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JWDD004-11 JWDD004-Halpin-v6 July 18, 2005 20:40
Chapter 11
Equipment Ownership
RFID Application in Construction
The Need
For tracing and identifying construction equipment on construction sites,
electronic identification tags are becoming widely used. With Radio
Frequency Identification (RFID) technology, no line of sight or direct
contact is required between the reader and the tag. Since RFID does not
rely on optics, it is ideal for dirty, oily, wet, or harsh environments. RFID is
an automatic identification technology, similar to bar code technology, with
positive identification and automatic data transfer between a tagged object
and a reader. Since the RFID tags are read by low wattage radio waves,
instead of light waves (as with bar-codes), they will communicate through
non-metallic materials such as paint, plastic, grease, and dirt, and are
impervious to vibration, light, water, and heat up to 100§C in most cases.
The Technology
A RFID system consists of two major components (reader and the tag)
which work together to provide the user with a non-contact solution to
uniquely identify people, assets, and locations. The reader performs several
functions, one of which is to produce a low-level radio frequency magnetic
field. The RF magnetic field serves as a ÒcarrierÓ of power from the reader
to the passive (no battery required) RFID tag. When a tag is brought into
the magnetic field produced by the reader, the recovered energy powers the
integrated circuit in the tag and the memory contents are transmitted back
to the reader. Once the reader has checked for errors and validated the
received data, the data are decoded and restructured for transmission to a
user in the format required by the host computer system. The RFID tags
used are both readable and writable. This capability enables information to
be written back to the tag for enhanced asset management. RFID tags do
not require a line of sight for identification, and readability is not affected
by bright lighting situations.
Hand held RFID device
11.1 GENERAL
Equipment resources play a major role in any construction activity. Decisions regarding
equipment type and combination can have a major impact on the profitability of a job.
In this respect, the managerÕs goal is to select the equipment combination that yields the
maximum production at the best or most reasonable price. Quite obviously, the manager
must have a basic understanding of the costs associated with a particular piece of equipment.
He must also be capable of calculating the rate of production of the piece or combination
169
170 Chapter 11 Equipment Ownership
of equipment. The cost and the rate of production combine to yield the cost per unit of
production. For example, if it is estimated that the cost of a particular fleet of haulers and
loaders is $500 per hour and the production rate is 750 cu yd/hr, the unit price can be easily
calculated as $0.66 per cubic yard.
Construction equipment can be divided into two major categories. Productive equipment
describes units that alone or in combination lead to an end product that is recognized as
a unit for payment. Support equipment is required for operations related to the placement of
construction such as movement of personnel and materials and activities that influence the
placement environment. Typical production units are pavers, haulers, loaders, rollers, and
entrenchers. Hoists, lighting sets, vibrators, scaffolds, and heaters represent typical classes
of support equipment. In most cases, equipment units are involved either in handling construction
materials at some point in the process of placing a definable piece of construction
(e.g., crane lifting a boiler, pavers spreading concrete or asphalt into lifts on a base course)
or in controlling the environment in which a piece of construction is realized (e.g., heaters
controlling ambient temperature, prefabricated forms controlling the location of concrete
in a frame or floor slab).
In heavy construction, large quantities of fluid or semifluid materials such as earth,
concrete, and asphalt are handled and placed, leading to the use of machines. The equipment
mix in such cases has a major impact on production, and the labor component controls
production rates only in terms of the skill required to operate machines. Therefore, heavy
construction operations are referred to as being equipment intensive. Heavy construction
contractors normally have a considerable amount of money tied up in fixed equipment
assets, since capitalizing a heavy construction firm is a relatively expensive operation.
Building and industrial construction require handwork on the part of skilled labor at
the point of placement and are therefore normally not as equipment intensive.
Equipment is required to move materials and manpower to the point of installation and
to support the assembly process. Emphasis is on hand tools; and, although heavy equipment
pieces are important, the building and industrial contractors tend to have less of their capital
tied up in equipment. Also because of the variability of equipment needs from project
to project, the building contractor relies heavily on the renting of equipment. The heavy
construction contractor, because of the repetitive use of many major equipment units, often
finds it more cost effective to own this equipment.
