# Ihab Saad – Calculating Equipment Cost

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Music. Hello again, and welcome to construction equipment. Today

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we're going to talk about estimating equipment cost.

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Definitely, as we have mentioned already in class, that cost is one

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of the major functions that the project management manager is

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responsible for. And today we're going to talk about estimating

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equipment. Since this is a construction equipment class,

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we're going to learn about what are the different components of

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the equipment cost. And then we're going to talk in some more detail

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about equipment depreciation, how it is part of the cost component,

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and it has to come in our cost estimates as well.

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So building and industrial construction depend more on labor

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and material. So residential construction, for example, and to

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certain extent, commercial construction, rely on labor and

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material. So they are labor and material intense, intensive.

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However, heavy construction, highway construction or heavy

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civil projects, is very much equipment dependent, therefore the

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equipment cost component is the most predominant one, much more so

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than labor or even materials. So when you think about a pavement

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project, for example, or heavy earthwork project, you're gonna

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find that the cost of the equipment is the predominant cost,

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because there's no cost of material. Pretty much the earth is

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already there. So the cost of excavating, the cost of

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transporting, the cost of compacting, etc, which is

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predominantly the cost of the equipment with some parts of labor

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component as well.

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So construction equipment must earn sufficient revenue to cover

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the contractor's investment cost, which is the ownership cost and

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the operating cost.

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Let's treat equipment like an asset. It is an asset. So the

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contractor purchased it, purchase it, it to make profit out of it.

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So we have to account for its costs. We have to account for any

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expenditure that we make related to the equipment, and hopefully

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we're gonna make a profit out of the utilization of that equipment

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as well. So the contractors must be able to estimate the ownership

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and operating costs, oh and oh for each piece of equipment that they

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own. Equipment can be owned, it can be also rented or leased. The

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contractor does not have to lock his or her money in a big asset

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like equipment, they can rent it or they can lease it. However, the

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rental cost and the lease cost, in some cases, might exceed the

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ownership and operating cost. So there's an advantage of not

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locking a large amount of capital in equipment, but at the same

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time, you're going to pay a little bit more for that rental.

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And costs are used to determine rates to charge projects for

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equipment use, which is going to be charged as part of our bid and

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decisions regarding disposal, purchase, rental or lease of

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equipment, we need to know at certain points in time, is it

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going to be better to purchase the equipment and depreciate it along

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the project, or is it going to be more economical to rent the

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equipment for short term? Or is it going to be more equipped more

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economical to lease it for a medium term, not exactly the same

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length as owning it and not as short as renting it.

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So when we start talking about equipment, we have two major types

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of equipment that's at least one of the classifications. One of

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them is that it's production equipment which is producing units

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that alone or in combination, lead to an end product that is

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recognized as a unit for payment. So, for example, concrete mixers,

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they produce concrete which can be a part of the bit items that is

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concrete, asphalt, same thing and so on, so including pavers,

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collars, loaders, rollers and trenches that excavate trenches

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and so on. Because the unit, whether it's cubic yard or linear

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foot or whatever, for the for the trench excavation, it's an end

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product by itself, and it's produced by this piece of

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equipment. So this is the first type, which is called production

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equipment. The second type is called support equipment, and this

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is equipment that's still needed for the project, yet it does not

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produce end units that can be counted as bid items. So it's

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required for operations related to the placement of construction,

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such as movement of materials and personnel and activities that

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influence the placing environment. These include hoists or cranes,

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vibrators, scaffolds, transit mixers, etc. Scaffolds, for

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example, are gonna need it for the project because that's where the

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labor are gonna stand to place concrete or to place

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masonry or whatever. But you cannot have a pay item in the bid

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by itself, called scaffolds is going to be embedded and

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calculated in the cost of the units where that scaffolding is

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going to have an effect. So.

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Now talking about equipment costs, it can be divided into four major

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components, and these are going to be ownership, operation, including

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maintenance and repair overheads, and finally, profit, because we

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need to make profit out of that piece of equipment. So the

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contractor's accounting system is the best source of information for

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these figures, historical data is the best method of determining

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cost. So we're going to look at historical data for similar

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projects in the past. How much did we spend on these different parts

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of that cost? And as you can see, the ownership cost is the

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predominant part of that cost, because purchasing the equipment,

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that huge asset, is a big bulk, and then the operational cost,

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including running that piece of equipment, maintaining it,

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repairing it from time to time, and then any overhead that's going

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to be charged on that piece of equipment, including, for example,

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the cost of storage. If that equipment is not being used, where

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are we going to store it and keep it safe? And then finally, profit

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we need to charge again. Since it's an asset that the contractor

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locks his or her money to purchase that asset, they have to get a

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return on that investment, which is going to be in the form of

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profit that's going to be charged to the client or the owner.

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The ownership and operation cost

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for the equipment. Ownership costs are incurred, whether the

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equipment is used or not. And think about it this way, if you

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have a truck, and the truck is kept locked in a garage, for

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example, you're not making use out of it. Well, you're not getting

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any profit. First of all, the value of that car is going to

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deteriorate with time. Although you have not used it, that's just

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a fact of depreciation, so you are losing money by keeping it locked.

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So whether it's working or not, its value is going to decrease.

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The operating costs, however, are incurred only when the equipment

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is being used, because it's related to the equipment usage,

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whether it's going to be fuel, grease, filters, maintenance, etc,

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it's going to be related to the use and the amount of use of that

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piece of equipment. So parts of ownership costs, we have

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depreciation, interest that you have to pay for a loan, for

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example, to purchase that piece of equipment, taxes, insurance,

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again, whether you use it or not, storage and license fees. All of

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these are part of the operating costs, regardless of whether the

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equipment works or not. On the other hand, the operating costs

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include maintenance and repair, which are, as I said, proportional

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to the use of the equipment tires, including repair or replacement of

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these tires, fuel that's going to use to be used to run that

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equipment, service filters oils, grease, which are the things that

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you need to keep replacing on a regular basis, downtime. We're

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going to talk about that little bit later on. And finally, the

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operator. Operator, if that equipment has an operator, a

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driver, or someone who is going to run that piece of equipment,

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that's going to be part of the operating cost, because their cost

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is going to be only charged if the equipment is being used. That's

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the major differentiation between ownership and operating

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and as you can see here graphically, the ownership cost

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goes down with time,

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whereas the operating cost goes up with time, the older the piece of

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equipment, the more operating cost is going to have. It's going to

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require more maintenance, more repairs, etc. Whereas the

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ownership cost is going to go down because of depreciation, the value

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of that equipment is going to keep going down until it becomes, at

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least on the books zero you might have the equipment still

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functioning, still producing. And in this case, the ownership cost

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is going to be pretty much nothing.

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The ownership costs are best estimated by the time value of

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money analysis method. We talked about the time value of money. In

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the previous lecture, we learned about how to draw the cash flow

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and the different types of the present value, the future value,

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the annuities and so on. So this is one way of calculating the

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ownership cost. The contractor will know the purchase price and

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must estimate the ownership period for. How long are they planning to

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own that piece of equipment, whether it's until it becomes

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totally obsolete and its value becomes zero on the books, or are

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they going to set it to use and get some residual or salvage value

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from selling that piece of equipment? This information will

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account for depreciation. We need to calculate this information to

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be able to calculate the amount of depreciation that's going to be

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charged on that piece of equipment every year.

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The ownership cost is also called the fixed cost, because, again, it

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does not depend on the utilization of the equipment how many hours or

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how many days it is time dependent or time related because of the

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effect of obsolescence or.

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The effect of depreciation, as we have seen, it goes down over the

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years. It's calculated by relating the estimated total service life

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in hours to the total total cost of the equipment working during

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these hours. If the equipment is idle for some of those hours, cost

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is taken as part of the general overhead.

