Equipment Costs, Cost Guides and Claims
BY JOHN RANNESTAD, PE, LEED AP – Senior Consultant
Not too long ago, I finally caved in and bought a new car. I distinctly remember the moment the salesperson and I agreed to the deal and how much it was going to cost. I also know its fuel economy very well as that was one of the reasons why I bought it. Though I know some of the important costs in owning my car, I don’t really know how much it costs me to drive it. I suspect most car owners are in the same boat. This is because it’s not as simple as adding up a few figures. There’s more to it than just the purchase price and gas mileage.
Unlike everyday car owners, contractors need to have a much better handle on how much their equipment is costing them. After all, equipment costs are usually a large percentage of the construction cost. Obviously, knowing equipment costs is important for being able to track job profitability and how a project is doing with respect to its budget. It is also vital knowledge for bidding work in order to avoid underbidding a job or submitting an uncompetitive price.
Owners have a vested interest in knowing about equipment costs as well, especially in connection with pricing equipment for extra work and claims. The question on owners’ minds is, “Is the price we intend to pay for this work fair?”
This is Part 1 of a two part article. Part 1 identifies and explains the basic cost components incurred in connection with owning and using construction equipment. It will also discuss how State Departments of Transportation (DOT) typically price and pay for equipment. Included, are a summary and comparison of two popular equipment cost rate guides that are used to estimate hourly equipment costs. In a later newsletter issue, Part 2 will discuss how the Blue Book rates can vary from actual costs and demonstrate several unique circumstances that are often encountered when pricing equipment for claims and extra work.
Basic Equipment Cost Components
With contractor owned equipment, the costs that contractors incur for having and using that equipment fall into one of two general categories; ownership costs or operating costs. Ownership costs are costs that incur whether or not the equipment is used. Operating costs are costs that are incurred because the equipment is being used.
In the operating cost category, there are several cost elements. These include cost for fuel, filters, oil, grease (often referred to as FOG), tire wear, minor repair and major overhaul. Major overhaul costs are for rebuilding or replacing larger components, such as the engine and transmission. Minor repair and routine maintenance includes replacing items like belts, filters, hydraulic lines and other minor components. Both minor repair and major overhaul costs include the parts and labor associated with the work.
Within the ownership cost category, there are costs for depreciation, financing and a group of indirect type costs. Financing cost is the interest expense on the amount of money borrowed to purchase the equipment. Depreciation is the distribution of the acquisition cost of a piece of equipment over its useful economic life. There is no one bill or canceled check specifically for depreciation, rather, it is calculated by the Contractor from the purchase price, delivery cost, sales tax, duration of the equipment’s useful economic life and the value of the equipment at the end of its life.
There are a number of generally accepted methods that are used by accountants for calculating depreciation on contractor owned equipment for a contractor’s financial records. Perhaps the simplest and most commonly used method is straight line depreciation. When this method is used, the yearly depreciation cost is calculated as the purchase price plus tax and freight minus salvage divided by the useful life in years.
Depreciation is calculated a bit differently by the equipment cost rate guides because the price of equipment cost is incurred by the hour. While these rate guides also use the straight line method, they use a more elaborate calculation, wherein the cost of certain consumable material included in the purchase price, such as tires, are deducted from the acquisition cost. This is due to the wear of those consumables being covered by other areas of the rate or is priced separately. The rate guides also substitute the total economic life in terms of hours for the useful life in years in order to derive an hourly deprecation cost.
A third category of ownership costs include a number of indirect type costs that can be tied to the ownership of equipment. This category includes costs for equipment licenses, property taxes, storage, insurance, inspections, mechanic training, record keeping and highway permits. If a construction company rents a piece of equipment, a contractor usually incurs additional cost beyond the rental invoice.
The relative responsibilities of the equipment supplier and contractor should be spelled out in the rental agreement. Often, the contractor incurs additional operating type costs, including those for fuel, filters, oil, grease, minor repairs, normal periodic maintenance, delivery and permits. The contractor may also have to pay for major repairs, tire wear and insurance depending upon the terms of the rental agreement. Depreciation, interest expense and costs for licenses, property taxes and storage are typically included in the rental rate, as well as some additional cost for the overhead and profit of the rental company.
The rental agreement may also define how many hours of use are included in the rental price for whatever period the equipment is rented for. It is common for the use to be limited to 176 hours per month or 40 hours a week, representing the number of normal work hours during a week or month.
Contractor Equipment Cost Accounting
Where do all these costs show up in a contractor’s books and accounting records? Well, it depends upon the contractor’s chosen accounting method. In my experience as a construction claims consultant, contractors are not consistent in their methods of accounting for equipment costs and there is a range of methods employed that can either accurately account for actual equipment cost on projects, not measure equipment costs at all or offer something in between.
