6.

3 EQUIPMENT
ECONOMICS
INTRODUCTION
 The economic analysis of construction equipment is primarily
concerned with the determination of owning and operating costs for
an item of equipment and the identification of the optimum economic
life for an item of equipment.

 Owning and operating costs are usually computed on an hourly basis.

 An estimated cost per unit of production is necessary for bidding

purposes, but actual production costs must be known for job cost
control and management.

 The objective when planning a job and selecting equipment is to

minimize the cost per unit of production.
INTRODUCTION
 The ultimate objective of a profit-making construction organization
should be to maximize profits and not necessarily to minimize costs.

 Economic analyses supporting a decision on equipment replacement

are aimed at determining the equipment replacement interval that will
yield the maximum profit on the equipment investment.

 The period of equipment ownership that yields the maximum profit

on the equipment investment may be considerably shorter than the
economic life of the equipment.
Time Value of Money
 Everyone is aware that the amount of money held in a savings
account will increase with time if interest payments are allowed to
remain on deposit (to compound) in the account. The value of money
left on deposit after any period of time may be calculated using
Equation 1.

F  P(1  i) n

where
F = value at the end of n periods (future value)
P = present value
i = interest rate per period
n = number of periods
Time Value of Money
 The expression (1+i) n is often the single-payment compound interest
factor. Equation 1 can be rearrange to find the present value (present
worth) of some future amount, resulting in Equation 2

F
P
(1  i ) n
where
F = value at the end of n periods (future value)
P = present value
i = interest rate per period
n = number of periods
Time Value of Money
 These equations form the basis of a type of economic analysis
commonly called engineering economy.

 The methods of engineering economy are widely used to analyze the

economic feasibility of proposed projects, to compare alternative
investments, and to determine the rate of return on an investment.

 However, because of their complexity and the difficulty of accounting

for the effects of inflation and taxes, these techniques have not been
widely used within the construction industry.

 Construction equipment owning costs, for example, are usually

determined by the methods described in the following section rather
than by employing engineering economy techniques. A present worth
analysis, however, is very helpful when comparing the cost of
different alternatives. This is illustrated by the rent-lease-buy analysis.
1. EQUIPMENT COST
Elements of Equipment Cost
 Equipment owning and operating costs (O&O costs), as the name
implies, are composed of owning and operating costs. Owning costs
are fixed costs that are incurred each year whether the equipment is
operated or not. Operating costs, however, are incurred only when
the equipment is actually used.

 In following the procedures of this section, you will note that it is

necessary to estimate many factors, such as fuel consumption, tire
life and so on. The best basis for estimating such factors is the use of
historical data, preferably those recorded by your construction
company operating similar equipment under similar conditions. If
such data are not available, consult the equipment manufacturer for
recommendations or follow the procedures suggested in this section.
1. EQUIPMENT COST
Owning Costs
 Owning costs are made up of the following principal elements:

 Depreciation
 Investment cost (or interest)
 Insurance cost
 Taxes
 Storage cost
1. EQUIPMENT COST
Owning Costs - Depreciation
 Depreciation represents the decrease in market value of an item
of equipment due to age, wear, deterioration, and obsolescence.
In accounting for equipment costs, however, depreciation serves
three principal purposes.

i. Evaluating tax liability

ii. Determining the depreciation component of the hourly

equipment cost

iii. Determining the depreciation amount to be used in a

replacement decision analysis.
1. EQUIPMENT COST
Owning Costs - Depreciation
 the depreciation and investment components of equipment
owning costs will be calculated together as a single cost factor.

 In calculating depreciation, the initial cost of an item of

equipment should be need full delivered price, including
transportation, blocking or packing charges, unloading, initial,
assembly and servicing, sales taxes, and import duties when
applicable.
1. EQUIPMENT COST
Owning Costs - Depreciation
 For rubber-tired equipment, the value of tires is usually
subtracted from the amount to be depreciated because tire cost
will be computed separately as an element of operating cost.

 Equipment salvage value should be estimated as realistically as

possible based on historical data.

 The equipment life to be used for depreciation purposes should

represent the equipment's expected economic or useful life. This
will depend on the type of equipment involved, the conditions
under which it will operate, and the practices in the industry.

 The useful life for general construction equipment has historically

been 5 years.
1. EQUIPMENT COST
Owning Costs - Depreciation
 There are a number of methods for calculating depreciation.
However, the most commonly used methods are the straight line
method, the sum-of-the-years'-digits method, the double-
declining-balance method, and IRS-prescribed methods.
Procedures for calculating depreciation by each of these
methods are given below.

i. Straight Line Method - the amount to be depreciated is spread

uniformly over the expected life of the equipment. Annual
depreciation is therefore calculated as the amount to be
depreciated divided by the equipment life in years (Equation 3).
The amount to be depreciated consists of the equipment's initial
cost less salvage value (and usually less tire cost for rubber-tired
equipment).
1. EQUIPMENT COST
Owning Costs - Depreciation

Straight Line Method

Dn = Cost – Salvage Value

N (3)

N = equipment life (years)

n = year of life (1, 2, 3, etc.)
1. EQUIPMENT COST
Owning Costs - Depreciation
Straight Line Method

EXAMPLE 1

Using the straight line method of depreciation, find the annual

depreciation and book value at the end of each year for a crawler
tractor having an initial cost of RM35,000, a salvage value of
RM5,000, and an expected life of 5 years.

