(Published in Construction Accounting and Taxation, March/April 2013 issue.)
Total annual construction spending put in place in the United States has dropped from a high of over $1 trillion pre-2008 to below $800 billion in the last few years according to FMI Corporation 2012 data. This 20 percent drop in spending has caused most contractors to evaluate their costs more diligently and in many cases to make drastic expense cuts. For construction companies with a large equipment fleet, this can be a daunting task.
During the heavy construction spending years prior to 2008, many construction companies increased their equipment fleet to match their growing workload. They were able to purchase and utilize the equipment on projects at a much cheaper rate than renting it from a third party. However, when construction spending started to decrease, most contractors found themselves unable to recover their fleet costs. In particular, contractors operating in the highway and civil industries typically carry a large amount of equipment on their balance sheet. These cuts in annual construction spending are increasingly impacting highway contractors, especially those that perform a large number of Department of Transportation projects. With the winding down of federal stimulus money coupled together with the fact that most local, state, and federal budgets are being cut, there are fewer funds available for large infrastructure projects, and this leads to a potential headwind for the industry. This is causing companies operating in these industries to take an even more diligent look at their equipment fleets and face some difficult evaluations.
Contractor cost centers
Contractors with large equipment fleets typically track all of their equipment- and shop-related overhead costs within a common cost center or pool. Typically these cost centers include costs such as depreciation, insurance, fuel and lubricants, shop labor and burden, small tools, and repair costs. Companies should set a goal to recover all of their equipment costs through internal equipment rate charges on projects. When evaluating costs on a more detailed level, most contractors track all equipment-related costs to each specific piece of equipment. In some cases, work order systems are utilized within the equipment shop to track all costs related to shop labor and burden as well as all costs related to external and internal repairs for a specific piece of equipment as the work is performed. In addition, fuel and lubricants can be tracked fairly easily on a daily, piece-by-piece basis whether refueling and lubrication is applied in the field or in the shop.
It should also be company policy to track the depreciation- and insurance-related costs on each piece of equipment throughout the year. Therefore, the majority of equipment- and shop-related costs should be able to be tracked to the specific item; however, most contractors will still have a pool of other indirect related equipment and shop costs such as small tools and other miscellaneous items.
Companies should allocate this pool of costs to each specific item based on a reasonable and systematic method, such as hours utilized. Tracking all of these costs to each specific piece of equipment allows the company to have an accurate tracking mechanism for the exact cost of each piece of equipment that they own. This also provides good historical tracking data for equipment cost review and enables the company to make a more informed decision when buying a piece of equipment versus renting. Exhibit 1 depicts an example of how the tracking per piece of equipment can be handled.
In the construction industry, it is also best practice to track the utilization rates on an hourly basis throughout the year. Contractors should set annual hourly budgets for each piece of equipment and compare the actual hours charged to projects throughout the year to the hours budgeted in order to help evaluate the company’s fleet size. This utilization tracking should be pushed down to a specific project basis. Project managers should be tracking utilization compared to budget on a daily and weekly basis for their specific ongoing projects.
By knowing the actual cost per piece of equipment and setting annual hourly budgets, the company can better understand its actual cost per hour, make better decisions on what rate should be charged internally on projects, and in turn recover its equipment costs. As noted in Exhibit 2, the budgeted cost per piece of equipment should include the acquisition recovery costs for depreciation and an interest component if necessary, budgeted repair costs, insurance, fuel and lubricant usage, estimated labor and burden costs, tires, and an allocation of other non-tracked indirect costs to determine the budgeted cost per unit.
The estimated annual hours should be compared to the annual cost to determine the actual internal cost per hour. Once that internal rate is set, companies must determine if their internal hourly cost is in line with market pricing in order to bid competitively and remain profitable. This is an important analysis because as workload decreases (driving down hours charged for the companies’ projects), the internal cost per hour increases and in some cases makes it difficult to be competitive compared to current market pricing. Most estimators and project managers have a good feel as to what the average market pricing is on equipment rates; however, there are also benchmarking guides available that give rate ranges for different areas of the country by piece of equipment.
