Business processes can thrive only in an environment of perpetual challenge. When the common wisdom becomes sacrosanct, new ideas
and the drive to improve stagnate.
The Basics: Time and Mileage
Fleet replacement policy is most commonly expressed in a combination of time and mileage, i.e., a number of months or mileage level. The logic behind this policy lies in the movement of fixed and variable expense during the life of the vehicle. Depreciation expense rises steeply the instant a vehicle is driven off the lot, generally leveling off, increasing very slowly but steadily as time progresses. Since depreciation expense is by far the largest fixed fleet expense, it is also the fixed expense most closely associated with replacement cycle analysis. The second major component in the replacement decision is variable expense, consisting of fuel, maintenance/repair, tires, and oil. Fuel costs, particularly today, are as large a part of variable expense as depreciation is of fixed expense. However, fuel costs generally are not time-in-service sensitive. The fuel efficiency of a vehicle (assuming it has been properly maintained) is usually the same the first months in service as it is two years down the road. Maintenance and repair is the next largest service-sensitive expense and is most often used in the replacement calculation. The maintenance/repair expense curve differs from that of depreciation; for the first year to 18 months. It consists almost exclusively of regular preventive maintenance (oil changes, tire rotations, etc.). At the 35,000-50,000 mile range, the two major predictable repair expenses — tires and brakes — generally occur. Thus, the maintenance/repair curve begins low, spikes when tires and brakes are purchased, declines and spikes again, creating a ratchet-style curve. The trick in replacement cycling is to replace vehicles at the point in their service lives when the combination of these two expenses is at its lowest. Traditionally, for the typical sales/service auto fleet, this point occurs during the third year, around 65,000-75,000 miles. For light trucks and vans, the time period is somewhat longer, with mileage approaching or exceeding 100,000.
Policy Based on Historical Data
The main point in this review is that replacement policy research and analysis is based upon historical data: depreciation history, variable expense cost per mile by mileage increments, and the like. Fleet managers review this data, and make replacement policy adjustments where necessary. Of course, individual exceptions to established policy happen. For example, a vehicle that reaches replacement criteria in late spring or early summer might be held over until the fall ordering season. Its used-vehicle market value is impacted by the fact that in only a few months, it will be another model-year older. Some vehicles are kept in service longer when transferred to a new hire for use in lieu of a rental while the hire awaits delivery of a new vehicle. However, replacement policy tends to be fairly static, remaining unchanged unless the company decides a budget squeeze requires they forego replacements for some period of time.
Shortcycling Can Offer Benefits
In recent years, however, research has led some in the industry to believe that shorter replacement cycles, as short as one year, can provide substantial savings. A number of justifications are given for this change in policy.
Reduced operating costs.The theory is that when vehicles are replaced on a shorter cycle, they will still be under warranty; thus, maintenance and repair expense will be limited primarily to preventive
maintenance and the occasional wear item failure (tires, belts, hoses).
Maximized fleet incentives. The same-level CAP (competitive assistance payment, also known as “rifleshot” money) taken over a 24-month service life is greater on a per-month basis than taken over 36 months.
Maximized model-year buy. A fleet using a shorter cycle rolls over more vehicles each year than a fleet with a longer cycle. For example, a 1,000-vehicle fleet on a two-year cycle buys about 500 units per year versus the 300 or so they roll over on a three-year
cycle. A bigger model-year buy may mean a larger CAP can be negotiated.
Greater resale value. Shortcycling brings newer vehicles, with lower mileage and in better condition, to the used-vehicle market.
Improved driver morale. Drivers are provided new vehicles more often, an advantage when recruiting, hiring, and retaining talented employees.
Each of these points has merit. However, each has drawbacks as well.
Reduced Operating Costs
Unquestionably, in gross dollars, newer vehicles incur lower maintenance and repair expense, a key determinant in developing replacement policy. Even a high-mileage fleet, driving 35,000 miles per year or more, remains under most new-car, bumper-tobumper warranty limits. This advantage under a shortcycle policy can stretch to the point when tire and brake expenses loom. Waiting until tire and brake expense are close risks losing resale value, since buyers discount for them. The trick is to remarket a vehicle with as much of the original equipment as possible, but to maximize mileage driven by selling the vehicle before it is too close to replacement. Here’s how the advantage stacks up.
Assume Vehicle A is replaced at 12 months, 24,000 miles. It has had eight oil changes at $25 each, four tire rotations at $20 each, and one wheel alignment at $25. The cost per mile at replacement is figured as follows.
Total m/r expense: $305
Cost/use calculation: $305 X 100 = 30,500 cents
30,500 cents / 24,000 miles = 1.27 cents per mile.
