Yellow Iron, Black Smoke
Yellow Iron, Black Smoke
Rate Calculations
In today's episode Mike and I talk about rate calculations, estimations, and important concepts of Chapter 6 in Mike's overhauled book, Construction Equipment Economics V2 . Be sure to check out the book at cempcentral.com/book
Welcome to yellow iron, black smoke, your podcast for engaging conversation on Construction Equipment Economics and Management. I'm Michael Kelley, your host. In today's episode, Mike Vorster and I talk about rate estimation and all the complications there of, we also talk about the six month boot camp that I'm doing, which is a hands on approach the CMP way for VISTA by viewpoint users, and we talk about important concepts from Mike's rebuilt book construction equipment, economics, version two, be sure to check out his book on his website at cempcentral.com. Hello, Mike, good to have you here to talk about chapter six, your new book,
Mike Vorster:Michael, always a pleasure to be with you. And wonderful to be with everybody. Again, it's another super super day in in southern Florida, where we're just so glad it actually rained yesterday. But you know, we're from the Pacific Northwest. And so whenever it doesn't rain for a couple of weeks, we start looking around like the sky is falling. But I have here a copy of your new book. Thank you for that. Thank you again, for that. I've just been, I've been thumbing through it. Every opportunity. So it's, so it's so it's out. It's out. So I'm very excited about it. Of course for the flurry of it coming up sales are good, which is cool. And but very pleased that it's art. It's sort of how shall I say, a capturing of many years and capturing of lots and lots of experience on the subject? It's good to have it out.
Michael Kelley:How has the response been? Have you have you heard gotten the feedback from from all your old friends that have read the first book?
Mike Vorster:Yeah, what I'm hearing and what everybody in many ways I was hoping they were going to say is that the format for the new book is very good, because I focused it on trying to, to ensure implementation, because among the things that I say in the in right in the beginning of the book is that success doesn't come from your knowledge, but it comes from your ability to implement that knowledge. So in putting the framework together for the book, I've sort of concentrated on implementation, more than sort of the science of it.
Michael Kelley:Yeah, that's, that's good. And that's obvious. And it helps me a lot, because that's, that's so much of my, my role is I'm trying to implement this trying to get people to actually experience change in their company. And it's interesting, because they could they can implement just one small thing. If it's the low hanging fruit, then they can see a massive change.
Mike Vorster:Yeah, yeah. And, and, you know, I haven't sort of said, the first thing you've got to do is, know and understand your cost. There are substantial portions of the book that relate to managing fleet age, managing utilization, and reliability, which are things that one can really do. And those things, of course, give you the lead indicators, which influenced your cost. And so it's sort of, yes, there's the cost accounting part of it, which you and I enjoy. But then there are the practical day to day things of utilization, and reliability, which I think a lot of folk can make a lot of improvement in, in those two areas. That'll massively cost.
Michael Kelley:Yeah. And in fact, one of the things that I noticed just my I just read through this again, of course, in preparation for today, and one of the sections, I'm sure we'll get to as a sensitivity analysis and the impact of the repair and labor costs on the rate calculation. But yeah, I'm getting I am getting ahead of myself, here. You are. But it's exactly what you said. I mean, that reliability, reliability is such a critical part.
Mike Vorster:Well, one of the things that while we bridge the gap between reliability and cost is again, something which I try to make very, very clear. And that is that every down event is a cost event. Yeah. Because if you don't have any down events, the big ugly cost events don't occur your day to day cost events, things like fuel and web parts, and so on and so forth, which we're going to talk about, of course, do occur. Every down event is a cost event is not a bad, or concept to sort of put up on the wall and live by.
Michael Kelley:Yeah, well, the last couple times, we got together, we talked about costs, specifically last time was chapters four and five in your book, The owning and operating costs. And you know, it's so interesting because a lot of my job, I feel like when I'm working with VISTA customers, is helping them just set up their accounting software so that they can even find these cuts. But before we get into this rate calculation and the whole the whole thing here, maybe it'd be good for us to recap some of your thoughts on why we have these two different categories. To choose different buckets of cost and why we track them that way.
Mike Vorster:Yeah, owning costs and operating costs. And frankly, I don't know how you can manage the cost aspects of the fleet. If you don't make a very clear distinction between owning and operating costs, it's kind of mixing oil and water run. Because they are so so. So very different in each owning cost and operating costs, each needs to be managed with the skill care and attention it deserves owning costs, mostly fixed when you make the deal. Alright. And they are mostly fixed costs. And there's little risk, little uncertainty with regards to only cost except, of course, ownership period, and utilization, right? operating costs are variable costs, and they depend on your day to day decisions. And so operating costs are highly variable, variable costs. And they, they really are so so so different, you have to understand how they behave. And you have to understand the risks that are associated with the two of them. And, you know, I think the only way you have any chance at all of understanding and managing quipment cost is by focusing independently on owning costs and operating costs. Yep. Yeah,
Michael Kelley:I think so. And what's interesting is, you say, you don't know how people could do it without it. Well, they do it by gut feel. But when you actually talk to them, and you listen to what they're saying, even their gut feel when the you know, the guys that are bidding on the yellow tablets, and they're standing in the on the driveway of their customer, and they're scribbling things down, and then they hand of a kind of a half scribbled estimate on paper, and the person chain shakes. And they say, that's good. Those guys, they have an understanding that there's two different kinds of costs, even if they haven't yet been able to articulate it. And you can hear that when they talk about their machines.
