Careful cost analysis is essential to
business planning and profitability
By Irwin Post
Machinery is crucial for most timber harvesting, sawmilling, and value-added work with wood. While some tasks can be successfully completed with just a few hand tools, machines can greatly increase productivity and reduce the physical effort required. Chain saws, farm tractors, sawmills, dry kilns, planers, forklifts, skidders, bulldozers, and many other machines can be central to getting tasks done properly and efficiently.
If harvesting trees on your woodlot or milling logs into boards is your hobby, then the machines you own may be dictated by your desires and/or the depth of your pocketbook. If, however, you operate a serious part-time or full-time business, a thorough understanding of the costs of owning and operating machinery is essential to your profitability. An analysis of these costs will help you make good business decisions about buying machines and/or upgrading to more modern and productive ones.
Fixed costs are the costs of ownership; the expenses incurred, whether the machine is parked or used every single day. There are several components to consider when estimating fixed costs: the price of the machine; the amount of time you will own it; its value at the end of this time (called the salvage value); and the cost of money, insurance, and taxes. Sometimes there are other costs that belong in the fixed category as well, such as buildings needed to house the machine, special tools for operation or maintenance, and the expense of a spare-parts inventory. Fixed costs are usually determined on a yearly basis.
Dividing the yearly cost by the number of hours of use per year provides an hourly cost, which is very useful for pricing products or services and for making purchasing decisions.
Price, Salvage Value, and Depreciation
The price of the machine, whether new or used, is the only item in this list that you can know at the outset; all the others need to be estimated. For new equipment, the amount of time you plan to own it is very important, as most machines, like cars and trucks, depreciate significantly in the first few years and then lose value more slowly after that. The salvage value depends on the age and condition of the machine when you part with it, inflation, and the machine’s desirability in the marketplace. Machines desired by homeowners and part-time users, such as wood planers, smaller farm tractors, and small bulldozers, tend to have high salvage values. In contrast, there is a very limited market for older large and specialized equipment, so salvage values for skidders, industrial woodworking machinery, and large earthmoving equipment tend to be low.
To estimate annual depreciation, subtract the estimated salvage value from the price of the machine and divide the result by the expected number of years of ownership.
The Costs of Money
We all know that it costs money to use money. If you borrow money to buy a machine, you will pay interest on the amount of money borrowed. For the down payment (or total amount, if you buy out-of-pocket), you will incur what economists call a “lost-opportunity cost,” which is the return you would get from investing the money, combined with the cost of not having the flexibility to use that money elsewhere (a difficult number for a small business to estimate).
The cost of money is tied to interest rates. At this writing, interest rates are historically quite low, so the cost of using money is relatively low.
In practice, you can estimate the cost of money by multiplying the amount of money you put down by a lost-opportunity cost and adding the annual interest cost of your loan, if any.
I currently use 5 percent for my lost-opportunity cost. Note that if you keep the machine after a loan is paid off, you will then have a lower money cost and, hence, lower annual fixed costs. There are formulas that adjust for this and depict a constant cost of money for the entire time you will have the machine. Alternatively, you can consider the annual loan payments in your computations to more accurately reflect cash flow and to conservatively plan for the time when the payments will end. The amount of the annual interest payments can then be set aside for increased maintenance costs as the machine ages and for eventual replacement. It can be instructive to do the computations both ways.
Insurance and Taxes
Insurance costs are generally a percentage of the value of the machine. The rates for your area and specific machine can be obtained from insurance agents. It can be worth shopping around.
Some localities tax machinery annually, with the tax calculated as a percentage of the value. Both amounts need to be estimated to determine your annual fixed costs.
We can represent the fixed costs as equations:
Annual Fixed Costs = Depreciation + Money Cost + Insurance + Taxes
Hourly Fixed Costs = Annual Fixed Costs / Operating Hours per Year
Note that the number of operating hours per year is a very important part of the estimates. For relatively new machines, the number of hours on the machine has a large impact on the salvage value. For older machines, age and condition are more important than the number of hours. For the hourly fixed costs, the effect is profound: doubling the number of operating hours, for example, nearly halves the hourly fixed costs if the depreciation is unchanged.