Vehicle B is replaced at 30 months, 60,000 miles. It has incurred 20 oil changes, six tire rotations, two wheel alignments, one set of tires at $400, and one brake overhaul at $180. The cost per mile on Vehicle B is figured as follows. Total m/r expense: $1,250
Cost/use calculation: $1,250 X 100 = 125,000 cents
125,000 / 60,000 miles = 2.08 cents per mile Clearly, not only are gross maintenance/repair dollars lower, but the critical cost/use ratio is significantly lower as well with the shortcycled vehicle. These results may not hold up, however, if Vehicle B is driven an additional 30,000 miles, during which it is safe to say that tires and brake expense might not be repeated, and only additional preventive maintenance must be done. But the argument for shortening replacement policy based upon reduced operating costs is a strong one.
Maximizing Fleet Incentives
The increased per-month CAP reduction is more complicated to analyze. In theory, taking a CAP over a shorter period results in a greater per-month-of-service life amount. Taken in isolation, this is true. A $2,000 incentive “amortized” over 24 months totals roughly $83 per month; over 36 months, the total is $56. Whether this is an advantage depends upon how incentives are treated. If they’re provided directly to the fleet as cash, the shorter cycle is indeed a boon. Many fleets, however, use the incentive to reduce the capitalized cost of the vehicle under their lease agreement. All things being equal, the shorter cycle doesn’t provide any benefit. Assuming that at replacement the unamortized vehicle value is equal to the resale value, it’s a wash. Normally, however, with like vehicles, resale on the shorter cycle does not cover the unamortized book value, if the vehicles are amortized at the same rate. The bottom line is the benefit of a shorter cycle regarding maximizing the effect of CAPs is not only difficult to see, it depends upon how the fleet books the cash. If the money is simply deposited, little difference is found. The faster cycle results in fresh incentives. However, higher prices could offset them. If incentives are used to reduce capitalized cost, lease payments are higher, pinching cash flow. No simple answer is apparent to the question of whether shortcycling provides this benefit.
Maximizing Model-Year Buys
One benefit of shortening replacement criteria is clear. When more vehicles are purchased, CAP incentives can increase. Manufacturers offer fleet customers competitive assistance payments, or CAPs, when the fleet agrees to certain levels of new orders during a model-year. The more orders, the greater the incentive. The manufacturers’ ultimate goal is to move a fleet to single source. A fleet of 1,000 vehicles, replaced on a 36-month cycle, orders about 300 units in a model-year. The same fleet replaces as many as 500 units if the cycle is shortened to 24 months. These additional 200 orders might be worth a great deal in negotiating model-year incentives with the manufacturers. More orders, greater incentives, and more of them. Shortcycles can indeed translate into more incentive cash, a benefit if there are no offsetting expense increases in lifecycle costs.
Greater Resale Value
Replacing vehicles on shorter cycles results in newer, lower-mileage, and presumably, better-conditioned vehicles on the resale market, translating into higher proceeds. True enough, but only in absolute dollars. Resale value is not the single component in the replacement decision. Net depreciation is the factor that counts. Resale value must show a substantial increase to offset the higher book value, assuming that in both instances, the vehicles are amortized at the same rate. Here’s how it would look.
Cap Cost: $20,000
Amortization rate: 50 months (2%/month)
Service: 36 months
Reserve: $20,000 / 50 = $400/month
Book Value at Replacement: $20,000 – ($400 X 36) = $5,600 In this example, a $20,000 vehicle, amortized over 50 months and replaced after 36 months in service has a book value of $5,600 at replacement. The following scenario illustrates the difference if the same vehicle was replaced after 24 months. Cap Cost: $20,000
Amortization Rate: 50 months (2%/month)
Service: 24 months
Reserve: $20,000 / 50 = $400/month
Book Value at Replacement: $20,000 – ($400 X 24) = $10,400 The book value covered at replacement time is $10,400 or $4,800 greater than the same vehicle at 36 months. Obviously, the question is whether the actual market value would be that much greater if the cycle was reduced from 36 months to 24 months. It is entirely possible that the market value would be greater. However, it’s equally possible that it would not. Creating policy under such uncertain circumstances can be a risky undertaking, taken in isolation. If the fleet manager isn’t convinced that market value would be greater, the vehicle must be amortized at an appropriately faster rate, negatively affecting cash flow.
