Asset replacement planning and financing: A key strategy for controlling fleet costs

Paul Lauria
Vice President and Director
Fleet Management Services Group
DMG-MAXIMUS, INC.

Tim Ammon
Senior Consultant
Fleet Management Services Group
DMG-MAXIMUS, INC.

Securing sufficient funds to replace vehicles and equipment in a timely manner has long been one of the bigger challenges facing many fleet management organizations. The recently promulgated Governmental Accounting Standards Board (GASB) Standard 34 promises to put even more pressure on public-sector fleet managers to evaluate the effectiveness of their fleet replacement efforts. GASB 34 requires governmental entities to account for the depreciation of governmental (i.e., “general”) fund fixed assets and, by implication, to divulge to bond rating agencies and potential investors how well they are managing the replacement of such assets, whether they be streets and sidewalks or motor vehicles and computers. In view of the fact that a weak fleet replacement program can have a significant negative impact on fleet safety, reliability, and operating costs, this standard is a welcome catalyst for reassessing and, in many cases, reengineering deficient replacement planning and financing practices.

An effective fleet replacement program has two components: a replacement planning and decision making process that determines when each vehicle and piece of equipment should be replaced; and a financing and funding process that ensures that money is available to purchase a replacement asset when the desired replacement date is reached.

The fleet replacement plan

Two types of information are needed to develop a fleet replacement plan: an inventory of the assets to be replaced and a set of planning parameters. The inventory should include information such as the current class, age, life-to-date usage, and life-to-date maintenance and repair cost of each asset. Replacement planning parameters include expected service life, current purchase price, an inflation rate, and expected salvage value. Other factors that are unique to each fleet, such as changes to fleet size and/or composition, must also be included in order to complete the set of planning parameters to be used.

Developing a replacement plan involves applying the planning parameters for a class of vehicles or equipment to each asset of that type in the fleet inventory. The result is a projected replacement date, replacement cost, and salvage value for each asset in the inventory. In order to ensure that each unit in the fleet is included in the plan, a planning horizon of at least 15 years should be used. Needless to say, vehicles that have short replacement cycles may be scheduled for replacement several times over the course of a 15-year planning period.

Once an initial replacement plan has been developed, it is important to study it carefully to determine how “implementable” it is. For example, does the plan reveal that a large percentage of the assets in the fleet is due or overdue for replacement? If so, how will this backlog of replacement needs be eliminated? Are there significant peaks and valleys in year-to-year replacement costs? Is it realistic to expect that sufficient funds will be available to make all of the planned replacement purchases in years of peak spending needs? Are there significant disparities in fleet age and future spending requirements among different organizations or departments whose assets are included in the plan? How do future replacement spending needs, on average, compare with replacement funding levels (adjusted for inflation) in recent years? If there is a large backlog of replacement needs, it probably is due to the fact that past funding levels have been too low.

The answers to such questions are important in deciding if and how to adjust a baseline replacement plan in order to improve the prospects of replacing all assets in accordance with their planned replacement dates. Such adjustments might include lengthening replacement cycles for some types of assets, deferring the initial replacements of certain units, and reducing purchase prices by acquiring cheaper vehicles. Unfortunately, no amount of “tweaking” of replacement cycles, costs, dates, or other parameters will completely eliminate year-to-year peaks and valleys, let alone a large backlog of replacement needs. This is not to say, however, that there are not ways to deal with such challenges. Their solution often lies in choosing the right method of financing the replacement plan (i.e., future replacement costs), rather than in manipulating the plan itself.

Replacement financing options

The replacement financing options available to organizations that operate vehicle and equipment fleets basically are the same as those available to individuals planning to buy a new car: cash; savings; debt; or some combination of these approaches. There are distinct advantages and disadvantages associated with each option.

Cash

The advantages of financing fleet replacement purchases with cash are that this approach is exceedingly simple to use and that, once a vehicle has been purchased, its user does not need to worry about the capital cost of the vehicle for many years. If a fleet-user organization has no difficulty in securing all of the funds it needs to purchase vehicles, no matter how large or volatile such needs are from year to year, this is by far the best financing method to use. Unfortunately, few public-sector organizations enjoy such conditions. Consequently, cash financing of vehicle purchases generally is the worst method of financing a fleet replacement plan.