On one end of the spectrum, there are the contractors who allocate all or most of their equipment costs to general and administrative cost accounts and never attempt to allocate equipment costs to a particular job. In such cases, actual project equipment costs are not readily available and may not even be able to be ascertained. Equipment is considered part of overhead and is included in their estimates as part of overhead markup.
On the other end of the spectrum are contractors who allocate all or most of the equipment operating costs to the job where the equipment is being used. Equipment costs that cannot be charged to the job directly, such as depreciation, or costs that the contractor chooses not to charge to the job directly, are accumulated in a separate indirect cost pool. Internal hourly rates are set up to account for the cost elements that are not charged to the job directly in order to distribute these costs to the jobs as the equipment is being used.
Typically, when the internal hourly rate system is used, adjustments are necessary to account for actual costs that vary from those used by the contractor in estimating its internal equipment rates or for equipment that is utilized more or less frequently than what the contractor estimated in determining the internal rates. Up or down adjustments to these internal rates or to the equipment costs charged to the jobs are made periodically to balance the contractors’ actual equipment costs incurred to the costs charged to the contractors’ jobs via the internal rates. Internal rates may be calculated by the contractor by estimating the annual costs then spreading them out to the number of hours the contractor estimates it will use the equipment that year.
When the contractor instead chooses to allocate a certain category of costs to the job directly, the corresponding hourly component for that cost is removed from the internal hourly rate so that the job is not charged twice. A sample internal owned equipment rate calculation is shown below (click here
to download the PDF).
Pricing Equipment Costs for Extra Work
Construction contracts vary as to how they handle the pricing of contractor owned-equipment used on extra work. Some of the more common ways include the following:
- Equipment rates and costs are negotiated during the course of the contract, on an as-needed basis. The pricing of extra work is based on the negotiated rates.
- Equipment rates are submitted, negotiated and approved at the start of the project. The preapproved equipment rates are then used in pricing extra work and time and material (T&M) work.
- Equipment rates are submitted with the bid and, upon award, become the contractual unit prices for equipment used on extra work.
- A contractually specified published rate manual is used to price equipment used on extra work and for figuring equipment cost on T&M work.
- The contract requires the contractor to be paid actual cost for equipment for extra work, and if the actual cost cannot be readily determined, allows the use of specified rate manual to price equipment.
In addition to contract provisions governing the pricing of equipment costs for extra work, some contracts also contain provisions addressing the pricing of equipment cost in connection with contractor claims. Often, claimed equipment costs are limited to actual costs.
Federal Regulations Governing Pricing of Equipment on State DOT Projects
Federal policy, specifically Part 31 of Title 48 Code of Federal Regulations (CFR31.105), sets the framework for how DOTs are required to deal with pricing equipment used in connection with contract modifications. These regulations state, in essence, that allowable equipment costs for contractor owned equipment should be based on the contractor’s actual equipment cost when the data is available from the contractor’s accounting records, or when such costs can’t be determined from the records, from a predetermined cost recovery rate schedule, whose rates only include amounts for the cost elements allowed by the regulations. The Federal Highway
Administration has somewhat modified these regulations by allowing State DOTs to use qualifying predetermined rate guides without having determined whether or not actual equipment cost is available.
According to the federal regulations, allowable ownership costs should include depreciation and may include the Cost of Facilities Capital (CFC). Allowable operating costs may include costs for such items as fuel, filters, oil, grease, servicing, repairs, maintenance and tire wear. The policy specifically disallows interest costs.
What is CFC?
The Federal Regulations (CFR31.205-10 & CFR 9904.414), state that CFC is “an imputed cost determined by applying a cost of money rate to ….the net book value of tangible capital assets and of those intangible capital assets that are subject to amortization”, and is “not a form of interest on borrowings.” My understanding of this definition is that CFC represents a rate of return on the value of the contractor’s equipment. I picture it as a measurement of the money that didn’t flow to the contractor because the contractor had its capital tied up in equipment. In other words, since the contractor had money tied up in the value of its equipment, the contractor was prevented from putting that capital to work elsewhere, where presumably it would have earned a return on its investment.
The federal regulations require that CFC be computed using a rate of return equal to that of the cost of money rate that is periodically set by the United States Treasury. For the first half of 2010, this cost of money rate was 3.25%. The reason why CFC is “not a form of interest on borrowings” is because the value of the equipment isn’t dependent upon whether the funds used to purchase the equipment were from retained capital or borrowed. Rather, CFC depends upon how much the equipment is worth, which constantly changes as the equipment ages.
With respect to rented equipment, federal regulations (CFR31.105 & CFR31.205-36) allow reasonable rental cost after consideration of rental costs of comparable property, market conditions, type, life expectancy, condition and value of the property leased, available alternatives and other provisions of the agreement with the contractor. With the exception of cost for major repairs, the costs incident to operating the equipment that are not included in the rental rate are allowable. In other words, the regulations allow DOTs to pay for oil changes on rented equipment if needed for the work, but if the equipment’s engine suddenly conks out, they’re not going to pay for a new engine just because it died on their watch.