11.2 EQUIPMENT OWNING AND OPERATING COSTS
The costs associated with construction equipment can be broken down into two major
categories. Certain costs (e.g., depreciation, insurance, and interest charges) accrue whether
the piece of equipment is in a productive state or not. These costs are fixed and directly
related to the length of time the equipment is owned. Therefore, these costs are called fixed,
or ownership, costs. The term fixed indicates that these costs are time dependent and can be
calculated based on a fixed formula or a constant rate basis. On the other hand the operation
of a machine leads to operating costs that occur only during the period of operation. Some
of these costs accrue because of the consumption of supplies, such as tires, gas, and oil,
and the widespread practice of including the operatorÕs wages in the operating costs. Other
costs occur as a result of the need to set aside moneys for both routine and unscheduled
maintenance. Thus operating costs are variable costs.
The total of owning and operating costs for items of equipment such as tractors, shovels,
scrapers, dozers, loaders, and backhoes is typically expressed on an hourly basis. These two
categories of cost accrue in differentways. Ownership costs are usually arrived at by relating
the estimated total service life in hours to the total of those costs. If the equipment is idle
for some of those hours, the relevant costs would be taken up as part of general operating
overhead; when the equipment is in use, the hourly costs are charged to the job or project.
11.3 Depreciation of Equipment 171
Figure 11.1 Cost components in a production unit.
Operating costs are variable in total amount, being a function of the number of operating
hours, but these hourly costs are found to be relatively constant.
The hourly charge for a piece of equipment is made up of four elements. An allowance
for estimated hourly overhead costs is added to the ownership and operating costs. The fourth
element is an amount for income or profit. A schematic illustration of this breakdown of
the hourly charge for a piece of equipment is shown in Figure 11.1.
Ownership costs are composed of two elements: first, an estimate for depreciation on the
cost of using the equipment itself. Each piece of equipment represents an estimated number
of hours of useful service life and the depreciable value, the major part of its original cost,
is divided by the total hours to yield a charging rate for this element of equipment costs.
The second component of ownership costs consists of estimates of allowance for interest,
insurance, and taxes.
Operating costs cover a broader range of items, the principal elements being: fuel,
oils and lubricants, hydraulics fluid, grease, filters, and other supplies; maintenance, general
overhauls, and repairs; and parts replacement (cutting edges, blades, buckets), tire
replacements, and the like. Also included here are the direct labor costsÑ the operatorÕs
wagesÑincluding all of the expense loadings for holidays, sick leave, and insurance.
To the direct operating costs just enumerated are added allowances for general overhead
expenses and the indirect costs of supervisory labor. This total establishes the total hourly
cost of owning and operating a unit of equipment. A percentage markup is added to provide
for an income or profit element.
Some of these costs are incurred and paid for concurrently with the operation of the
equipment, but the allowances or estimates included for items such as repairs and maintenance
are provisions for costs that will have to be paid at some future time.
General administrative costs (e.g., overhead), including items such as telephones, stationery,
postage, heat, light and power, and the costs of idle equipment in general are aggregated
together as general overhead expense, an allowance that forms part of the hourly
charging rate.
11.3 DEPRECIATION OF EQUIPMENT
The method by which depreciation is calculated for tax purposes must conform to standards
established by the Internal Revenue Service (IRS). Federal law has introduced the use of
fixed percentages as given in published tables to calculate the amount of depreciation for
various classes of equipment and depreciable property. The tables have replaced accelerated
methods referred to as the declining balance and sum-of-years-digits (SOYD) methods,
which were used prior to 1981. Since the methods used under pre-1981 legislation are still
relevant in understanding the tables presently used and are still required in some situations,
they will be described briefly.
The four most commonly used methods of calculating depreciation on equipment prior
to 1981 are:
1. Straight line
2. Declining balance
172 Chapter 11 Equipment Ownership
Figure 11.2 Factors in depreciation.
