Depreciation - Turn a problem to an opportunity

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Depreciation is a problem for all rental fleet managers, and the CFO. And its a problem for sales and marketing too. Get it wrong and your profits will evaporate, your fleet will wither and revenues fall, and you simply won't be able to reinvest and compete. But by thinking laterally its possible to turn Depreciation into to a huge opportunity. Particularly for fast depreciating assets. 

The biggest cost for most (not all) rental companies is buying and maintaining their fleet of rental items. These are the things that customers want and they must have. But once bought they have to be accounted for - and they'll be added to the fixed assets of the company. From then on, and at every reporting period (usually monthly), they must have an asset value assigned to them. A 'book value'.

Instinctively we all know that things lose their value over time and with use. It’s not always true - some assets can rise in value. But generally most types of goods and equipment see their value melt over time. For some types of rental goods this happens slowly; such as a 40ft metal shipping container which can be used for 15 years. But when you consider the value of the latest phone you'll know that it plummets quickly. This fall in value is a problem for the CFO of a Rental Company, because the financial accounts should always reflect the realistic market value of the company’s assets. And so various methods are used to calculate the declining value of each asset - its monthly depreciation.

Most commonly the value of an asset is depreciated at a fixed rate over its working life. If the working life is deemed to be 50 months, and the value at the end of this time is zero then the depreciation is set to (100 %  / 50 months)=2% per month of the original cost. If the working life is deemed to be 25 months, and the value at the end is zero then the depreciation is set to (100/25)=4% per month. Etc.

So far so good. This is exactly how most rental companies account for Depreciation. Exactly how my company did it too. But there are real problems with this approach. And it leaves opportunities untapped. For example:

In the real world the value of an item plummets at the start of its life, and then levels out, its definitely not constant! And of course rental premiums should always be higher for new items. Therefore, with fixed rate depreciation and high initial monthly premiums, the rental profits of an asset are artificially inflated at the start of its life. And this isn't good. First of all its bad accounting and of course those inflated profits attract inflated corporation tax. And it isn't good for the fleet management either. Because those inflated profits will increase the temptation to add more and more new products as route to boost profits. Anyone paid on 'profit'* will naturally press for more investment.  And yet, all the while the older assets will stagnate and lose money; because and they 'cost' the same as new products in depreciation, and they simply can't command the same premium any more. If you're not very careful you'll run out of cash or your rental fleet will turn to mush. 

And if you think this won't happen. Just have a look at the rental businesses that are up for sale. They are rarely in great shape and all too often you can trace the problems back to a rental fleet that's been poorly managed. 

If you think that I'm recommend a different way of calculating and accounting for Depreciation, you'd be right. But this is not just a financial management issue for the CFO, this is a real fleet management issue and a sales and marketing issue too. So my approach is not just a simple change in accounting procedure, its more fundamental, and delivers success and profits by motivating everyone to do the right things at the right time. 

* I advocate paying almost everyone on profit, but that's another blog post for another day.

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