If a predetermined rate schedule is used to compute operating costs above and beyond the rental invoice, the components of the operating rate need to match up with those operating components excluded from the rental invoice to avoid duplication.
The Equipment Rate Guides
Although federal regulations favor using actual equipment costs, computing these costs can be a challenge, especially with contractor owned equipment. For one thing, not all contractors’ accounting systems and procedures are set up to easily identify and segregate costs for equipment. Contractors that use the internal equipment rate approach might get close to approximating actual cost, but again, these rates are based on estimates and the hourly cost for equipment won’t be known until a full year’s cycle of equipment use is experienced or until the full life cycle cost is experienced and the actual salvage value, total hours of use and total maintenance costs are known.
In addition, internal rates may not capture all equipment costs either. If the rates don’t capture all costs, then in the end, either those costs would have to be deciphered from the contractors’ accounting records or they would have to be estimated. As a result of these challenges, many State DOTs use qualifying predetermined rate schedules in some manner for pricing equipment that is used to perform extra work on their projects. Two of the more popular cost recovery guides that are used on all types of projects are the Blue Book and United States Army Corps of Engineer’s Construction Equipment Ownership and Operating Expense Schedule (ACOE) Equipment Schedule.
The Blue Book
The rate schedule most widely used by State DOTs for pricing contractor owned equipment is the Blue Book. The Blue Book is published by EquipmentWatch and is updated quarterly, semi-annually or annually, depending upon the equipment. According to their website, the Blue Book is currently specified by 47 of the 50 State DOTs. Blue Book rates are derived using estimated values for purchase price, salvage value, economic life, depreciation, maintenance and overhaul, as well as indirect equipment costs such as storage and permits, average annual hours of use and operating costs and the Treasury’s cost of money rate. An example of how the Blue Book estimates these figures is provided by its method to estimate purchase price. For this, the Blue Book uses the most recent manufacturer’s suggested list price plus an estimated discount to reflect the condition where list prices are higher than the actual selling price.
The bottom line is that, in essence, the estimated costs for the various components are annualized or figured for the economic life, and then divided by the estimated annual hours of use or total lifetime hours to derive an hourly rate for each of the cost components. The hourly rate for all the cost components are then added together and multiplied by 176 hours, the customary number of working hours in a month, to determine a monthly ownership rate published in the Blue Book. Rate adjustment factors are then applied to the rate to account for older equipment whose cost was likely different from the most recent list price used in the rate calculation.
To account for regional differences, such as disparities in annual working hours due to the effects of weather, the Blue Book includes regional adjustment factors to apply to the base monthly rate. The Blue Book also includes estimates for weekly and daily rates for when equipment is used on a shorter term basis. The weekly and daily rates contemplate a reduced number or annual working hours to account for more downtime associated with employing the equipment on a short term basis.
The federal policy on DOT projects is to pay for equipment costs based on the monthly rate since this rate already contemplates the normal downtime of owned contractor equipment. The Blue Book rate includes CFC but does not include interest costs in accordance with federal requirements. The Blue Book includes major overhaul costs in the ownership portion of the rate even though this is an operating cost. The major overhaul in the Blue Book ownership rate may help align with the federal regulations, allowing charges on third party rented equipment.
The Blue Book also provides percentages that allow the user to calculate the various components of the ownership portion of the rate separately. This is useful if, for some reason, only certain portions of the rate were allowable or if a breakdown was needed.
The United States Army Corps of Engineer’s Construction Equipment Expense Schedule
The ACOE Equipment Schedule is a rate manual that is referenced by federal regulations as being a predetermined rate schedule available for use by State DOTs to price contract modifications. The most recent and historical publications are available online.
The ACOE Equipment Schedule is broken down into 12 pamphlets, with each pamphlet providing the equipment rates for a different geographical region. By calculating the rates by region, the ACOE manual is able to account for the regional differences that affect equipment costs, such as weather.
This publication is comprehensive, up to date and customizable. The publication contains many rate tables for certain baseline equipment. The manual requires the rate to be adjusted if the equipment being priced doesn’t match closely enough to the baseline equipment listed or if certain conditions are different enough from the assumptions used to price the baseline equipment. The manual enables one to build up all the components of the rate separately and supplies all the necessary information to develop custom rates as well, say for example, to account for a different purchase price.
