The Top 10 Depreciation Control Strategies
Depreciation represents the largest single portion of the lease rate and is established in a variety of different ways. While other fixed cost factors include the lessor's service fee, cost to finance (interest rate), and the profit required by the lessor, depreciation should remain the biggest influence in making decisions. Essentially, depreciation is the estimated residual value of the vehicle at replacement subtracted from the total capitalized cost. This is then converted into a factor. The most common factor used in the fleet industry is two percent. This reduces the capitalized cost to zero over a 50-month period or will closely approximate the residual value when sold after a period of time. Each month, two percent of the capitalized cost is reduced to produce a current book or unamortized value of the vehicle. The factor used should vary on the expected useful life of the vehicle in question. The longer the service, the lower the factor. The depreciation and interest will be spread over a longer period of time. Setting a depreciation factor too low will result in a deficiency at lease end, while setting too high a factor produces a credit to the lease. The following 10 control strategies can help you cut costs and increase your overall bottom line and cash flow.
1. Vehicle Selection
The first step to depreciation control is to select the most cost-effective make and model(s) and equip them for maximum usage and eventual resale. Getting all this at the lowest possible cost reduces depreciation expense. The fleet manager is financially responsibile to secure the best vehicle for the job at the lowest cost. This cost also includes the vehicle operating expense. The safety factor of the vehicle while performing its job, however, must also be considered. This is a consideration that cannot be stressed too highly. In determining vehicle requirements, the driver and other managers should provide input to the decision process from a financial, operational, and resale perspective.
2. Matching Vehicle to Depreciation Factor
When determining a depreciation factor, the expected useful life and the approximate market value of the vehicle at lease-end are the two most important factors to consider. Other factors include vehicle specifications, job assignment, mileage, and added equipment. Keep in mind that one factor does not always fit all vehicles and all usages. Vehicles used in low-mileage areas should have a lower factor or lease term, 60 months for example. Determining the depreciation factor for your fleet is a crucial step in preparing your budget. The point is to calculate the number of months it will take to write off vehicle acquisition costs. For fleets that own vehicles, 36 months is the average period. The shorter the period, the higher the company's profits, since taxes for this period will decrease. For leased fleets, a longer write-off period is preferable, since it will help lower payments.
3. Depreciation of Vehicle Upfitting Equipment
There are a number of companies that use expensive upfits for their trucks. The question arises - should the cost of these upfits be capitalized to the lease cost of the vehicle? Some fleets have decided to depreciate them separately from the vehicles. Of course this option causes the number of assets on the books to increase. One factor to consider is whether the upfitted equipment will have a longer useful life than the vehicle. Another is whether the upfitted equipment can be transferred to another vehicle after the original vehicle's useful life has been exhausted. The cost of removal and transferring an upfit is relatively minor compared to ordering a new equipment package. Usually, the cost of the transfer can be capitalized to the cost of the new vehicle. I was in a unique situation during my fleet management tenure. I had similar vehicles in different parts of the country. I had buyers for my depreciated vehicles in North Carolina who only wanted the base vehicle (cab and chassis) so they could add their own upfitting. This led us to transfer our upfits to new cab and chassis. When ordering for this territory, I added the cost of the upfitting to the initial acquisition, and then added the removal and transfer cost to the new vehicle. In the Midwest, I capitalized the equipment separately because the costs associated with my needs were higher, and I wanted to keep better track of the assets. Each vehicle should be evaluated individually when making this decision.
4. Fall Resale Market Influences
Vehicle resale values peak in the October/November time frame. Attempting to acquire new vehicles in this period is recommended, and you should design a depreciation schedule around this time frame. In addition, at this time the automotive manufacturers usually offer an "early ordering incentive" to fleets, thus reducing costs. Upfitting a vehicle usually takes three to eight weeks. If you cannot get delivery during this time, it is recommended that you target completed delivery in the spring market. This is the second most profitable time to resell vehicles. The timing of the delivery of new vehicles is important in reducing capitalized cost as well as increasing resale income of used vehicles.
5. Capitalize Incentives
Over the past two years, depreciation expenses appear to have stabilized. One factor has been the introduction of more factory incentives. If you capitalize those incentives, you can see the impact on net depreciation. However, if you take rebates in the form of cash upfront, you get a one-time cash flow bump rather than over the entire lease period. Reduce your cap cost by taking the incentives directly to the cost of the vehicle. Doing so will also give you a higher profit when selling your vehicle.
6. Executive Vehicle Depreciation
As stated earlier, matching the vehicle to the depreciation period is paramount. Executive vehicles pose a different challenge in this regard. Most executive vehicles are replaced every two years. It is possible to do a 24-month lease and leave the residual at zero. However, the impact to cash flow is not good. Turning to a 36- or 40-month lease is the smart way to go. The fair market value then will more closely match the residual on the lease at the time it will be sold. In the case of executive vehicles and their impact for tax considerations when bought by the executive, consult with your tax/payroll department so you can have all the answers for that executive's questions. He or she is not a person who wants a surprise at the end of that lease.
7. Changing Lease Terms
Depending on the lessor, it may be possible to change an existing lease term during the duration of the lease. If you can make this change retroactive to the inception of the lease, then you can either get the difference refunded to your company or have an available credit to use for the duration of the lease. Before taking this step a number of factors must be considered. While this change will increase cash flow from month to month, it will leave a higher residual at the end and a smaller profit or larger loss at the time of resale. Of course, the savings each month received by increasing the lease term offset this. All things considered equal, use your savings monthly and don't wait for a big refund at the end. Depending on the size of your fleet, you may not even notice the savings since you are saving more from your lower depreciation costs on a monthly basis.
When preparing your fleet budget, it is a wise move to look at the last few years of all line item costs. This includes depreciation. The key to controlling depreciation is to consistently use the lifecycle cost analysis. You have to do an acquisition-to-disposal lifecycle cost analysis to determine actual cost. Throughout the year, monitor how you match your budget. Consider any changes to your company. Has the company expanded or down- sized its fleet or has the personality changed? These issues must be addressed in determining how you monitor and continually control actual costs in comparison to established budget. The more often you compare actual costs to projected budget, the easier it is to correct variances that may occur.
9. Lessor Involvement
Some fleet managers make the mistake of thinking they know everything about their fleet. However, using contacts at your fleet lessor can give you valuable insight into all types of vehicle operating costs, including depreciation. Lessors have the tools and software to provide information and best practices scenarios for all vehicles based upon vehicle history. This invaluable tool should be used to compliment the internal tools you currently use. Future model changeovers, redesigns, estimated costs (fixed and variable), and resale value are areas to discuss with your fleet management company to determine a budget. This information can help you decide not only the type of vehicle you acquire, but also determine the type of lease term to use for that vehicle. While all fleets are not the same, the basic information provided from your fleet lessor should not be dismissed.
10. Market Awareness
The last recommended strategy is to educate yourself as much as possible on the developments and trends in the automotive industry. Don't look at just what is happening with the manufacturers. Check out what upfitters are doing and what the market is doing to interest rates. Research current resale values of vehicles in your fleet to determine if your lease factor or term needs adjusting. Check all costs involved in running your fleet. Get your hands on as many industry publications as possible and don't be afraid to ask difficult questions of your lessor and those in your organization who need vehicles. While these strategies are proven ways to control depreciation, today's fleet manager needs to continually "re-engineer" his or her way of thinking to keep up with current market trends. There will always be faster and better ways of doing things. However, basic sound principals should be the foundation in controlling all fleet costs.
David Fern has more than 15 years of fleet management experience. He currently works as a fleet consultant and can be reached at [email protected]