Mike Vorster:Yeah, I think so. I think so I think that's perfectly true. But in many cases, they have that understanding. And then, particularly with regards to owning costs, they sort of say, Well, I don't really understand this awfully well. So I'll just leave it aside and let it be what it is, okay, I'm gonna concentrate on the things that I can influence on a day to day basis. That's my repair parts, my maintenance, on fuel, oil, grease, and all those sorts of things. And, and in many cases, folks see owning costs, sort of let them be what they are we live with a will repay the notes, repay the leases, repay the depreciation on the machines, and and it's sort of a almost a black box to many people.
Michael Kelley:Yeah, well, let's move on to the rate calculation itself. So this, this whole chapter, chapter six, is about the rate calculation. And it's about using these ownership and operating costs that we've hopefully accumulated over some time to deter to calculate a rate.
Mike Vorster:Yeah, well, one of the things I need to say right up front is that the title of the chapter is wrong. misleading, and I debated whether I would leave it as such, but I thought I would, because that's what everybody talks about the rate calculation, right? Because it's not a calculation in anybody's way, shape or form. It is an estimate. And if I had been true to the process, I would, in fact, have title the chapter rate estimate, because it's not a calculation. It's a big, ugly, hairy estimate, okay, you're going to spend a bunch of money on this machine to buy it. And over the next 567 years, you're going to own it, you're going to own it, and operate it and oil and grease it and fix it, and so on and so forth. Your rate calculation, and I'm going to we let's use the phrase, but every time we use the phrase, let's put it in quotes. The rate calculation is this hairy estimate, there's this estimate of a single dollar per hour number, which represents and kind of constand as a proxy for all those very calculated all those very cost events, you're going to experience over the next five or six years. And so it really is a big estimate. And you've got to have to estimate all the transactions you're going to incur. Put them together, and then pretend you can express those transactions or on a single cost per hour number, which is scary, right?
Michael Kelley:Right. Exactly. Because because there's good hard math in the end We could assume too much have too much confidence. Because all of that good heart math is simply multiplying estimates against each other and adding estimates with each other.
Mike Vorster:Yeah, yeah. And we mustn't let the good hard maths and the two decimal places, convinces that it's anything other than an estimate. Right above or above all, this comes back to the very, very fundamental process of all estimating whether it's equipment rate cut, estimating, or whether it's job estimating for bidding purposes, that the accuracy and quality of your estimate doesn't come from the complexity of the way you crunch the numbers, it becomes from the quality of your estimates, right, as with bidding, you're going to have the most sophisticated computer program in the world to calculate your your estimated net cost of the job. But if you get all your production rates wrong, and if you get all your resource costs wrong, the mathematics is not going to help you out of that problem with the equipment rate calculations, the mathematics is not going to help you out of a problem. Yeah, associated with not having good estimates, right? I
Michael Kelley:mean, because in the end, we're like you said that there's a bunch of cost events that are going to happen into the future. If you bought a brand new machine, you might have that machine for many years and 10,000 hours, and you're going to have some cost events that happen for many years. And it's it's impossible to know, within the degree of certainty what those cost events are. So we're estimating those cost events so that we can charge the jobs appropriately. That's that's the primary job here with the recalculation, right.
Mike Vorster:Right. And we must take care and right up front, we must understand that the mathematics or the calculation methodology that we wrapped these estimates up in, can improve the quality of the estimates, right, many people who sort of think about estimating or great estimating or rate calculation, as we've said, we're going to call it in a black box, we'll do it in a black box produce these inputs and outcomes, this output, they lose sight of the fact that those inputs to the calculation are all big, hairy, ugly estimates. Now we can use all our experience to improve them. There are in the bottom line their estimates, right.
Michael Kelley:That's right. And, and that's what's interesting, you hit on an interesting point there, using your experience, does help us validate our projections into the future. But I see that all the time where people are looking back, and they're almost like blindly saying, This is what we've experienced with all of our john deere 250s. And so therefore, that's our cost. And then you say, well, but wait, didn't you have that big gold mine stripping operation where? And they said, Well, yeah, we were running three shifts? Well, okay, let's let's, is that, is that going to continue in the future? And there's no, we're actually moving that over that, you know, most of our work for the big excavators for that size excavators is going to be in our commercial division. And so then you need to think through that. Not that it's not, that means that the history is irrelevant. It just means that it may be not applicable to the next period of life for that class of excavator.
Mike Vorster:Yeah, we must be the student of our experience, not the slave of our experience. All right. And that's, that's a whole brand new one. And that's essentially what you were saying is that a lot of people are tend to be sort of slaves of their experience, and just take their experience for what it is. We must take our experience. It's something that teaches us We must be a student of our experience. Yeah,
Michael Kelley:yeah. Yeah. Yeah. Interesting. Well, in the book, you do have proposed format for the calculation itself, specifically for the heart math that we're talking about. It seems like maybe, you know, this is an interesting format for this, of course, people have have the access to the book in a lot of cases, and they can see things online, etc. But in an audio only format here, maybe you can just take it through, take us through that calculation, kind of at a high level, the macro level.