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So if the equipment is in use hourly cost is charged to the

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project, you're going to estimate how much it costs you per hour as

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if you were renting it, not exactly at the same price of

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rental. Because again, here we have another dilemma. What if a

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contractor owns the equipment and charge the client for the price of

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rental? Theoretically speaking, the contractor is going to make

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more money because the price of rental is higher than cost of

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ownership. But on the other hand, if that price is too high, the

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total bid price for the contract is going to become too high, and

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the contractor may be out of the competition. So these are the two

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criteria that we have to balance at the same time, how much are we

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going to charge the owner in a way that's going to enable us to

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achieve maximum possible profit, and at the same time still be

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competitive and be able to win the bid. So that ownership cost is

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going to consist of the two main components, estimating the for

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depreciation on the cost of using the equipment, and estimates for

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of allowance for interest, insurance and taxes, which, again,

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as we mentioned before, are part of the fixed or ownership cost.

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This is by the definition of the IIT, the

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industry Institute, construction industry Institute,

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the ownership cost includes interest, taxes, insurance and

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storage itis and license costs, and these are used to establish

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the minimum attractive rate of return. Minimum attractive rate of

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return, the interest is going to be charged for borrowed money or

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the return expected from invested money, which is the cost of

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opportunity, or the cost of the lost opportunity. If the money is

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borrowed, you'd have to return it back with an increase that's

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called interest. If the money is yours, you're going to assume as

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if you have invested this money in another endeavor, and that money

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is giving you a return on investment. That alternative

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return on investment, you're going to charge it to the owner, because

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you lost that other opportunity by locking your money for that

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particular project. Taxes are going to be include the personal

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property taxes for owning that asset, the insurance for general

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liability insurance to cover damage or injury caused by the

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equipment. And equipment insurance to cover physical damage to the

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equipment, very similar to liability insurance, the full

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coverage that you have on your car, if you want to have the peace

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of mind of if anything happens to my car or my assets going to be

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replaced, then you're going to have the full coverage if only you

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want to protect against your own mistakes, against the others. So

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if you hit someone, or if you hit another car that your insurance

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company is going to pay for their payers, that's going to be the

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just, just the general liability insurance storage is going to be

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the cost of protecting the equipment when not in use on the

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project. And that's a good practice, definitely. And finally,

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the license costs, which are fees, pet for plates and other user

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permits. Again, the The easiest example is your car. You have to

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pay for the renewal of your license plates every year.

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And for each piece of equipment, the equipment manufacturer is

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going to include a some pages in their users manual that show you

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how much to charge for how many hours that equipment is going to

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be used. So if it's going to be used, for example, 6000 hours a

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year, then this is what you're going to charge if it's going to

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be 5000 4000 3000 2000 and so on. So it tells you guide for

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estimating hourly cost of interest, insurance and taxes

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based on the number of hours that equipment is going to be used per

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year. That comes for a caterpillar contractor. It comes with within

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the manual of that country, of that piece of equipment, of that

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tractor.

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Now let's look at an example. Here. A contractor has purchased a

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tractor for \$155,000

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they are not coming cheap, with an expected useful life of 12,000

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hours,

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12,000 operating hours, not calendar hours, and estimates. The

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contractor estimates that its annual usage will be about 2000

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hours per year. So from that, we can expect that we're gonna own it

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for or a service life of six years. That's 12,000 divided by

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2000

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the salvage value at the end of the tractors useful life, which is

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six years, is estimated to be about 12% of the purchase price,

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12% of this 155,000

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the contractor estimates his ownership cost factors to be the

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interest is going to be 9% everything is related to the.

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The purchase price, 9% the tax is 2% the insurance, 2% storage, 1%

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What would be the estimated annual ownership cost if it's operated

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under average conditions?

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So again, we need to calculate the total ownership cost and then

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divided by the number of service lives, service life years to get

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that operating cost per year, ownership cost per year. So the

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expected useful life, 12,000 hours period of ownership, 12,000

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divided by 2000 that six years minimum attractive rate of return,

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which is basically the sum of these numbers, nine plus two plus

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two plus one, that's equal to 14%

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the sandwich value. Imagine that's going to be 12% of the purchase

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price, which is 155,000

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so you're going to be able to sell that piece of equipment at the end

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of the six years for \$18,600

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so the present worth

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of that salvage value today, this is going to be in six years. What

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is the worth of these \$18,000.06

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100 today? The present worth of the sandwich value is 8,481.6

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subtract the present worth

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of the salvage value from the purchase price. So this is

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basically the cost of using that piece of equipment today convert

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to an annual series. You remember when we did that in the previous

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class by you using an annuity based on the present value. So

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it's going to be equal to \$37,655.23

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therefore the cost per hour is going to be that 37,655

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divided by 2000 hours per year, which comes up to 18 \$83 per hour.

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So for each hour this piece of equipment is going to be working,

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is going to cost you 1883 you have now to charge the owner a little

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bit over and above that, to include for your own profit,

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the operating cost. So far, we have talked about the ownership

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cost. Now let's talk about the operating cost. The operating cost

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is also called the variable costs, and it's a function of a number of

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operating hours, quantity proportional. It's not exactly

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time related, because, again, if the equipment is kept locked or

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unused, there is no operating cost. There is ownership cost, on

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the other hand, so it's quantity proportional, includes fuel,

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lubricants and other consumables, filters, tires, etc, maintenance,

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overhauls and repair and operators wage including fringes. Again,

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remember here when we talk about, for example, a

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crane operator getting \$50 an hour. The \$50 an hour are not

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exactly the cost of that grain operator, because you're going to

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charge more for that. There's going to be insurance, workers

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comp, taxes, Social Security, etc, so, and the other benefits. So

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basically, it might be something like maybe \$80 an hour. So that's

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the exact that's the actual cost of that labor.

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The best source of data for estimating operating costs is from

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historical records, again, looking at our track record how much it

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costs in the past. The next best source is to use cost factors

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provided by equipment manufacturers for the specific

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equipment. As we have seen in that book on Caterpillar Tractor.

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They're gonna give you some indices on how much to calculate

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for that cost. That's if you do not have any historical

00:18:48 --> 00:18:52

information. So the operating costs can are generally

00:18:52 --> 00:18:55

influenced, or greatly influenced by the age of the equipment. Of

00:18:55 --> 00:18:58

course, the older, the more it's gonna cost you, because it's gonna

00:18:58 --> 00:19:03

require more repair, more replacement of consumables. It's

00:19:03 --> 00:19:05

state of repair and maintenance. If you keep it in good condition,

00:19:05 --> 00:19:08

it's going to cost you less. If you abuse it, it's going to cost

00:19:08 --> 00:19:11

you more. And it's operating conditions. Again, if it's working

00:19:11 --> 00:19:15

in a very harsh environment, that's going to need more upkeep

00:19:15 --> 00:19:19

cost. If it's working in normal conditions, then again, that cost

00:19:19 --> 00:19:20

is going to be reduced.

00:19:24 --> 00:19:27

Maintenance and repair costs are roughly estimated by using a

00:19:27 --> 00:19:30

percentage of the annual straight line depreciation amount.

00:19:31 --> 00:19:34

There's going to be a table that provides factors to be used to

00:19:34 --> 00:19:37

estimate hourly maintenance and repair costs, again, depending on

00:19:37 --> 00:19:43

the type of equipment, since the factors are based on 10,000 hours

00:19:44 --> 00:19:50

of operating hours. They must be adjusted so the hourly repair cost

00:19:50 --> 00:19:54

is going to be the equipment repair factor from the table,

00:19:56 --> 00:19:59

times the useful life in hours times.

