In countless organizations around the country, the "Great Recession" has sidetracked—if not wreaked havoc on—fleet replacement plans and funding levels. Unlike employees, vehicles don't talk back when officials decide trimming fleet size or postponing replacement purchases is a good way to help balance an organization's budget. And let's be honest about such cuts: deferring $1 million worth of replacement purchases this fiscal year in a fleet that typically spends this amount annually on fleet replacement will not result in an immediate increase in fleet operating costs of $1 million or more.

We all know there is an inherent trade-off between fleet capital and operating costs: spend more on replacement to replace vehicles sooner, and operating costs will be lower and residual values higher; spend less on replacement, however, and the reverse will be true. But such trade-offs don't occur so quickly that most organizations can't "save" money in a given fiscal year by postponing replacement purchases.

Over the long term, however, organizations risk increasing overall fleet costs by curtailing replacement spending too much in pursuit of short-term budget savings. Depending on the current age of a given fleet, the supposed savings from such actions may prove nothing more than a temporary, costly illusion. While recessions often serve a useful corrective to unchecked increases in fleet size and fleet-related spending that can occur during economic boom times, fleet managers should work very hard to try to prevent such economically difficult times from doing lasting damage to fleet replacement plans and, as a consequence, to the performance and total cost of ownership of their fleets.

In keeping with the old adage that necessity is the mother of invention, fleet managers need not view the recent recession and its continuing aftermath simply as a time to keep their heads down and wait for the economic storm clouds to clear, but rather as an opportune time to reassess and perhaps re-engineer the methods they use to manage and pay for fleet replacement costs. Significant fiscal challenges represent an opportunity to explore fleet management strategies and practices often given little attention during good times and to get decision makers to consider which courses of action really can reduce fleet costs and which ones won't.

Vehicle Replacement Economics

The economic principles of timely vehicle replacement are well known to fleet professionals and are illustrated in Chart 1 (see pdf) , derived from cost data on a particular type of truck in a large municipal fleet. As the trend lines in this chart indicate, the capital (i.e., depreciation) cost of a vehicle diminishes over time, while its operating (e.g., maintenance, repair, and fuel) costs increase. The combination of these two costs produces a U-shaped total lifecycle cost curve.

Ideally, a vehicle should be replaced around the time this total cost of ownership is at a minimum—before the total cost curve begins to turn upward. In the case of the types of trucks shown in Chart 1 (see pdf) , we found the optimal replacement cycle—from the standpoint of minimizing total cost of ownership—to be four years. The actual cost estimates and computations on which this conclusion was based are shown in Chart 2 (see pdf) .

As indicated in this table's bottom row, the equivalent annual cost of the type of truck analyzed is lowest under a replacement cycle of four years, but only moderately more so than under a three- or five-year replacement cycle.

Conducting a lifecycle cost analysis of a particular vehicle type frequently reveals its total cost of ownership curve is, as in this particular example, somewhat shallow or flat at the bottom. This means there is not a single point in time at which an asset should be replaced to minimize its total cost, but a period of time, often lasting as much as two or three years in duration, during which it can be replaced with only a small variation in this cost.

Thus, deferring fleet replacement purchases to accommodate short-term budget constraints does not necessarily increase total fleet costs immediately. However, if an organization traditionally has not replaced vehicles in a timely manner, even a temporary reduction in replacement spending can result in immediate increases in fleet operating costs—principally in maintenance and repair expense.

Decision makers who assume cutting replacement purchases is a good way to help balance the budget must understand such cuts usually transfer a portion of the fleet costs from the capital to the operating side of the general ledger. Regardless of its net effect on current fleet capital and operating costs, the deferral of replacement purchases today unquestionably increases future replacement spending needs, and continually putting off or underfunding vehicle replacements unquestionably creates replacement spending backlogs that can become quite large and difficult to overcome.[PAGEBREAK]

Replacement Funding Requests Vulnerable

Even during good economic times, securing sufficient funds for timely vehicle replacement is a challenge for many organizations. This challenge stems in part from a lack of understanding of the trade-off between a vehicle's capital and operating costs, as illustrated in Charts 1 and 2 (see pdf) .