Mike Vorster:Yeah. Well, the, it's you honor it by saying there's math, it's just arithmetic, right? It's just a spreadsheet. And it's a very standard format, most of the OEMs if not all the OEMs some rate estimating rate calculating format, there will look essentially alike. There are some folk who produce black boxes, like I've said, Give me these numbers, and I'll add them subtract them multiply and divide them behind a shield of science, if you wish. And then if you're the result, but I don't like black boxes at all, for things like this, I like to flat openness of a spreadsheet. So the format that sits in the book is nothing new, it's nothing special. It's nothing new, you unique. But of course, I think it's nicely it's nicely put together. And how I put it together is in in four pieces, really, because the first piece of the of the calculation, or the first piece of the estimating process, is that you've got to make some assumptions as to the ownership period of the machine. Okay. And we'll look back and talk about that later, then you have to make some assumptions, and estimates regarding your owning costs. And they require certain skills and aptitudes and certain information, then, of course, are the operating costs, where a lot of people think that it that it really is in a substantial portion of it is there. But those requires skills and assumptions and methodologies, and so on and so forth. And then of course, there's the third of the big three, which is fuel in the estimating of your of your fuel costs. So when I look at the format, if we want to look at the format at a macro level, it starts by saying what are our ownership period assumptions? What are our earning cost assumptions and calculations? What are our operating cost, assumptions and calculations? And then fuel and indirect and those sorts of things come at the end?
Michael Kelley:Well, yeah, it's just it's kind of funny, because I said, I started out by saying, describe the math to me. And what you described instead was all of the assumptions, which really highlights the fact that this is an estimate, not a calculation.
Mike Vorster:Yep, yep. Yep. It's the assumptions. I don't find anything fascinating about adding, subtracting, multiplying and dividing for a 10 numbers, and you can do four things to 10 numbers. So that's what it is. And the guys that did Excel helped us an awful lot. Do that with speed and precision. Yeah. We make our assumptions and then let let the spreadsheet do the numbers for us. Yeah.
Michael Kelley:Well, let's let's dive into the assumptions. And you said first, that the ownership period is one of the major assumptions that has to go into this.
Mike Vorster:Yeah, yeah. Well, that's, that's one of the ones that the folk don't really grasp and don't really understand. Because most of the red calculation format stock, but right at the top, as does mine, you know, how long are you going to keep the machine? Well, that is a big, ugly, hairy estimate. And it has this huge impact on owning costs. Okay, particularly on residual market value. Then, the next one is and how many hours do you think it's going to work? Well, that's a big hairy estimate. And it has this huge impact on particularly repair parts and labor, because if you keep many hours, you're going to be spending on repair parts and labor at a huge, huge thing. And then, of course, the scariest estimate of war is your utilization, which is of course, your ownership period, hours divided by your estimated ownership period in years, hours per year. All right. Now, these ownership estimates, ownership period estimates and assumptions, they affect almost everything that follows. Okay. And then I frequently smile when I talk with folk on this subject. And that is that you make these estimates upfront in the first couple of minutes of your of the process. And then you take them as sacred throughout the rest of the calculation. Alright. You forget the the risks associated the uncertainties associated with the ownership period assumptions, and bake those risks and uncertainties into the rest of the calculation. All right. And then the other one, of course, is you make this ownership period. assumption, how close is it to the optimum ownership period? In other words, how close is it to the sweet spot? Right, or how close is it just to something you thought it was, and so I can't overestimate the importance of what in my format is line eight, or a line eight appears in almost every single one of the subsequent lines. You make the estimates early You make the estimates when you kind of confident you bake those estimates into everything else that follow. So ownership period, huge issue.
Michael Kelley:So so let me play with some math here just to see if I understand correctly, because let's say you have a machine you bought for $120,000, you assume you're gonna sell it after 10 years, and you're gonna have a residual market value of$20,000. Right? So now you have$100,000 worth of costs that you're going to experience over the life of the machine. And you know, traditional accounting depreciation, it's while you divide that by the number of months, you say it's 10 years, right? You're gonna experience$10,000 cost per year, the, the wrinkle that you really added into this was, well, what's the utilization? Or how many hours are you going to be running that, because we know that if we're running that machine, 2000 hours a year, right, and we're going to get to 10,000 hours on that machine by year five, it First of all, it's unlikely that it's going to get to 20,000 hours, you know, depending on the type of machine, but it's unlikely it's going to get to 20,000 hours, and not have ballooning operating costs. But second, it's unlikely that when it gets to that 10 year mark, if it did have 20,000 hours, that it would have a residual market value of anything more than scrap metal.
Mike Vorster:Everything's moving all the time. And and the thing that that scares me about what you've just said, is that we take these largely fixed when you ink the deal, fixed costs them, and we express them in dollars per hour.
Michael Kelley:Yeah,
Mike Vorster:so what we're actually doing, and if I can remember some of my management accounting, what we're actually doing is we very realizing a fixed cost. And one of the things we absolutely must know, is that very realizing a fixed cost is very risky process. And so expressing our fixed cost of ownership, however difficult it may be to estimate them, but then expressing or very realizing those fixed costs of ownership and expressing them as a cost per our way. That's high risk stuff. Okay, that's high risk stuff. And we do it subconsciously, in the right calculation.
Michael Kelley:Right, right. And essentially, what we're trying to do with this rate calculation is - is to get our costs back to recover our costs, we want to have a $0 end result. So then we have the we've recovered from the jobs, all of the ownership costs. In this case, if we're talking about the ownership period, the ownership period costs that we experience, and that when we sell that machine that we are we're at zero, that would be that would be ideal.
Mike Vorster:Yeah. But But the only way we're going to if we visualize a fixed cost, the only way we're going to get to zero, is if we achieve the utilization.
Michael Kelley:Sure. That's right. So So here's a question about ownership period, then how often should I examine my assumption? Because if I bought that machine, that same machine 100 with $100,000, cost, right, the $20,050, residual value, etc. And I assumed 1000 hours per year, 10,000 hours, 10 years? And based all my kit rate calculation on that? How often should I sit down and say, is my rate actually correct? How much is it? Should I be doing that every week? Should I be doing that? Once a year? what's what's a practical frequency to examine those assumptions?