SOLUTION

D1,2,3.4,5 = 35,000 — 5,000 = $6,000

5
1. EQUIPMENT COST
Owning Costs - Depreciation

Book Value
Depreciation
Year (end of period)
(RM)
(RM)

0 0 35,000
1 6,000 29,000

2 6,000 23,000

3 6,000 17,000

4 6,000 11,000
5 6,000 5,000
1. EQUIPMENT COST
Owning Costs - Depreciation
Sum-of-the-Years’-Digits Method
 The sum-of-the-years'-digits method of depreciation produces a
non-uniform depreciation which is highest in the first year of life
and gradually decreases thereafter.
 The amount to be depreciated is found in the same manner as
for the straight line method.
 The depreciation for a particular year is found by multiplying the
amount to be depreciated by a depreciation factor (Equation 4).
 The denominator for the depreciation factor is the sum of the
years' digits for the depreciation period (or 1 + 2 + 3 + 4 + 5 = 15
for a 5-year life).
 The numerator of the factor is the particular year's digit taken in
inverse order (i.e., 5, 4, 3, 2, and 1). Thus, for the first year of a
5-year life, 5 would be used as the numerator. The procedure is
illustrated in Example 2.
DN = Year digit x Amount to be depreciate
Sum of years’ digits (4)
1. EQUIPMENT COST
Owning Costs - Depreciation

Sum-of-the-Years’-Digits Method

EXAMPLE 2

Find the annual depreciation and book value at the end of each
year for the tractor Example 1 by using the sum-of-the-years'-
digits method.
1. EQUIPMENT COST
Owning Costs - Depreciation

Sum-of-the-Years’-Digits Method

SOLUTION

D1 = 5/15 x (35000 – 5,000) = 10,000

D2 = 4/15 x (35000 – 5,000) = 8,000

D3 = 3/15 x (35000 – 5,000) = 6,000

D4 = 2/15 x (35000 – 5,000) = 4,000

D5 = 1/15 x (35000 – 5,000) = 2,000

1. EQUIPMENT COST
Owning Costs - Depreciation

Book Value
Depreciation
Year (end of period)
(RM)
(RM)

0 0 35,000
1 10,000 25,000

2 8,000 17,000

3 6,000 11,000

4 4,000 7,000
5 2,000 5,000
1. EQUIPMENT COST
Owning Costs - Investment cost
 Investment cost (or interest) represents the annual cost of the
capital invested in a machine. If the equipment is purchased from
company assets (borrowed fund), an interest rate should be
charged equal to the rate of return on company investments.

 The investment cost is computed as the product of an interest

rate multiplied by the value of the equipment. The true
investment cost for a specific year of ownership is properly
calculated using the average value of the equipment during that
year.

 However, the average annual investment cost may be more

easily calculated using the value of the average investment over
the life of the equipment given by Equation 5.
1. EQUIPMENT COST
Owning Costs - Investment cost

 The results obtained using equation 5 should be sufficiently

accurate for calculation average owing costs over the life of the
equipment. However, the reader is cautioned that cost calculated
in this manner is not the actual cost for a specific year. It will be
too low not be used for making replacement decisions or for
other purposes requiring precise investment cost for a particular
year.
1. EQUIPMENT COST
Owning Costs - Insurance cost, Tax, and Storage
 Insurance cost represents the cost of fire, theft, accident, and
liability insurance for the equipment.

 Tax cost represents the cost of property tax and licenses for the
equipment.

 Storage cost represents the cost of rent and maintenance for

equipment storage yards and facilities, the wages of guards and
employees involved in handling equipment in and out of storage,
and associated direct overhead.
1. EQUIPMENT COST
Investment Credit

Investment credit is a mechanism which to encourage industry to

modernize production facilities by providing a tax incentive for the
purchase of new equipment.
Tax incentive that permit businesses to deduct a specified percentage of
certain investment cost from their tax liability.
When in effect, investment credit provides a direct credit against tax due,
not merely a reduction in taxable income.
A typical investment credit used during recent years allowed a tax credit
equal to 10% of the investment for the purchase of equipment classified
as 5-year property and 6% for cost basis (amount used for calculating
cost recovery deductions) must be reduced or a smaller investment credit
used.
1. EQUIPMENT COST
Operating Costs
 Operating costs include all costs directly associated with the
operation of the equipment and thus vary with the amount and
condition of usage. Operating costs include operator’s wages, which
are usually added a separate item after other operating costs have
been calculated.

 The principal elements of operating cost include:

 Fuel cost
 Service cost
 Repair cost
 Tire cost
 Cost of special items
 Operators’ wages
1. EQUIPMENT COST
Operating Costs - Fuel cost
 The hourly cost of fuel is found by multiplying the fuel
consumption per hours by the cost of each unit of fuel (gallon or
liter).