Improved Driver Morale
An important consideration in selecting vehicles, indeed, in providing them in the first place, is driver morale. Providing a company vehicle helps the company recruit, hire, and retain talent, and remain industrycompetitive. Replacing vehicles on a shorter cycle puts a driver into a new vehicle more often, and from a morale standpoint, this can only be a good thing. Not only does the driver enjoy the benefit of a new vehicle, but if the company has an employee purchase program, it provides the driver more opportunities to purchase a second car for family members. All in all, high morale translates to more productive employees. Replacing vehicles more often is a winner all around.
Other Issues to Consider
Advocates offer these and other reasons for shorter replacement cycles. One other argument holds that a vehicle “hot” in the marketplace can replace existing selections. The primary justification given for this approach is that the vehicle’s resale value is so strong, depreciation expense is actually reduced. The vehicle will be worth a great deal more than the incumbent vehicle when sold. The problem with this reasoning is that replacement policy is just that — policy. It is not a case-by-case decision- making process. Changing policy based upon specific, current circumstances may prove a mistake down the road. One example of such a mistaken decision-making is illustrated by the compact SUVs that entered the market only a few years ago. The overall SUV market had slumped from its peak in the early 2000s, as gasoline prices rose, and environmental concerns increased. Manufacturers reacted swiftly, developing more compact offerings, with smaller engines that achieved better fuel economy, even hybrid drives. They had the SUV cachet with none of the gas-guzzling baggage, and thus were projected to have strong value retention. For these reasons, compact SUVs were proposed as excellent replacements for the traditional four-door mid-sized sedan on many selectors. Although these cars were plentiful and priced below compact SUVs, their resale was weak because the market was flooded with them. Based upon resale value projections as much as $7,000 greater after two years in service than mid-sized sedans, some companies considered placing these vehicles in service and shortening the replacement cycle to 24 or even 12 months. However, problems arise if resale values don’t hold up as predicted. Higher capitalized costs make the change a lateral move at best, a costly mistake at worst. Such a move is based upon what may be bad data, rather than carefully researched and analyzed history. Some fleet managers choose the “chicken before the egg”; that is, if they’ve negotiated a particularly strong CAP program, sometimes by single sourcing, they’ve scheduled more replacements than established policy dictates to take advantage of the CAP. In essence, rather than first analyzing available data and changing policy, thus enabling a stronger negotiated CAP program, they’ve reversed the process and set the CAP program first, then changed the replacement decision as a result. This is backward reasoning.
Review and Conclusions
All in all, shortcycling may not be quite the panacea that some in the industry have presented. However, it can be a smart decision if all the stars align properly. Better CAP programs can be achieved.
A short cycle doesn’t negatively impact overall lifecycle costs.
Vehicles are available for which resale value will be demonstrably strong.
Nonetheless, the replacement decision will remain, as it always has, the result of careful analysis of historical
data, tempered by the flexibility to move quickly when opportunity
presents itself in the form of new models and the availability of factory assistance..
Fleet management is certainly no exception to the rule. What may have held true last year or a decade ago may not hold true today. Fresh ideas and challenges to what “everyone” knows is true maintain a regular flow of change coursing through this important discipline.
An example of this constant input from change occurs in developing fleet replacement policy. The concept is a simple one: determine the most cost-efficient point to replace a company-provided vehicle. For a long time, common wisdom has held that this point usually occurs during the third year in service, based upon the analysis of fixed (depreciation) and variable (fuel and maintenance/repair) costs. In recent years, however, some circumstances have changed, and the case has been made that more frequent replacement can save the company substantial sums.
The Basics: Time and Mileage
Fleet replacement policy is most commonly expressed in a combination of time and mileage, i.e., a number of months or mileage level. The logic behind this policy lies in the movement of fixed and variable expense during the life of the vehicle. Depreciation expense rises steeply the instant a vehicle is driven off the lot, generally leveling off, increasing very slowly but steadily as time progresses. Since depreciation expense is by far the largest fixed fleet expense, it is also the fixed expense most closely associated with replacement cycle analysis. The second major component in the replacement decision is variable expense, consisting of fuel, maintenance/repair, tires, and oil. Fuel costs, particularly today, are as large a part of variable expense as depreciation is of fixed expense. However, fuel costs generally are not time-in-service sensitive. The fuel efficiency of a vehicle (assuming it has been properly maintained) is usually the same the first months in service as it is two years down the road. Maintenance and repair is the next largest service-sensitive expense and is most often used in the replacement calculation. The maintenance/repair expense curve differs from that of depreciation; for the first year to 18 months. It consists almost exclusively of regular preventive maintenance (oil changes, tire rotations, etc.). At the 35,000-50,000 mile range, the two major predictable repair expenses — tires and brakes — generally occur. Thus, the maintenance/repair curve begins low, spikes when tires and brakes are purchased, declines and spikes again, creating a ratchet-style curve. The trick in replacement cycling is to replace vehicles at the point in their service lives when the combination of these two expenses is at its lowest. Traditionally, for the typical sales/service auto fleet, this point occurs during the third year, around 65,000-75,000 miles. For light trucks and vans, the time period is somewhat longer, with mileage approaching or exceeding 100,000.