Many decision makers also do not fully appreciate the role fleet plays in supporting an organization's primary mission. Intellectually, they may understand vehicles are a necessary tool for directly or indirectly supporting the delivery of goods and services. When push comes to shove, however, decision makers may be quick to cut fleet funding in the belief vehicle purchases are, at least to some degree, a discretionary expense deferrable during times of fiscal constraint.

However, the vulnerability of fleet replacement funding in most organizations stems less from a lack of appreciation of the importance of vehicles or the need to replace them on a regular basis, than from an inability to deal with year-to-year fleet replacement spending needs, inherently lumpy in most organizations.

Chart 3 (see pdf) illustrates the long-term replacement costs of a small government fleet of about 160 vehicles. The fleet comprises 56 different types of vehicles and pieces of equipment. The replacement cost (i.e., purchase price) in today's dollars of each of these assets ranges from $5,200 to $353,000. Their replacement intervals range from four to 20 years. The weighted average replacement cycle for all the fleet assets is 10 years, and the weighted average replacement cost is $62,000.

As demonstrated, projected annual replacement costs for this fleet are quite uneven, ranging from a low of about $250,000 in 2011 to a high of almost $3 million in 2016. This lumpiness is common in virtually all government fleets.

The biggest impediment many organizations face to replacing vehicles in a timely manner (and thus minimizing vehicle total cost of ownership) is the lack of a replacement program to deal with such volatile spending needs. Specifically, organizations do not know how to accommodate year-to-year changes in spending requirements when the source of funds for such expenditures is relatively static.

The solution to this problem lies in pursuing one of two courses of action:

• Eliminating the volatility in fleet replacement spending requirements.

• Eliminating the volatility in replacement funding requirements.

What's the difference?

Fleet Replacement Financing Alternatives: Ad Hoc Appropriations

Fleet replacement funding requirements are a function of the way in which an organization pays for or finances vehicle acquisitions. If vehicle acquisitions are financed through ad hoc appropriations of cash and outright purchase, year-over-year replacement funding needs are every bit as volatile as spending needs. This is because cash financing involves paying for a vehicle in full at the time it is acquired and placed in service, and because the confluence of replacement dates for the many vehicles and different types of vehicles in a typical government fleet results in peaks and valleys in the annual number of replacements.

Many organizations believe cash payments are the cheapest way to replace fleet assets. Interest charges are not involved in this financing method, as is the case with leasing, loans, or other types of "pay-as-you-go" financing. Thus, it would appear an economically as well as fiscally prudent way to acquire vehicles.

Such thinking overlooks the fact, however, that using cash to finance fleet replacement costs creates the volatile funding requirements illustrated in Chart 3 (see pdf) . While near-term peaks and valleys in annual replacement spending needs sometimes can be eliminated by manipulating the timing of the replacement of individual vehicles, no amount of such manipulation completely eliminates year-to-year fluctuations in spending and, hence, funding needs over the long term.[PAGEBREAK]

Volatile funding requirements, in turn, almost always result in deferring some replacement purchases in years of peak spending needs and/or weak economic conditions. For instance, the likelihood the city whose fleet replacement costs are shown in Chart 3 would actually spend more than 10 times as much in 2016 on the purchase of replacement vehicles as it would spend in 2011 is virtually zero.

Organizations that finance fleet replacement costs with cash usually have older fleets, large replacement backlogs, high vehicle maintenance and repair costs, and higher total costs of fleet ownership than organizations that use a financing approach allowing incremental payments for vehicle acquisitions. To be sure, for organizations whose financial resources are so great relative to fleet costs, paying for vehicles with cash is never a problem. However, such organizations tend to be the exception, rather than the rule.

