Cost understanding and awareness: Key steps in having a cost-competitive fleet management program

Randy Owen
Senior Vice President
Mercury Associates
Charlotte, North Carolina

Introduction
Fleet managers are under increasing pressure to lower costs these days. In the difficult economic climate of the past few years this pressure has had more to do with the need to balance the city or county budget than with political agendas or ideologies. However, bad economic times also are bound to increase decision makers' interest in the issue of outsourcing. This double whammy of fiscal imperatives and political scrutiny has caused more than a few fleet managers to go prematurely gray in recent years.

In many recent projects, clients hire us to help them assess the cost competitiveness of their fleet operation. During such projects, we frequently find that many fleet managers do not have a complete understanding of their program costs, cost analysis techniques, and financial management principles applicable to fleet operations. It is imperative for fleet managers to understand the many different ways in which cost information can be sliced, diced, interpreted, used, and misused. The question of whether or not a fleet program is cost competitive simply cannot be answered absent this understanding.

Types of Fleet Costs
Many different types of costs are involved in owning and operating a fleet: capital and operating costs; fixed and variable costs; direct and indirect costs; hard and soft costs; average and marginal costs; avoidable and unavoidable costs; current and future costs; and fiscal and economic costs. The distinctions and similarities between these terms are not just academic and important to accountants. Rather, they drive management and customer attitudes towards fleet management organizations and also have a profound impact on the question of the competitiveness of a fleet operation.

For instance, many fleet management organizations are allocated general overhead costs (i.e., indirect costs) for central services such as city or county administration, accounting, human resources, and purchasing activities. These costs can sometimes reach 25 percent or more of a fleet organization's total costs, although 5 to 10 percent is more common. Including these costs in an analysis of a fleet organization's cost effectiveness may create a false picture of its ability to compete with commercial vendors. This is because the legal, financial, purchasing, risk management, human resources management, and other overhead costs allocated to a fleet organization often do not diminish at all even if all fleet management functions are outsourced. That is, they are fixed and, therefore, unavoidable costs.

Fleet managers also need to understand the distinctions between capital and operating costs and how these costs are related. While fleet managers don't need to be told that old cars cost more to keep on the road than new cars, many have a very difficult time proving this point to decision makers and justifying their recommended fleet replacement plans during budget hearings. Finance directors scrambling to balance the budget during tough economic times of necessity have a short-term (one to two-year) focus and are interested in the fiscal rather than the economic consequences of decisions. This is true even though cutting fleet replacement budgets, while often characterized as "saving" money, actually only defers a current cost to a future year.

Moreover, the fiscal imperative of cutting vehicle replacement funding also impacts near-term economic and (so called) soft costs. The former are in the form of increased operating costs (i.e., maintenance, repairs, and fuel) that come with operating an aged fleet. The latter are associated with deteriorating safety, availability, reliability, and technological currency/capability of vehicles in the fleet. While these are referred to, somewhat dismissively, as soft costs (or nonpecuniary in the lexicon of economists) because they are difficult to quantify and do not represent immediate out-of-pocket expenditures, this does not mean that they are not real. Few individuals would argue, for instance, that they replace their personal cars in order to achieve immediate, hard cost savings. Rather, most of us take on a new monthly car payment for nonpecuniary reasons such as to ensure reliable transportation so that we don't miss work and get fired and so our family is not stranded on the side of a dark road at night.

While finance directors may understand conceptually that fleet operating costs eventually will go up if vehicles are not replaced in a timely manner, their immediate concern is to balance the budget. Consequently, it is unrealistic to expect them to make decisions based on considerations such as minimization of vehicle life cycle costs. While this is a worthy economic goal for all fleet operations, it is not always a fiscally attainable one. In order to be effective over the long term, a fleet manager generally must tailor his or her actions to immediate organizational imperatives (like cutting costs in some years and making investments in others), while also promoting policies and practices that maximize the ongoing cost effectiveness of the fleet (like replacing vehicles and equipment in accordance with sound life-cycle guidelines).

Financial Structure
A fleet organization's accounting practices and the manner in which its finances are structured also have a significant impact on an analysis of its cost competitiveness. This is another area where some fleet managers need to improve their education and skills. Many fleet organizations have implemented an Internal Service Fund, which is a clear best financial management practice for fleet organizations. These types of funds are used by state and local governments to account for the financing of goods and services provided by one department or agency to other departments or agencies, and to other government jurisdictions, on a cost-reimbursement basis. The use of an Internal Service Fund for a fleet management organization fosters a businesslike approach and has a number of distinct advantages including:

  • The ability to identify and accumulate the total cost of a support activity, including the depreciation of capital assets;
  • Facilitates costing and pricing of support services;
  • Allows for the accumulation of funds for equipment replacement; and
  • Allows the allocation of General Fund overhead costs to the Internal Service Funds for redistribution to the benefiting programs.