Policy Based on Historical Data
The main point in this review is that replacement policy research and analysis is based upon historical data: depreciation history, variable expense cost per mile by mileage increments, and the like. Fleet managers review this data, and make replacement policy adjustments where necessary. Of course, individual exceptions to established policy happen. For example, a vehicle that reaches replacement criteria in late spring or early summer might be held over until the fall ordering season. Its used-vehicle market value is impacted by the fact that in only a few months, it will be another model-year older. Some vehicles are kept in service longer when transferred to a new hire for use in lieu of a rental while the hire awaits delivery of a new vehicle. However, replacement policy tends to be fairly static, remaining unchanged unless the company decides a budget squeeze requires they forego replacements for some period of time.
Shortcycling Can Offer Benefits
In recent years, however, research has led some in the industry to believe that shorter replacement cycles, as short as one year, can provide substantial savings. A number of justifications are given for this change in policy.
Reduced Operating Costs
Unquestionably, in gross dollars, newer vehicles incur lower maintenance and repair expense, a key determinant in developing replacement policy. Even a high-mileage fleet, driving 35,000 miles per year or more, remains under most new-car, bumper-tobumper warranty limits. This advantage under a shortcycle policy can stretch to the point when tire and brake expenses loom. Waiting until tire and brake expense are close risks losing resale value, since buyers discount for them. The trick is to remarket a vehicle with as much of the original equipment as possible, but to maximize mileage driven by selling the vehicle before it is too close to replacement. Here’s how the advantage stacks up.
Assume Vehicle A is replaced at 12 months, 24,000 miles. It has had eight oil changes at $25 each, four tire rotations at $20 each, and one wheel alignment at $25. The cost per mile at replacement is figured as follows.
Total m/r expense: $305
Cost/use calculation: $305 X 100 = 30,500 cents
30,500 cents / 24,000 miles = 1.27 cents per mile.
Vehicle B is replaced at 30 months, 60,000 miles. It has incurred 20 oil changes, six tire rotations, two wheel alignments, one set of tires at $400, and one brake overhaul at $180. The cost per mile on Vehicle B is figured as follows. Total m/r expense: $1,250
Cost/use calculation: $1,250 X 100 = 125,000 cents
125,000 / 60,000 miles = 2.08 cents per mile Clearly, not only are gross maintenance/repair dollars lower, but the critical cost/use ratio is significantly lower as well with the shortcycled vehicle. These results may not hold up, however, if Vehicle B is driven an additional 30,000 miles, during which it is safe to say that tires and brake expense might not be repeated, and only additional preventive maintenance must be done. But the argument for shortening replacement policy based upon reduced operating costs is a strong one.
Maximizing Fleet Incentives
The increased per-month CAP reduction is more complicated to analyze. In theory, taking a CAP over a shorter period results in a greater per-month-of-service life amount. Taken in isolation, this is true. A $2,000 incentive “amortized” over 24 months totals roughly $83 per month; over 36 months, the total is $56. Whether this is an advantage depends upon how incentives are treated. If they’re provided directly to the fleet as cash, the shorter cycle is indeed a boon. Many fleets, however, use the incentive to reduce the capitalized cost of the vehicle under their lease agreement. All things being equal, the shorter cycle doesn’t provide any benefit. Assuming that at replacement the unamortized vehicle value is equal to the resale value, it’s a wash. Normally, however, with like vehicles, resale on the shorter cycle does not cover the unamortized book value, if the vehicles are amortized at the same rate. The bottom line is the benefit of a shorter cycle regarding maximizing the effect of CAPs is not only difficult to see, it depends upon how the fleet books the cash. If the money is simply deposited, little difference is found. The faster cycle results in fresh incentives. However, higher prices could offset them. If incentives are used to reduce capitalized cost, lease payments are higher, pinching cash flow. No simple answer is apparent to the question of whether shortcycling provides this benefit.