00:20:00 --> 00:20:05

Times the hourly depreciation rate divided by 10,000 hours or divided

00:20:05 --> 00:20:09

by 10,000 Let's see an example of that. So here is the table, for

00:20:09 --> 00:20:13

example. It shows equipment repair factors based on a 10,000 hour

00:20:13 --> 00:20:19

useful life. If the number of useful hours is going to be more

00:20:19 --> 00:20:23

than that, the equation has to be adjusted so it gives you here

00:20:23 --> 00:20:26

based on the different types of equipment. If it's a bottom dump

00:20:28 --> 00:20:32

without the tires, under favorable conditions, then the repair is

00:20:32 --> 00:20:35

going to be 30% under average condition is going to be 35%

00:20:36 --> 00:20:38

unfavorable condition is going to be more 45%

00:20:39 --> 00:20:43

for general contracting, a crawler tractor is going to cost that

00:20:43 --> 00:20:46

much. For quarrying, which is more abusive, is going to cost that

00:20:46 --> 00:20:50

much. Haulers, loaders, scrapers. So for different types of

00:20:50 --> 00:20:55

equipment, it can give you percentages on the equipment,

00:20:55 --> 00:20:56

repair factors,

00:20:59 --> 00:21:03

the tire costs. Tires are treated as a separate operating cost, as

00:21:03 --> 00:21:06

they have a different useful life than the equipment. The equipment

00:21:06 --> 00:21:11

might be working for seven years, 10 years, 10,000 hours, 20,000

00:21:12 --> 00:21:16

hours, but definitely, the tires are not going to serve for that

00:21:16 --> 00:21:19

whole period. They have to be replaced regularly. Track

00:21:19 --> 00:21:22

replacement for track mounted equipment is included in the

00:21:22 --> 00:21:23

maintenance and repair cost.

00:21:25 --> 00:21:28

Tires are subtracted from the purchase price when determining

00:21:28 --> 00:21:32

ownership cost. So when you have and we're going to see an example

00:21:32 --> 00:21:36

of that, a separate cash flow analysis is performed for the

00:21:36 --> 00:21:39

tires, when are you going to buy them for? How much? When there are

00:21:39 --> 00:21:43

they going to be replaced and so on. And we're going to use a table

00:21:44 --> 00:21:47

to estimate the tire life. With the table

00:21:48 --> 00:21:52

data and tire cost, develop a cash flow analysis to know, again,

00:21:52 --> 00:21:55

whether you're making profit on that piece of equipment or not.

00:21:55 --> 00:21:59

Tire maintenance and repair is going to be 15% of the hourly

00:21:59 --> 00:22:02

straight line depreciation for the tires.

00:22:04 --> 00:22:09

So let's look at the table here again. It shows for different

00:22:09 --> 00:22:13

types of equipment, under different operating conditions,

00:22:13 --> 00:22:19

what would be the service life of the tires. So for haulers, for

00:22:19 --> 00:22:23

example, under average conditions, the tires are going to serve for

00:22:23 --> 00:22:26

3200 hours, whereas under unfavorable conditions, you lose

00:22:26 --> 00:22:28

1000 hours, that's quite a lot.

00:22:32 --> 00:22:35

Fuel consumption. The rate of fuel consumption for equipment varies

00:22:35 --> 00:22:40

with the rated horsepower. The higher horsepower, the more fuel

00:22:40 --> 00:22:44

thirsty is gone. Thirsty is going to be and the duty cycle of the

00:22:44 --> 00:22:48

engine, the percentage of the time the engine is operating at maximum

00:22:48 --> 00:22:52

output, which varies with each piece of equipment and the

00:22:52 --> 00:22:56

operating conditions. Again, if you're working in harsh

00:22:56 --> 00:22:58

conditions, for example, you're going to have more fuel

00:22:58 --> 00:23:01

consumption, whereas if you're working in more favorable

00:23:01 --> 00:23:04

conditions, it's going to be less fuel consumption. Think about it

00:23:04 --> 00:23:08

again. To simplify things, think about it as your own car.

00:23:09 --> 00:23:13

The hourly fuel cost is going to be the fly with horse, horsepower,

00:23:13 --> 00:23:18

time, fuel factor, time, the fuel cost, and for the fuel factor, we

00:23:18 --> 00:23:22

again, each piece of equipment is going to have its own tables that

00:23:22 --> 00:23:26

can be used for that. So again, here for different types of

00:23:26 --> 00:23:31

equipment, and we have two columns, one for average

00:23:31 --> 00:23:35

conditions and one for unfavorable conditions. And then we have the

00:23:35 --> 00:23:41

two different types of of fuel, gasoline and diesel. By the way,

00:23:41 --> 00:23:44

these numbers are relatively old. They come from an old manual, and

00:23:44 --> 00:23:48

these have to be updated to reflect the increase in fuel

00:23:48 --> 00:23:51

prices. Of course, these prices are not valid right now, because,

00:23:51 --> 00:23:56

as we have seen just in the past couple of weeks or so, the gas

00:23:56 --> 00:24:00

prices have gone up. So it fluctuates from month to month,

00:24:00 --> 00:24:04

from year to year and so on. But in general, the trend is going up.

00:24:08 --> 00:24:12

Servicing costs again, to keep the equipment in a good condition, you

00:24:12 --> 00:24:16

have to maintain it. You have to spend some money to keep it in

00:24:16 --> 00:24:19

good condition. Filter oil and grease costs are estimated as a

00:24:19 --> 00:24:23

percentage of the hourly fuel cost. It Again, depends on the

00:24:23 --> 00:24:28

number of hours of operation of the equipment. So again, here we

00:24:28 --> 00:24:32

have a table that shows for different operating conditions,

00:24:32 --> 00:24:36

what would be the Equipment service factor as a percentage of

00:24:36 --> 00:24:38

the hourly fuel cost. The

00:24:40 --> 00:24:40

in

00:24:44 --> 00:24:48

downtime, we have already mentioned in class something about

00:24:49 --> 00:24:53

that piece of equipment working 50 minutes an hour or 45 minutes an

00:24:53 --> 00:24:57

hour or 55 minutes an hour or 30 minutes an hour. This is called

00:24:57 --> 00:24:59

downtime. Downtime is.

00:25:00 --> 00:25:03

Considered by using an operating factor when determining

00:25:03 --> 00:25:07

productivity rates. This operating factor, also known as efficiency

00:25:07 --> 00:25:11

factor, is a percentage equal to the amount actual number of

00:25:11 --> 00:25:16

minutes per hour the equipment is working and not idling. So the

00:25:16 --> 00:25:19

productive number of minutes per hour sometimes you need a few

00:25:19 --> 00:25:24

minutes to adjust the equipment, to orientate it, or to for the to

00:25:24 --> 00:25:27

start it up, to warm it up, or to cool it down, and things like

00:25:27 --> 00:25:31

that. This is not productive time, but it counts as part of the total

00:25:31 --> 00:25:36

duration the equipment is working. So it reduces the productivity of

00:25:36 --> 00:25:39

that equipment. We would say in this case that if the equipment

00:25:39 --> 00:25:45

works or produces 45 minutes of one hour. That's 45 over 60. So

00:25:45 --> 00:25:47

the efficiency of that piece of equipment, or the operating

00:25:47 --> 00:25:49

factor, is 75%

00:25:51 --> 00:25:55

there's no equipment that works at 100% efficiency. So the skill here

00:25:55 --> 00:25:58

is to maximize that efficiency. We know we're not going to be able to

00:25:58 --> 00:26:03

reach 100% but at the same time, we don't want it to be 30% or 20%

00:26:03 --> 00:26:04

that would be a lot of loss.

00:26:08 --> 00:26:12

And finally, the labor cost for the operator must be estimated

00:26:12 --> 00:26:18

using local wage rates and fringe percentages. And again, the human

00:26:18 --> 00:26:20

resources department in your company is going to know about

00:26:20 --> 00:26:23

that, and they're going to be responsible for giving you the

00:26:23 --> 00:26:27

numbers for the labor cost, the hourly wage rate, plus the cost of

00:26:27 --> 00:26:30

fringe benefits, including vacation, retirement insurance,

00:26:31 --> 00:26:36

whether it's health insurance and so on, workers comp, any other

00:26:36 --> 00:26:40

fringe benefits will have to be added to the labor cost. I

00:26:40 --> 00:26:40

dollars.

