NOTES - 08
EQUIPMENT
MANAGEMENT TIPS FOR THE CONSTRUCTION ENGINEERS
AND
PLANT & MACHINERY ENGINEERS
AN
INTRODUCTION TO CONSTRUCTION PLANT AND EQUIPMENT
EQUIPMENT
OWNING AND OPERATING COSTS
THINGS
WE SHOULD KNOW
Part - I
I. The following
components constitute major items of equipment ownership cost -
i. depreciation
ii. interest on
capital
iii. taxes
iv. insurance
v. storage charges
vi. transportation and
installation charges
viii. major repairs,
spare parts and overhaul cost
There are several
methods of computing the cost of the above components. This is particularly so
in respect of depreciation as well as major repairs, spare parts, and overhaul
cost. None of the methods gives exact cost under any operating conditions.
At best, they provide
the estimated cost based on past experience and thus, should be treated as a
close approximation of the cost. Records of previous usage of equipment are
very valuable but similar equipment to be used under different conditions on
future projects need not necessarily cost the same.
A number of factors
affect the ownership cost including the conditions under which the equipment is
used, the number of hours operated per year, the number of years used, the care
taken for maintenance and repairs, etc.
II. Depreciation
Depreciation is the
loss in value of equipment resulting from use or age. The owner is expected to
recover such a loss during the useful life of the equipment. There are a number
of methods of arriving at depreciation, commonly used in the construction industry.
The more common of these are the following:
i. Straight line
method
ii. Declining balance
method
iii.
Sum-of-the-years-digits method
In addition to the
above, other methods based on (i) production hours or (ii) production units,
are also occasionally used.
All the methods are
based on the computed value of the total cost of the equipment which usually
includes the purchase price, initial transportation, unloading and assembling
at the destination. The purchase price usually includes a number of taxes such
as sales tax, excise duty, customs duty (in the case of imported equipment),
octroi, etc.
The various methods of
arriving at the depreciation cost are now discussed.
i.
Straight line method
In this method, it is
assumed that the value of the equipment will decrease at a uniform rate over
the life of the equipment. The depreciation cost per unit of time is obtained
by dividing the original cost less the estimated salvage value at the end of
its useful life.
For example if the
original cost of equipment is Rs. 1 lakh and its useful life is 10,000 hours
spread over a period of five years, the cost of depreciation is worked out as
below :
The original cost Rs.
1,00,000
Salvage value Rs.
10,000
-------------
Total depreciation
cost is Rs. 90,000
Hourly depreciation
cost = Rs.90,000 / Useful life 10,000 hrs
-------------
= Rs.9 per hr.
Sometimes the same
straight line method is used for arriving at the depreciation cost per unit
item of work. This method is commonly used for equipment whose life is
determined on output basis rather than on time. Examples of such equipment
include rock crusher, rock drilling equipment, rubber tyres, batteries,
conveyer belts, etc.
ii.
Declining balance method
Under this method,
salvage is ignored on the theory that the mechanics of the computation will
always leave a residual balance. The estimated life of the equipment in years
will give the average percentage of depreciation per year. This percentage is
double for "Double declining balance method". The value of the depreciation
during any given year is determined by multiplying the resultant percentage by
the value of the equipment at the beginning of the year. As already mentioned,
while the estimated salvage value is not considered, the depreciated value is
not permitted to drop beyond a reasonable salvage value. The computation of
depreciation based on the declining balance method in respect of the previous
example shall be as follows:
Depreciable Cost Rs.
1,00,000
Less: 1st year
depreciation at 20% Rs. 20,000
Book value after one
year Rs. 80,000
Less: Second year
depreciation at 20%
of Rs.80,000 Rs.
16,000
Book value after two
years Rs. 64,000
Less: Third year
depreciation at 20%
of Rs.64,000 Rs.
12,800
Book value after three
years Rs. 51,200
Less: Fourth year
depreciation at 20%
of Rs.51,200 Rs.
10,240
Book value after four
years Rs. 40,960
Less: Fifth year
depreciation at 20%
of Rs.40,960 Rs. 8,192
Book value after five
years = Rs. 32,768
If the double
declining balance method is used, the calculations are performed using double
the rate of depreciation i.e. 40 % instead of 20 %. The resultant book value
after five years as per this method will be Rs. 7,776/-. This figure appears to
be too low compared with the salvage value of Rs. 10,000/- estimated earlier
while applying the straight line depreciation method. As the value of the
equipment may not be depreciated below a reasonable minimum salvage value,
Rs.10,000/- shall be taken as the salvage value.
iii.
