How Costs, Charges Affect Equipment Finances

Equipment managers must understand definitions and applications in order to communicate them to the rest of the organization

Construction Equipment - September 1, 2005

Mike Vorster
Contributing Editor

There is a big difference between a cost and a charge. Understanding the difference and applying them appropriately enables you to manage the financial side of the fleet more effectively.

A cost is money out the door: a payment that you have made to an independent organization arising from purchased goods or services. A charge is money set aside or transferred to another part of your organization to allow for costs that will be incurred in the future.

You incur a cost when you pay a rental company $2,000 per month to rent a trench roller. The amount is known, the money leaves the organization, and the liability is established.

You incur a charge if you take $1,500 per month for depreciation on a trench roller you own, because you know that the roller is worth less now than it was a month ago. The money will not leave your company: It will be set aside and used at some point in the future to purchase, or help purchase, a replacement machine. The liability is established (you used the roller this month), but the correct amount will not be known until the roller is sold and its value determined.

In order to understand how the differences between costs and charges relate to the business aspects of equipment management, let's compare what happens when we use outside rental equipment with what happens when we use our own equipment and charge ourselves for its use.

Let's assume that we generate $100 in contract revenue, we incur $55 in construction costs for labor material and subcontractors, and we pay an outside equipment rental company $35 for equipment. The scorecard is straightforward: We earned $100 and spent $90 ($55 + $35) for a gross profit of $10 (see table).

The finances are more complicated when we use our own equipment and have an operating responsibility center and an equipment responsibility center set up with their own scorecards.

For the operating group, we have the same contract revenue and construction costs but now have $37 in equipment charges paid to our own equipment group. This gives a "Gain on Operations" of $8. This is not a profit because it is not the difference between income (money earned) and expenditure (money paid out).

For the equipment responsibility center, the equipment charges paid by the operating responsibility center are recorded as equipment charges received of $37, the actual equipment costs are $34, and the "Gain on Equipment" is $3.

The final, and most important, scorecard shows the results for the company as a whole. The equipment charges paid and equipment charges received cancel out, so the only important numbers are $100 in contract revenue, $55 in construction costs, and $34 in actual equipment costs. The gross profit is $11: the difference between the revenue $100 and the expenditure of $89.

This example shows that equipment charges, either paid or received, only play a role in the internal scorekeeping process. They do not affect the gross profit. The company would have made $11 regardless if the equipment charges paid and received were set at $27, $37 or $47.

Internal complexities

People and organizations are not as simple, however, and internal scorekeeping between interdependent responsibility centers such as operations and equipment can easily lead to tension and conflict. It is therefore important that the internal charge rates are set at a level that is seen to be fair and reasonable and that they reflect our best estimates of the actual costs that will be incurred if everyone does their jobs to the best of their abilities.

Internal charges are about motivation, morale and performance measurement. They give managers a way to set and achieve goals for responsibility centers and should promote collaboration rather than conflict.

The cost-recovery rate charged for a given machine is a complex combination of charges and costs. Let's assume we have a machine with an internal charge-out rate of $100 per hour broken down into eight components shown (see diagram).

Fuel is the easiest to manage; here is a $15 per hour charge for fuel, and we incur the corresponding costs every evening when we fill up the tank. We can track costs recovered and costs experienced on a precise short-term basis and make sure that the cost-recovery rate remains correct.

Depreciation is at the other end of the spectrum. We set the hourly depreciation charge at $27 based on a purchase price of $576,000 and an assumed residual market value of $144,000 after eight years at 2,000 hours per year. There are many unknowns, but it is our best estimate. The rate thus enables us to charge $27 against the work performed by the machine for every hour the machine works to provide for an actual depreciation cost we estimate to be $432,000 over the next eight years.

Licenses and insurance, wear parts, tires and preventive maintenance are also relatively simple. Charges are levied at the appropriate rates for each hour that the machine works, and actual costs are incurred at relatively frequent and relatively regular intervals.

Repair parts and labor is difficult. The $23-per hour-rate is set on the assumption of a fair and reasonable budget of $368,000 for 16,000 hours. No hour will cost $23, some will cost substantially more and many will, we hope, cost less; but the rate can only be achieved if everyone works together to ensure that the actual costs are kept within the $368,000 budget.

Cost-recovery rates are charges set at the level required to recover our best estimate of the actual costs we expect to incur in the future. If our records show that it actually cost us $464,000 to run our wheel loaders for 16,000 hours, then the cost recovery rate must go up to $29. Of course, there will be argument about whether the increase from $368,000 to $464,000 was due to the working conditions, the transmission that failed at half its expected life because of inappropriate shifting, or an increase in mechanics wages.

These conversations are a normal part of business life, but it is critical that they address the problem (increased cost) as opposed to the symptom (an increased cost-recovery rate). The former will fix the problem; the latter will just add to tension and conflict.