The principal disadvantage of this approach is that it results in annual replacement funding requirements that often are quite volatile. Most organizations have difficulty budgeting significantly different amounts for fleet replacement purchases from year to year. Consequently, cash appropriations often are insufficient to accommodate all funding requirements in those years of above-average replacement spending needs. A cash financing approach also requires fleet replacement funding requests to, in essence, compete with other capital funding needs that often are more popular with decision makers and tax payers. The combination of these factors-volatility and competition-is the principal cause of large replacement backlogs in many fleet operations. Needless to say, a financing approach that creates such backlogs is powerless to overcome them.

Savings

In order to mitigate the drawbacks of financing fleet replacement costs with cash, many organizations utilize a sinking or reserve fund. Under this approach, fleet users make regular contributions-usually through the payment of monthly lease charges-to a fleet-wide “savings account” in which funds are accumulated to defray annual replacement costs. If lease charges are calculated and applied properly, this method usually ensures that there is enough money to pay for a new vehicle when it is due to be replaced. Since this approach also spreads the capital cost of replacing a vehicle over its useful life, it also eliminates most if not all of the year-to-year volatility associated with funding fleet replacement costs. An added benefit of sinking funds is that the payment of regular lease charges for the use of vehicles encourages user organizations to pay attention to fleet utilization levels. Under a cash financing approach, in contrast, users often see little benefit in disposing of under-utilized vehicles whose purchase price they view as a sunk cost.

The principal drawback of using a sinking fund to finance fleet replacement costs is that few organizations know how to calculate and apply charge-back rates properly. Some set them too high, with the result that replacement fund balances become large and susceptible to “raiding.” Others set them too low, with the result that fund balances are insufficient to replace all vehicles in accordance with the schedules on which the lease charges are based (with predictable effects on customer satisfaction). These and other considerations-for instance, co-mingling of capital and operating funds, compliance with federal costing principles, and treatment of salvage proceeds and interest earnings-make sinking funds difficult to administer. This financing approach also is ill suited to eliminating large replacement backlogs.

Debt

The third major approach for financing a fleet replacement plan is the use of debt. Whereas cash financing involves funding the full cost of a replacement vehicle at the time it is acquired, and the use of a sinking fund involves funding this purchase (through regular contributions to a savings account) before it is completed, debt financing allows fleet users to pay for replacement vehicles after they acquire them-that is, as they use them up. Debt financing programs take many forms, including certificates of participation and other bond programs in which a government jurisdiction issues its own securities for sale to investors; revolving lines of credit and fixed-term loans from banks and other commercial lenders; and closed-end leases from the financing arms of major vehicle and equipment manufacturers.

The disadvantages of this approach include the high interest rates associated with some types of debt “facilities,” and the perception among many elected officials and other decision makers that it is fiscally irresponsible to use debt to finance the purchase of assets that are so pivotal to the day-to-day operations of public works and other organizations. In many states, an added complication is that the use of certain types and amounts of debt financing by a county, city, or other governmental entity requires state approval.

Despite these limitations, debt financing sometimes offers significant advantages over the other financing methods discussed above. One is the elimination of peaks and valleys in year-to-year replacement funding needs; as with a sinking fund, this method allows fleet users to amortize vehicle capital costs over several years. Another is ease of administration: there are no replacement fund balances to manage (or protect) under this approach, and charge-back rates are little more than a pass through of the lender’s principal and interest charges along with a mark-up for the fleet management organization’s administration of the replacement program.

In economic terms, debt financing can be cheaper than paying for vehicles with cash (from ad hoc appropriations or from a sinking fund), since most governmental entities in the United States can borrow funds at tax-exempt interest rates while investing cash (that otherwise would be spent on vehicles) at taxable rates. The spread between these two interest rates can be as much as 1.5 to 2 percentage points. The final benefit of debt financing is its ability to finance a fleet renewal program (i.e., the elimination of a large replacement backlog) without imposing unrealistically large funding requirements on an organization.

Summary

There is no “one size fits all” approach to financing fleet replacement costs. The relevance and significance of the advantages and disadvantages of the three major financing methods discussed here will vary from organization to organization. It is impossible to adequately evaluate the suitability of-let alone to properly implement-a particular approach in a particular organization without first quantifying long-term replacement needs and costs using an effective fleet replacement planning process.

The benefits of such a process extend well beyond the evaluation of alternative financing methods, however. The ultimate goal of every fleet replacement program should be to replace all vehicles and pieces of equipment in a timely manner. The best maintenance facilities, maintenance technicians, and information systems in the world will be of limited effectiveness in ensuring fleet safety, reliability, efficiency, and effectiveness if an organization cannot meet this simple goal.

For more information, contact Paul Lauria at 301-869-2002 or plauria@dmg.maxinc.com, or Tim Ammon at 301-869-2002 or tammon@dmg.maxinc.com.