00:26:43 --> 00:26:46

Now let's look at an example. Contractor has purchased a wheeled

00:26:47 --> 00:26:51

loader. Wheel Loader means we're going to have tires \$414,000

00:26:52 --> 00:26:56

and plans to use it about 2000 hours per year.

00:26:57 --> 00:27:01

The contractor anticipates disposing of the loader after

00:27:01 --> 00:27:05

using it for six years. So the estimated total number of hours is

00:27:05 --> 00:27:08

12,000 hours, and realizing a salvage value of \$35,000.06

00:27:10 --> 00:27:11

years from now,

00:27:12 --> 00:27:17

tires, tires for the loader cost 4000 for a set of four, quite

00:27:17 --> 00:27:20

expensive, and the brake horsepower rating of the loaders.

00:27:20 --> 00:27:26

Diesel engine is 105 horsepower. The operator will earn \$35 an

00:27:26 --> 00:27:32

hour, including fringe benefits and diesel fuel costs 1.2 dollars

00:27:32 --> 00:27:35

per gallon. As you can see, these are old prices. Right now, it's

00:27:35 --> 00:27:36

close to \$4 a gallon

00:27:37 --> 00:27:40

at the minimum, attractive rate of return of 12%

00:27:41 --> 00:27:45

what are the contractors, hourly ownership and operating costs for

00:27:45 --> 00:27:50

the loader? So let's break down this information into smaller

00:27:50 --> 00:27:54

pieces and take it step by step to calculate what we need to know.

00:27:54 --> 00:27:57

First of all, as we have mentioned, we're going to subtract

00:27:57 --> 00:28:01

the cost of the tires from the purchase price of the equipment.

00:28:01 --> 00:28:03

So we have total purchase price 114,000

00:28:04 --> 00:28:07

the cost of the tires, 4000 therefore the cost of the

00:28:07 --> 00:28:10

equipment, we're gonna consider it as 110,000

00:28:14 --> 00:28:19

so the purchase price less tires, 114,000 minus 4000 that's 110,000

00:28:20 --> 00:28:24

the ownership cost is going to be the annual ownership cost plus

00:28:24 --> 00:28:28

labor cost plus operating cost plus repair cost. And what we have

00:28:28 --> 00:28:34

here at the bottom is a cash flow for that equipment. So we have a

00:28:34 --> 00:28:38

purchase price minus the tires at the beginning, and then six years

00:28:38 --> 00:28:42

later we have a salvage value. And in between, we're going to assume

00:28:42 --> 00:28:46

we have annual cost, which is going to be like an annuity.

00:28:48 --> 00:28:54

I would like you to to try to work on that problem at home and show

00:28:54 --> 00:28:57

me your answer and be glad to discuss it in class. Or we can

00:28:57 --> 00:29:01

discuss it one on one, just follow the instructions and follow the

00:29:01 --> 00:29:05

tables that we have used. It's a very straightforward problem.

00:29:07 --> 00:29:11

Now we're going to move to overheads, which are added to the

00:29:11 --> 00:29:15

direct operating cost. These include allowances for general

00:29:15 --> 00:29:16

00:29:18 --> 00:29:23

and project overhead expenses, general overhead expenses, like,

00:29:23 --> 00:29:27

for example, you have a headquarters and you are renting a

00:29:27 --> 00:29:31

building, and you have telephone costs, stationary heat, trend cost

00:29:31 --> 00:29:32

of either equipment,

00:29:34 --> 00:29:38

etc. All of these are general overheads or administrative

00:29:38 --> 00:29:41

overheads. And at the same time, you also have indirect cost on the

00:29:41 --> 00:29:45

project itself, including the salary and the cost of the

00:29:45 --> 00:29:48

superintendent, the project manager, a secretary outside, a

00:29:48 --> 00:29:52

security guard, maybe a temporary fence around the site, maybe a

00:29:52 --> 00:29:57

temporary access road. All of these are considered as overheads

00:29:57 --> 00:29:59

because they are not part of the permanent construction.

00:30:00 --> 00:30:02

It. And you cannot pinpoint

00:30:03 --> 00:30:07

any particular cost item for the cost of the project manager. For

00:30:07 --> 00:30:10

example, the salary of the project manager. The project manager is

00:30:10 --> 00:30:16

not gonna lay bricks or pour concrete or erect steel and so on.

00:30:16 --> 00:30:19

He's going to be supervising the whole operation. Therefore, the

00:30:19 --> 00:30:23

salary of the project manager has to be absorbed by all of these

00:30:23 --> 00:30:24

different pay items in the bid.

00:30:27 --> 00:30:31

Finally, profit. And that would vary from one company to another

00:30:31 --> 00:30:34

and to vary from one market to another based on the current

00:30:34 --> 00:30:38

market conditions and based on the competition. So it's a percentage

00:30:38 --> 00:30:41

of the markup which is added to provide for an income or profit

00:30:41 --> 00:30:44

element, because, again, you have money locked in that piece of

00:30:44 --> 00:30:48

equipment, you need to have a return on that investment in the

00:30:48 --> 00:30:49

form of that profit.

00:30:52 --> 00:30:56

That ends our first part of the lecture talking about the

00:30:56 --> 00:31:03

different costs components of ownership, operation, overheads

00:31:03 --> 00:31:07

and profit, and now we're going to focus on equipment depreciation.

00:31:07 --> 00:31:11

How does that affect the cost of the equipment? And how are we

00:31:11 --> 00:31:13

going to calculate the depreciation? What are the

00:31:13 --> 00:31:17

different methods for the calculation of depreciation? So

00:31:17 --> 00:31:21

first of all, what is depreciation? It is the decrease

00:31:21 --> 00:31:25

in equipment book value due to its usage or due to time.

00:31:27 --> 00:31:30

So if you have purchased a piece of equipment today, brand new, it

00:31:30 --> 00:31:31

costs you \$200,000

00:31:33 --> 00:31:35

you have used it for a year,

00:31:36 --> 00:31:41

then it has lost part of its value because of the consumption of that

00:31:41 --> 00:31:42

equipment, the wear and tear.

00:31:44 --> 00:31:47

On the other hand, if you kept this piece of equipment brand new,

00:31:47 --> 00:31:48

locked in a storage area

00:31:49 --> 00:31:52

and try to sell it, one year later, the price is going to drop

00:31:52 --> 00:31:56

down again. Why? Because of relative obsolescence, there's got

00:31:56 --> 00:31:59

to be a new model with new features and so on. Same thing

00:31:59 --> 00:32:03

again, as your car. Think about your car as a piece of equipment.

00:32:04 --> 00:32:07

Most of the cars, unless it's an is considered as an antique car or

00:32:07 --> 00:32:12

something like that. Don't watch these shows on on TV, but regular

00:32:12 --> 00:32:13

cars, the one that you and I drive,

00:32:15 --> 00:32:18

if you use it, you're going to lose money. If you don't use it

00:32:18 --> 00:32:23

and keep it garaged, you're still going to lose money. So you lose

00:32:23 --> 00:32:23

either way,

00:32:25 --> 00:32:28

it's an expense that can be deducted from revenues, resulting

00:32:28 --> 00:32:32

in lower taxes. Now this is the positive aspect of depreciation.

00:32:32 --> 00:32:36

Since the value of your asset has decreased, you have to pay less

00:32:36 --> 00:32:38

taxes on that asset.

00:32:39 --> 00:32:42

The resulting tax savings can be used to replace the equipment. So

00:32:42 --> 00:32:46

instead of saying, Okay, I have a tax break because of the age of

00:32:46 --> 00:32:49

that piece of equipment, so I'm gonna use these savings to go on a

00:32:49 --> 00:32:53

trip, for example. No, that's not the purpose of the tax break. The

00:32:53 --> 00:32:56

purpose of the tax break is enabling you, enabling you to save

00:32:56 --> 00:33:00

some more money so that when this piece of equipment becomes totally

00:33:00 --> 00:33:03

obsolete, you would be able to replace it with these savings.

