Is Cash Still King?
The potential for lower acquisition costs, greater control over resale pricing, no debt added to the balance sheet – these are a few advantages of purchasing vehicles outright, which traditionally has been the prominent fleet acquisition strategy for many utility companies.
But according to Paul Lauria, president of Mercury Associates (www.mercury-assoc.com), a fleet management consulting firm based in Rockville, Maryland, there’s also a big downside to cash: It can lead to “suboptimal decision-making” that undermines your fleet’s performance, especially in an era of low interest rates. Lauria contends that paying for equipment over time – whether with a loan or lease – or as needed with short-term rentals creates a more flexible structure where fleet departments can improve the age, condition and performance of their vehicles at a significantly lower total cost of ownership.
“Any organization that wants to optimize the total cost of ownership of its fleet has to figure out the right balance of capital and operating expenditures,” Lauria said. “A lot of organizations don’t do this; they underspend on fleet replacement costs, with the result that they overspend on fleet operating costs.”
So, why has the utility industry traditionally resisted financing equipment purchases? In what ways does cash purchase impact fleet decision-making? And how can fleets strike a more optimal balance between capital and operating expenditures? During UFP’s recent conversation with Lauria, who has advised hundreds of government and utility fleets since 1985, we dug deeper into these questions. Here are edited highlights.
UFP: From your perspective, why have utilities tended to resist the idea of financing their vehicles?
Paul Lauria: Traditionally, investor-owned utilities have preferred to own their fleet assets because the amount of fixed assets carried on their balance sheet is one of the things that goes into setting rates. So, having assets on the balance sheet can be advantageous financially, even though it may be disadvantageous from a fleet management perspective. Leased assets are owned by the lessor, not the lessee, so switching from ownership to leasing might adversely affect a company’s rate base.
A company can finance the purchase and ownership of fleet assets with debt, which does not create this problem. However, many utilities have statutorily established or self-imposed limits on how much debt they can carry on their balance sheet. So, if they have to choose between borrowing money for infrastructure projects – such as building a new power plant or transmission line – and borrowing money to buy vehicles, it’s not surprising that they’re going to want to use their borrowing capacity for more expensive capital projects.
But when you say that cash can lead to “suboptimal decision-making” by fleet departments, what do you mean by that? In what ways?
The first thing you see with organizations that purchase vehicles outright with cash is that they tend to put off the replacement of vehicles as long as possible. That’s because, in the short term, from a financial impact standpoint, fixing an old vehicle is always going to require less cash than replacing that vehicle.
If the only way management will let me buy a new truck is to secure $50,000 in funds to pay for that truck up front, then it will always be easier for me to scrounge up $5,000 or even $15,000 to repair that truck than get $50,000 to replace it. This incentivizes fleets to put off purchasing replacement vehicles as long as possible, despite the ongoing costs from repairs and downtime. Decisions that make no sense from an economic or total cost of ownership perspective can make perfect sense from a short-term budgeting and cash flow perspective.
The second drawback of purchasing fleet assets outright with cash is that, once an asset is in the fleet, users of the asset tend to treat it as though that capital cost doesn’t exist anymore.
What do you mean?
Say two years ago we bought a $50,000 truck, but the mission of the business unit for which the truck was acquired has changed. They’re not using the truck very much anymore, but hey, it’s “paid for.” We paid for it two years ago, right? So, let’s hang on to it just in case we need it. Or maybe we’ll keep it and use it for some other purpose – even if it’s not necessarily the best type of truck for that purpose. This one’s paid for, so we’ll make do with it.
The problem with this type of thinking is that, in reality, a vehicle is not paid for until it is no longer in the fleet. The capital cost of a vehicle is what you paid to acquire it minus the proceeds you received when you disposed of it. In other words, this type of thinking ignores the fact that there is an opportunity cost – the cash that can obtained by selling an asset – that is incurred when a company holds onto that asset when it no longer needs it to fulfill a bona fide business need.
So, with outright cash purchase, you’re less inclined to get rid of that asset even though, in real economic terms, it is depreciating every day. In contrast to when you acquire an asset using a loan or lease, there’s not an awareness of the ongoing cost of having that piece of equipment sitting out in your yard.
But how does paying for the vehicle over time help change this dynamic?
When an organization leases or debt finances fleet replacement costs, it is better attuned to the management of the total cost of ownership of those assets than is the case when it purchases them outright. These financing methods make it hard to ignore the 40 percent or so of a fleet’s TCO that is depreciation. Spending $15,000 to repair an old truck doesn’t seem very logical if you can acquire a $50,000 replacement truck under a loan or lease where the capital cost of that truck in the next year is only $7,000 or so. So, whether we’re talking about a lease or a loan, those kinds of pay-as-you-go financing methods lead to better decision-making related to the allocation, repair and replacement of fleet assets.
Why do you think it’s important for utility fleet managers to explore alternative vehicle acquisition strategies in today’s market?
We’re in the latter stages of a long economic expansion. At some point in the not-too-distant future, there will be another recession, and with that – as many fleet professionals know from painful past experience – there will be a cutback in fleet replacement funding levels. So, the time to be getting your fleet replacement house in order – to institute a multiyear replacement planning process, to determine appropriate replacement cycles for the key types of vehicles in your fleet, to assess the merits of alternative financing methods – is now, while the economy’s still good and interest rates are still low. Once that window closes, it will be too late for many companies to do these things until the next recession is just a memory.