Annual Operating Hours
It is easy to overestimate the number of hours a machine will be used in a year. At first glance, one might think that a machine used full time for a single shift would accumulate about 2,000 hours a year (40 hours per week x 50 weeks per year). While this is often true in factory situations, it would be rare for small timber-harvesting, sawmilling, and woodworking businesses. Depending on the business, factors like weather, maintenance and repair, other work, customer interaction, etc., limit the actual operating hours.
For example, consider a one-person, full-time, custom-sawing business with a portable sawmill. In addition to sawing the logs, time is spent transporting and setting up the mill, interacting with customers, chasing parts, completing office work, sharpening blades, performing maintenance tasks and repairs etc. Assuming a 2,000-hour work year, one would do very well to actually clock 1,000 hours on the sawmill. For one, person businesses such as mine, where I use several machines to do my work, operating hours for major machines commonly range from under 50 hours to a few hundred hours each year. A notable exception is dry kilns, which generally run around the clock. Kilns can easily work for many thousands of hours each year, even in part-time operations.
Variable costs are the operating costs; expenses that occur only when a machine is used. These include energy (electricity or fuel), consumables, regular maintenance items (such as oil and filters for engines), and repair costs. The value of the time spent on
maintenance and repairs is an important cost, even if you do it yourself.
Remember that if you are in business, you should be paying yourself for every hour you spend working, just as you would be paid if you were to work for someone else’s business.
Some people include the cost of operator’s labor as part of the variable costs of running a machine. There is some logic in doing this in situations where the labor and machine hours are nearly the same. In my business, I prefer to keep these costs separate.
Energy usage is a significant variable cost for many types of machines. It can be estimated in a variety of ways. Experience can be the most accurate and is also useful in evaluating whether or not an estimate is in the right ballpark. For example, I know from experience that the 20-hp gas engine on my sawmill uses about ½ gallon of fuel per hour when milling by myself. There is a direct relationship between horsepower and energy usage. If you don’t have relevant experience, the formulas below can help in estimating energy costs per hour:
Electricity: hp x 0.83 x cost per kWh;
Diesel: hp x 0.037 x cost per gallon (source: p. 30 of How to Improve Logging Profits by Benjamin F. Hoffman); Gas: hp x 0.043 x cost per gallon (source: p. 30 of How to Improve Logging Profits by Benjamin F. Hoffman.
These formulas tend to yield high estimates, because they assume the motor or engine will be used at full load all the time. In most applications this is not the case, so you can often decrease the costs generated by the formulas based on experience.
Large Electric Motors in Rural Areas
I want to make special mention of electricity as an energy source. It has many advantages: There are no fumes at the site of use; electric motors are quiet and require virtually no maintenance (as compared to engines); electric motors are very efficient (typically over 90 percent); and electric motors have very long lives. This makes electricity a nearly ideal energy source for stationary machinery.
For those of us who work in rural areas and for part-time users, however, large electric motors can be problematic. One factor is that most large motors require 3-phase electricity (large 3-phase motors cost far less than equivalent single-phase motors and can use smaller diameter wires and less expensive switches). Three-phase power is rarely available in rural areas, so to use 3-phase motors, you will have the significant added expense of a phase converter.
Another factor to consider is that there may simply not be enough electric power available through the existing power lines. If this is the case, your large motor can cause a “brownout” whenever it is started or has a heavy load and its life will be significantly shortened. For this reason, you should check with the electric power company if you are thinking of installing a motor larger than 3 hp. If the electricity available is inadequate, you will need to either pay for upgrades to the power lines (usually prohibitively costly) or install your own generator (which is also costly, and requires significant maintenance).
