The price of not knowing costs. As more customers switch from prioritizing purchase price to life-cycle costs, knowing how to calculate the total financial burden of operating equipment is increasingly important. Volvo CE's Dr. Govi Kannan explains 'cradle to the grave' arithmetic.



Construction equipment is often the biggest investment many operations make. But knowing quite how big an investment is not always easy. If a study of construction equipment by Virginia Tech in the US is to be believed, then owners on average spent the same on repairs during the life of their machines as they spent on the initial purchase price. The problem is that many of these costs lie obscurely hidden under a raft of operating cost variables.

Knowing the real cost of owning machines is of interest to more people than just the company accountant. It can also help answer such dilemmas as: 'How should I pay for my machine - savings or finance?', 'How long should I keep it?', 'What do I need to charge for it to make money?', and: 'What should my maintenance strategy be?'

The fact is that having the optimal equipment policy in place can play a significant part in determining profitability and competitiveness - and yet few users of construction equipment are sufficiently aware of their costs to do it effectively. It's easy to see why: equipment managers have to juggle lots of variables, such as asset management, job costing, analysis of fleet performance (age, cost, reliability), ownership period and economic decisions (repair, replace, rebuild, retire), financing methods, preventative maintenance programs and repair guidelines. Added to this, the only aspect of this mix that is known with certainty is the purchase price. All other costs, such as residual value, repair, maintenance and wear parts are, at best, guesstimates.

Total Cost of Ownership

As can be seen, working out all the costs of a machine 'from cradle to grave' is not easy - but it can be done. Likely costs in the future can be discounted back to give a present value, so that units of work such as production per hour (ton/hr or yd3/hr etc), cost per hour ($/hr etc) or unit cost ($/tonne etc) can be calculated. Establishing the unit cost is especially useful as it can compare dissimilar machines (gauging cost with output) - so it can compare small loaders and small trucks against large loaders and large haulers, etc.

The costs of a machine can be classified as either 'fixed' or 'variable'. Things like purchase price, depreciation, and interest are fixed, as they arrive when the machine is bought and vanish when it is sold. In-between these two points you need to pay these costs regardless of whether the machine is being used or not. On the other hand operating costs are those incurred only when the machine is put to work (e.g. fuels, tires, wear parts, repairs etc). Unfortunately, it is often only fixed costs, such as purchase price that tend to be considered when deciding the type and brand of machine to buy. But with equipment costing tens, and sometimes hundreds of thousands of dollars, operating costs as well as fixed costs need to play a part in the evaluation process.

It's good to guess

The only certain way to calculate the hourly owning and operating cost of a machine is to wait until you have sold it, add up all the money spent on it and divide by the hours worked. However, it is better if you can estimate what the costs may be rather than what has happened (and the money has been spent). Good estimating requires the use of data, realistic assumptions as to what may happen, and an understanding of the uncertainties involved. Fuel consumption, tire wear and preventative maintenance can be estimated using modern tools and techniques. You can use auction results to establish the fair market value. Even repair costs can be estimated, on the basis that they rise as the machine grows older and are a function of application and environment.

The ideal ownership period is one based on costs (ownership and operating) rather than physical condition. How long you keep a machine should include a discussion on the likelihood of component failure versus average lifespan. But one of the most important factors is the role played by the operator. The way equipment is operated has the largest impact of all on operating costs. How well an operator uses the equipment is a function of knowledge and commitment - do they know how to use the machine properly and are they motivated enough to do so?

Preventative maintenance is an unalloyed good, and should be seen as an investment rather than a cost. It acts as 'the eyes and ears in the field' and helps avoid breakdowns. The worse thing about breakdowns is the collateral damage it causes. A $500 bearing can ruin a $7,000 transmission - and then there is also the cost of lost production through the machine's unplanned downtime. It is hard to measure this collateral damage but its impact is undoubtedly huge. When it comes to preventative maintenance: "If it isn't broken, don't fix it" becomes "Change it before it gets broken"!

The calculation

Despite the fact that there are many variables, when it comes to creating an actual calculation we find that we are not 'data poor' but rather lack a structure of turning the available data into the information we need. A lot of useful information is captured by machines' on-board computers and manufacturers can also help provide the necessary data. By using a computer it becomes easy to create a simple but very useful spread sheet.

It is important to collect data on ownership and operating costs separately, and when creating the spreadsheet to use well known categories (depreciation, fuel, insurance, tires etc). Also, don't always assume the 'worst case scenario', as bidding for work on such a conservative basis may mean the resulting costs leave you uncompetitive when tendering.

Here is an example of how to construct a total cost of ownership spread sheet:

A. Purchase price (inc. options, delivery & set up costs). Often these are the only cost known with certainty.

B. Purchase price minus tires/tracks (best estimate). Tires and tracks are operating costs and so should be removed from the owning costs.

C. Ownership period. The intended life of the machine in the fleet is the period over which depreciation is divided. This can be based on economic life or physical life, or a compromise of the two.

D. Residual value. The future market value of the machine - discounted back to a present value. Here, trade magazines and auction results can help to find a reasonable estimate of final realizable value.

E. Annual depreciation cost. This is calculated by deducting the residual value from the purchase price and dividing the remaining amount by the No. of years the machine is to be kept.

F. Interest rate - used to work out the cost of capital. (Can vary depending on whether own funds are used or borrowings).

G. Calculation of interest cost based on average annual value.

H. Machine tax, if any.

I. Insurance costs (annual).

J. Fuel cost (e.g. per liter/gallon). Assume the present cost of fuel - as it can vary wildly over the lifetime of a machine and is almost impossible to predict accurately. It can be changed easily once the spreadsheet is created.

K. Fuel consumption per hour. (Based on application, environment, operator skill/commitment and machine design.)

L. Preventative maintenance cost. (Including material, labor, travel time and mileage.)

M. Interval in hours (corresponding to cost as stated in 'L').

N. Tires/tracks (the cost of a complete set).

O. Lifetime of tires/tracks for a given application (in yrs).

P. Repair cost for the intended life. (This is worked out by setting up a separate spreadsheet showing all major components' lifespan, parts and labor costs). The life of components and wear parts typically depend on the environment, application and competence of the operator. The rise in repair costs is the single most important factor in determining how long to keep a machine.

Q. Operator cost (on an annual basis). These can be left out if only a machine cost is needed.

R. Expected use in terms of working hours per year.

Once the spread sheet is constructed, you can quickly see a variety of useful information; such as real ownership costs per hour, real operating costs per hour - as well as a total overall hourly cost for owning and operating the machine. The sensitivity of individual variables can then be identified, by adjusting the assumptions and noting the impact changes have on costs (e.g. what happens if the price of fuel rises by $0.50 per gallon?). By focusing on the elements that have the biggest impact on results, and taking extra effort to ensure these figures are as accurate as possible, users can make investment decisions with a good deal more confidence.

Knowing the true cost of running a machine allows customers to have the most appropriate fleet for their need, bid more accurately for jobs and also choose their optimum point for replacing equipment. It is possible to lift the shroud of uncertainty regarding total cost of ownership and make the ambiguous seem - if not quite crystal clear - then at least a lot less foggy.