Keeping up with the Joneses
The carwash equipment you purchased several years ago will inevitably be followed in time by a new generation of equipment designed to wash and dry cars better, faster or more economically.
Consequently, the people who sell equipment would have you believe that what you are using now is obsolete and the “new and improved” model is essential if you are to continue operating efficiently. However, there are different kinds of obsolescence, and carwash equipment that's obsolete in one sense may remain perfectly fine in another.
Technological change ensures that older carwash equipment will eventually become obsolete. However, if the decision to replace equipment is made solely on the basis of it not being the latest and greatest, operators are spending cash and taking out loans they could avoid. For carwash equipment to be truly obsolete and a candidate for replacement, the equipment should be functionally obsolete. In other words, it will no longer do the job.
The Super-Duper pitch
When carwash equipment can no longer serve its purpose, it has either deteriorated or the function has changed. Let us assume that the owner of Johnny’s self-service carwash bought a Super-Duper in-bay automatic system five years ago. Today, the friendly Super-Duper salesman arrives with news that the 5-year-old machine is obsolete because Super-Duper II is now available. Super-Duper II can produce two more cars per hour and it comes with a wheel brush attachment and an auto-cashier with audio and video, making the old machine technologically obsolete.
A closer look at the use of the old machine reveals that Johnny’s volume hasn't changed much and that only 70 percent of the unit’s production capacity is currently being used. Quality, volume and maintenance expenses have remained relatively consistent over the years and the market hasn’t changed that much. The old machine isn't functionally obsolete because it is still capable of doing the job it was intended to perform at essentially the same cost.
No matter how new-and-improved a carwash system is, it is not the equipment (old versus new) that needs to be assessed. Of course, if the equipment is broken down and can't be repaired at reasonable cost, a replacement decision is likely in order. Otherwise, what needs to be considered first is the application.
If the application remains the same and the old equipment will still do the job, the equipment, although technologically obsolete, isn't functionally obsolete. Conversely, if the application has changed to where the old equipment can't perform at all or can't perform fast enough or economically enough, then the old equipment is functionally obsolete and replacement is probably necessary.
There are times when it makes sense for carwash operators to go for the new bells and whistles of the latest model. However, this decision should be made when the acquisition will increase volume, revenue or produce meaningful cost savings. Therefore, there are two important steps involved in deciding when to keep or replace carwash equipment. The first is to determine whether the equipment is functionally obsolete.
If the old equipment is still capable of doing the job, the second step is to subject the old and new equipment to a comparison of all costs of owning and operating both. Since the costs of acquiring new carwash equipment will usually outweigh the costs of retaining and maintaining the old equipment, it's an infrequent occurrence for the new equipment to prove more cost effective than the old unless the parameters of the application have changed.
The replacement decision
The performance of all carwash equipment will decline with age. Routine maintenance can help keep equipment working efficiently, but there will always be a point in time when the repair parts and labor become too expensive and it is less expensive to buy a replacement. Therefore, the replacement decision hinges on the relationship between cost and time.
There are a number of approaches to be used to evaluate this decision such as return-on-investment analysis, cost-to-benefit analysis, quadratic regression analysis and other methods. Each method has advantages and disadvantages and the rewards and risks of the situation will usually lead to one method being selected over another.
For example, if the carwash operator believes his equipment is still good and wants to avoid spending cash or borrowing money, a particular method may be chosen for the purpose of skewing the returns to make replacement look less worthwhile. Conversely, a sales representative may inflate the returns from the investment to make replacing the equipment look more worthwhile.
Some equipment representatives will support the replacement proposal with a simple return-on-investment (ROI) analysis. ROI is a calculation used to determine if a proposed investment makes sense.
For example, if you invested $50 today and then received $100 back at the end of one year, your ROI for the investment would be 50 percent. Simple ROI is often used to present business cases because the ROI concept is easily understood when the costs and returns are expressed over a short period of time (i.e. one year) and can be derived simply and unambiguously.
In this case, the action that provides the higher ROI is the better investment.
There are factors that can render simple ROI calculations less trustworthy. First of all, simple ROI says nothing about the magnitude or inherent risks involved in the investment. Second, when the timeframe for the analysis is short (i.e. one year), relatively small changes in costs and returns can have a major impact on simple ROI calculations. Third, the act of replacing carwash equipment involves financial consequences that extend several years into the future.