Mike Vorster:Well, practical frequency and frequency that I talk a lot about is Hey, guys, you have to calibrate your rates at least once a year. Now notice we've introduced a new term in the in the process, and that is, we've been talking about calculating, and how much of calculating do we do? And how much calibrating do we do? Right? It's very seldom we actually start with a blank piece of paper and do a calculation. Sure, they should be reasonable and proper way of doing the calculation. But once we've done that calculation, and once we've got this experience as to what our actual utilization is, if our utilization estimates have been incorrect, either too high or too low, that we need to have the courage to calibrate calculation we did based on the knowledge we've experienced. And I my suggestion there is that that you do that at least annually go through the rate calibration process is to annually to make sure that your calculation was based on reasonable assumptions.
Michael Kelley:Right? So really what we're calibrating when we're calibrating the rate, really what we're doing is we're examining the ownership. Well, among other things, the ownership period assumption. And we're saying, We assumed this length of time, we assumed this utilization, we assumed this residual market value even. That's another portion that I would say in there. And we're calibrating that to say is, you know, has the business environment changed? And has our market changed? it in do? Do these really still apply? So interesting one one year? Well, so then the the next you talked about ownership, the next two assumptions that you talked about, what if I have it right, as the are the operating cost assumption? And the Oh, I'm sorry, the owning cost assumption and operating costs assumption, those two cost assumptions, because we were talking about owning period assumptions. So now we have cost assumptions. But is there so much assuming about owning costs?
Mike Vorster:Well, not as much as they are not as much as not, there aren't as many assumptions or estimates associated with owning class, as there are with operating costs, if we've set the ownership period assumptions aside, because most of your only costs are fixed, renewing the deal, you know, the purchase price, or you know, your lease commitments, so you know, your loan commitments or whatever it might be. But hang on, there's the residual market value. And what are your What are your estimates regarding the residual market value that machine is likely to have at the end of the ownership period, either in years or in hours? So there's at least there is a your market value. But then, of course, there are things like licenses, insurances, property taxes, and all of those sorts of things. Right, right. And so those assumptions, the amounts are fairly well known, or they should be fairly well known. So why do I say should be? Well, what's important is that the same cost categories that you use to do your rate calculation must be used in your costing system, so that you can actually learn from your costing system. Because if you are going to have a line in your rate calculation that says, cost of licenses, insurance, you should have a cost code in your costing system that says licenses and insurances, so that you can calibrate the line in your rate calculation, using the cost bucket in your costing system. Surprisingly, how seldom that occurs, that folk use this language in their rate calculation system, and then a completely different language in the cost coding system.
Michael Kelley:Right. I see it all the time. It's so and I think that one of the things is that there's because the because this is an estimate, and it's so focused on people trying to bid work, like the estimating for the jobs, that there ends up being this connect at times anyway, between the folks that are coding the costs, or the equipment shop. And the people who are primarily concerned with setting the rate, which is oftentimes at least in in young companies, the people in the estimating department.
Mike Vorster:Yep, yep. Or you've got the people in the estimating or the or the other equipment Management Group, during the rate calculations, who are completely unfamiliar with your code of accounts. Yep, that had nothing to do with setting up the code of accounts. That's right. If your code of accounts is not speaking the same language as your read estimating system, then none of the experience you gain by coding your actuals in terms of your current account, code of accounts, can be used to build knowledge and calibrate your rate calculation.
Michael Kelley:So that's one thing I noticed when I was rereading the this chapter, is that you said that we should use the interest charges when we're building our rate when we're doing our cost recovery from the jobs. So we're basically building a rate that includes some kind of interest. I had I had a lot of pushback in the last boot camp that we did that those five companies that came a lot of pushback on that specific piece, with some people saying, well, we borrow sometimes we don't borrow all the time and other people saying well, we we want to we want to see a return on on equity or return on investment they will say we just apply the same amount of interest based on the amount We pay for our line of credit or, you know, these different these different things that they're trying to include into their, into their cost calculation. You specifically call out interest, the amount you're paying in hard dollars to finance that piece of machinery in aggregate, those kept that category of machineries.
Mike Vorster:that a little bit, you put your you put your finger on, and why, why am I surprised, you're put your finger on the most controversial component of the owning cost calculation, right? Return on the money that you've got invested in the machine, I will tell you, that of the folks that I work with, or have worked with, the number of folks who include some provision for interest are very much in the minority. But of course, when you write something down, you need to write it theoretically correct not as applied in practice a row. And that's fine include return on on equity or interest in the read calculation. Very few people do it. Because a lot of folks say, hey, all we want in our rate, our equipment, owning and operating costs, hourly rate is a hard costs of putting the machine to work. And funny little things, funny things like interest on the money we've invested. And those sorts of things sort of cloud the issue. And in any case, borrowing money is a corporate, indirect corporate overhead, it's a thing that company does, right? And then return on investment is a thing that the bottom line pays for. All right. And so we produce a bottom line profit to generate a return on owner's equity. And if we include a return on owner's equity in the rate calculation, then perhaps we are taking profit on profit. Because isn't that what our bottom line net income after tax is all about? Right? Right. And so that is a hugely controversial issue are relatively few folk dude. But it is the theoretically correct thing to do to say, but for this machine, my line of credit would not have been so extended. Right? And therefore, this machine must bear some of that burden. Right,
Michael Kelley:I definitely see people falling into three camps, just like you said that ignoring it entirely, charging the amount of interest on that, you know, per machine, you know, if they finance specifically for that machine, and then people who apply an assumption of their of their cost of capital, I have one, one company who actually includes more than just the cost of capital, it's their expected return. And so, but that's just one I can't say that's a large group of people. But it but there's a sizable minority of people who are putting their cost of capital, they're saying, in general, borrowing money cost me this.