 The most accurate method for determining hourly fuel

consumption is by actual measurement under similar job
conditions.

 However, when estimates are required, fuel consumption can be

estimated from manufacturer’s data or by the use Table 1.

 This table provides approximate fuel consumption factors in

gallons per hour per horsepower (gal/h/hp) or liter per hour per
kilowatt (ℓ/h/kW) for major types of equipment under light,
average, and severe load conditions.
1. EQUIPMENT COST
Operating Costs - Fuel cost
1. EQUIPMENT COST
Operating Costs - Service cost
 Service cost represents the cost of oil, hydraulic fluid, grease,
and filters, as well as the labor required to perform routine
maintenance service.

 Equipment manufacturers provide consumption data or average

costs for old, lubricants, hydraulic fluid and filters for their
equipment under average operating conditions.

 When consumption data are used, hourly consumption adjusted

for operating conditions is multiplied by cost per item to find
hourly cost of these consumables.

 Labor cost for service is then estimated based on the planned

maintenance program and prevailing wage rates.
1. EQUIPMENT COST
Operating Costs - Service cost
 Since service cost is related to equipment size and severity of
operating conditions, a rough estimate of hourly service costs
can be made based on the equipment’s fuel cost (Table 2).

 For example, using Table 2 the hourly service cost of a wheel

loader operated under severe conditions would be estimated at
50 percent of the hourly fuel cost.
1. EQUIPMENT COST
Operating Costs - Repair Cost
 Repair cost represents the cost of all maintenance and repair
except for routine service and the replacement of high wear
items (such as ripper tips and shanks blade cutting edges).

 Repair cost constitutes the largest single item of operating

expense for most construction equipment.

 Repair costs depend on equipment application, operating

conditions, and maintenance standards. As would be expected,
average repair costs are relatively low for new machines and rise
as the equipment ages.

 Lifetime repair cost is usually estimated as a percentage of the

initial cost less tires (Table 3). It is then necessary to convert
lifetime repair cost to an hourly repair cost. A simple
conservation involves dividing lifetime cost by the expected
equipment life in hours to yields an average hourly repair cost.
1. EQUIPMENT COST
Operating Costs - Repair Cost
1. EQUIPMENT COST
Operating Costs - Repair Cost
 Although this method is valid for average repair cost over the life
of a machine, it can be very inaccurate when used for estimating
repair cost in the early or late years of equipment life.

 As you might expect, repair cost are typically low for new
machines and rise as the equipment ages. Thus it is suggested
that Equation 6 be used to obtain a more accurate estimate of
repair cost during a particular year of equipment life.
1. EQUIPMENT COST
Operating Costs - Repair Cost
 The method is similar to that used for calculating depreciation
using the sum-of-the-years’-digit method except that the year
digits are used in their normal order (i.e., 1 for the first years, 2
for the second years, etc.). The procedure is illustrated in the
following example.

 EXAMPLE 3

Estimate the hourly repair cost for the second year of operating
of a crawler tractor costing RM40,000 and having a 5-years life.
Operating conditions are average and the machine will operate
2,000 hr during the years.
1. EQUIPMENT COST
Operating Costs - Repair Cost
 SOLUTION

Lifetime repair cost factor = 0.90 (Table 3)

Lifetime repair cost = 40,000 x 0.90 = RM36,000

Hourly repair cost = (2/15) + (36000/2000) = RM 2.40/h

1. EQUIPMENT COST
Operating Costs - Tire Cost
 Tire cost represents the cost of tire repair and replacement.
Among the components of operating cost for rubber-tired
equipment, tires cost usually exceeded only by general repair
cost.

 Tire cost is also among difficult to estimate because of the

difficulty in accurately estimating tire life. Estimation if tire can
best be made by consulting good historical time record. If these
are not available, a rough estimate can be obtained by the use of
Table 4.

 Tire replacement cost is divided by tire life in hours to find hourly

tire replacement cost.
1. EQUIPMENT COST
Operating Costs - Tire Cost
 Tire repair cost is usually estimated as a percentage of tire
replacement cost. Unless good historical data are available for
estimating tire repair costs, an estimate of 15% of tire
replacement cost is suggested.

 Thus, Equation below may be used to estimate tire repair and

replacement cost.

Tire cost ($/h) = 1.15 x Cost of a set of tires

Expected life of tires
1. EQUIPMENT COST
Operating Costs - Tire Cost
1. EQUIPMENT COST
Operating Costs - Special Items
 The cost of replacing special high-wear items such as ripper tips,
shanks and shanks protectors, and blade cutting edges should
be calculated as an item of operating cost. The cost of any
unusual items also be included here. Such costs are then
converted to an hourly basis.

Operating Costs - Operator

 After other operating costs have been determined, the operator’s
hourly wage is added to determine total hourly operating cost for
the equipment. Be sure to include all costs, such as worker’s
compensation insurance, Social Security taxes, overtime or
premium pay and fringe benefits in the hourly wage figure.