While these features are good, having them requires the publications to lay out all sorts of equations, tables and factors. As a result, the publication appears complicated and difficult to work with. I found that a couple of hours spent reading the introduction and methodology sections and working through a few examples went a long way in helping me understand the publication. The publication also provides the contact information for someone you can call for assistance. When I called, it was quick, easy and very helpful. There is also an Excel spreadsheet that is available from the ACOE that you can use to facilitate calculating equipment rates. The spreadsheet is called CHECKRATE and is available online. Not having an online version like the Blue Book is however a disadvantage.
The ACOE Equipment Schedule uses various analytical methods, estimates and assumptions to calculate equipment rates. The methodology is similar to the one described in the Blue Book wherein the lifetime or annual costs for the equipment are estimated then divided by the hours of use in the expected life or year to derive an hourly rate. The ACOE Equipment Schedule does not include a computation of a weekly or daily rate like the Blue Book does, but rather, allows the user to calculate the hourly rate based on any amount of annual utilization. If the actual cost of fuel is higher than assumed by the standard calculation, the user can calculate hourly fuel costs based on any price per gallon. Variances from the average operating conditions, cost of money rates, engine horsepower, purchase price discount, sales tax and utilization can also be accounted for if necessary.
The ACOE Equipment Schedule also provides a means to calculate rates on older, fully depreciated equipment and can be used to compute rates for when equipment is used more than 40 hours per week.
With more than 40 hours per week use, the manual adjusts the CFC portion of the rate. There appears to be two reasons for adjusting this element. The first is that standard 40 hour per week rate already contemplates recovery of the full amount of CFC cost in a week. A second possibility is that when the equipment is used more than planned and the equipment reaches the end of its lifespan quicker, the contractor’s capital is tied up in that piece of machinery for a shorter amount of time.
Comparison of the Blue Book and ACOE Rates
There are other differences between the Blue Book and the ACOE Equipment Schedule. For example, the ACOE equipment schedule includes major overhaul in the operating portion of the rate as opposed to Blue Book, which includes the ownership portion. Another difference is that the ACOE Equipment Schedule doesn’t use the full cost of money rate when calculating CFC, but rather discounts the rate by 25% in order to avoid apparent duplication when applying estimated markups for overhead and profit. Additionally, unlike the Blue Book, the ACOE Equipment Schedule does not include indirect costs in its rates, such as those for license fees, property taxes, storage and insurance costs because it assumes that these costs are normally included in the contractor’s field and home office compensation.
To illustrate how the rates of the Blue Book and the ACOE Equipment Schedule vary, I compared rates derived from each rate manual for an identical piece of equipment, a model year 2000, Link Belt HC-238 II truck crane, furnished with 260’ of boom, a third drum and hook block (see PDF). Some of the key assumptions that were used to figure the ACOE Equipment Schedule rate include a $1,197,389 list price, a 20,000 hours of equipment life and 1,360 hours of use per year. The rates that were calculated were derived assuming the costs were incurred in July of 2003. A comparison of the rates given by the two rate schedules is shown below.
As shown, there is a difference of $63.99/hr on the rate for the crane, $20.32 of which can be traced to the fact that the ACOE rate does not include other indirect ownership costs. There is an $8.81 difference in the depreciation element and a $3.29 difference in the CFC element. These differences are likely due to different assumed purchase prices, depreciation periods or annual hours and with CFC, the previously mentioned discount taken by the ACOE Schedule computation. The remaining $31.57 is due to differences in the remaining rate elements for fuel, FOG, tire repair and wear and minor and major overhaul.
The specific source of the difference cannot be determined because of the way the rates are broken down. However, since the repair elements are a large percentage of the cost, I suspect that a large portion of the difference resides there. Finally, it is noteworthy that the repair rate element exceeds the depreciation element in the above noted example. In other words, it going to cost more to maintain and fix this piece of equipment during the course of its life in order to keep it operational than it did to purchase it. Significant major overhaul costs are the prime reason. This sort of scenario is not uncommon with large heavy construction machinery because
engines, drives and other large components are expensive.
In Part 2 of this article, we’ll discuss the frequently overheard contractor/owner debate about who is making out better from using Blue Book rates and the nuts and bolts of figuring equipment costs for equipment that is idle, equipment that is working extended hours and equipment that is fully depreciated.
For additional information, please contact the author, John Rannestad, at 860-704-6100 or John.Rannestad@arcadis-us.com
ABOUT THE AUTHOR
Construction Claims Newsletter
John Rannestad, PE, LEED AP is a Senior Consultant for ARCADIS. He has extensive experience with the analysis of entitlement, CPM schedule analysis and calculating cost impacts. He has wide ranging experience in structured negotiations, mediation and arbitration, and serves as an arbitrator for the American Arbitration Association and the American Dispute Resolution Center. He has been involved with numerous projects, including those involving the construction of roads, bridges, rail facilities, airports, schools, libraries, hospitals and wastewater treatment plants. You may contact the author, John Rannestad, at 860-704-6100 or John.Rannestad@arcadis-us.com