An additional consideration when performing budgets and tracking hours charged to projects is idle equipment time. It is becoming commonplace for companies to have equipment on the job site that is sitting idle because it may not be currently needed on another project; in busier times, it is commonplace to hoard equipment on job sites. Companies need to be tracking these idle hours and accounting for them. The company may consider charging hours to the project on which the idle equipment is located so that the hours can be tracked. On a project by project basis, the project manager must be aware of tracking the down time in some manner so that those hours can be captured for accurate financial reporting
Companies should fully evaluate these costs and budgets in conjunction with the annual financial and capital expenditure budget processes. These rates and cost recovery analyses should then be revisited on at least a quarterly basis to ensure that the company continually recovers its costs and maintains profitability on its jobs.
Evaluating equipment fleet size
As noted above, for companies with a fleet size that was built up pre-2008, it is crucial to recover all internal costs to avoid unallocated equipment costs at the end of the reporting period that negatively impact gross margin and net income. Maintaining good equipment tracking using the methods noted above allows a company to make better informed decisions on whether their fleet is too large and to make more accurate evaluations on whether to sell certain pieces of equipment. Focusing on the equipment fleet should be part of the company’s five-year strategic plan. Management should plan to evaluate all equipment–even equipment that might be considered specialty type equipment that historically has not had as high of a utilization rate as the average piece of equipment. If the entire equipment fleet for the company is below 75 to 80 percent on a utilization percentage; or if there are single pieces of equipment that are below 50 percent on a utilization percentage, the company should really consider eliminating specific pieces from its fleet.
Construction equipment spending is on a downward trend as most companies are looking for ways to downsize their equipment fleet and instead rent certain equipment on an as-needed basis. It might also be a good time to exchange older equipment for newer equipment with improved technology. The new technology should allow the company to be more efficient in the field and generate increased margins, resulting in an improvement to their bottom line.
As part of the budget process and evaluation of the equipment and shop center, companies should also consider evaluating other factors including efficiencies and cost-saving opportunities. Companies should evaluate the repair work being performed internally and determine if there could be a cost savings by outsourcing certain repairs to a more efficient third party. Companies may also consider utilizing a fleet program for on their on-road vehicles, which could move the normal maintenance to a third party and let the shop employees spend their time repairing more “high dollar” equipment. Shifting some of the shop related duties may also allow the company to reduce overtime shop hours being paid and ultimately reduce equipment cost pools. It would also be a good time to start to inventory all shop supplies such as batteries, belts, hoses, tires — and then track these items. A good tracking mechanism can ultimately help with cost savings. Another best practice for the shop would be to set up accurate preventive maintenance schedules for all equipment and ensure that these schedules are being adhered to. In busier times, it is easy to let equipment run for many hours in excess of normal scheduled maintenance because of the demand on job sites; however, in the long run, if accurate maintenance schedules are followed it will help maintain the value of equipment and cut down on long-term repair costs.
If a company currently is not tracking equipment costs in this manner, it would be a best practice to perform a five-year look-back evaluation on each piece of equipment to determine if costs are properly aligned with the rates being charged to projects. There are many available software and general ledger packages that have modules to help track equipment costs and utilization. Many companies that do not have a software package will perform this tracking outside their accounting system. The important aspect would be, however, to start tracking these costs and performing these evaluations if the company is not already doing so.
Implementing best practices on an equipment fleet and shop center costs will allow the company to have better control of its equipment fleet and make more-informed business decisions. With the current construction spending levels across the country, it is extremely important to have a good handle on equipment costs in order to put the company in the position to be as profitable as it can be. Also, knowing and understanding the true cost of the company’s equipment fleet and its utilization will ultimately lead to better estimating of job costs on future projects which is extremely important in the current tight bid environment.