Reserve Fund

For most organizations, it is easier to budget, say, $3,000 per year for seven years, than $21,000 every seventh year to fund a vehicle replacement. One method of financing fleet replacement purchases that allows an organization to spread out the capital costs of vehicles in this way is a replacement reserve or sinking fund.

Under this financing approach, an organization makes regular contributions to a fleet-wide "savings account," often through the use of an internal cost charge-back system under which the business units that use vehicles pay a fixed monthly amount for each vehicle in their possession. As long as the contribution or charge-back amounts are calculated and applied properly, funds accumulated in the replacement fund should be sufficient to ensure enough money is available to pay for the purchase of a replacement unit when each vehicle in the fleet reaches the end of its useful life.

Chart 4 (see pdf) illustrates the effect of a reserve fund on long-term fleet replacement funding needs. Although projected spending needs are the same as those shown in Chart 3 (see pdf) , annual contribution amounts (i.e., funding requirements) are relatively smooth and predictable. This stability is made possible by the replacement fund balance, which ebbs and flows in tandem with annual peaks and valleys in spending needs. The key to achieving the predictable funding line shown in this chart is calculating charge-back rates to properly account for the timing and magnitude of, and inflationary increases in, vehicle purchase prices and residual values and interest earnings on the fund balance.

By eliminating most, if not all, the year-to-year volatility associated with funding fleet replacement expenditures, a reserve fund increases the likelihood sufficient funds will be available to replace all fleet vehicles in a timely manner. Annual funding requirements are predictable under this financing approach, making them less susceptible to competition from other spending requests and less a target for decision makers who may equate ad hoc funding requests with ad hoc, which is to say discretionary, spending.

An added benefit of using a reserve fund and charge-back system to finance fleet replacement costs is the payment of regular lease charges for the use of vehicles encourages fleet users to pay attention to fleet utilization levels. Under a cash financing approach, in contrast, users often see little benefit in disposing of underutilized vehicles. Users view the purchase price of these vehicles, paid in full at acquisition, as a sunk cost. Organizations that have instituted fixed monthly charges to finance fleet replacement costs have seen voluntary reductions in fleet size of as much as 20 percent.[PAGEBREAK]

A major drawback of reserve funds, however, is they are costly to establish if an organization has already developed a large backlog of replacement needs. Large amounts of cash (the cash "infusions" shown in Chart 4) must be deposited in the fund or charge-back rates must be set artificially high to provide the working capital needed to start replacing vehicles.

Another drawback is many organizations do not know how to calculate and apply charge-back rates properly. Some set rates too high, with the result that the fund balance becomes too large. Others set them too low, resulting in insufficient money to replace all vehicles according to the replacement cycles on which the internal replacement charges are based.

Even when rates are calculated properly, a fleet replacement fund may be "raided" during an economic downturn to meet other funding needs, undermining a well-designed replacement program in a single year. Both revenue shortfalls and fund balance raids can seriously damage the goodwill of fleet users who have faithfully made monthly payments to the reserve fund expecting to replace their vehicles in accordance with specified replacement cycles. These and other factors can make reserve funds difficult to set up and administer.

Leasing and Loans

Like a reserve fund, leasing, loans, and other types of debt financing allow an organization to spread out the capital costs of fleet vehicles over a period of several years. Rather than accumulating reserves internally to purchase replacement vehicles, however, these approaches involve tapping into the capital markets for the money to acquire vehicles.

The impact of leasing on the long-term replacement funding requirements of the 160-unit fleet we have been discussing is illustrated in Chart 5 (see pdf) . As shown, this financing approach is similar to a reserve fund in its ability to eliminate most of the volatility in year-over-year replacement funding requirements. As such, it offers many of the same benefits as a reserve fund without a reserve fund's drawbacks.

