Before making any decisions on owning/renting/hiring heavy machinery, you need to understand the costs. In this blog, we are going to focus on understanding in detail the costs of OWNING and OPERATING heavy machinery.
1) FIXED COSTS
Fixed costs are broken down into the following:
a) Price, Depreciation and Salvage Value
The price is the only number you know from day 1, while the other two numbers need to be estimated. New equipment depreciates dramatically at the beginning and then tapers off. The salvage value is the biggest unknown of the three in that it depends on inflation, how long you hold the machine, the condition of the machine, the quality of maintenance, and the demand for that machine at the time of deciding to get rid of it. Larger and more specialized machines boast lower demand while smaller and more versatile machines tend to have higher salvage values.
b) The Costs of Money
Many people have difficulty in understanding the cost of money. Their understanding only goes as far as when they borrow money and there is an interest amount that is payable. If you borrow money to buy a machine, it is easy to calculate the cost of that money. If, however, you use cash to buy a machine, they are under the impression that the money is “free” because there is no explicit interest rate. There is a cost and economists call it an “opportunity cost” and it is at this point that people get lost. By buying the machine, you need to calculate the cost of tying that money up in the machine and not having it on hand to use that money elsewhere. For small businesses, this can be a difficult cost to calculate.
The formula for opportunity cost is as follows: Opportunity Cost=FO−CO
where:
FO=Return on the best "foregone" option
CO=Return on the "chosen" option
For example, your business is growing at 30 percent per year (return on equity which is net income divided by shareholders equity). You decide to pay cash for a machine. Is that a smart decision? Let’s apply the formula. Let’s assume that you could finance the machine at 20 percent.
In this case, FO is 30 percent – that is the return if you invest in your business ignoring taxes. CO is the chosen option. You could have borrowed the money at 20 percent for the machine but you paid cash. In this case the Opportunity Cost is 30% - 20% = 10%. You would have been better off financing the machine and investing the cash into your business and expanding into different markets etc. Let’s also assume that you paid cash for the machine and then found you had no working capital to pay rent, salaries etc. You go to the bank and borrow money – the same bank that was prepared to lend you money for the machine. The interest rate is no longer 20% but 40% because there is no asset to secure the debt.
c) Insurance
No one likes to buy insurance. It is not an impulse buy. No one is filled with joy and satisfaction when their insurance policies need to be renewed. We don't want insurance but we know that we need it. It is prudent to transfer specific risks to a third party. You take enough risk in your business – it is not prudent to expose yourself to additional risks that can easily be covered. If you do not ensure the risks over which you have no control, you are placing your business at risk.
We can represent the fixed costs as equations:
Annual Fixed Costs = Depreciation + Money Cost + Insurance
Hourly Fixed Costs = Annual Fixed Costs / Operating Hours per Year
Operating Hours per Year
This is an important variable in the equation and herein you will find the beauty of some very simple mathematics. In the equation of Hourly Fixed Costs, you will notice there are inputs. One is fixed (annual fixed costs) and one is variable (operating hours per year). Look at what happens when you increase the denominator (operating hours per year) – your hourly fixed costs come down. Let’s look at an extreme example. If you are able to double your operating hours per year, you will be able to HALVE your hourly fixed costs. That is mind-blowing stuff! This statement does, however, come with a small caveat. We assume that depreciation remains the same. That could be a little on the aggressive side because if you are sweating your machines twice as hard, it is hard to do that without having some impact on the depreciation and workable life of the machines.
Annual Operating Hours
If you ask any average office worker who clocks in at 9 am and clocks out at 5 pm how many hours he works in a day, he will probably say: “Well, I am in the office 8 hours minus 1 hour for lunch, the answer is 7 hours”. Yes, but how many of those 7 hours are actually spent working, in between checking your phone, chatting to Bob from accounting at the water cooler, going to the men’s room, etc.” After factoring in all these ‘distractions”, he is probably coming out at around 5 hours.
The same is true in the estimation of the operational efficiency of your machines. In controlled factory situations, you may be able to make a solid estimate. But when your assets are out in the elements and subject to factors like the weather, the need for maintenance and repair, the physical limitations of human operators amongst other things, your number may be considerably lower. This means that you need to be conservative and realistic in this calculation.
2) Variable Costs
Variable costs are the operating costs; expenses that occur only when a machine is used. These include energy (electricity or fuel), consumables, regular maintenance items (such as oil and filters for engines), repair costs, and the wages paid to the operator of the machine. The value of the time spent on maintenance and repairs is an important cost, even if you do it yourself. You need to place a monetary value on the time it takes for you to affect these DIY repair jobs.
a) Energy Use
Given that in South Africa there are very few electric powered pieces of machinery, your big energy cost is going to be diesel and oil. If you have been in business for a while, you should have a good idea of the hourly diesel consumption given the specifications of your machine. You will also know your oil consumption. For those starting out, consider the following consumption scenarios for a typical excavator (source: https://transportation.ae/equipment-fuel-consumption/): Low Consumption (6-12 liters per hour)
Low power consumption tasks are those that lead the engine to a load factor of between 20 to 40%, such as Excavation and movement of material to the designated station located at ground level, digging of shallow ditches for public works or application on low-density materials, including the movement of scrap metal.
Average Consumption (12-18 liters per hour)
The work of average consumption leads the engine to a load factor with 40 to 60%, among them stands out: The interrupted load of trucks, excavation of materials with low to medium density, and with the service ladle between 60 to 90% of their capacity. It includes the loading of logs, modification of landscapes, etc. In which the team makes few trips with distances ranging between 100 and 200 meters
High Consumption (18-24 liters per hour)
The work of high consumption will lead the engine to a load factor of 60 to 80%, the most common tasks include the continuous loading of trucks, excavation in rock or blast rock floors, transport displacements exceeding 200m in length in those that the soil provides difficult traction and great impacts
b) Repair and Maintenance
Maintenance refers to all those activities that should be done on a regular basis to keep your machines running in good shape. Minor repairs add up over time, especially when unanticipated problems require shutting down your operations and sourcing parts. A significant repair to a major piece of equipment can cost tens of thousands of rands and may sometimes cost more than the machine is worth, in which case, replacing the machine may make sense. The irregularity of major repairs makes them difficult to forecast and budget.
General Rules on Repair and Maintenance
For most machines, the total maintenance and repair costs over the life of the machine will equal 75 percent of the new cost of the machine. For machines that operate on tracks (such as bulldozers), the maintenance and repair costs over the life of the machine will equal 100 percent of the new cost of the machine.
Machine Life Spans
Large mining-class machines should be able to attain service lives ranging anywhere from 60,000 to 100,000 hours, depending on local maintenance and repair capabilities and costs. By dividing the new cost of the machine by its expected life in hours and multiplying by 70 percent or 100 percent, you arrive at an estimate of its maintenance and repair costs per operating hour.
Total Owning and Operating Costs
By combining the estimated fixed and variable costs, you come up with the total cost of owning and operating the machine on both a yearly and hourly basis. You can use these equations:
Total Annual Costs = Annual Fixed Costs + Annual Variable Costs =
Annual Depreciation, Money, Insurance + (Hourly Energy,
Consumable, and Maintenance and Repair Costs) x Operating Hours per Year
Total Hourly Costs = Hourly Fixed Costs + Hourly Variable Costs =
Annual Fixed Costs / Operating Hours Per Year + Hourly Energy,
Consumable, and Maintenance and Repair Costs
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