Business MattersContractor

Equipment selection with the use of basic maths

Equipment selection with the use of basic maths - Contractor Mag - Oct 2017 - Featured Image

OREST PROTCH lives in British Columbia, Canada and works at a remote oil camp on a week in week out rotation. In his free time he writes articles on better business. This one explains how you should use basic maths ideas to select between two types of heavy equipment. His example 
figures out the payback between a tandem axle or tri-axle water tanker truck, but the formula can be flipped to an excavator, dozer or a crane purchase or anything else for that matter.

I AM GOING TO start this article with a four letter word. If you are overly sensitive you may want to close your eyes while reading it and if you are holding a hot beverage, then taking safety first, put it down. Are you ready? MATH. I hope that got by the editor’s censor pen. [amended from now on to a five letter word: maths, Ed]

While you settle your heart beat down and stop hyperventilating let’s continue and talk about two scenarios. But since they are related we will roll them into one as we go on.

The first one, a two parter, is that you are an employee thinking or dreaming about starting your own contracting business. How do you convince a banker to lend you cash for your dream or perhaps convince a spouse to let you do it? How do you not lose what could be your life’s savings? And the more ambitious laid-off workers may be counting on their former contacts in industry to help justify starting up their own small entrepreneurial businesses to try and make a go of it as a way to make a living in tough economic times.

The second is that you are already established in the field but are wondering why the business across the street is thriving, even during economic downturns, while yours is struggling or not meeting financial expectations. At the same time many of your competitors may still be adding to their fleets and succeeding in making money.

Are their business skills maybe more astute or is that they are simply more attuned to the KISS principle of business success using maths tools, and that is what we are going to go over, the Keep It Simple Stupid principle. Hopefully no offence was taken as none was meant to be given.

So rolling these two scenarios together what we have is a topic about money.

And to put it simply, if you do the maths you will make the money. And money is the honey that keeps us economically secure. And if you believe you can do it, then you will. But you have to have the real belief that you can make money. You have to see yourself doing it. We will work through some examples of what I am talking about so you can see it, because “teaching people to visualise an outcome is more effective than teaching people what to do.”

Trying to convince a bank or other lender, or even a hesitant spouse, that you know what you are doing and getting the funds to support your venture can be a very scary proposition. This is especially true if you are putting your house or other personal chattels up as collateral to get the loan to buy a piece of equipment. Equipment purchase justifications and decisions can keep many aspiring entrepreneur or manager up at nights.

First you need to answer some questions:

  • Is the purchase required to help you start a new career?
  • Is the purchase required to replace an aging piece?
  • Is it needed to get a new contract?
  • Is it required to make an existing operation more efficient?
  • Do you buy used or do you buy new?

There is one critical answer for one specific question that can help those being asked to finance the equipment, including getting approval from a spouse, and that is, “are you using the correct maths tools to make and base your decisions on?”

Justification to purchase mobile equipment, small or large, is in the end no different for a new small owner/operator entrepreneur than it is for the purchase of equipment for a large multi-national. They need the same monetary justification to make them profitable.

So now let’s look at some examples of simple maths analysis to help make the selection between two pieces of equipment.

Normalised run calculations

We will say that we need to select between two used tank trucks, as do not really want to buy a new one whose paint is still pristine. One is a two-axle unit (tandem) and the other a tri-axle unit. One can carry a bigger load than the other but also has more costs associated with it. We will call them Truck A and Truck B. Truck B costs more and its load capacity is greater but also has higher maintenance/servicing operating costs. This includes all costs such as fuel, oil changes, brake servicing, debt servicing and insurance.

The big problem here is the same as the one you face when you walk up to a huge all-you-can-eat buffet. Our eyes are bigger than our stomach. In this case our eyes can be bigger than our potential profit generating centre. How do we make the right choice to maximise our profit and pay the bills?

Work through the following chart, a simple spreadsheet. It is called a “Normalised Run” analysis.

