Subject: Purchase price vs real price
This $250,000 Dozer
Is Not FREE
I was looking for holes. As a salvage expert working for sureties who were exposed to enormous losses by sudden contractor failure, I was completing jobs across the country and at the same time studying the financially distressed contractors’ financial records to discover what went wrong. What happened here? Why did this firm suddenly go broke? I uncovered a lot of holes in their accounting for the real cost of equipment ownership.
The objective is to produce net income. As equipment is used and ages and loses part of its service value, depreciates — an element of expense. This is a continuous expense of operating the business. Depreciation is based on the purchase price, however because the company has to replace that piece of equipment at some point in the future, the replacement cost will be more than the purchase price.
Where Was the Hole?
What does a $250,000 dozer actually cost the company? Not $250,000; that’s for sure. The real cost of equipment ownership goes far beyond the purchase price. Traditional accounting assigns a “useful” life and writes the purchase price off over that useful life. The real cost to the company needs to include the cost to replace this piece of equipment in the future. Fuel and repairs were expensed as occurred but sometimes charged to “overhead,” not attributed to a job. This method may collect all the costs associated with a piece of equipment but the objective is to “recoup” all costs incurred.
Recognizing and Attributing True Cost
In addition to the purchase price, the true cost of replacement, wear and tear, idle time, inflation, depreciation, and maintenance all eventually come due whether they are accounted for or not. In addition, the majority of equipment cost does not occur concurrently with the equipment’s usage, thus equipment intensive-contractors usually have a positive cash flow that is often mistaken for profit. The cost of owning equipment is a function of both time and usage. We need to recognize and attribute both cost categories.
- Depreciation – As assets such as equipment age, used or not used in operations, they lose part of their service value –They “depreciate”. A portion of the purchase price of the asset (equipment) expires in each accounting period during the useful life of the equipment.
- Inflation – It is an economic reality that inflation is a cost of doing business and, for an equipment-intensive contractor, replacement cost must be considered. If a contractor does not account for replacement cost, they are charging equipment at rates that only repay the company for the amount they paid for the machinery originally, however the replacement equipment will cost more. They will pay a higher price in the future for the same equipment because of inflation.
- Replacement Cost – The replacement cost divided by the useful life of the equipment must be charged to the jobs each year to protect profits.
- Idle Cost – When equipment is not being used do the costs of ownership cease? Of course not. Therefore, it is critical that the true replacement cost be charged against jobs for the life of the equipment. That is to say, if a piece of equipment is destined to be in service only six months of the year, the estimated monthly costs must recoup the annual costs. Otherwise the unattributed six months of replacement cost may “fall through the cracks” and be charged to overhead. Since “overhead” enjoys no revenue stream, this unseen cost mysteriously reduces profits and is one of the “holes” that causes financial distress.
- Interest Expense – Lest we forget, if equipment is purchased on credit, the interest expense must be included in the real cost of ownership, or again, it will be charged to the empty “overhead” barrel, misstate the true cost of each job leading to inefficient bidding practices and diminished profits and cash flow. If equipment is purchased with cash, the value of money should also be considered.
- Maintenance –These very real costs must be captured in a timely manner to account for the true cost of ownership of equipment. However, because some of these costs are yet to be incurred, they must be estimated and accounted for to ensure annual and monthly costs are accurate and properly attributed. Otherwise, they will mysteriously erode profits by popping up in “overhead” expense accounting long after the job has been completed.
Too often a portion of equipment cost, sometimes substantial, is not recognized, estimated or properly attributed to job expense. This is one of the big unseen holes in accounting for the real cost of equipment ownership. To make sure you are not stepping into any hidden holes right now and go to the Equipment Cost Management portion of the Manual of Construction Practice on this site.