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Thoughts on Equipment Costing

Equipment Costing: What You Don’t Track Can Hurt You
 

I.    INTRODUCTION

Logging companies invest literally millions of dollars in processors, skidders, and other types of equipment to run their operations.  From an economic standpoint, making an investment in such capital equipment only makes sense if the revenue generated by the equipment exceeds the cost.  All too often, loggers face the specter of bankruptcy as a consequence of failing to measure their costs correctly.  Just ask Ritchie Brothers. 

Calculating your equipment cost is not only important for measuring your profitability, it is also important because many mills spend a great deal of time estimating equipment costs in order to set logging rates.  Specifically, they estimate the costs per productive machine hour that a contractor should be able to achieve for each machine involved in harvesting a cut block.  They then convert the hourly cost to a cost per output (e.g., cubic meter), based on an estimated production per hour ratio.  For example, if the hourly cost of a buncher is calculated as $150.00, and it produces at a rate of 50 M3/Hr, the cost per cubic meter is calculated at $3.00.  This rate-setting exercise theoretically ensures that the contractor earns enough to cover his equipment costs and earn a decent return on his investment.

The question, of course, is how to arrive at this hourly cost figure, and what exactly it should include.  There is no set formula for calculating the cost of a piece of equipment, but an accounting cost “build-up” approach is fairly common.  Under such an approach, one identifies all the relevant expenses on an annual basis and then spreads them over productive hours in order to arrive at an appropriate hourly cost.  This paper explores the types of costs typically included in such a build up and identifies some of the key issues involved in measuring the costs.

II.    ACCOUNTING FOR YOUR EXPENSES

The expenses used by most logging companies and mills in their cost build-up exercise generally fall into four basic classifications: routine operating/service expenses, operator costs, capital expenses (depreciation and insurance), and a return on investment.  There are a number of subtleties within these four basic categories that can significantly impact the final costing figure.  When analyzing your equipment costing, it is important to take these subtleties into consideration.  In this section, we explain the four basic categories in more detail, and point out some of the subtleties that should be considered within each category.

1.  Operating Expenses.  

Operating expenses are relatively straightforward and include the cost of all fuel and fluids, routine maintenance and service expenses, and any other expenses related to the day-to-day operation of the machine.  Often, equipment owners have difficulty tracking the exact fuel consumption by a piece of equipment and rely on an estimate of consumption per hour.  Thus, fuel expenses are usually calculated based on an estimated consumption per hour and estimated annual operating hours.  In order to reduce the uncertainty of this calculation, it may be worthwhile to make the effort to track fuel consumption more precisely, even if just for a short time, to obtain a better estimate of fuel use per hour.  Of course, recently, the most uncertain element in this calculation is the price of diesel which has varied widely over the past couple of years. 

Maintenance/service and repair expenses paid to third parties are relatively easy to track; the cost of using your own operators and mechanics to maintain your equipment is more complex.  An important omission that loggers often make when calculating these costs is that they fail to account for the full cost of their own mechanics and shop.  If you use your own employee mechanics to perform your equipment maintenance and repair work, be sure to include their full costs, including direct payroll expense, a payroll load for EI, CPP, benefits, etc., plus an allocation for the use of any tools or shop that you employ.  Essentially, your mechanics should be costed as if they were an outside repair shop. 

2.  Operator Expenses. 

The costs of employing the machine operator should generally be separated into their own distinct category, apart from other machine operating expenses.  It is common practice for loggers and mills to use an “All-Found” rate in their equipment cost build-up, which includes some general industry assumptions about labor costs.  These generalized labor cost assumptions are not, however, necessarily reflective of the true labor costs that you face. 

When calculating your equipment costs, it is important to use your own actual operator costs (including the costs of any overtime you have to pay, and any union wage benefits that you face), rather than relying upon industry standard assumptions about labor costs.  Ensure that your operators keep time sheets accounting for all their time, and have them distinguish between time spent productively operating a machine and time spent doing other things (such as safety meetings, machine repairs due to a break-down, daily machine service, etc).  When accounting for the labor costs associated with a machine operator, be sure you account for the cost of all labor hours (both down time and productive time).  Also, be sure to include a payroll load that reflects the costs CPP, EI, and any benefit packages you provide.