Calculating fully burdened mechanic labor rates is easier for organizations that use an Internal Service Fund since all costs associated with owning and operating a fleet are included in the fund. Consequently, comparisons of billing rates between organizations that use an Internal Service Fund and those that do not often are difficult and seldom are valid. Moreover, we often see organizations make significant errors in their rate calculation methodology. Some organizations overstate their labor rate by not charging for many fleet services (such as daily rental motor pool vehicles, car wash services, and parts acquisition and supply services). With no charge for these services, associated costs must be recovered by the labor rate—a practice that inescapably drives the rate higher.

Conversely, many organizations understate their labor rate by, for example, overestimating the number of billable hours that mechanics can produce. In general, a fleet organization is doing very well if on average mechanics can produce 1,500 billable hours out of the 2,080 hours that they are paid. Using a higher number as part of the rate calculation methodology naturally leads to a lower labor rate (and often to an organization not recovering enough revenue to pay its costs).

Accurate charge-back rate calculation is more important than merely as a means to move money around so that the fleet organization can balance its budget. Rather, a good charge-back system can fundamentally affect the cost competitiveness of a fleet program by improving the consumption of fleet resources (as a result of making vehicle users accountable for their behavior by charging them directly for the costs of the vehicles and related services they consume) and the provision of fleet services (by giving fleet users clear and understandable transaction-based invoices so they can hold fleet management organizations accountable for the quality and costs of the goods and services that they provide).

In addition to facilitating more accurate cost-of-service analyses and charge-back rate development, organizations with an Internal Service Fund also have more effective fleet replacement programs. This is because such organizations have the ability to charge monthly lease fees for vehicles and place these fees in a reserve account to finance the future replacement of the fleet. Consequently, if properly managed, the replacement of the fleet becomes a mostly automatic process that is separated from the annual budget development wars. As a result, fleet organizations that have an Internal Service Fund are not placed in the position of having to compete for scarce capital funding each year with other higher priority programs (such as police, fire, road maintenance, etc.). As fleet managers well know, they rarely win such a competition.

Conclusions
Fleet managers who are asked to prove the competitiveness of their programs, or to reduce costs, need to first understand what costs decision makers are interested in. If fiscal managers are interested in reducing current costs to help balance the budget, then deferring fleet replacement purchases for a year or two may be a good answer. Another (and perhaps better) solution may be to reduce any unneeded cash balances in the reserve account of an Internal Service Fund. This can be accomplished through careful financial analysis of fleet replacement funding needs over the next ten years or so and devising an optimized cash flow that matches year-to-year funding requirements with revenues so that the fund remains solvent without accumulating a large balance. It can also be accomplished by switching to lease-purchase financing so that the same number of vehicles can be acquired over the next few years for much less cash.

If, on the other hand, the city manager is looking for lasting economic savings, then there are really only three ways to achieve this: by reducing the size of the fleet, by reducing service levels, or by improving efficiency. Fleet costs can be reduced by removing under-utilized vehicles from the fleet and requiring the users of those vehicles to meet their mobility needs in other ways, such as by sharing a fleet vehicle with other employees; by renting a vehicle from an in-house motor pool (or a commercial provider) on an as-needed basis; by using an employee shuttle or public transportation; or by driving their personal vehicles and being reimbursed for business use. Rightsizing a fleet is certainly one of the best ways to achieve lasting fleet cost savings. However, asking a fleet manager to play vehicle cop is often untenable and detrimental to customer relations. Still, the savvy fleet manager needs to find a way to consult with his clients and to motivate them to turn in unneeded vehicles. The best long-term way to accomplish this is through the use of an effective cost charge-back system.

Reductions in fleet service levels, on the one hand, almost always result in costs being shifted from the fleet management organization to customer agencies rather than in true cost savings. For example, if a fleet organization loses a lot attendant position in a budget cut, the $40,000 or so in salaries and benefits associated with this position is not actually saved. Rather, customer agencies now may have to use their higher-priced employees to shuttle vehicles to the shop for preventive maintenance and to vendors for warranty repairs. As a result, the average cost of providing shuttle services has increased and, in combination with the soft cost of lost customer productivity, the anticipated savings from the budget cut never materialize.

The other and ultimately the best way to eliminate fleet costs is to provide services more economically and efficiently. This means reducing the costs of the inputs to a fleet operation, whether they be employee labor, materials and supplies, fuel, contractual services, or facilities. Organizations that know their costs have an appropriate financial structure and an effective cost charge-back system, and are inevitably in a better position to justify to decision makers that they are providing a high level of fleet services at a competitive price. Such organizations also tend to be more proactive in proving their competitiveness and in explaining the fiscal and economic implications of cost-cutting proposals. As a result, these organizations rarely suffer debilitating cuts in fleet replacement funding or drastic reductions in operating funds. They also tend to be the organizations that are not subjected to outsourcing initiatives.

Randy Owen can be reached at (704) 906-8898 or at rowen@mercury-assoc.com.

Editor's Note: Constructing Fleet Charge-Back Rates in Public Works, a CD-ROM, describes the benefits and methods of effective charge-back rate systems. The publication Shop Rate Guide provides a step-by-step approach for developing shop rate schedules tailored for public works fleet services. Both can be ordered online at www.apwa.net/bookstore or call the Member Services Hotline at (800) 848-APWA, ext. 3560.