The electricity you use may be subject to a “use demand charge.” This is a special charge for the peak amount of electricity that you use in any given billing period. For infrequently used machines, this charge can have a dramatic impact on the energy costs. For instance, in my last shop, I learned to turn off my electric dehumidification kiln before starting my large planer with a 7½-hp motor and its shavings blower with a 3-hp motor; forgetting to do so…rdquo;even once…rdquo;would add about $25 to my monthly electric bill.
Consumables are those supplies that get used up when the machine is working. Examples include sanding belts for a belt sander, bandsaw blades for a band mill, inserted teeth for a circular mill, and chains and bar and chain oil for chainsaws. Some machines have high hourly costs for consumables, whereas others have little or no costs in this category.
Repair and Maintenance
Maintenance refers to all those activities that should be done on a regular basis to keep your machines running in tiptop shape. It includes the daily start-up and shut-down checks and the regular greasing, oiling, changing fluids, etc. I include the time spent sharpening saw blades and chain saws in the consumables category, though one could argue that they belong in the maintenance category. Good maintenance is good for business: It increases machine life and salvage value and decreases unexpected breakdowns and repair costs.
Repair is a wild card. Minor repairs add up over time, especially when unanticipated problems require shutting down your operations and a trip for parts. A broken hydraulic hose, for example, may take only 15 minutes to replace but may require a long trip to get a replacement. (For this reason, I try to keep a good selection of spare parts at my work site. Fifteen minutes is a minor expense and annoyance compared to two hours or more when I don’t have the part on hand.) Major breakdowns can be very expensive, both in lost-production time and in parts and labor costs. A significant repair to a major piece of equipment can cost many thousands of dollars and may sometimes cost more than the machine is worth…rdquo;in which case, replacing the machine may make sense. The irregularity of major repairs makes them difficult to forecast and budget. I’ve sometimes gone for more than a year without a major repair and other times I wonder if I have been cursed. Last winter, for example, I had major breakdowns on three different machines.
Maintenance and repair costs are often lumped together when estimating hourly variable costs, as they are interrelated and there is significant overlap. For example, replacing worn-out tires can be thought of as maintenance, while replacing a badly punctured tire is a repair. Needed repairs are often detected and performed when doing maintenance, so which category should they be put into? Considering the costs together can make things simpler.
My “Rules of Thumb”
If you were the repair and maintenance manager for a large company with a fleet of hundreds of machines, you could generate good numbers for your average maintenance and repair costs for each machine per operating hour. For a small business with only a few machines, we need to use rules of thumb to estimate the costs. Here are the ones I use:
For most machines, the total maintenance and repair costs over the life of the machine will equal 75 percent of the new cost of the machine.
For machines that operate on tracks (such as bulldozers), the maintenance and repair costs over the life of the machine will equal 100 percent of the new cost of the machine.
Machine Life Spans
To use these rules of thumb, it is necessary to estimate a machine’s life span in hours. I think of the life span in terms of how many hours it would make sense to keep the typical machine of its size and type going with full-time use and good maintenance. The life spans I use for estimating maintenance and repair costs are 1,000 hours for professional quality chain saws, 2,000 hours for cabinet-shop-quality woodworking machines, 5,000 hours for farm tractors and portable sawmills, 10,000 hours for skidders and earthmoving machinery, and 20,000 hours for large industrial woodworking machines. These numbers may be very different from the actual life span of any given machine and appropriate judgment should be used to take into consideration the quality of the machine and how it is used.
By dividing the new cost of the machine by its expected life in hours and multiplying by 70 percent or 100 percent, you arrive at an estimate of its maintenance and repair costs per operating hour.
Note that this is an average over the life of the machine. Normally the repair costs are quite low when a machine is brand new (and often covered by warranty) and climb as the machine gets older. Therefore, it makes sense to adjust the result downward for a new machine that you plan to keep for only a part of its life and upward for a machine that you buy in used condition.
New, Slightly-Used, Well-Used, or Used-and-Abused?
When buying machines, one generally has a choice between buying new and various conditions of used. Over the years, I’ve gained the following insights:
•Used high-quality is generally better than new low-quality.