3.  Capital Expenses. 

Capital Expenses include insurance and depreciation.  Insurance is generally straightforward to calculate; depreciation is not.  Typically, depreciation is calculated on a straight-line basis, where the depreciation basis is the cost of the machine (less salvage value) plus any capitalized repairs (e.g.  a new engine). 

While this method is simple, it is a poor reflection on the true economic depreciation a machine experiences over its life.  Typically, a machine will lose a greater percentage of its original value in the early years of its life and this decline will steady off as the machine grows older.  In reality, the depreciation expense should be higher in the first few years and decline later on.  The “declining balance” depreciation method, used for tax purposes, is designed to approximate more accurately the observed economic depreciation than the straight-line method.

Just how much of an effect do different depreciation methods have on the overall equipment costing estimate? Suppose we take a machine that costs $100,000, lasts 5 years, and has a salvage value of $25,000.  The straight line method will yield an annual cost of $15,000, with a present value of $56,862 (at a 10 percent discount rate).  If we use the tax rule of 30 percent declining balance depreciation, the present value over five years is $67,173 -- a difference of 18 percent.  Though using the straight line method is simpler, we must recognize that it tends to introduce a downward bias in the cost of the machine.

Having noted this difference, it is important to recognize that maintenance expenses actually behave in an offsetting manner to the pattern of economic depreciation.  Maintenance expenses tend to be smaller at first and then grow over a machine’s life.  So, if you choose to use the straight-line approach for depreciation because it is easier, you should also use an ‘average’ level for maintenance and operating expenses (where the average reflects an expectation of expenses over the life of the equipment), and not just the current year.  For example, if you use the current year expenses for a new machine, this amount will understate the average expenses over the life of the machine unit.  The point here is that if you level out depreciation over the life of the machine, you should also level out the maintenance expenses as well.

4.  Return on Investment. 

The expected income stream earned by any asset must cover the return the investor requires to make the investment.  This amount is your profit.  The question, of course, is how to assign a rate of return to your capital investment.

The typical calculation of this return involves a ‘weighted cost of capital’ approach: take the debt-financed share of the asset and assign a market interest rate to that share.  Then add a return to the equity-financed share. 

For example, suppose a machine has an acquisition cost of $100,000 of which 80 percent is assumed to be financed by debt at a 5 percent interest rate and the remaining 20 percent is financed by equity and assigned a return of 10 percent.  In this case the weighted cost of capital would be 6 percent = ((.80 x 5) + (.20 x 10).  This 6 percent is then multiplied by the ‘average’ investment in the equipment.  The average investment is the average annual basis you have in the asset.  In our example, if the machine were to last four years and have a salvage value of $20,000, the average investment (basis) would be $60,000.  So, the 6 percent return would be applied to $60,000 basis, to yield a net return of $3,600.  This return is then spread over the annual number of production hours to calculate the profit element per machine hour.

Because debt is assumed to be less risky than equity, this approach results in a lower cost of capital (and thus a lower profit to you!) than if the entire purchase was financed by equity.  Does this approach make sense? There is another competing (and, some would argue, more sound) view that says the cost of capital is independent of the method of financing.  That is, the financing arrangements allocate the risk of the investment among different investors (you and the bank), but do not change the total risk inherent in the investment. 

A basic premise of economic theory is that the expected income stream earned by any asset must cover the return the investor requires to make the investment, otherwise the asset will not be purchased.  Depending on the variability of the income earned by the machine, the investor will require an extra ‘risk’ premium over and above the market risk-free interest rate.

