It's equal to the interest the firm pays on borrowed working capital. It can also be equal to the revenue generated by the firm's investments in payroll, materials and assets.

    Some CFOs expect the return on capital invested in equipment to be equal to the prime-lending rate. Another group argues that because construction is a risky business, it should produce better-than-average returns. To them, 12 to 15 percent interest is reasonable.

    Tomorrow's residual today

    If you plan to maintain the value of your investment by charging project owners a rate equal to the machine's loss in value while you own it (purchase price minus residual value), you're taking an important first step in accounting for true equipment costs. This is actual depreciation. The difference between this loss-in-value figure and depreciation schedules for tax purposes is that tax law dictates how long an asset can be depreciated based on issues other than the actual life of the machine. Loss in value, or value to be recovered by work, should represent actual machine life. Forget tax depreciation when calculating equipment costs. Focus on actual depreciation.

    Residual value plays a big role in calculating real depreciation. Because it is a future transaction, don't forget to adjust residual value for inflation's natural erosion of purchasing power. Recently, U.S. inflation has hovered around 3 percent. The residual value you take in 5, 7 or 12 years is going to buy less replacement equipment than it would today. Adjust the residual value down for the affects of inflation, and you'll recapture the full loss in value of the machine during its life.

    Rental rates established without benefit of inflation adjustment won't generate enough revenue to recoup depreciation. For example, resale rates suggest the tractor you just bought for $135,000 will sell for $47,250 in seven years. But that $47,250 is going to buy less in seven years. If you don't want to lose money to inflation, you adjust the value of the future transaction—the sale of the machine—for 3 percent inflation with a compound interest calculation. Here's the equation:

    P = F/(1 + i)n

    P = present value

    F = future income or expense

    i = interest or inflation rate

    n = time before the transaction

    Here's how it works:

    $47,250/(1 + .03)7 = $38,419

    The compound-interest equation is also used to adjust the value of future expenses, like planned overhauls, to make sure your rates provide adequately for those costs.

    Should they affect rates?

    How you recoup capital costs—in the equipment rate, as part of profits, or creative billing—is a policy matter that may be best left to company financial officers. Adding capital costs to rates is often resisted because it inflates estimates, and there's a lot of competitive pressure to reduce hourly equipment rates.

    Be careful how you manage machines if the internal rates you charge operating groups for machines neglect or discount interest and/or inflation. Leaving these largest elements of ownership cost out of machine rates makes it very difficult to accurately compare the cost of rental, leasing, or other alternatives to the cost of owning a machine. An artificially depressed rate might convince you to own a machine that is actually cheaper to rent, or to do work yourself that a subcontractor is bidding cheaper. You can't know for sure unless you compare the rental rate to your own actual costs, including real depreciation and interest. If the rental company or the subcontractor wants to field equipment without covering their full interest and depreciation costs, it seems unwise to give away your own money trying to compete.

    Accurate depreciation schedules contribute to estimates that reflect the real cost of doing business with equipment. Including in each machine's hourly cost the actual depreciation, and a percentage for return on the firm's capital investment, results in a real cost number you can use to make smart business choices. There's no rule that says you can't discount equipment rates in order to win a fierce bidding competition. But if all the costs are accurately represented in the rate, at least you will know how deep you can cut prices before you lose money on the job.