•Technology improves over the years, but at different rates for different types of machines. For instance, a 35-year-old bulldozer or skidder in good condition can be very productive (though probably not quite as productive as a new one of equivalent size), but a 35-year-old chain saw would be considered unsafe and unreliable by today’s standards.
•A machine in need of repair can be a bargain, but it can also be a disaster. I once made the mistake of buying a used wood splitter that didn’t run. The owner told me some mice had eaten the wires on the engine, but that everything else worked well. By the time I had the splitter in A-1 operating condition, I had replaced everything except the I-beam and some hydraulic hoses. I would have been far better off buying a new wood splitter or building one from scratch.
•By computing the owning and operating costs for a new machine and different qualities of used machines, you can determine which has the lowest hourly owning and operating costs for your situation. Remember that other factors such as probable reliability, availability of parts, safety, and level of technology are also important considerations in buying decisions.
•For high-priced machines (say over $10,000 new), the anticipated annual number of operating hours is often a major factor in choosing from new, slightly-used, or well-used. As a rough guide, new generally makes sense for over 1,000 operating hours per year, slightly-used in the range of 500 hours, and well-used for fewer than 200 hours. The longer the typical life and the higher the quality of the machine, the more comfortable I am with a well-used machine.
•For low-priced machines (say under $1,000 new), I tend to buy new, even if my expected annual use is low. This is because annual ownership costs aren’t much greater than for a used machine (usually less than $100 more) and I get the warranty, latest technology, and spare-parts availability advantages of a new machine. I will probably have greater reliability and shopping for the machine generally takes less time.
Total Owning and Operating Costs
By combining the estimated fixed and variable costs, you come up with the total cost of owning and operating the machine on both a yearly and hourly basis. I like to use these equations:
Total Annual Costs = Annual Fixed Costs + Annual Variable Costs =
Annual Depreciation, Money, Insurance, and Tax Costs + (Hourly Energy,
Consumable, and Maintenance and Repair Costs) x Operating Hours per Year
Total Hourly Costs = Hourly Fixed Costs + Hourly Variable Costs =
Annual Fixed Costs / Operating Hours Per Year + Hourly Energy,
Consumable, and Maintenance and Repair Costs
Keeping these equations in front of me when I do the calculations helps ensure that I haven’t omitted any important factors.
I also like to perform a sensitivity analysis of the most important variables, especially when thinking about buying a machine. To do this, I perform the computations with a range of values for the cost of the machine (to simulate buying new, somewhat-used and very-used…rdquo;I also vary the hourly maintenance and repair costs appropriately) and the number of operating hours per year. In addition to helping with purchasing decisions, the sensitivity analysis provides a better understanding of how differences in projections will affect the financial picture.
Using the methods above and some research, you can make a good estimate of the fixed and variable costs of owning and operating a machine that you already have or are thinking of buying. It is important to bear in mind that these are average costs and that the actual flow of money out of your business for the machine may vary dramatically over short periods of time. Some items, such as loan payments, insurance premiums, and taxes, occur on a regular basis.
Energy costs and consumables are generally paid for in “chunks” that correlate to how much the machine is being used. Repair costs can be scheduled or totally unexpected. For example, I know that the tracks on my bulldozer are nearly worn out and that I should replace them and related parts within the next few hundred hours (or possibly decide to replace the machine or do without a bulldozer). I can budget for the costs and schedule the work for a convenient time. However, when the bearings in one of the dozer’s final drives failed last winter, I had to contend with the costs of the repair at that time. Thus, the cash flow curve can be very bumpy.
Some big items can remain hidden if you haven’t done a careful analysis. As a case in point, consider someone who decides to go into a full-time portable sawmilling business. Let’s assume this person invests their savings into the mill and sharpening equipment (say $28,000) and an initial supply of consumables and miscellaneous items (another $2,000). Business is good and there is almost always money in the back pocket. There is one really difficult time when the engine needs to be replaced but a credit card comes to the rescue and is paid off in four months. After five years and 5,000 hours on the sawmill, it is time to replace it – a lot of things are worn out and it would be great to have a new mill with some extra features to make the work easier. But where is the money for the new sawmill?