Mike Vorster:Yeah, into the owning cost calculation. Yeah. But owning cost portion of the rate calculation, you need to be very, very careful that you're not ending up taking profit on profit is included return in owning cost portion of their rate calculation, when it comes to marking up the bid should mark up their equipment portion of the bed by a smaller percentage, because there really is a return in what they've defined as cost.
Michael Kelley:Exactly. And that's, I think that it doesn't it to a certain extent, it doesn't matter which of the of the of the options you go with, as long as there's clarity with the rest of the organization, clarity and consistency and understanding across the organization and understanding. And and I think that that's a piece that you mentioned early on that. We talked about the when you said that, you know as it's a black box calculation, and if you have a black box calculation, but you've made this assumption about owning costs, for example, then you hand it over to your estimators and then now they're losing work, because they just simply don't haven't been communicated or don't understand. I think that's a critical thing.
Mike Vorster:And if you've got, say, $1.50 an hour for return on capital, do you actually return that dollar 50 to the CFO? You hold it in the equipment account and use it for the fact that fuel has gone up a little. Alright. You've got that provision in your rate estimate. You have to in fact, render unto Caesar what is Caesar's which is the CFO gets the return on Capital portion of the right calculation in exactly the same way as your fuel supplier gets the fuel portion of your rate calculation. All right. And because in one case they supply and capital in the other case, say supplying fuel or case, but it's it's a simplification with regards to fuel, but of course, the fuel portion generates your budget for the fuel. And the return on capital portion generates your budget for the return on capital, which goes to the CFO. Yeah, so not only do you include it, but who do you give it to? is a separate question.
Michael Kelley:Right? That is a separate question. And at least that sometimes that's that's the real politically fraught question there. Absolutely, yes. Absolutely. And it's get it gets worse if there's bonuses involved. But let's, uh, let's talk about operating costs. He said that was another one of the big assumptions is is the operating costs that you're going to experience?
Mike Vorster:Yes, yes. And, and the vast majority of operating costs, I found useful to estimate them on the basis of the cost of inaction, and the frequency of inaction. What does it cost you to do a 500 r pm service? How often do you do a 500? RPM service? Okay. What does it cost you to replace an undercarriage? How frequently do you replace undercarriages? All right, similarly, for cutting edges in web parts. So for many of the constant operating cost categories, you can estimate them on the basis of the cost of inaction, multiplied by or divided by the interval between an action, okay. But again, your code of accounts, if your code of accounts has doesn't separate under carriage actuals, you're never going to have anything that you can use to calibrate your undercarriage estimates. Okay. So again, your code of accounts has got to match your rate, estimating structure, or flip it around your rate estimating structure has got to match your code of account, there's got to be a communication between the code of accounts people and the rate estimating folk great. But of course, the big unknown is repair parts and labor, right? Where it it's a question of experience, it's a cost, which isn't constant through the life of a machine. And it's that upward sloping curve that we that we've already spoken about.
Michael Kelley:And we talked about this earlier, I said about the sensitivity analysis that you had done in there. It was kind of an intimidating word to me, actually, it's been long enough that I've done sensitivity analyses in school, that but if I understood right, a sensitivity analysis, basically saying, How much does this assumption has to do with the end result? how sensitive is the end result to this assumption? And if I understood correctly from rereading that, that the repair parts and labor, it's very sensitive to that if you if you get that wrong, your rate is wrong?
Mike Vorster:Absolutely, absolutely. The big three and are in a sensitivity analysis, of course. And there's a formal sensitivity analysis done in the book, the big three in the sensitivity analysis, of course, utilization, which we've spoken about. Number two is repair parts and labor. And then number three, is what masquerades as as purchase price, which is in fact the main driver of owning costs. Sure, sure. And, you know, if you if you look at the total expenditure on your fleet, don't be surprised if owning costs, operating costs of fuel come to about the same right now fuel, the fuel consumption, we've got better data and so on and so forth. So fuel consumption is a big issue, but it doesn't swing as much as owning costs. So operating costs can swing,
Michael Kelley:right? Well, it doesn't it doesn't swing as much in terms of over the life of the machine. It doesn't change as far as gallons per hour, but it sure can change. It change as far as dollars per gallon.
Mike Vorster:Yep, yep, yep. And of course, the skills aptitudes and attitudes that you need to estimate. operating costs are very different to the skills aptitudes and attitudes you need to estimate owning costs. Because for owning costs, you need someone whose background and mindset is banking, finance, depreciation, cost of capital, and for your operating costs. You need someone whose background is, you know, lefty loosey, righty tighty parts and labor, oil and grease company. notes and all those sorts of things. So, again, in this process, the skills aptitudes and attitudes that you need to, to make those estimates are very, very different, which is reason why you split them and keep them apart. Yeah,
Michael Kelley:yeah. One of the things that you haven't mentioned so far, are all of your indirect costs. So it's not enough, at least in my experience, where these these construction companies, it's not enough to just own the machines, but they have to own the things that that allow them to own the machines, or at least they have indirect they have these indirect expenses, expenses that they wouldn't have, if they simply rented everything. Yep.