00:33:03 --> 00:33:09

That's the major purpose of these tax breaks due to depreciation,

00:33:12 --> 00:33:15

as we mentioned, it's caused by wear and tear, deterioration,

00:33:15 --> 00:33:20

obsolescence or reduced need, and the depreciation determines the

00:33:20 --> 00:33:24

decline in market value during time period. So if I want to know,

00:33:24 --> 00:33:27

for example, at the end of the third year, what is that piece of

00:33:27 --> 00:33:30

equipment worth, how much has it depreciated, I should be able to

00:33:30 --> 00:33:34

determine that determines the depreciation amount to use in

00:33:34 --> 00:33:39

replacement decision analysis. So knowing how much by how much has

00:33:39 --> 00:33:43

the equipment depreciated, and what's the book value?

00:33:44 --> 00:33:47

When am I going to be able to save enough money to replace that piece

00:33:47 --> 00:33:51

of equipment? That's going to come from these calculations. It's also

00:33:51 --> 00:33:53

used to evaluate the tax liability, how much taxes do you

00:33:53 --> 00:33:58

have to pay? And realistically reflects the asset and the

00:33:58 --> 00:34:01

liability of a company. This is something related to accounting

00:34:01 --> 00:34:05

and bookkeeping. When maintaining the assets and liability columns,

00:34:05 --> 00:34:07

depreciation is going to come into play there.

00:34:10 --> 00:34:13

There are four different methods to calculate depreciation. Which

00:34:13 --> 00:34:16

one are you going to follow? Either one is fine. Any of these

00:34:16 --> 00:34:20

four methods is fine. Each one has its pros and cons. We're going to

00:34:20 --> 00:34:23

learn about that in a minute. So there we have something called a

00:34:23 --> 00:34:27

straight line depreciation method, which is the most straightforward,

00:34:27 --> 00:34:32

the easiest one to calculate some of the years. Method, declining

00:34:32 --> 00:34:37

balance method, and finally, production method. Production

00:34:37 --> 00:34:41

method depends on the equipment is going to depreciate depending on

00:34:41 --> 00:34:45

how much use you actual usage? Have we used it for? So for

00:34:45 --> 00:34:49

example, you'd say, all right, in the first year I drove my car

00:34:49 --> 00:34:54

30,000 miles, but in the second year I drove it only 5000 miles.

00:34:54 --> 00:34:56

Should the depreciation be the same? No, in this case, according

00:34:56 --> 00:34:59

to the production method, it's going to depreciate more during.

00:35:00 --> 00:35:03

The first year because you drove it more and less during the second

00:35:03 --> 00:35:06

year because you drove it less. So let's look at each one of these

00:35:06 --> 00:35:10

four different methods and see what it entails. How to make the

00:35:10 --> 00:35:12

calculations and make some comparison between them.

00:35:14 --> 00:35:18

The straight line depreciation method depreciates the equipment

00:35:18 --> 00:35:22

value equally in each of the years the equipment is owned. So

00:35:22 --> 00:35:27

regardless of how much you have used it, as long as you have owned

00:35:27 --> 00:35:30

it for a year, there's a fixed amount of depreciation for that

00:35:30 --> 00:35:33

year. It doesn't vary between the first year and the last year of

00:35:33 --> 00:35:36

the life of that equipment. It's exactly the same amount.

00:35:38 --> 00:35:42

So n, r is the annual depreciation rate. We're going to learn about

00:35:42 --> 00:35:46

that in a minute. N is the number of years the equipment is owned,

00:35:47 --> 00:35:52

so r is the reverse of N. It's one over n. If you're going to piece

00:35:52 --> 00:35:56

that own that piece of equipment for six years, then r is equal to

00:35:56 --> 00:36:00

one over six. If you're going to own it for 10 years, R is going to

00:36:00 --> 00:36:03

be one over 10. If you're going to own it only for two years, then 1r

00:36:04 --> 00:36:05

is going equal to one over 2d.

00:36:07 --> 00:36:12

Is the annual depreciation amount in dollar amount. P is the

00:36:12 --> 00:36:17

purchase price, and F is a salvage value at the end of n years.

00:36:18 --> 00:36:21

Again, if you're going to own this equipment for six years and then

00:36:21 --> 00:36:24

sell it, then you're going to get some money at the end of six

00:36:24 --> 00:36:29

years. That's the salvage value, which is f. Therefore the

00:36:29 --> 00:36:33

depreciation, the annual depreciation amount, the actual

00:36:33 --> 00:36:37

amount you have to deduct for depreciation, is equal to r times

00:36:37 --> 00:36:41

p minus F, r times p minus F,

00:36:43 --> 00:36:48

the book value, equipment value at the end of each year after the

00:36:48 --> 00:36:51

annual depreciation has been subtracted. So at the end of the

00:36:51 --> 00:36:55

first year, what's my equipment worth at the end of the second

00:36:55 --> 00:36:58

year, which would be BV two, the book value at the end of year two,

00:36:58 --> 00:37:06

BV four, at the end of year four, etc. So BVM is equal to BVM minus

00:37:06 --> 00:37:11

one the previous year minus dM, the book value at year M, let's

00:37:11 --> 00:37:16

say at year five is equal to the book value at year four minus the

00:37:16 --> 00:37:19

amount of depreciation for year

00:37:21 --> 00:37:26

five, which, in case of straight line, is going to be the same, DM,

00:37:26 --> 00:37:32

d1, is equal to d2, is equal to D, M, it's exactly the same. So book

00:37:32 --> 00:37:37

value m is the book value in year M, dv, m minus one is the book

00:37:37 --> 00:37:41

value at the year m minus one, and DM is the annual depreciation

00:37:41 --> 00:37:44

amount, again, in straight line method, that amount is the same

00:37:44 --> 00:37:45

regardless of the year.

00:37:47 --> 00:37:50

And this is the graphical representation of the straight

00:37:50 --> 00:37:52

line method. As you can see, it's a straight line.

00:37:53 --> 00:37:56

00:37:57 --> 00:37:59

and we end with the salvage value,

00:38:00 --> 00:38:03

and we depreciate the price of the equipment over the years. In this

00:38:03 --> 00:38:06

case, for example, the service life of that equipment is five

00:38:06 --> 00:38:10

years. We depreciate it over the years, and that amount would be

00:38:10 --> 00:38:15

the annual depreciation amount. So it's \$3,000 per year, as you can

00:38:15 --> 00:38:16

see from the graph.

00:38:20 --> 00:38:23

Again, an example is going to make things very clear,

00:38:24 --> 00:38:26

a contractor purchase a greater for \$250,000

00:38:27 --> 00:38:28

so P is 250,000

00:38:29 --> 00:38:35

and plans to use it for six years. N is six years. The estimated

00:38:35 --> 00:38:38

salvage value is 60,000 F is 60,000

00:38:40 --> 00:38:44

using the straight line method of depreciation accounting, what is

00:38:44 --> 00:38:47

the annual depreciation amount of and the book value of the

00:38:47 --> 00:38:52

equipment at the end of the third year? So m is equal to three.

00:38:52 --> 00:38:57

Let's look at the application of the equations R, the annual

00:38:57 --> 00:39:02

depreciation rate. These are the equations here, D, annual

00:39:02 --> 00:39:07

depreciation amount, which is r times p minus F, the book value at

00:39:07 --> 00:39:12

year M is BVM minus one minus dM. So book value at the end of year

00:39:12 --> 00:39:18

one book value at the year zero, which is the purchase price minus

00:39:18 --> 00:39:23

depreciation at year one book value at the end of year two is

00:39:23 --> 00:39:26

the book value of year at the end of year one minus depreciation.