But the real limiting factor in the final selection is the “breakeven” amount which is the amount of unit production where the cost of the two systems is identical. It can be used for tank trucks, cranes, dozers, skidders, harvesters, excavators, bobcats and flatbeds.

Regardless if we use tonnage, volume, cubes or number of bucket scoops per day, we have to come up with our own uniform production rate that we will use to compare both used tank trucks. Once we do that we continue our little maths exercise.

The spreadsheet then does what is called a “normalised run” calculation where it determines what it costs to do 1000 production units and then extrapolates that to our total or expected units in the contract, in our example, over a 5 year period.

It can be as simple or as complicated as you want to make but in reality it is pretty straight forward. You can find the actual one critical break-even formula online or in a basic economics textbook.

In our example the breakeven production is 240,000 cubes and so with a production need over five years of 220,000 cubes, tank truck B is unjustifiable as the breakeven point is above the number of production units in the potential contract. Tank truck A is the more financially sound way to go. It will save approximately $95,000 over the five years we intend to own the truck.

That is money that can be spent on more equipment, a new car or a family vacation. Money talks.

The bigger truck may look like a better investment since it can carry more, but the numbers show the reality of the selection. A different contract may show that truck B is indeed justified.

Do this calculation, while of course adding more realistic numbers to the actual real overhead per 1000 “units” of production, and you will go a long way to making your banker, and your spouse, see that you know what you are doing. It shows that you stepped away from the all-you-can-eat buffet and ended up taking a smaller plate back to your table.

But another contract or a different set of circumstances may show that a bigger truck is needed especially if you want it to moonlight on a night shift on a different job.

But as simple and nice as this sounds we still have to look at another maths analysis tool that is largely ignored by many small businesses and owner/operators to their financial detriment and that is the “Foregone Investment” of the purchase.

This is the money lost forever if we had invested the money to earn interest income instead of buying the equipment at this point of time. This is actually negative cash flow to a company’s accounts and you need to show it as a negative to get a true picture of your financial status. Chances are your competition does not do this. But you should. Maybe talk to your accountant on the tax savings ramifications. They could be significant.

Also each piece of equipment not only has a purchase price but at the term end of our example of five years it has a salvage value when it is sold or traded in. To an accountant this is also future income. (Figure 2) This should also show up in your income calculations over the length of the contract.

Go through the following chart.

If we were to take the purchase price of either piece of equipment and invest it in dividend paying stocks, and taking into account the borrowing interest rate and the salvage value of the systems, we come up with the sales cash flow needed for each unit to make the purchase more cost effective than investing the money to earn interest over the same life term as the contract time length.

For Truck A we need to make a real profit of $18,000 a year, $20,000 for Truck B, just to be at the same “cash in the bank” if we had simply invested the money instead of buying the truck. That’s $90,000 and $102,000 over the five years of the contract.

The last line also shows that Truck B would need to generate approx. $2,400 more cash flow profit yearly than the cheaper Truck A and this works out to approx. $12,000 over our term length for the work of five years.

So now this is where your personal accountant comes in to figure out if over the long term Truck B  is actually more cost effective than Truck A. This comes down to how much you can charge for your services, what the competition is, and if your contacts will come together for you to help you make some money and pay the bills.

The accountant will have to take into consideration such things as the tax laws of your country that you are working in, the tax credits for investment of equipment in your country and any available grant money available for equipment investment.

“Foregone Investment” is a cash flow analysis that makes some businesses see black in their accounting books whereas the owner/operator across the street doing the same work sees red in their accounting books. Cash flows of all sorts needs to be taken into consideration to make money.

Spreadsheets like the ones we just looked at make it easy to instantly see what happens when you manipulate your cost and production variables. It also gives you the tools needed to convince the bank or spouse to let you get on with the need of making money and paying the bills.

Never underestimate the value of simple maths analysis to run your business and to maximise profits by ensuring you make the best financial decisions possible.

Your bottom line depends on it.

This article first appeared in Contractor October 2017.

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