Mike Vorster:Yes, there is the infrastructure, you need to, to maintain the fleet, you know, there's lights and water and, and rent and all those sorts of things for the shop and for the yard and for the management and the administration, who pays for the guy that looks after the yard? Who pays for cleaning the shop? Who pays all that indirect labor, that goes to supporting the shop and yard and or part consumables in the shop that you are cannot be directly coded or to any particular work order, and so on and so forth? And so, yes, there needs to be a component in the rate calculation that provides for the indirect costs associated with both owning, in other words, the administration of the ownership side, and operating the resources, facilities and administration of the operating side of the house. Right. All that is done varies hugely across the spectrum of companies. Some folks say that, you know, it's pro rata the rate, it's a margin, if you wish, or a markup on the cost estimate. Other folks say, Well, you know, the big machines actually use the yard less than the small machines, because it's all the compressors and lighting plants and things like that, that give us a headache and our workload in the yard. So yeah, they've got to carry more than the big machines. Yeah. But then there are some folks who say we handle all those invariants truly, as an indirect budget, don't include it in the red calculation. Great. But that varies all over the place. I think that the equipment account is a ship on its own bottom, I think the equipment account needs to carry its own indirects. And I think that therefore does need to be a component in the rate calculation to, to carry the end
Michael Kelley:What surprised me, I did a analysis with five companies have their indirect costs. And so you know, of course, everybody's categorizing them differently and handling them differently, just like you mentioned earlier, and I was expecting the result of my analysis, to come to some two to 3% of the overall equipment revenue. And, and what I, when I told these, these equipment managers, this, I was like, well, it's only two or 3%, they all looked at me and they kind of like they they kind of looked at each other. And they said not ours or are yours. I was just wrong. And my assumption was wildly wrong. It's it was somewhere between depending on on the situation, you know, between 10 and 20% of the amount that they're charging their jobs. So their total equipment revenue, or the total equipment cost recovery for a year, that some tip between 10 and 20% of their expenses are these indirect expenses. Now, whether or not there including it in the rate calculation is one thing, but they are experiencing these costs, they are experiencing leases on their buildings, they are experiencing admin labor, to you know, help with all the compliance and all the regulatory things that they have to do DOT, all that kind of thing, you know, especia ly all of this emissions testing that they need to do these d ys. And .... These are real c sts. And so when we're talk ng 10 to 20% of the equipment osts, for a sizable fleet, we' e talking a lot of money. And so it can't, it doesn't ap ear to me to be something hat can be simply ignored. I must be handled.
Mike Vorster:Well. My call the the first rule of managing indirects is to make sure that there are indirects because it's one of the things I experienced is that now shop, rent and electricity in the shop and all those sorts of things. Those are true indirects One of the things I experience is that this plane can I use the word ladies laziness in cost coding to a work order causes you to leave a lot of parts cost under the indirect cost packet. Sure, I buy a lot of filters on a bulk order, I put them in my filter store, I'm just gonna take them out of the store and, and use them as I maintain the machines. And so all of a sudden, those photos on our indirects, because I haven't allocated them to the work order. Yep, I have been less than Sarah, in my allocation of labor to work orders. So the difference lies in a bucket called indirects. Yep. So the first thing that I do, and the first thing I would encourage listeners to do when they think about indirect is to say, are these truly an allocatable costs? Or are they in fact, an allocated costs. And when you talk, I've seen indirect paths in the 30s and 40 percents of the parts that ended up assigned to units at a work order level, simply because I didn't know the machine number on which we were going to install this cutting it, or I bought a bunch of cutting edges, right? Who cares about which machine it goes on to?
Michael Kelley:Oh, man, inventory, inventory is a thorn in everybody's side.
Mike Vorster:Everybody side and so not properly, it makes sure let me say it again, make sure these are an allocatable costs, which must therefore lie in overheads and indirect, versus just simply an allocated costs. Right? Right. Having no place in indirects. And in and in overhead costs, right? The equipment manager is an indirect but sure, an equipment technician is not an indirect rate. Yeah.
Michael Kelley:And in small fleets, that's where you have - there's there's people who fill both roles, right, you have people who are wrenching, but then maybe they come in for a portion of their day to plan out the day for the rest of the mechanics. Right. And they have there is there is a mix, but you need to, I think that that's a really good heuristic there. indirects are the unallocated costs. And they shouldn't be the unallocated costs, or that should be as small as possible. Yes, everybody needs a junk drawer. But if you have if your junk drawer is the size of your whole kitchen, then you know, you're going to be eating out a lot.
Mike Vorster:Absolutely, absolutely. And you know, the most frequently used cost code is the 999 cost code alright? So it is frequently remembered, because code is my mind. All right, I know. I put this on my nine, nine, nine, let's go.
Michael Kelley:Yeah, I flipped that around for some people and called it the 666 code so that people put less to it. I'm curious now about the big risks that you see that you've seen, you know, we've talked about these assumptions, talked about the repair parts and labor, we talked about the ownership period. It just it just seems like that. With all of these things, we're making a number of sizable guesses, right? Where what's the result of this? What are those big risks? And what is the what? What happens if we get it wrong?