Sum-of-the-years-digits method
In this method, all
the digits representing each year of the estimated life of the equipment are
totaled. Thus, for the estimated life of five years in the previous example the
sum of the digits will be 1+2+3+4+5 or 15. The depreciable cost for this method
will be the total cost of the equipment less estimated salvage value. During
the first year the depreciation will be 5/15 of the depreciable cost. During
the subsequent years of the depreciation will be as follows:
2nd year 4/15
3rd year 3/15
4th year 2/15
5th year 1/15
The schedule of
depreciation cost for the previous example using this method shall be as per
the following table:
DEPRECIATION
AS PER SUM-OF-YEARS-DIGITS METHOD
End of the year
|
Depreciation ratio
|
Depreciation for the year (Rs.)
|
Book value (Rs.)
|
1.
|
5/15
|
30,000
|
70,000
|
2.
|
4/15
|
24,000
|
46,000
|
3.
|
3/15
|
18,000
|
28,000
|
4.
|
2/15
|
12,000
|
16,000
|
5.
|
1/15
|
6,000
|
10,000
|
iv.
Production hours method
In this method,
Rs.90,000, depreciable value, is being apportioned over 10,000 hours of
expected operation so that each hour could be charged at Rs.9/- to cover
depreciation.
v.
Production unit method
Here, Rs.90,000,
depreciable value, would be apportioned over 30,000 cu.m. of earth-work which
the machine is expected to move during its life. Thus, the depreciation cost
per cu.m. would be about Rs.3/-Another method sometimes used for large jobs and
joint ventures is to change entire cost of the equipment to the job and to sell
or value the equipment at the end of the job, crediting job cost with the sale
price or salvage value at the end of the job.
Strictly speaking,
this method does not come under the category of depreciation.
As already mentioned,
the above methods are at best estimates and do not yield the actual rate of
depreciation. Further, accuracy in this respect is not warranted for the
purpose for which the depreciation is normally worked out. Depreciation
computations are required for one or more of the following purposes:
i. Tender estimates
ii. Job costing
iii. Calculation of
ownership cost
iv. Calculation of
income tax
The choice of the
method of depreciation and the estimated useful life is generally selected on
the basis of close approximation to a specific condition on construction jobs,
rate of wear and tear, obsolescence, etc. While the accountants and other
non-operating personnel usually set a high value for the useful life of the
equipment, some of the larger construction agencies work on the principle that
equipment loses half of its value on each job and in the long run if the job
lasts for one to two years, this rule of thumb often proves to be very
appropriate. Some agencies, instead of establishing a rate for each piece of
equipment, will establish a composite rate for each type of equipment.
Composite rates have the advantage of convenience of accounting and are justified
in respect of small items of equipment.
Actual depreciation
charges even on smaller items of equipment tend to vary depending on job
conditions and thus complicate job costing. For tendering purposes; many
agencies use standard hourly rates. These rates can either be computed for each
class of equipment based on the total depreciable cost or may be extracted from
published data. While a number of organizations elsewhere have been publishing
such data annually, such publications are not being produced in India. One of
the most commonly used document is titled "Computing owner equipment
cost" published by Associated General Contractors of America. For
equipment of European origin, a document called "Register of Construction
Equipment" is published periodically by BAUVERLAG GmbH, Berlin. This
document, apart from giving the technical data for various items of equipment,
also provides data regarding useful life of equipment, operating life, average
minimum value, depreciation to the repair cost, etc.
Time concepts for use
and evaluation of equipment:
Useful life
Useful life is the
period in years during which the equipment can be economically used based on
previous experience. The useful life is influenced by wear and tear of the
equipment; the degree of care and maintenance and regular repairs, the climatic
effects, density of utilization, technological obsolescence, etc.
Useful years
This corresponds to
the useful life specified in the income tax rules.
Operating life
This is the period of
time between manufacturing and scrapping of the equipment.
Commissioning time
This represents the
time during which an equipment item is available at the project site and cannot
be used elsewhere.
Actual working life
This is usually much
shorter than either the useful life or the useful years. It generally
represents the useful life minus the following:
- Transportation,
erection and dismantling time.
- Time taken for
changing attachments.
- Down time due to
unavoidable circumstances.
- Time for
maintenance, repairs, etc.
II. Depreciable cost
For the purpose of
calculation of depreciation, the total cost of a unit of equipment includes the
CIF purchase price, customs duty, initial transportation cost and cost of
unloading and installation at its first destination. The assessment is
straight-forward in the case of direct new purchases. Different concepts are
required to be adopted for assessing the depreciation for the purpose of
preparation of tenders. Many of the construction agencies may already be in
possession of the particular items of equipment in various conditions of use,
with partial depreciation already having been effected. In such cases, only
historical costs will be available. It will not be correct to use such cost in
view of particularly inflationary conditions.
Under such
circumstances, the most common practice is to obtain quotations for the cost of
similar new equipment at the time of preparation of tender estimates and use
such values for computation of depreciation. Such a practice has proved to be
reasonably accurate. In the case of new equipment, the cost of spares and
repairs will be comparatively low. Whereas, in the case of partially used
equipment, higher cost towards spares and repairs will be attracted. However,
in general, as a thumb rule it may be assumed that the cost of depreciation
plus the cost of spares and repairs during any particular year of useful life
of the equipment will be reasonably constant.
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