Maximizing Model-Year Buys
One benefit of shortening replacement criteria is clear. When more vehicles are purchased, CAP incentives can increase. Manufacturers offer fleet customers competitive assistance payments, or CAPs, when the fleet agrees to certain levels of new orders during a model-year. The more orders, the greater the incentive. The manufacturers’ ultimate goal is to move a fleet to single source. A fleet of 1,000 vehicles, replaced on a 36-month cycle, orders about 300 units in a model-year. The same fleet replaces as many as 500 units if the cycle is shortened to 24 months. These additional 200 orders might be worth a great deal in negotiating model-year incentives with the manufacturers. More orders, greater incentives, and more of them. Shortcycles can indeed translate into more incentive cash, a benefit if there are no offsetting expense increases in lifecycle costs.
Greater Resale Value
Replacing vehicles on shorter cycles results in newer, lower-mileage, and presumably, better-conditioned vehicles on the resale market, translating into higher proceeds. True enough, but only in absolute dollars. Resale value is not the single component in the replacement decision. Net depreciation is the factor that counts. Resale value must show a substantial increase to offset the higher book value, assuming that in both instances, the vehicles are amortized at the same rate. Here’s how it would look.
Cap Cost: $20,000
Amortization rate: 50 months (2%/month)
Service: 36 months
Reserve: $20,000 / 50 = $400/month
Book Value at Replacement: $20,000 – ($400 X 36) = $5,600 In this example, a $20,000 vehicle, amortized over 50 months and replaced after 36 months in service has a book value of $5,600 at replacement. The following scenario illustrates the difference if the same vehicle was replaced after 24 months. Cap Cost: $20,000
Amortization Rate: 50 months (2%/month)
Service: 24 months
Reserve: $20,000 / 50 = $400/month
Book Value at Replacement: $20,000 – ($400 X 24) = $10,400 The book value covered at replacement time is $10,400 or $4,800 greater than the same vehicle at 36 months. Obviously, the question is whether the actual market value would be that much greater if the cycle was reduced from 36 months to 24 months. It is entirely possible that the market value would be greater. However, it’s equally possible that it would not. Creating policy under such uncertain circumstances can be a risky undertaking, taken in isolation. If the fleet manager isn’t convinced that market value would be greater, the vehicle must be amortized at an appropriately faster rate, negatively affecting cash flow.
Improved Driver Morale
An important consideration in selecting vehicles, indeed, in providing them in the first place, is driver morale. Providing a company vehicle helps the company recruit, hire, and retain talent, and remain industrycompetitive. Replacing vehicles on a shorter cycle puts a driver into a new vehicle more often, and from a morale standpoint, this can only be a good thing. Not only does the driver enjoy the benefit of a new vehicle, but if the company has an employee purchase program, it provides the driver more opportunities to purchase a second car for family members. All in all, high morale translates to more productive employees. Replacing vehicles more often is a winner all around.
Other Issues to Consider
Advocates offer these and other reasons for shorter replacement cycles. One other argument holds that a vehicle “hot” in the marketplace can replace existing selections. The primary justification given for this approach is that the vehicle’s resale value is so strong, depreciation expense is actually reduced. The vehicle will be worth a great deal more than the incumbent vehicle when sold. The problem with this reasoning is that replacement policy is just that — policy. It is not a case-by-case decision- making process. Changing policy based upon specific, current circumstances may prove a mistake down the road. One example of such a mistaken decision-making is illustrated by the compact SUVs that entered the market only a few years ago. The overall SUV market had slumped from its peak in the early 2000s, as gasoline prices rose, and environmental concerns increased. Manufacturers reacted swiftly, developing more compact offerings, with smaller engines that achieved better fuel economy, even hybrid drives. They had the SUV cachet with none of the gas-guzzling baggage, and thus were projected to have strong value retention. For these reasons, compact SUVs were proposed as excellent replacements for the traditional four-door mid-sized sedan on many selectors. Although these cars were plentiful and priced below compact SUVs, their resale was weak because the market was flooded with them. Based upon resale value projections as much as $7,000 greater after two years in service than mid-sized sedans, some companies considered placing these vehicles in service and shortening the replacement cycle to 24 or even 12 months. However, problems arise if resale values don’t hold up as predicted. Higher capitalized costs make the change a lateral move at best, a costly mistake at worst. Such a move is based upon what may be bad data, rather than carefully researched and analyzed history. Some fleet managers choose the “chicken before the egg”; that is, if they’ve negotiated a particularly strong CAP program, sometimes by single sourcing, they’ve scheduled more replacements than established policy dictates to take advantage of the CAP. In essence, rather than first analyzing available data and changing policy, thus enabling a stronger negotiated CAP program, they’ve reversed the process and set the CAP program first, then changed the replacement decision as a result. This is backward reasoning.
Review and Conclusions
All in all, shortcycling may not be quite the panacea that some in the industry have presented. However, it can be a smart decision if all the stars align properly.
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