How to Make Internal Rates Work

Use these six pointers to minimize administrative malfunctions

Construction Equipment - May 1, 2005

Mike Vorster
Contributing Editor

Few things affect a company more than the administrative procedures that define how internal equipment rates are set and used throughout the organization. Almost everyone is affected one way or another: A rate of $120 per hour for an excavator defines how competitive a company is when bidding trenching work, creates a baseline for equipment budgeting and cost control, and strongly influences the job costs for all activities that use excavators. Equipment rates — and the fine print that defines policy for things like minimum hours per week — are extremely important.

Setting and using internal rates is more art than science. Managers need to understand the implications of their decisions and must appreciate that neither rates nor policy can be set without regard for the dynamics and competitiveness of the organization as a whole.

Here are six pointers to help make the system work effectively.

1. Know how the system works

Many owning-and-operating costs occur as large, easily identified expenditures that cannot be expensed immediately and must be spread over the life of the machine. The simplest way to handle the situation is to estimate the total lifecycle cost of the machine, calculate an average hourly or daily cost-recovery rate, and charge this against the work performed by the machine on an hourly or daily basis.

The internal equipment cost "paid" by operations and the internal equipment revenue "received" by equipment are one and the same, and in the final analysis, the company sees only the difference between contract revenue and actual equipment cost. No money changes hands and no money leaves the company. Any inaccuracies or inequities in the internal cost-recovery rate cancel themselves out when results from field and equipment operations are consolidated at a company level.

Internal cost-recovery rates are not the same as external rental rates. They are designed to facilitate equipment costing, establish internal budgets, and measure performance.

2. Know the true costs

An internal cost-recovery rate must, as an absolute minimum, do just that: recover the true internal cost of owning and operating a particular machine or group of machines throughout their economic life. This means that accurate cost records must be kept and a systematic method used to convert cost data into reliable estimates. (See "How to Benchmark Repair Costs," April 2004, or at ConstructionEquipment.com.)

Estimating lifecycle owning-and-operating costs is not an exact science, but the process is greatly improved if a standardized format is used to ensure that the calculations are as consistent and accurate as possible. (See "How Estimates Affect Cost Calculations," March 2004, or at ConstructionEquipment.com.) Most companies use average rates for machines in a given class in order to simplify the process and ensure that the rates themselves, as well as the estimates and job costs based on these rates, are independent of costs unique to a particular machine.

3. Know what the rate includes

There must be a clear and explicit understanding of what is included in the rate and what is considered to be a direct job cost. Most would agree on items such as fuel and ground-engaging tools, but items such as damage to sheet metal and cab glass, accidents, and abuse require clear definitions.

The overhead costs of running the shop and managing the fleet must form part of the cost-recovery rate if they are not accounted for elsewhere. Everything needs to be covered.

Internal rates should rightly include a component designed to recover a return on the equity capital invested in the fleet and used to produce completed construction. Most companies like to cost their fleet as break even, and a margin or contingency factor is seldom included in the internal-rate calculation. This simplifies the bid mark-up process but makes it almost certain that the equipment account will show a loss due to the smallest variation in utilization, fuel cost, insurance or any other unknown.

4. Remember estimating

The fact that inaccuracies or inequities in the internal-cost recovery rate cancel themselves out at a company level gives the impression that it is not important for the rates to be as accurate as possible. Nothing can be further from the truth.

Rates that are too low cause estimates to be too low, and conversely, rates that are too high significantly reduce competitiveness in the bidding process. Rates must therefore be carefully reviewed before they are used in an estimate. Many companies make adjustments to allow for the fact that competition, working hours, or operating conditions vary from job to job. This is a wise thing to do and certainly ensures that equipment rates are appropriate to the conditions on the job.

Adjustments must be made with care, however, and discounts or upward changes in the rates must be tracked to ensure that they serve the intended purpose and do not become part of every day operations.

5. Be aware of the market

Published cost guides (such as those presented in the Rental Rate Blue Book, set out in the Army Corps of Engineers Pamphlet EP 1110-1-8, or given by most manufacturers) provide excellent references and serve as a good check on assumptions. Comparisons must be made with care, and appropriate adjustments made to ensure that the same cost categories are included in all cases.

Calibrating rates with external published sources or knowing where and why internal rates differ from published rates is important as it adds credibility and permits benchmarking with industry standards.

6. Know your organization

Internal rental rates, budgets, responsibility centers and other accounting tools are designed to motivate and measure management performance. The procedures used should be as simple as possible, provide good actionable information, and bring teams together rather than drive them apart with petty quarrels over who carries what cost.

The personalities involved, a clear understanding of responsibility, accountability, a commitment to common goals, and teamwork play an important part in the success of any internal rental rate structure.