3. Sum of years digits
4. Production
Declining balance and sum of years are referred to as accelerated methods since they allow
larger amounts of depreciation to be taken in the early years of the life of the asset. (Only the
declining-balance method will be described in this chapter.) The contractor usually selects
a method that offsets or reduces the reported profit for tax purposes as much as possible.
In effect, for companies paying taxes at the corporate rate (assume 34%), each dollar of
depreciation reduces the amount of tax paid by 34 cents (assuming that the depreciation
does not reduce revenue below zero).
Most heavy construction contractors assume that each machine in the fleet is a small
Òprofit centerÓ and will attempt to apply any depreciation associated with a piece of equipment
to offset the profit generated by that machine. The major factors to be considered in
calculating the depreciation of an asset are shown in Figure 11.2. The three major factors
form the three sides of the depreciation ÒboxÓ that are linked by the method of depreciation
selected. They are:
1. Initial cost or basis in dollars
2. Service life in years or hours
3. Salvage value in dollars
The amount that can be depreciated or claimed by way of a tax deduction is the difference
between the initial net value of the asset and its residual or salvage value. This is referred
to as the depreciable amount and establishes the maximum number of depreciation dollars
available in the asset during its service life.
The declared initial cost of the asset must be acceptable in terms of the IRS definition
of depreciable cost. For instance, suppose a $75,000 scraper is purchased. The
tires on the scraper cost $15,000. These tires are considered a current period expense and
therefore are not depreciable. That is, they are not part of the capital asset for purpose of
depreciation. The tires are considered consumables and have a service life different from
that of the asset. In this case, the initial value of the scraper for depreciation purposes is
$60,000.
The initial depreciable cost or basis is often referred to as the net first cost. In addition
to the purchase price minus major expenses, items such as tires, freight costs, and taxes are
included in the net first cost and are part of the amount depreciable. If we have purchased a
rubber-tired wheeled tractor, the net first cost for purposes of depreciation would be arrived
11.3 Depreciation of Equipment 173
Table 11.1 Estimated Service Life Table (Caterpillar Tractor Co.)
Excellent Average Severe
Type of conditions: conditions: conditions:
equipment hours hours hours
Track-type tractors
Traxcavators
Wheeled loaders 12,000 10,000 8,000
Wheeled tractors
Scrapers
Motor graders 15,000 12,000 10,000
To determine the cost per hour due to depreciation, the above information
may be used as follows:
Depreciation cost per hour =
Purchase price - Tire value
Estimated service life in hours
at as follows:
Purchase price $84,000 (FOB1 at factory)
Less tires $14,000
$80,000
Plus tax at 5% $ 4,000
Plus freight $ 2,800
Net first cost $86,800
The depreciable basis for the calculation of depreciation allowances is this first cost of
$86,800.
The concept of salvage value implies that there is some residual value in the piece of
equipment (i.e., scrap value) at the end of its life. Unless this value exceeds 10% of the
first cost of the equipment, this value is neglected and the entire first cost is considered
to be available for depreciation. In the case cited, if the salvage value is less than $8,680,
the entire first cost will be considered as depreciable and the piece of equipment will yield
tax payment reductions in the amount of $29,512 (i.e., $86,800 ¡Ñ 0.34) across its service
life.
The IRS publishes tables indicating the appropriate service life values. Most construction
equipment items fall into the 3-, 5-, or 7-year service life categories. Manufacturers
typically publish tables such as that shown in Table 11.1 indicating a variable service life
based on operating conditions. Service life is defined by the IRS tables, and the only question
has to do with the category or class of property to which an equipment type is to be
assigned.
Given the present highly defined system of depreciation based on fixed tabular percentages,
decisions regarding depreciation are simplified as to whether an accelerated or linearly
prorated system of depreciation is to be used. To better understand the concepts behind the
tables and the prorated system, two of the basic methods of calculating depreciation will be
discussed in the following sections.
1FOB is discussed in Section 16.2 of Chapter 16. In this case it indicates the cost of the equipment at the factory
prior to shipment.