Mike Vorster:Yeah. And particularly, the big risk is hours per year utilization. The big risk is this business virilizing a fixed cost, okay. And so, in my world and in everything I've always looked at, in the rate calculation, those hours per year that you use to divide into your annual costs have more impact than anything else. And of course, there's hours per year or in that top panel of the format, right, that gets baked into the whole process and that you've forgotten by the time we get down to line six, you've forgotten how, how scary that line eight was, you know, the lines above work, okay. And so, utilization is the is the big risk, repair parts and labor. If it is, if your assumption with regards to ownership period is kind of longer than the expected life of the first set of components, then repair parts and labor is going to become a very big risk, because baked into your rate calculation as therefore an estimate for some fairly substantial component replacement. Now, the way a lot of people get away from that is they say, well, we're going to get rid of it, before we get into the main Major Component replacement thing means we're going to keep the ownership period short. Or if we keep the ownership period short, we're going to have a high ish residual market value, we're going to have very high loss in value during that short ownership period, because we know our residual market value comes down early. Now, utilization is going to become critical, because we've got that fixed cost of ownership, that now has to be very alized by utilization, all right. But you can sell them get rid of some of the repair parts and labor risk by doing that. But you should know what repair parts and labor costs are. And you should be able to use your data to minimize repair parts and labor risk. Of course,
Michael Kelley:it's kind of interesting, you know, I'm going into these companies, and helping them with their new accounting system and helping, you know, sometimes they're switching accounting systems. And that's why they're where they're helping them with their equipment accounting, sometimes it's, they already have Vista, we typically work with VISTA clients specifically. And they're just help hoping that we can help them with the equipment portion of it all over the map, but one charge that I get leveled against me, I'm not. And sometimes I feel like it's accurate. And sometimes I feel like just an ad hominem, you know, depends on my mood. But they use the words ivory tower, they use the words too much college. Sounds like that would work good in in the office, but not in real life. Those kinds of things will don't they'll tell me when I'm talking about this rate calculation. Right? Of course, part of it is I think that maybe I just encourage a little bit too much debate when we're talking about these kind of things. Because I enjoy the debate, maybe more than I even enjoyed the end result. I feel like that, that all of that is when they're in the mode of they're struggling through understanding why do we need to have a standard rate? Why can't I? Why can't I just change it on every job? Why can't I just go with my gut? Why? Well, you know, what, they're asking these questions of me like what, you know, this is this is a lot of work to put into, why do we need a standard rate calculation, I had one guy in the middle of a class I was, you know, leading the class and going through this the diagrams and whiteboards and all this and he and he said, Hold on, Michael, why are we doing this? And I kind of like to ask the same question, why what are the advantages, really, of this of a rate calculation, and specifically a standard one,
Mike Vorster:the folk who makes those comments are in many, many ways, right? If they are equipment folk, because you can run a an equipment fleet, you can get all your machines to start, you can fix them, you can you can run an equipment fleet, without knowing what it costs you. Alright, and you can walk around and kick the tires and, and I guarantee you, you can, you can run your motorcar without knowing what your motorcar costs you right? You can get to and from the supermarket, you can get the dirt moved without knowing what your equipment costs, no doubt about it. But there's one thing that you cannot do. And that is you can't prepare a bid without knowing what your equipment costs. Because one of the things I say to folk is, would you bid a job, a paving job, if you knew the cost of asphalt with the same degree of confidence and accuracy, as you know the cost of the paver, okay, because the cost of the work is the cost of the resources that are consumed in the production of that work. Now you are going to consume asphalt in the production of this paved highway, you're also going to consume a paver or portion of a paver or a substantial portion of the life of a paver in the production of that paved highway. You have to know the cost of the resources you need to produce the work, if you are going to estimate an offer under contract, a bid to do that work, what we estimate work would we offer to build a bridge if we didn't know the cost of labor? Right? Or if we didn't know the cost of concrete, right? So the if the folks that are talking to you about equipment costs, or equipment people there's a ring of truth in what they're saying. to you. But the principal and critical role of the rate calculation is the role it plays in estimating. Because let's imagine, you've your rate calculation is 30% line, and you build your estimated cost of your equipment into your bed 30% lighter than it should be, who gets that 30%? The owner? Okay, right, because you have offered to do the work using resources that are that you've discounted, the same way as if you offer to place concrete at a 30% less than what it costs you to buy the concrete, right, bring the owner concrete at a discounted rate. Now, are you gonna offer your owner your labor at a discounted rate? You're gonna offer you owner your materials at a discounted rate, are you going to offer your owner your equipment at a discounted rate? You've got to know the rate for your equipment, the same as you've got to know the right for your labor and your materials. Okay. And so I would encourage the folks who say that to you, I would say to them, hey, look, let's talk to your estimators. The folk who have actually grown to understand that equipment rates are more about equipment estimating than about equipment management, are actually grasp the importance of chapter six.
Michael Kelley:Yes, yes, exactly. That's that's just it is that you know that there's there is no college, that's going to prepare you there is no ivory tower that's going to prepare you to accurately estimate those costs. What what's what's going to happen is experience, go and talk to the people that have experience. If you're talking about the ownership costs, go talk to the the old graybeard that has been buying and selling equipment for a very long time, and then come back to me with some assumptions. Go and talk to that mechanic that's been wrenching for a very long time, and then come back to me with the assumptions. And then and then we can use the formula, we can use the the, we can use the the categorization, we can use the spreadsheet, the simple arithmetic to use those good assumptions to come up with a rate calculation to do everything that you just said to then specifically to not give money away. Yep, yep. In our in our bidding process.
Mike Vorster:The section in the book that's called know your costs shouldn't be read and understood by estimators, not by equipment, not by equipment managers as much, because an equipment manager can actually manage a fleet without knowing his cost. Sure, not as well as you and I would like of course, right. But an estimator, flat cannot prepare an estimate without knowing the cost of the resources that are going to build the work. Right. Right. Hey, we're gonna pay, we're gonna put down this piece of concrete paving. I'll tell you what, you don't know the cost of concrete.
Michael Kelley:Yeah, right. Go. Let's see, let's see what happens.