00:39:26 --> 00:39:30

Book value at year three, book value at year two minus

00:39:30 --> 00:39:32

depreciation. Let's look at the numbers.

00:39:33 --> 00:39:36

We said that the service life is going to be six years. Therefore R

00:39:36 --> 00:39:40

is the verse of n, reverse of n1, over n. So it's point 167,

00:39:42 --> 00:39:47

the annual depreciation amount is R. D equals r times p minus f,

00:39:47 --> 00:39:51

which is point 167, that factor times the purchase price, 250,000

00:39:52 --> 00:39:55

minus 60,000 the salvage value, which is 190,000

00:39:57 --> 00:39:59

and that gives us 31,006

00:40:00 --> 00:40:00

166.6

00:40:01 --> 00:40:06

\$7 per year, the value of that equipment is going to go down by

00:40:06 --> 00:40:12

that fixed amount every year, the book value, BVM, BVM minus one

00:40:12 --> 00:40:16

minus dM. So at the end of year one, the book value at the

00:40:16 --> 00:40:22

purchase price 250,000 minus the depreciation for year 130 1000 so

00:40:22 --> 00:40:25

the book value at the end of year one 218 333,

00:40:27 --> 00:40:29

at year two, we're gonna start with the book value of the

00:40:29 --> 00:40:33

previous year. 218 333, minus 31 666,

00:40:35 --> 00:40:35

which gives us 186.666

00:40:38 --> 00:40:41

at the end of year three, which is what we're looking for. We're

00:40:41 --> 00:40:42

00:40:43 --> 00:40:44

minus 31 666,

00:40:45 --> 00:40:46

which gives us \$155,000

00:40:47 --> 00:40:52

value of that equipment at the end the book value of the equipment at

00:40:52 --> 00:40:54

the end of year. Three, very straightforward, very easy.

00:40:58 --> 00:41:03

So here's a table that shows the value of that equipment, the book

00:41:03 --> 00:41:07

value at the end of each year up till the time you sell it at the

00:41:07 --> 00:41:10

end, at the salvage value, which is the 60,000

00:41:12 --> 00:41:16

and as you can see, depreciation amount does not vary with the

00:41:16 --> 00:41:19

years. It's the same every year. That's a straight line method,

00:41:22 --> 00:41:25

a second method, which is called the sum of the years method.

00:41:27 --> 00:41:30

In this case, we do not have a fixed amount for the depreciation.

00:41:30 --> 00:41:34

It varies from one year to another. The annual depreciation

00:41:34 --> 00:41:38

rate differs for each year. In this case, the annual depreciation

00:41:38 --> 00:41:45

rate is equal to n minus m plus one divided by sum of the years.

00:41:45 --> 00:41:49

What does that mean? N is the number of years the equipment is

00:41:49 --> 00:41:52

owned the service life of that equipment. In the previous

00:41:52 --> 00:41:53

example, it was 6m.

00:41:55 --> 00:41:57

Is the specific years in which depreciation is being determined.

00:41:58 --> 00:42:01

So in the previous example, we wanted to know what's the book

00:42:01 --> 00:42:03

value at the end of the third year. In this case, M would be

00:42:03 --> 00:42:04

equal to three.

00:42:05 --> 00:42:09

Soy, which is the sum of the years, is the sum of the years

00:42:09 --> 00:42:15

that equals n plus n minus one plus n minus two, and so on, which

00:42:15 --> 00:42:20

is sort of the factorial of n divided by two. So the sum of the

00:42:20 --> 00:42:24

years is equal to n times n plus one over two.

00:42:26 --> 00:42:27

Remember this equation

00:42:28 --> 00:42:32

and the annual depreciation amount very similar to the previous

00:42:33 --> 00:42:41

example, straight line, DM equals RM times p minus f, so the sum of

00:42:41 --> 00:42:47

the years is already incorporated in the RM, and therefore DM

00:42:47 --> 00:42:51

becomes same equation as with a straight line. The annual

00:42:51 --> 00:42:57

depreciation amount is the annual depreciation rate times purchase

00:42:57 --> 00:43:00

price minus salvage value,

00:43:02 --> 00:43:05

looking at the same example with exactly the same numbers,

00:43:06 --> 00:43:06

250,006

00:43:07 --> 00:43:12

years, average value, 60,000 now we're going to use the sum of the

00:43:12 --> 00:43:15

years method and see what's the value of that equipment at the end

00:43:15 --> 00:43:19

of the third year. Let's go back a couple of slides here. At the end

00:43:19 --> 00:43:21

of the third year, according to straight line,

00:43:22 --> 00:43:23

the value was \$155,000

00:43:24 --> 00:43:27

remember that, and the depreciation amount per year was

00:43:27 --> 00:43:28

31,666.67

00:43:30 --> 00:43:34

now let's see, according to the sum of the years, how are these

00:43:34 --> 00:43:35

numbers gonna differ?

00:43:38 --> 00:43:42

Notice here that at the very beginning, the depreciation amount

00:43:42 --> 00:43:47

is really high, and then it starts going down and down and down.

00:43:48 --> 00:43:55

So the sum of the years again, n equals six, so soy equals six

00:43:55 --> 00:44:00

times six plus one, seven divided by two, so six times seven over

00:44:00 --> 00:44:01

two that's 21

00:44:03 --> 00:44:11

now Rm is equal to n minus m plus one divided by Soi, n 6m

00:44:12 --> 00:44:17

at the end of third year, three plus one divided by

00:44:18 --> 00:44:23

Soi, which is 21 so six minus three plus one divided by 21

00:44:24 --> 00:44:28

that's the rate that we're looking for for the third year,

00:44:29 --> 00:44:31

which is point 1905,

00:44:33 --> 00:44:36

the depreciation amount is that factor point 1905,

00:44:37 --> 00:44:41

which is going to vary again from one year to another, times

00:44:41 --> 00:44:45

purchase price minus salvage value. So point 1905, times

00:44:45 --> 00:44:50

250,000 minus 60,000 and that gives 36,000 \$190.48

00:44:53 --> 00:44:57

compare that again with the number that we got from here. 31 660,

00:44:58 --> 00:44:58

6.67

00:44:59 --> 00:44:59

you.

00:45:00 --> 00:45:03

Find that the sum of years gives a higher

00:45:06 --> 00:45:10

depreciation rate at still at year three, year four is going to be

00:45:10 --> 00:45:11

less.

00:45:12 --> 00:45:15

And the book value here is equal to \$114,285.70

00:45:19 --> 00:45:23

in the previous example, I believe it was 115 Oh, it was 155

00:45:24 --> 00:45:27

so again, the book value is much less in this case,

00:45:29 --> 00:45:32

which means you're going to pay less taxes, so you have a higher

00:45:32 --> 00:45:35

depreciation rate, and that's going to enable you to have lower

00:45:35 --> 00:45:38

taxes to pay for the equipment. That's one of the benefits of

00:45:38 --> 00:45:40

using the sum of the year's method.

00:45:44 --> 00:45:49

The third method is called declining balance. Declining

00:45:49 --> 00:45:53

Balance also assumes that you're going to have a higher

00:45:53 --> 00:45:56

depreciation at the beginning, lower depreciation at the end.

00:45:56 --> 00:45:59

Looking at the same example that we've been giving your car,

00:46:01 --> 00:46:06

if you purchase a used car, the difference between a 2007 and a

00:46:06 --> 00:46:10

2008 model is not going to be that much. Of course, the 2008 is going

00:46:10 --> 00:46:12

to be more expensive, but the differential is going to be small.

00:46:13 --> 00:46:17

Compared to a 2011 from a 2012

00:46:18 --> 00:46:22

as they always say, you lose about

00:46:25 --> 00:46:29

maybe 10% of the value of your car in the first 15 minutes.