174 Chapter 11 Equipment Ownership
11.4 STRAIGHT-LINE METHOD
An accountant (and the IRS) would describe the straight-line method of calculating allowable
depreciation as being based on the assumption that the depreciation, or the loss in value
through use, is uniform during the useful life of the property. In other words, the net first
cost or other basis for the calculation, less the estimated salvage value, is deductible in equal
annual amounts over the estimated useful life of the equipment. An engineer would call
this a linear method. This simply means that the depreciable amount is linearly prorated or
distributed over the service life of the asset. Let us assume that we have a piece of equipment
that has an initial cost or base value of $16,000 and a salvage value of $1000. The service
life is 5 years and the depreciable amount is $15,000 (initial cost minus salvage value). If
we linearly distribute the $15,000 over the 5-year service life (i.e., take equal amounts each
year), we are using the straight-line method of depreciation. The amount of depreciation
claimed each year is $3000. This is illustrated in Figure 11.3.
The remaining value of the piece of equipment for depreciation purposes can be determined
by consulting the stepwise curve of declining value. During the third year of
the assetÕs service life, for example, the remaining base value, or book value, of the asset
is $10,000. If we connect the points representing the book value at the end of each year
(following subtraction of the depreciation), we have the Òstraight line.Ó
The concept of the base value, or book value, has further tax implications. For instance,
if we sell this asset in the third year for $13,000, we are receiving more from the buyer than
the book value of $10,000. We are gaining $3000 more than the depreciated book value
of the asset. The $3000 constitutes a capital gain. The reasoning is that we have claimed
depreciation up to this point of $6000 and we have declared that as part of the cost of doing
business. Now the market has allowed us to sell at $3000 over the previously declared value,
demonstrating that the depreciation was actually less than was claimed. We have profited
and, therefore, have received taxable income. Prior to the 1986 tax law, a capital gainwas not
taxed at the full rate but at approximately half of the tax rate for normal income. Presently,
capital gains are taxed as normal income (i.e., 34%). Business entities have been pressing
for the reinstatement of the alternate capital gains tax rate.
The base value for depreciation is affected if we modify substantially the piece of equipment.
Assume in the above example, that in the third year we perform a major modification
on the engine of the machine at a total cost of $3000. Since this is a capital improvement,
the term basis is used to refer to the depreciation base. The modification increases the base
Figure 11.3 Straight-line depreciation.
11.5 Declining Balance 175
Figure 11.4 Adjustment of basis.
value of the unit by $3000 as shown in Figure 11.4. It also may extend the service life of the
asset. Something similar occurs if we make some improvements to a building. The value is
increased and this added value can be depreciated.
If we can depreciate real property, can we depreciate the house in which we live?
Depreciation represents a cost of doing business. Since in most cases we do not Òdo businessÓ
in our own home, our home is not a depreciable asset. You can, however, think of some
instances in which a person conducts some business at home. Special depreciation rules
apply to that situation.
11.5 DECLINING BALANCE
One of the accelerated methods previously (prior to 1981) used is the declining balance
method. When applied to new equipment with a useful life of at least 3 years, the effective
rate at which the balance is reduced may be twice the straight-line rate. For this reason,
the expression double-declining balance (DDB) is used when this IRS option is applied to
new assets. For assets that are not purchased new but are secondhand, the optional rate is
150% of the straight-line rate. In this method, it is the rate that is important since it remains
constant throughout the calculations. Formally stated, in the declining-balance method, the
amount of depreciation claimed in the previous year is subtracted from the book value (base
value) at the beginning of the previous year before computing the next yearÕs depreciation.
That is, a constant rate is applied to a balance which is declined each year by the amount
claimed in the previous year. For new equipment the rate is calculated by dividing 200%
by the number of service life years (SLY) (i.e., 200/SLY). For used equipment the rate is
150% divided by the service life years.
To illustrate, consider the $16,000 piece of equipment used in discussing the straightline
method.We will assume the piece is purchased new at this price. Since the service life
of the unit is 5 years, the constant rate to be applied will be 200%/5=40%. The calculations
for this example are summarized in Table 11.2....
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