Mike Vorster:Yeah, I remember that. I know what I would do sitting on the, on the board, alright. conversations, or as that as a responsible manager, if it comes in and says, Sir, he has my bid, I'd like to finalize it, you look at it and say, Well, how well do you know that it cost a concrete? Or no, I didn't know anything about concrete. I don't know how they're, you know, I never called a concrete supplier. I just thought that was a good number. Right? You say How well do you know the cost of your equipment that you've put into this, but at the cost of your equipment in this bird, in many instances is up here by a third and a quarter of the cost of the bird? Right? Would you bid for work, knowing the cost of materials with the same degree of accuracy and confidence as you know, the cost of your equipment?
Michael Kelley:Right, exactly. And the answer is clearly no, as evidenced by every estimating department out there that I've worked with. So another question that I get fairly frequently as How do I know if I have the right numbers? And and they they're looking for some kind of validation? But of course, it's a hard question to answer because, because, since everything does rest on the assumptions that they've made about their company, of course, there is no right answer, but They're What have you seen when people are trying to compare their rates to others? I mean, you know that I think the Army Corps of Engineers has one. But isn't. Aren't there other industry benchmarks?
Mike Vorster:Yes. And the blue book, of course, has a lot of state DOT's have benchmark values? Alright. And yes, the role of benchmark, benchmark values do have a play a role in the in the rate setting process. But, you know, first thing to do is to make sure that you have included in your rate, the same sort of things, interest on capital, alright. Is it in the Army Corps of Engineers? Is it in the deities? Is it in the bluebook calculation? Is it in your calculation? And more often than not, there's a return on capital component in a in a theoretical benchmark calculation, and not in yours? And you say, Yes, we can beat them by 10%. Or another one that folk use a lot about for benchmark rates is equipment rental business?
Michael Kelley:Sure. Yeah. I've heard that a lot. What can I get it for? If I just go out in the street and get it?
Mike Vorster:Get it now? Well, let's be sure that the rental equipment rental business has got profit and return on capital because their share, that's the only source of income and their shareholders are going to want profit and return on and or return on capital. Alright. And in their in their business? The other thing is, are the rental terms and conditions the same? Have you got a minimum 40 hours a week? Because your rental company? Sure is hangers got something that handles standard time? All right? Have you got a provision in your rate for less than normal fair wear and tear, because Rest assured the rental company does not and will be back charging you for more than normal fair wear and tear. Okay. And so again, we have this business of comparing apples with apples, comparing apples and oranges. And when we do that, we just need to make sure that you know, this is an apple, this is an orange era, the similarities, here are the differences. We can bridge the similarities, we can understand the similarities, and bridge the differences. But look, not only at where if you're using rental look, not only at the number, but look at the terms and conditions, and especially the two I've mentioned, and that is the terms and conditions regarding utilization. And the terms and conditions regarding other than fair wear and tear.
Michael Kelley:Yeah, well, we've got a lot, a lot of hay down here. What would you say the bottom line is? What do we what do we really need to think about as we as we wrap up this rate calculation episode,
Mike Vorster:Michael, what I would like our listeners to really remember and ponder and understand and make part of their thinking is that a rate for a machine is an awful lot like an insurance premium. You are making small regular payments to provide for and cover the cost of a large, discrete event. Okay. And our rate is such it's a small, regular payment to cover the cost of large discrete payments. Maybe there was a large discrete payment three months ago when we bought it, or there'll be a large discrete payment in two months time when we replace the undercarriage, but we are making these small regular payments to cover the cost of large discrete events that we hope like Hang on, not going to happen. Right, right, right. But then as soon as you have that as part of your of your thinking process. I'd like everybody to remember that the higher your costs are high or premium right because you can't manufacture stuff stuffs a cost is a cost is a cost. And in the end, you've got a setup a process, or making these small continuous payments that cover the cost of these large discrete events. Man manage the large discrete events. The small, regular payments will lover in exactly the same way as you manage your Are your relationship with your insurance company? Think about it right? As an insurance premium?
Michael Kelley:Yeah, yeah, I think that's useful. I think it's a usual useful metaphor, because everybody, well, most most people anyway, have a vehicle that they're driving. And if you experience several accidents, have some siblings that have teenage teenagers, and they're experiencing this rate premium increase due to the proclivity of the teenager to experience these large, discrete events, and this is you know, it. Yeah, that resonates? Well, good. I think that that covers it. I think this is a really important chapter in the book, I think that well, I can say that nothing in all of the different work I've done with different companies has provoked as much debate internal debate at companies as the conversation surrounding the rate calculation. And I really, really appreciate the work you've done here to make this clear, so that we can have debates about one thing at a time. Let's talk about the ownership period assumption. Let's talk about the ownership cost assumption. Let's start with the operating cost assumption. Because it can it clarifies things for these people that are trying to their best to establish a rate that is fair and works for them that establishes their the correct the correct premium to cover their actual costs.
Mike Vorster:Yes, and remember our conversation about successes is come it comes as a from a team work, alright. And suspicion, if you wish, and uncertainty and a lack of knowledge about the rate is one of the issues that really, really, really causes a lot of bad hygiene in the business or right. And that if we focus on the fact that success is a team sport, the members of that team have got to the right calculation and understand the right calculation. Because I've, it's difficult for me to conceive of the team playing together if the rate is a source of mistrust.
Michael Kelley:Yeah, exactly. Well, good. Thank you for today. I'm sure we'll be talking soon about the next chapter or chapters. And I look forward to that.
Mike Vorster:Let's do that. Let's do that. Look forward to it very much indeed. And appreciate your time and everybody's time to listen to this old man practicing along playing along about the thing that really fascinates him.
Michael Kelley:Yeah, well, I can tell you just from the number of downloads that there's a lot of people who like to hear that old man traveling along so keep it up. That's it for today, folks. See you next time.