00:46:30 --> 00:46:35

If you drive it out of the lot of the car dealership for five miles,

00:46:36 --> 00:46:39

you lose about 110 of the value of that car because it's already a

00:46:39 --> 00:46:43

used car. So the depreciation at the very beginning is very high,

00:46:44 --> 00:46:48

and then it keeps on going down as the equipment becomes older.

00:46:49 --> 00:46:54

When applied to equipment purchased secondhand, if you buy a

00:46:54 --> 00:46:57

used equipment, it assumes that the initial value is 150%

00:46:59 --> 00:47:00

of the straight line rate.

00:47:03 --> 00:47:06

And for new equipment, the rate is calculated by dividing 200%

00:47:08 --> 00:47:12

by the number of service life years. So that's why it's called,

00:47:12 --> 00:47:15

sometimes double declining balance, that you assume that the

00:47:15 --> 00:47:19

value of the equipment is 200% of its own, of its value if it's

00:47:19 --> 00:47:22

calculated at the straight line method. We're going to see a

00:47:22 --> 00:47:24

numerical example on that as well,

00:47:26 --> 00:47:30

just graphically looking at a declining balance, or double

00:47:30 --> 00:47:35

declining balance and straight line. If you can see here, the

00:47:35 --> 00:47:39

amount of depreciation for the straight line is fixed. The height

00:47:39 --> 00:47:42

of each step is exactly the same for the service life of the

00:47:42 --> 00:47:45

equipment, whereas in case of declining double declining

00:47:45 --> 00:47:51

balance, huge depreciation the first year little bit less the

00:47:51 --> 00:47:55

second year less the third year by the fourth year is much less than

00:47:55 --> 00:47:56

the straight line.

00:47:57 --> 00:48:00

So again, that enables you to deduct a lot of the value of the

00:48:00 --> 00:48:05

equipment at its early service life.

00:48:08 --> 00:48:11

Now, for the calculations of the declining balance, the annual

00:48:11 --> 00:48:15

depreciation rate is applied each year to the remaining book value.

00:48:16 --> 00:48:19

The annual depreciation rate is x over n.

00:48:20 --> 00:48:25

In the previous examples, we had one over n. Now here we have x

00:48:25 --> 00:48:29

over n. That's the major difference, that x is it can range

00:48:29 --> 00:48:34

anywhere between 1.25 to two. We mentioned that for new equipment,

00:48:34 --> 00:48:37

it's going to be two. For used equipment, it's going to be in a

00:48:37 --> 00:48:41

good condition, it's going to be 1.5 in a not so good condition, it

00:48:41 --> 00:48:42

might be as low as 1.2 5n.

00:48:44 --> 00:48:47

Is the number of years the equipment is going to be owned,

00:48:47 --> 00:48:52

and the actual annual depreciation amount is going to be the book

00:48:52 --> 00:48:52

value

00:48:54 --> 00:48:57

at that year minus one times r.

00:48:59 --> 00:49:02

So again, same example, just to have a comparison,

00:49:03 --> 00:49:03

250,006

00:49:05 --> 00:49:08

years, 60,000 and we need to know

00:49:09 --> 00:49:13

at the end of the third year. Now assuming that, when the contractor

00:49:13 --> 00:49:17

purchased that piece of equipment, was it new, or was it used? Let's

00:49:17 --> 00:49:23

see. It says assume x is 1.5 which means it was used, because if that

00:49:23 --> 00:49:29

equipment was purchased new, then x would be equal to two. So based

00:49:29 --> 00:49:32

on this information, let's see how we're going to calculate the

00:49:32 --> 00:49:33

depreciation rate.

00:49:34 --> 00:49:41

R equals 1.5 over 6x over n, which is equal to point two five. So the

00:49:41 --> 00:49:45

depreciation rate is point two five, and that's fixed. However,

00:49:45 --> 00:49:49

the depreciation amount is going to vary again, if you look at it

00:49:49 --> 00:49:54

this way, at the very first year, very high depreciation rate, which

00:49:54 --> 00:49:55

is based on this equation,

00:49:58 --> 00:49:59

the book value at here.

00:50:00 --> 00:50:04

By m minus one divided by times r.

00:50:11 --> 00:50:14

So in this case, it was the 250,000

00:50:16 --> 00:50:19

which is the book value at year m minus one year zero

00:50:22 --> 00:50:25

times R, which is point two five, which means 250,000

00:50:26 --> 00:50:30

divided by four gave us the depreciation amount 62,500,

00:50:31 --> 00:50:36

subtracting that amount from the from the book value at Year Zero,

00:50:36 --> 00:50:37

which was the 250,000

00:50:38 --> 00:50:40

gives us a book value at year one of 187,500

00:50:43 --> 00:50:45

we're going to use that book value at year one to calculate

00:50:45 --> 00:50:49

depreciation at year two, the value at year two to calculate

00:50:49 --> 00:50:55

depreciation at year three, and so on. And look at this. We started

00:50:55 --> 00:50:59

with a depreciation, rate of depreciation amount of \$62,500

00:51:01 --> 00:51:06

by the end of year one. And look at this at the end of year six,

00:51:06 --> 00:51:07

it's \$56

00:51:08 --> 00:51:12

negligible. So we have already consumed all of the that piece of

00:51:12 --> 00:51:13

equipment.

00:51:18 --> 00:51:18

Okay,

00:51:19 --> 00:51:24

so again, here, here's an example between buying a piece of

00:51:24 --> 00:51:29

equipment using it for five years. If it's purchased new, then 200%

00:51:29 --> 00:51:33

is going to be divided by five years, giving 40% every year. If

00:51:33 --> 00:51:35

it's purchase used, we're going to use 150%

00:51:37 --> 00:51:42

so 150% divided by five years, gives 30% every year, and based on

00:51:42 --> 00:51:46

the value of equipment, we're going to calculate the

00:51:47 --> 00:51:50

depreciation for each year. And as you can see, it's dropping down

00:51:50 --> 00:51:51

very quickly.

00:51:56 --> 00:51:59

The last method, which is the production or use method, it's

00:51:59 --> 00:52:03

very simple. It's not a function of age of the asset for a specific

00:52:03 --> 00:52:07

year, the depreciation depends on the amount of asset usage in that

00:52:07 --> 00:52:10

year. So if we're gonna you purchase that piece of equipment

00:52:10 --> 00:52:11

for 250,000

00:52:12 --> 00:52:17

sell it in six years for 60,000 and we know we're gonna use it for

00:52:17 --> 00:52:20

a total of, let's say, 100,000 hours, or 10,000 hours, whatever

00:52:20 --> 00:52:24

number of hours we're going to have, a proportion of that for

00:52:24 --> 00:52:28

each year. If I use it for 2000 hours per year, the cost per hour

00:52:28 --> 00:52:32

is that much. So the depreciation for that year is that much. If I

00:52:32 --> 00:52:35

use it more in the second year or less in the second year, the

00:52:35 --> 00:52:39

depreciation can go up or down. In all the other examples, we found

00:52:39 --> 00:52:44

that the depreciation either was straight line equal, or it started

00:52:44 --> 00:52:48

going down as in the sum of years, or in the declining balance here,

00:52:48 --> 00:52:52

however we have the exception, it can go up, because if you use it

00:52:52 --> 00:52:55

more, the depreciation amount can go up.

00:52:58 --> 00:53:00

So here is an example

00:53:01 --> 00:53:04

at the end of Year Zero, we did not use it. That was the book

00:53:04 --> 00:53:05

value.

00:53:06 --> 00:53:10

And this is the salvage value. So the consumption is going to be

00:53:10 --> 00:53:10

100,000

00:53:15 --> 00:53:21

we used. We produced 2800 cubic yards. So 2800

00:53:22 --> 00:53:28

times 10, which is the cost per hour, gave us 28,000 so the

00:53:28 --> 00:53:32

equipment value dropped by 28,000 the following year we only used

00:53:33 --> 00:53:39

1600 cubic yards, so which means a certain number of hours, therefore

00:53:39 --> 00:53:43

the consumption was 16,000 less than the previous year, and then

00:53:43 --> 00:53:47

the third year, we used it more. So the consumption went up, the

00:53:47 --> 00:53:50

depreciation went up as well, and so on. It can go up or down

00:53:50 --> 00:53:54

depending on the amount of usage, and that's why it's called the

00:53:54 --> 00:53:54

usage.