Since the cost of replacing carwash equipment comes up front and the benefits accrue over time, the time value of money needs to enter the ROI calculation. We can illustrate this concept with an example of an in-bay automatic replacement at a retail petroleum site.
This example includes a touch-less in-bay automatic with a price of $100,000 (installed) and a monthly payment of $2,400 based on a lease factor of 0.24.
As shown in the profit and loss statement, the new machine provides an incremental benefit of $18,180 ($82,980 - $64,800) or a simple ROI of 18.2 percent (18,180/100,000). The uplift in sales volume and revenue is a result of improved customer satisfaction and image and a reduction in downtime and maintenance expenses.
If we extend this benefit out over the useful life of the new machine (assumed to be 5 years), the cumulative gain would be $90,900 or a simple ROI of 90.9 percent.
However, in order to provide a good business case, investors should see the timing of expected inflows and outflows; an attempt to include and quantify every benefit and cost in the financial analysis; and a time-based cash flow summary which is the basis for calculating standard financial measures such as net cash flow, net present value, pay-back period and internal rate of return.
Obsolescence and costs
Studies on the operating characteristics of commercial and industrial equipment suggest that obsolescence and running costs for equipment are inversely related.
An appropriate investment cost figure would include obsolescence, changes in revenue and expenses, arbitrary cost allocations for all benefits and expenses and the opportunity cost of the investment.
The analysis should include “real” costs like credit card fees, building maintenance, depreciation, office supplies and administration fee (labor allocation) which are often omitted in a simple ROI analysis along with other expenses like rent and property taxes. After all, the in-bay building at a retail petroleum site occupies real property that could otherwise be used for another revenue generating purpose.
Future cash flows for the “old” and “new” cases will be discounted into present values using a discount rate that represents the project’s cost of capital. The series of future positive cash flows is then reduced into one present value. Subtracting this value from the initial investment provides the net present value (NPV) of the investment. The action with the higher NPV should be accepted.
To account for the rate of equipment obsolescence, maintenance expense for the new machine will increase from 0 percent of revenue in year one, to 12 percent of revenue in year five. Maintenance expense for the old machine increases from 15 percent of revenue in year one, to 16 percent in year five.
To account for the change in downtime, sales volume for the old machine will be reduced by 3 percent each year from the baseline beginning in year one.
Sales volume for the new machine will be reduced by 3 percent each year from the baseline beginning in year two.
The lease factor of 0.24 for a $100,000 machine is equivalent to an annual interest rate of 15.5 percent (discount rate).
Average revenue per car is held constant at $5.77 for “old” and $6.17 for “new.”
As shown in the charts in their sidebars, although the average ROI of 14.1 percent is less than the company’s cost of capital (15 percent), the replacement appears acceptable because the NPV for the replacement is greater than the NPV for keeping the old equipment.
The risk of the investment includes the probability of the outcome and the impact if it occurs. Not all risks will happen, but no one can know with certainty as to which risks will occur and when.
There are no certainties that another site could achieve the same improvement. In order to account for the inherent risk of actions that have financial consequences in future years, investors should make some provision for uncertainty. This can be accomplished by making general assumptions about the most likely (ML), optimistic (O) and pessimistic (P) outcomes for the replacement scenario.
Likelihood = (O + 4 * ML + P)/6
L = (162,000 + 4 * 157,950 + 120,000)/6
Likelihood = 152,300
In our example, the pessimistic outcome is based on the assumption that the improvements will not materialize. The optimistic outcome is based on the assumption that the “new” machine will achieve 100 percent of the expected improvements. The most likely outcome is based on the assumption that the “new” machine will achieve 97.5 percent of the expected improvements. If we recalculate NPV using the likelihood of achieving revenue of $152,300 instead of $162,000, the annual average ROI drops to 10.6 percent (cost of capital is 15.5 percent) and the replacement decision becomes much less worthwhile than keeping the old machine.
The volatility of returns subject to risk underscores the importance of accounting for uncertainty and including and quantifying all benefits and returns in the financial analysis used to support the equipment replacement decision.
Carwash operators should realize their equipment is never obsolete just because there is something available in the market that is “new and improved.” In many cases, it will pay to go with what’s in place as long as the carwash equipment will do the job within all time, cost and quality constraints.
Robert Roman is a former carwash, express lube and detail shop operator and is president of RJR Enterprises (www.carwashplan.com), a leading consultant to the carwash industry. Robert is a member of PC&D’s Honorary Advisory Board. He can be contacted at firstname.lastname@example.org.