Pay Me Now or Pay Me Later

Some decision makers equate putting off vehicle replacement purchases with saving money, but sooner or later you have to pay the piper.

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Funding for vehicle replacement purchases is a frequent target of budget cutters when a company is under pressure to reduce costs or increase profits. Unlike employees, vehicles don't talk back when management decides that postponing replacement purchases is a good way to help balance the budget. While periodic economic downturns and the financial pinch they create can serve as a valuable corrective to the sometimes unfettered spending of, say, the late 1990's, many organizations risk increasing overall fleet costs if they tip the balance of fleet replacement spending too far in the other direction.

The Economics of Vehicle Replacement
The economic principles that should drive fleet replacement spending are hardly a mystery. Anyone who has ever owned a vehicle for any length of time knows that capital costs (a vehicle payment, for instance) are high and operating costs (e.g., repair) are low when a vehicle is new. Over time, however, capital costs diminish -- when the vehicle payments come to an end, for example -- and maintenance and repair costs increase; sometimes unpleasantly so, such as when an unexpected and unexpectedly large repair bill puts a crimp in your plans to replace that old sofa or buy the big-screen TV you've been eyeing. Keeping an older vehicle is, in fact, a bit of a crap shoot: you hope to enjoy freedom from vehicle payments as long as possible, knowing that declining reliability and increasingly frequent trips to the repair shop eventually will force you to suck it up and go shopping for a new vehicle.

The diagram below illustrates these twin economic phenomena graphically. The combination of diminishing capital costs and increasing operating costs produces a U-shaped total life cycle cost curve. From an economic standpoint, vehicles should be replaced around the time that their operating costs begin to outweigh their capital costs -- that is, when the total cost curve has bottomed out and begins to turn upward.

When you take the time to actually quantify the life cycle costs of a particular type of vehicle, you often find that this total cost curve is relatively shallow or flat at the bottom. This means that there is not a single point at which the vehicle should be replaced in order to minimize its cost, but a period of time -- often lasting as much as four or five years in duration -- during which it can be replaced. Thus, deferring replacement purchases in order to accommodate short-term budget constraints does not necessarily increase total fleet costs immediately. However, if an organization traditionally has not done a good job of replacing vehicles in a timely manner, even a temporary reduction in replacement spending can result in immediate increases in fleet operating -- principally maintenance and repair -- costs.

The point of all this is that decision makers who cut funding for fleet replacement purchases in the belief that this is a good way to help balance the budget should understand that such cuts often just transfer fleet costs from the capital to the operating side of the general ledger, and may actually increase these costs overall if vehicle repair costs rise more than capital costs (i.e., depreciation) fall. Moreover, continuously deferring fleet replacement purchases increases future replacement spending needs, often resulting in growing and increasingly daunting vehicle replacement backlogs.

The Hidden Costs of an Aging Fleet
When you stop and think about the factors that prompt most individuals to go shopping for a new vehicle, improving their cash flow usually is not one of them. Six months' worth of payments on a new vehicle generally exceed all but the most brutal of repair bills on an old one. So why buy a new vehicle? Because the indirect or "hidden" costs of the old one become, in a word, intolerable. What are these costs? Lack of reliability. Lack of availability. Uncertain safety. Unacceptable condition and appearance. Lack of new technology, whether it be a built-in CD player or a hybrid-electric engine. Perhaps most importantly, lack of predictability of future vehicle costs. Many individuals prefer high but predictable vehicle payments to infrequent but unpredictable repair bills.

The potential implications of these factors for a fleet of vehicles are significant:

• Reduced employee efficiency and lost productivity.
• Increased fleet size to compensate for higher vehicle out-of-service rates.
• Bigger repair bills resulting from driver neglect, or even abuse, of older vehicles with which they are unhappy.
• Reduced employee morale.
• Higher accident rates and increased liability exposure.
• Lower customer service levels.
• Perhaps most importantly, since motor vehicles are one of the most visible symbols of many companies, a poorer company image.

Many of these costs will never show up, as such, on an income statement, but that in no way diminishes their impact on companies that rely on vehicles to conduct business. Bottom line: pay now or pay later.

Three Keys to Improving Fleet Replacement Practices
1. Even during good economic times, devoting sufficient funds to replacing vehicles in a timely manner is a challenge for many organizations. This challenge stems in part from a lack of understanding of the interrelationship, described above, between capital and operating costs and of the financial and operational consequences of keeping vehicles in the fleet too long. Life cycle cost analysis of alternative replacement cycles is a good way to address misconceptions in these areas.

2. Many management decision makers do not fully appreciate the role vehicles play in supporting a company's mission, whatever it may be. Intellectually, they may understand that vehicles are a necessary tool for directly or indirectly supporting the delivery of goods and services. When push comes to shove, however, decision makers may be quick to cut fleet funding in the belief that the purchase of vehicles is at least to some degree a discretionary expense that can be deferred when cash is tight. This probably is not the mindset of FedEx or Greyhound, whose vehicles are the lifeblood of their business, but many business owners whose operations are equally dependent on motor vehicles simply do not think of their fleet operations in this way. Measuring the impact of vehicle out-of-service rates on things like employee productivity and overtime costs and customer service levels are a good way to illustrate these linkages.

3. The principal reason that many organizations don't replace their vehicles in a consistent and timely manner is the lack of a replacement program that can deal with inherently volatile fleet replacement spending needs. Specifically, they do not know how to accommodate year-to-year changes in spending requirements when the source of funds for such expenditures is relatively static. The solution to this problem lies in pursuing one of two courses of action: eliminating the volatility in fleet replacement spending requirements, or eliminating the volatility in replacement funding requirements. What's the difference? The approach you use to finance your vehicle purchases. We'll explore several alternative approaches in a future column.

Paul Lauria is the president of Mercury Associates, Inc. (www.mercury-assoc.com), a fleet management consulting firm that works with fleets of all types and sizes. He can be reached at plauria@mercury-assoc.com.