00:53:59 --> 00:54:03

There's another concept that's called amortization of the

00:54:03 --> 00:54:07

equipment. Amortizing the equipment comes from more M, O, R

00:54:07 --> 00:54:14

T, which means that that's a Latin word. So the practice we're going

00:54:14 --> 00:54:17

to assume that we're going to consume totally that piece of

00:54:17 --> 00:54:22

equipment with zero salvage value on this particular project. So we

00:54:22 --> 00:54:25

bought the equipment new by the end of the project, that equipment

00:54:25 --> 00:54:27

is going to be worthless, therefore we're going to charge

00:54:28 --> 00:54:32

all of its cost to the client as part of our bid price. So the

00:54:32 --> 00:54:35

practice of charging the owner an amount to be used to purchase

00:54:35 --> 00:54:40

replacement equipment is referred to as amortizing the equipment. We

00:54:40 --> 00:54:44

are killing that equipment gradually, amortization leads to

00:54:44 --> 00:54:49

larger revenue, resulting in taxes on the amount charged to the owner

00:54:49 --> 00:54:53

to amortize the equipment. So that's sort of an opposite of

00:54:54 --> 00:54:55

depreciation.

00:54:56 --> 00:54:59

It's again, we're going to assume that the total value of the

00:54:59 --> 00:54:59

equipment is going.

00:55:00 --> 00:55:03

To be used over that particular project, so we're going to charge

00:55:03 --> 00:55:06

the whole value of the equipment to that particular project, which

00:55:06 --> 00:55:10

is going to result in more receivables from the owner higher

00:55:10 --> 00:55:13

price, which means we're going to have to pay more taxes.

00:55:16 --> 00:55:21

Now renting versus purchasing, there are some advantages to

00:55:21 --> 00:55:24

00:55:24 --> 00:55:27

definitely will give you a lower price per unit for the production

00:55:27 --> 00:55:31

that you achieve. However, what are the benefits of renting that?

00:55:31 --> 00:55:36

Advantages of renting equipment include, first of all, no large

00:55:36 --> 00:55:41

inventory of specialized equipment with infrequent use, so we're not

00:55:41 --> 00:55:44

gonna buy every piece of equipment that we need. There are some

00:55:44 --> 00:55:47

pieces of equipment that we're gonna use probably once every

00:55:47 --> 00:55:50

other project, once every other year. There's no meaning in

00:55:50 --> 00:55:54

keeping that equipment on our books and locking the money in the

00:55:54 --> 00:55:58

value the asset of that equipment. So it would be better to rent it

00:55:58 --> 00:55:59

whenever we need it,

00:56:00 --> 00:56:05

continuous access to new and efficient equipment. Again, you're

00:56:05 --> 00:56:08

going to rent the state of the art. If there are any new

00:56:08 --> 00:56:10

developments in the equipment market, they're going to be

00:56:10 --> 00:56:14

reflected in the newer models. Whereas your older, older model,

00:56:14 --> 00:56:17

if you do not upgrade it or update it, which is going to cost you

00:56:17 --> 00:56:19

money, is not going to be the state of the art.

00:56:20 --> 00:56:24

No need for warehouse and storage facilities. You're going to bring

00:56:24 --> 00:56:27

it only when you need to use it and return it whenever you don't.

00:56:27 --> 00:56:32

So you don't have to keep it stored, saving on insurance

00:56:32 --> 00:56:34

premiums because you do not own that piece of equipment. Therefore

00:56:34 --> 00:56:38

you don't have to pay the insurance for owning it. And

00:56:38 --> 00:56:42

reduced need for maintenance and easier accounting. Easier

00:56:42 --> 00:56:45

accounting, because very clearly, the cost of equipment, in this

00:56:45 --> 00:56:48

case, is going to be the rental price that you pay. We're not

00:56:48 --> 00:56:51

going to worry about Depreciation or Amortization or anything like

00:56:51 --> 00:56:55

that. It's just the rental price that you pay and no maintenance

00:56:55 --> 00:56:58

fee. However, no maintenance fee on the other hand, because again,

00:56:59 --> 00:57:02

you're gonna rent it in a good condition, you're going to return

00:57:02 --> 00:57:06

it in a good condition. The renting agency is going to service

00:57:06 --> 00:57:09

that equipment. Is going to maintain it so that next time you

00:57:09 --> 00:57:13

rent it again, it's still in a good condition. Going back to the

00:57:13 --> 00:57:18

same example, think about going on a long trip, and you don't want to

00:57:18 --> 00:57:22

overuse your car, or you're not sure whether your car is in good

00:57:22 --> 00:57:25

condition or not. Is it going to break down or not? So in this

00:57:25 --> 00:57:28

case, you may decide, okay, I'm gonna rent I'm gonna rent a car.

00:57:28 --> 00:57:32

It's gonna be more expensive to rent the car. You know, the your

00:57:32 --> 00:57:38

car doesn't cost you \$50 a day or \$100 a day, right? So, but on the

00:57:38 --> 00:57:41

other hand, you're getting the peace of mind that if anything

00:57:41 --> 00:57:44

goes wrong, I'm just gonna return that car and I'm gonna get a new

00:57:44 --> 00:57:48

one, and this car is going to be the latest model, is going to be

00:57:48 --> 00:57:52

well maintained. I don't have to pay any insurance, I don't have to

00:57:52 --> 00:57:55

pay any taxes. It's just a rental price that I'm going to be paying.

00:57:58 --> 00:58:03

And finally, here is an example on the ownership cost. It shows the

00:58:03 --> 00:58:07

different elements that we have talked about so far, and it shows

00:58:07 --> 00:58:11

sort of a breakdown of the example that we have discussed at the

00:58:11 --> 00:58:15

beginning of this lecture. I hope that in this lecture, you've

00:58:15 --> 00:58:19

learned about what are the elements of equipment cost,

00:58:19 --> 00:58:23

including ownership, operation, overheads

00:58:24 --> 00:58:25

and profit

00:58:27 --> 00:58:30

and utilization, including

00:58:31 --> 00:58:36

taxes, including permits, etc. And then we learned about how the

00:58:36 --> 00:58:39

breakdown of each one of these, how to calculate each one of

00:58:39 --> 00:58:44

these. We also learned about the different methods for depreciating

00:58:44 --> 00:58:47

the equipment. We talked about four different methods. We looked

00:58:47 --> 00:58:53

at the comparison of the four. It's all on accounting principles,

00:58:53 --> 00:58:58

by the way, and the IRS accepts any of these different methods for

00:58:58 --> 00:59:01

accounting. All of them are accepted, whether it's going to be

00:59:01 --> 00:59:06

straight line or some of the years, or is going to be the

00:59:06 --> 00:59:10

double declining balance or the utilization and use method. And

00:59:10 --> 00:59:13

then we talked about amortizing the equipment. What do we mean by

00:59:13 --> 00:59:18

amortization? And then finally, if we are able to calculate the cost

00:59:18 --> 00:59:22

of ownership of the equipment at every year, or based on the number

00:59:22 --> 00:59:26

of hours or number of units of utilization, we can easily compare

00:59:26 --> 00:59:31

that to the cost of rental, and we can make the decision whether it's

00:59:31 --> 00:59:34

going to be more economical to rent the equipment, or is it going

00:59:34 --> 00:59:38

to be more feasible to own that equipment and account for all of

00:59:38 --> 00:59:42

these differences. I hope you learned about all of these things,

00:59:42 --> 00:59:45

and I'd be glad to answer any questions when we meet in class.

00:59:46 --> 00:59:47

Have a great day bye.

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