Keep Control When Utilization Changes

With costs accurately based on annual usage, month-to-month variances can't be allowed to affect machine management

Construction Equipment - May 1, 2004

Mike Vorster
Contributing Editor

Nothing impacts the economics of equipment ownership more than utilization. The number of hours a machine works in a year determines the rate at which fixed annual costs are recovered. Understanding the hourly owning-and-operating cost calculation and recognizing that most owning costs occur on an annual basis puts the equipment manager in a position to measure the impact of low utilization and develop strategies that control the situation.

In March, we detailed an owning-and-operating cost estimate for a wheel loader that was purchased for $190,000 and sold for $52,000 after having worked 9,000 hours during its five-year ownership period (see table).

The estimated hourly owning cost of $22.94 is only valid at the assumed utilization of 1,800 hours per year. If, for example, the loader works 1,500 hours in the year, then it will only recover $34,410 (1,500 × $22.94) of the $41,288 in annual fixed costs and the under-recovery of $6,878 will be seen as a "loss" of $4.58 per hour ($6,878/1,500). On the other hand, if it works 2,000 hours, then $45,880 of fixed costs will be recovered to give an over-recovery of fixed costs or a "profit" of $4,592.

Neither the under-recovery nor the over-recovery of the fixed costs arises because of changes in the cost estimate—they arise purely because utilization is different from the break-even value of 1,800 hours per year.

Two approaches to address the problem of over- and under-recovery of fixed costs and to manage utilization are found in practice. The first relies on minimum monthly hours to encourage utilization in the field, and the second uses two rates to recover owning-and-operating costs separately.

The minimum-hours concept has some disadvantages. For example, assume our wheel loader is charged out at the combined owning-and-operating rate of $50.65 for 150 hours per month even in a month that it actually worked 125 hours. The minimum hours (150) ensure that fixed costs are fully recovered but give rise to an excess operating cost recovery of $693 (25 additional hours at $27.71). There are no real operating costs to set against these additional billed hours, so operating-cost management becomes difficult due to the difference between the hours billed and the hours actually worked. Then if the machine works 170 hours in the next month, excess owning costs have been recovered, generating a "profit" of $459 (20 × $22.94) due solely to excess utilization.

This variation in cost recovery strains relationships between equipment management and operations management due to the justifiable belief that equipment is "having it both ways": It is protected from the risk of low utilization and is over-compensated when utilization is high.

In the dual-rate method, machines are charged the owning rate for the assumed utilization minus any downtime at the operating rate for the actual hours worked. Our wheel loader would thus be charged at a rate of $3,441 per month (150 hours × $22.94) plus $27.71 for each hour worked.

This mechanism seems simple and straightforward: There are no over- or under-recoveries of owning costs, and the way the machine is charged matches the way that costs are incurred. The fixed monthly charge motivates the field to work as many hours as possible and ensures that they take full responsibility for utilization.

But there are two disadvantages. First, the effect of over- or under-utilization is not measured and recorded, and no data are available to measure effective fleet utilization. Second, the hourly owning-and-operating rate used for estimating and job costing will vary with the hours actually worked and will cause inconsistencies in these two important areas.

Options for success

Equipment managers have many options available to develop the policies and procedures suited to their situation. Some, like the use of minimum hours, give rise to complicating issues and tensions within the organization. Others, like the classic dual-rate approach, are appealing in their simplicity but do not produce data needed to benchmark, measure and manage fleet utilization.

The successful equipment manager will do the following:

Know the utilization assumed in the owning-and-operating cost calculation. This is your benchmark for recovering fixed costs. You must achieve at least this utilization in the long run.

Know the split between the owning-and-operating cost components of the rate. Owning costs are largely fixed, and the rate is dependent on the actual utilization achieved.

Measure and quantify over- and under-recoveries of fixed costs. Know what they are, know why they have occurred, and do not let them mask the real effect of operating-cost problems.

Minimize the impact of downtime on utilization and understand that the fleet size, fleet balance, and operating decisions that impact utilization are frequently outside your control.

Define, agree and implement mechanisms that place the risk and responsibility for fixed-cost recovery where it can best be managed.

There are a number of strategies that companies can adopt to ensure that utilization is seen as a priority. Good approaches will clearly quantify the impact of utilization on the economics of owning and operating the fleet. They will also place the risk and responsibility for utilization where it is best managed to encourage effective utilization of the fleet.

Not measuring the effect of utilization on the economics of owning and operating the fleet and thereby causing the impact to be carried in the equipment account has three real disadvantages. First, over- and under-recoveries of fixed costs will mask the real effect of operating-cost problems unless they are clearly separated and well understood. Second, the equipment manager will be held responsible for a situation over which he or she has little control. Third, there will be little motivation to improve utilization in the field as both the negative impacts of low utilization and the positive impacts of high utilization will be carried in the equipment account.

These disadvantages can easily be overcome by calculating the over- or under-recovered fixed costs on each machine on a monthly basis and assigning these as a credit or a debit to a special job cost code. If the assumed utilization, minus any downtime, and the owning cost portion of the rate are known, then the calculation is simple and straightforward. The utilization cost code will measure the effect of over- or under-utilization and will provide management with the data needed to balance and correctly size the fleet on each job. Responsibility and authority will be matched, and operations will be strongly motivated to ensure optimum utilization.

Wheel Loader Cost Example
Assumed Annual Utilization	1,800 hours
Annual Depreciation	$27,600
Annual Interest Cost	$8,088
Annual Cost of Insurances, etc.	$5,600
Total Annual Owning Costs	$41,288
Hourly Owning Cost		$22.94
Hourly Operating Cost		$27.71
Total Owning-and-Operating Cost		$50.65