What happened? Cash flow was basically good for the past five years, so it seemed like the business was doing just fine. But when it came time to replace the sawmill, the cash was not there – in other words, the cash flow for a longer time period was terrible. In reality, this business was living off its assets and thus looked falsely profitable because the annual depreciation and the cost of using money were not considered in the accounting. Note that while small repair items were covered out-of-pocket, there wasn’t money on hand to pay for the replacement engine, and that money had to be borrowed.
The point of this example is that a business has to look at its equipment owning-and-operating costs from a long-term perspective. The business in the example above should have accounted for all the costs; it missed the depreciation, the cost of using money, and the full costs of maintenance and repair. Depreciation amounted to $30,000 less the salvage value (say $5,000) divided by the number of years (5), or $5,000 per year. The cost of using money was $30,000 times an appropriate lost-opportunity value (say 5 percent), or $1,500 per year. The cost of maintenance and repair, using my rules of thumb, amounted to $28,000 times 70 percent divided by 5,000 hours, which equals $3.92 per hour. For 1,000 hours of use per year, this comes to $3,920 per year, only part of which was accounted for by the business. Thus, the business should have been putting aside $5,000 + $1,500 + $3,920 = $10,420 per year. The $1,500 could go into the owner’s pocket; essentially it is “interest” for the amount initially “borrowed” from savings for the purchases. Maintenance and repair costs should have been paid from this money, including labor for the person doing the work – that is, the owner/operator plus any hired services. At the end of the five years, there would have been money to purchase a new mill. Actual maintenance and repair costs may have been greater or less than the amount budgeted, and the salvage value may have been different, resulting in a surplus or deficit, but there should not have been any big surprises.
Some people like to maintain separate accounts – either on paper or actual bank accounts – for the depreciation and maintenance and repair categories. It is good discipline to set aside the estimated amounts for each machine and to remember what this money is for. A need to draw on it for other purposes is a sure sign that all is not financially well with the business.
Good financial management is essential for any business to survive for the long term. The owning and operating costs of machinery are major expenses for most timber harvesting, sawmilling, and value-added businesses. It is impossible to project exact costs and probably not worth the bookkeeping time to precisely track all the costs for a small business. However, good estimates are invaluable. I’ve found that my rules of thumb work, as I’ve been spared the surprise of huge unbudgeted expenses. When a machine needs a major repair or it is time to replace it, I know where the money is coming from. Plus I sleep much better as a result!
My Excavator – A Case Study
Over the years, I’ve hired or rented earthmoving equipment for digging foundations and trenches, clearing land, and building woods roads. When planning my recent move, I considered whether or not it made sense for me to buy an excavator. In addition to putting in a long driveway, clearing land, burying utilities, and excavation that would be required for buildings and a septic system, I knew I would be building a lot of woods roads on the new land. I estimated that I would average 75 operating hours each year for at least five years – this amount of usage suggested the “well-used” category.
From experience, I knew that I wanted an excavator that weighed in the range of 15,000 pounds and had a blade (smaller ones don’t have enough muscle to efficiently deal with the stumps and rocks I’d need to move, and having a blade adds stability to this size machine). Some investigation into the used-excavator market indicated that I should be able to find a good machine that would meet my needs for about $20,000. Should I buy? It was time to get the calculator out.
One advantage of well-used machines of this nature is that there is very little, if any, depreciation, if the machine is kept in good operating condition. Since I planned to do this, I felt comfortable estimating that the salvage value would equal the machine’s cost. This meant that my annual depreciation cost would be $0. Since I would buy the machine from savings, I would have a lost-opportunity cost, which I estimated at 5 percent, or $1,000 per year. Adding fire, theft, and accident insurance for the machine to my business policy would cost me 0.5% of the value each year, or $100 per year. There is no annual tax on machines where I live and I wouldn’t need a building for the machine. Spare-parts inventory would amount to a few filters and thus be a trivial cost. My total annual fixed cost would therefore amount to about $1,100. For 75 hours of use per year, the hourly fixed cost computes to $14.67.
