A Machine-Replacement Strategy

It's more than a financial decision. Replacement must be integrated into an organization's business planning.

Construction Equipment - July 1, 2005

Mike Vorster
Contributing Editor

The process of reviewing the fleet, deciding which units to sell or replace, and developing a capital expenditure plan is one of the most important tasks that an equipment manager performs. There are no simple rules, and many factors must be taken into account. Replacement is certainly more than the process of looking at cost trends, selling old units, and buying new ones.

The classic replacement assumption is that we will sell an old wheel loader and replace it with a new, but essentially similar, model. Replacement decisions are seldom that simple and the options never that constrained. We could replace the old wheel loader with a new loader, or we can decide to sell it and buy an excavator, a dozer or nothing at all.

Replacement enables us to evaluate the composition and size of our fleet. We must take a broad view and use the opportunity to adjust the fleet so that it supports the company's long-term operational plans.

Integrating equipment replacement and business planning enables us to make systematic decisions that recognize financial constraints, maximize fleet utilization, and minimize fleet costs. Good replacement decisions evaluate the operational, mechanical and financial aspects of continued ownership of the existing machine as well as all alternatives.

Operational Aspects. Business planning and the forecasting process drive operational aspects of machine replacement. The company makes its best estimates of the work that it will be performing and evaluates equipment needs based on those estimates.

Estimating equipment needs in the quarrying business is relatively easy: The nature of the work does not change much, and the key uncertainty is the volume of material that will be produced. On the other hand, infrastructure sectors deal with work that can vary tremendously. Volume depends on success in a competitive bidding environment.

In either case, replacement decisions must be integrated with business planning. The fleet must be constantly adjusted to ensure that it can produce the quantity and quality of work needed to achieve stated operational goals. Adjustments to the fleet made possible by replacing identified units must be made in a rational way with the objective of maximizing the utilization of the core fleet and using short term rentals or other arrangements to accommodate peak demands.

Metrics such as the ratio of contract revenue to budgeted equipment cost, tons of paving per month per paver, or volume of excavation per month per excavation prime mover can be used to analyze construction backlog and ensure that replacement decisions are consistent with company forecasts, business plans and market demands.

Mechanical Aspects. There are two parts to the mechanical aspect of the replacement decision. The first, obsolescence, measures technological advancement in new equipment relative to previous models in so far as productivity, quality of work performed, simplicity of operation, fuel efficiency, safety, and environmental compliance are concerned. The second, deterioration, measures the degree to which the performance of the existing machine has declined in terms of reliability, uptime and reparability.

Obsolescence and deterioration work together to drive the replacement decision from a mechanical point of view. Solid, well-built cranes experience little of either and are usually kept for a long time. On the other hand, main-line pavers are — or should be — replaced fairly frequently based on obsolescence relative to the newer, more advanced models and deterioration in high-stress, high-wear components.

Obsolescence is difficult to measure except when hard facts are available, such as the cost of modifications necessary to ensure environmental compliance. Other factors, such as simplicity of operation, are more subjective but, in many cases, equally important.

Deterioration is easy to measure. Metrics such as mechanic hours spent on repair and maintenance per operating hour, mean time between failures, down hours per operating hour, and availability are routinely used to quantify and justify this aspect of the replacement decision. (See "Quantitative Measures," September 2004, page 91.)

Financial Aspects. Financial aspects frequently — and wrongly — drive the replacement decision. They are listed here as third for a good reason: This is where they should come in the process.

Examples of focusing only on the financials are converting a rental-purchase agreement because you have already sunk a substantial amount in the machine, buying a machine because it is offered on irresistible terms, and investing in the fleet because you want to maximize depreciation allowances. These considerations neglect the fact that lifecycle owning and operating costs are influenced by factors beyond the initial purchase price.

The financial aspects of the purchase decision, the future owning and operating costs of the existing machine, and the expected minimum lifecycle owning and operating costs of the replacement machine are all important. They must not, however, drive the decision and produce results that make no sense from an operational or mechanical point of view.

Two things are important from a financial point of view. First, you must know and understand the costs for the machine you are planning to replace and be in a position to make a reasonable assessment of its owning-and-operating cost for the year ahead. The focus must be on the future. Past costs are sunk, and although you may be tempted, it makes little sense to hold onto a machine for which you have no work simply because you spent a substantial sum on the hydraulic system a year ago.

Second, you must estimate the owning-and-operating cost, the economic life, and the productivity of the replacement machine. These values are important because replacement revolves around a simple question, "Will keeping this machine or replacing it produce the lowest cost per unit in the future?"

Analyzing the operational, mechanical and financial aspects of the decision to sell one machine and invest in another ensures that the decision is integrated in the best interests of the company as a whole. Some factors, such as current work loads, deteriorating reliability, and increasing operating costs can be quantified. Others, such as future work loads, the benefits of the latest technologies, and improved productivity can only be estimated.

Regardless of the complexity of the decision, there are three overriding and simple reasons why we need to replace machines and constantly renew our fleet.

First, we must always make the capital investments needed to replace the machine hours used up in any given period. If we do not, we will be living off our seed corn and will be on a downward spiral of increasing age, increasing cost, and decreasing reliability. (See "Buy What You Burn," October 2004, page 63.) Systematic, orderly and constant replacement will ensure that the fleet retains its value as a productive asset that supports the company's operations and enables it to succeed in a competitive market.

Second, we must manage the average age of our fleet with care, especially if we use average-cost recovery rates. Young fleets and old fleets exhibit different cost patterns, and it is easy to believe that the gains made when a young fleet operates below budget are "profit" when in reality they are nothing more than provisions for the high operating costs that come with the later years of the machines' economic life. An old fleet will show exactly the opposite picture. It is difficult to maintain control when spasmodic replacement causes fleet average age to swing from very young to very old.

Third, fleet performance is all about reliability, availability, uptime and production. Every machine experiences deterioration and obsolescence. In the end, replacement is the only way to start again, revitalize your fleet, and maintain your productive capacity.

Competent policies for maintenance, repair and rebuild extend life — replacement renews it.