Foremost among the benefits of leasing and debt financing is consistent and predictable - and therefore unobtrusive - annual fleet replacement costs. Remember the dramatic peaks and valleys in funding requirements under a cash financing approach (i.e., like those shown in Chart 3, see pdf ) and the ability to avoid making substantial outlays of cash in a particular year by simply postponing replacement purchases are the two primary causes of organizations cutting fleet replacement funding in a down economy. As demonstrated in Chart 5 (see pdf) , even a tenfold increase in replacement spending requirement costs between 2011 and 2016 has a relatively small impact on replacement funding requirements when vehicles are leased rather than purchased using ad hoc cash appropriations.

Chart 5 (see pdf) also illustrates another reason leasing and debt financing are particularly worthy of consideration at a time when many organizations are deferring fleet replacement purchases to balance budgets. Switching from cash financing to leasing generates sizable near-term budget savings. These savings result from the fact that buying involves paying for the full capital cost of replacement vehicles before they are used, whereas leasing and loans permit an organization to pay this cost as the vehicles are used.

Thus, transitioning to leasing permits an organization to shift most of the capital cost of a vehicle put into service this year to future years in which the vehicle will remain in its fleet. For instance, in our sample fleet, the cash required to replace the fleet under a cash purchase versus leasing approach are: $500,000 (cash purchase) versus $30,000 (leasing) in Year 1 and $2.94 million (cash purchase) versus $1.49 million leasing in Years 1-5.

Chart 6 (see pdf) shows a side-by-side comparison of the long-term funding requirements under these two replacement financing approaches. Some people might argue this chart illustrates little more than budgetary sleight of hand, in the sense that switching from buying to leasing (or loans) simply moves some fleet costs otherwise incurred today to future fiscal years.

Moreover, opponents of leasing and loans argue, such a switch comes with a "hidden" cost; namely, interest charges must be paid for the privilege of paying for vehicles over time rather than up-front. There is no question interest charges included in lease payments increase vehicle acquisition costs. Far less clear, however, is that leasing increases a vehicle's total lifecycle cost. If leasing allows an organization to replace vehicles in a timely manner that it otherwise would keep in service for too long, interest expenses incurred under a lease or loan financing program are likely more than offset by increases in vehicle residual values and reductions in vehicle maintenance and repair costs.

Given the shrinking and shrunken budgets with which many organizations are grappling due to the "Great Recession," a willingness to shift from pay-before-you-go to pay-as-you-go financing may make the difference between maintaining an effective fleet replacement program based on the economic principles of optimal vehicle replacement discussed earlier and undermining such a program and its impact not only on direct vehicle capital and operating costs, but also on vehicle availability, reliability, and safety. The icing on the cake is, for many organizations, such a shift could produce a sizable budgetary windfall that makes the fleet operation part of the solution rather than a contributor to a big budget deficit.

Conclusion

No single approach is "best" to financing fleet replacement costs. Each approach discussed here offers advantages and disadvantages from a fiscal, economic, administrative, and political point of view. The relative importance of such factors varies from organization to organization, depending on the circumstances they currently face. Clearly, however, the fiscal challenges facing many organizations today and the threat they pose to fleet replacement spending in these organizations warrant consideration of new ways of doing business.

Fleet managers must understand the long-term threats posed by the "Great Recession" to their replacement programs and thus to the safety, reliability, and total cost of ownership of the vehicles and equipment they manage. Fleet replacement spending is an easy target for budget cutters, notwithstanding its importance to the operation of safe, economical, and reliable vehicles.

It is up to fleet managers to ensure decision makers understand the full consequences of measures assumed to reduce fleet costs and save money. Equally important, fleet managers should recognize the best time to experiment and innovate often occurs when traditional business practices—or spending habits—no longer seem tenable or affordable.

There may never be a better time than the present to explore the benefits of changing fleet replacement financing approaches. Predictable long-term funding requirements, the timely replacement of vehicles, lower total fleet ownership costs, and immediate budget savings—these are benefits even the most aggressive budget cutter should find hard to resist.

Editor's note: This article appeared in the March 2010 issue of Government Fleet , a sister publication of Police Magazine.