Next I needed to compute the hourly variable costs. Using the fuel cost equation for a diesel engine and assuming 80 hp and $1.65 per gallon, estimated fuel cost came to $4.88 per hour. Since I knew that the engine wouldn’t operate at full load most of the time, I decided to decrease fuel cost by 1/3, which comes to $3.25 per hour.
To calculate hourly maintenance and repair costs, I first determined that the machine would have cost about $80,000 new and have an expected life of 10,000 hours. Since it is a track-type machine, I used 100 percent of new value, which yields an estimated average maintenance and repair cost of $8 per hour. The machine would be well-used, so I should expect my maintenance and repair costs to be significantly higher. I decided to double the $8 per hour average and use $16 per hour in my estimate. Since there are no consumable costs with an excavator, my total estimated variable cost came to $19.25 per hour.
My total estimated owning and operating cost came to $33.92 per hour, which I rounded to $34 per hour. I recognized that repair costs were a significant risk. What would be the consequences of a major repair, such as having to replace the engine or a final drive or the main hydraulic pump? With 75 hours per year for five years, I was estimating only 375 operating hours to divide into the cost of a major repair. Thus $5,000 in repair costs over and above what was already budgeted would add about $13 per operating hour. I’d have to keep this in mind; with really bad luck I could have even higher, unbudgeted repair costs.
Next it was time to compare the operating costs of buying an excavator with the cost of hiring the work done and with the cost of renting an excavator. In my area, hiring an excavator of this size would cost in the range of $85 per hour. With hiring, there would be the advantage that I could do other work during the time the excavator was working, though supervision time would definitely be required. Disadvantages would include scheduling problems and, depending on the operator, potential difficulty in getting the job done the way I wanted it done. Purchasing looked like a good decision when compared to hiring.
I can rent an excavator in the desired size range for about $1,000 per week. From experience, I know that I can expect to put about 25 hours a week on a rented machine, if I do a good job of planning. Thus I would need three weeks rental per year to average 75 hours per year. Because of scheduling considerations, I realized I had better estimate three separate rentals rather than three back-to-back weeks; this would entail a need to pay for three separate deliveries and pick-ups for the rented excavator. In addition, I would have to buy special insurance for the full value of the machine. I estimated that the delivery, pick-up, and insurance would cost $300 each time I rented. I would also have to buy the fuel for which I used my earlier estimate of $3.25 per hour. My total estimated hourly costs for renting an excavator thus came to ($1000 + $300) / 25 hours + $3.25 per hour = $55.25 per hour. While more favorable than hiring the work done, renting was still significantly more expensive than buying; I would have to have really bad luck in the repair department for the cost of buying to be as great as that of renting.
Even though I couldn’t put a monetary value on it, I recognized that there would be a significant advantage to having the excavator on-site all the time. Another advantage to owning an excavator would be the potential to do work for others at a profit. Armed with my analyses, I set out to find a suitable machine.
How did I make out? I found a 16-year-old excavator in good operating condition with about 5,500 hours on it for $18,000. Vermont state sales tax added another $1,080. In a year and a half, I have put about 150 hours on my excavator, which is more than my estimated annual average. I’ve had two paying jobs for others and helped out a good friend with the machine. I did have a major engine problem, which cost about $2,500 in parts and mechanic’s time, plus a few days of my time. Other maintenance and repair costs have been fairly small so far, so I am running about $1,400 behind budget in the maintenance and repair category when I include the value of the time I spent doing maintenance and repairs. Because of the greater-than-estimated annual operating hours, I am about $550 ahead of budget in the fixed-cost category. Fuel cost has been close to the estimate. Even with the engine problem, the decision to buy an excavator is looking good.
Reproduced with permission from www.sawmillmag.com