The financing arrangements serve to allocate the risk among different investors (e.g., you and your banker), but do not change the total risk inherent in the investment Thus, whether an asset is financed by debt or equity is largely irrelevant to the economic cost of employing the asset.  What matters is the underlying risk of the business in which the machine is employed.  Think about it: does paying off an equipment loan early (so that the bank no longer owns a part of your asset) somehow reduce the cost to you of owning that asset, and thus the profit that you must earn from it? It may reduce your monthly interest bill, but it does not reduce the economic cost of owning a $500,000 piece of logging equipment!

The moral of the story is that the equipment owner must be compensated based on the riskiness of his overall investment.  So, an overall cost of capital that is appropriate to the inherent riskiness of a logging business should be applied to the entire equipment investment (not just the equity-financed share).

So, what is the appropriate rate of return that should be used? As a back of the envelope calculation, we took a look at the financial performance of three of the largest lumber producers in western Canada, namely Weyerhaeuser, Canfor and West Fraser Timber.  For each of these three companies, we calculated the operating return on assets that each company earned over the 2001-2005 period.
The statement for each truck owner will show the payments for each 'pay like trucking' activity as a separate line for each load.

Operating Income as a Percent of Total Assets
Company	2001	2002	2003	2004	2005	Average
Weyerhaeuser	3.3	4.0	3.4	8.0	2.8	4.3
Canfor	3.5	4.3	6.7	27.0	9.7	10.2
West Fraser	9.7	14.0	5.2	16.5	10.2	11.1

Note: Operating income is defined as income before tax, interest and extraordinary items.  We have added back 80 percent of the countervailing/dumping duties that these companies have deducted and will be refunded forthwith.  Total assets are defined as the average of the beginning-of-the-year and end-of-the-year balances for total assets.

The table shows that these three companies have earned a return generally in the range of about 4 to 10 percent over the five-year period. The average across all years for all three companies is 8.5 percent. As one cog in the forestry products supply chain, it seems reasonable that the harvesting function should earn at least the same return as other parts of the forestry business.

III.    A WORD ABOUT ADMINISTRATIVE OVERHEAD

There are a variety of business practices amongst logging contractors and their mills with respect to the treatment of administrative overhead expenses.  These expenses are a fact of life for any company, no matter what industry.  They include such items as: the payroll costs of your accounting and clerical staff; the payroll costs of your supervisors when they are managing your operations or training new employees rather than running a piece of harvesting equipment; the cost of your own company pick-ups used to transport your workers to and from a job site; your office rent and office equipment; the cost of your company Christmas party; and any other costs incurred to run your business that does not fall into one of the four categories noted above.

Some mills provide an explicit dollar amount per volume harvested to cover administrative costs.  If your mill does not provide compensation for administrative overhead in such an explicit way, you will need to treat these costs as a fifth cost category that should be accounted for when building up to your hourly equipment cost rates.  These costs are as critical a part of running a successful, long-term logging operation as the repair and maintenance costs associated with your equipment, so make sure that you are compensated for them.

IV.    TRACK AND DOCUMENT

It is essential to have hard data in your hands when you enter rate discussions with a mill.  Caribou Software’s Logger’s Edge program, designed specifically for logging contractors, can help you in three basic ways:

1.  It can help you track your expenditures for operating expenses (fuel & fluids, mechanics, operators, etc.), including payments to third parties, payroll for your own employees, and a payroll load for your own employees.

2.  It can help you build up to an estimate of the operating cost for your own equipment.  The Logger’s Edge software includes a worksheet template that allows you to input your machine assumptions and then calculate your hourly equipment cost.  You can establish your own benchmark to gauge whether a job is a worthwhile undertaking or not.

3.  It can track your machine and labor hours and costs on each job, thereby providing a better picture of the underlying economics (read profitability) for each job.  This job costing exercise is a critical process for all loggers to go through in order to prepare for rate negotiations with mills or to prepare bids on new jobs.

The mills are sharpening their costing pencils, so yours needs to be even sharper.  As the old adage goes, information is power! To the extent that you track your cost and production data by machine, you have a fighting chance at the bargaining table.