August 2008, Automotive Fleet - Feature
Pros & Cons of Extending Replacement Policy
By Staff
Depreciation Expense More Difficult to Predict
Depreciation expense is even more difficult to predict. Depreciation is ultimately determined by the difference between the original cost of the vehicle and its resale proceeds. Resale markets are notoriously sensitive to several influences, such as season, weather, the number of similar vehicles on the market, fuel prices, and many other circumstances.
Taking a currently popular, fleet- equipped, four-door mid-sized sedan,
brought into service Oct. 1, 2007, with 16,000 miles, depreciation CPM is:
Original cost: $21,300
Wholesale value: $14,200
Depreciation: $7,100
CPM: 0.4438
A stunning result, but relatively accurate in the depiction of depreciation costs when a fleet vehicle, accumulating 2,000 miles per month, is sold prematurely.
Unlike variable costs, however, it is nearly impossible to project residual values in the volatile used-vehicle market, particularly for higher-mileage fleet vehicles. To illustrate how the depreciation curve differs from that of variable cost, consider the same vehicle, a 2007 sedan brought into service Oct. 1, 2007, with 40,000 miles:
Original cost: $19,780
Wholesale value: $8,900
Depreciation: $10,880
CPM: 0.2720
One additional year in service knocks the depreciation CPM down by nearly 42 percent. The depreciation curve effect and how it differs from that of maintenance and repair expense is evident, despite the difficulty of making such assumptions, and it will continue for the balance of the vehicle’s in-service time. Further, adding variable cost projections to the calculations, the combination of the two declines over time:
- At eight months in service, with 16,000 miles, the total cost is 0.4511 cents per mile.
- At 20 months in service, with 40,000 miles accumulated on the odometer, the total cost is 0.2984 cents per mile.
Since depreciation is the largest portion of total lifecycle costs that vary over time and with the accumulation of mileage, it would appear even as maintenance and repair expense ratchet upwards, the longer a vehicle is kept in service, the lower lifecycle costs are. (Certainly, today’s fuel prices have boosted fuel costs to equal or exceed depreciation; however, theoretically, fuel costs do not vary with time and mileage.)
Extending Replacement Policy Beyond 70,000 Miles
Using reasonable assumptions and some real-world numbers, we’ve seen that in the first two years of service, holding costs decline as mileage is accumulated. What, then, might happen if vehicle service life is extended beyond the 70,000 plus-or-minus miles that seems to be the most cost-efficient time?
To do so, service life would have to be extended beyond 80,000 miles. At that point, the next tire/brake event occurs, variable cost spikes once again to its highest point yet, and replacing the vehicle at that time locks in that higher cost. Meanwhile, the depreciation curve continues to level off.
To manage the risks of extending fleet vehicle service life, vehicles must be carefully and regularly maintained. In addition, there should be a regular schedule of condition reports with supervisor sign-off and required follow-up.
Again, using the same maintenance and repair projections, at 95,000 miles (just short of four years in service), the variable CPM is 0.0243 cents per mile. (The “ratchet” effect is evident; it is lower than at 80,000, but not back down to the previous low of 0.0199 CPM at 75,000 miles.)
The difference between the residual value at 75,000 miles and at 95,000 miles is not nearly as much as that between 16,000 and 40,000 miles, i.e., the leveling off of the depreciation curve. The simplest explanation for this phenomenon is that a vehicle is never worth “zero.” As long as the vehicle is running and has no major physical damage, it will always command some resale price. Even with serious issues, it will always have salvage value.
Logically, it seems as though with the depreciation curve leveling and maintenance/repair costs a much smaller part of overall lifecycle costs, an extended vehicle lifecycle is a reasonable change. Recalling “common wisdom,” however, as vehicle mileage accumulates beyond the 75,000-mile mark, the risk of major mechanical component failure becomes a factor in the decision.
It cannot be assumed, for example, a transaxle or engine will fail. However, once it happens, all the formulae described previously go out the window, and the fleet manager is stuck with thousands of dollars in unanticipated cost and the possibility of a mechanical total loss.
There is the additional effect of the 100,000-miles “milestone,” when the psychological effect of the odometer turning over can have a seriously negative effect on residual value at wholesale or auction.
Some would say there is little reason not to keep a vehicle in service beyond that century mark. If an engine is “bad,” most likely it will fail long before that 100,000-mile increment. Additionally, today’s vehicles carry powertrain warranties that extend to that level (assuming, of course, the vehicle has been properly maintained).
Combining this longevity factor with the ever-leveling depreciation curve, vehicles might become cost-efficient well beyond normal, or even extended, replacement cycle parameters. Finally, add the fact that the effect of increasing vehicle prices and assumption of a new, higher lease rate are avoided.