Payback method —Too simple and too expensive

According to the Society for Maintenance and Reliability Professionals (SMRP), 86% of the manufacturers surveyed do not use a life cycle cost model when designing new capital equipment projects. Indeed, the design and installation philosophy of many companies appears to be one of lowest installed cost and minimum adequate design (MAD).

07/01/2001


According to the Society for Maintenance and Reliability Professionals (SMRP), 86% of the manufacturers surveyed do not use a life cycle cost model when designing new capital equipment projects. Indeed, the design and installation philosophy of many companies appears to be one of lowest installed cost and minimum adequate design (MAD).

While minimum adequacy may be theoretically appropriate, the problem for many companies is that the basis for this idea is often poorly defined. It is driven by constrained capital budgets and demanding schedules, and ignores life cycle cost.

The point of this article is not to be overly critical of any particular analysis method, but to encourage balancing of all the appropriate issues, including consideration of life cycle cost principles.

Typical small capital project

Assume that the anticipated cost of a project is $1 million, and the annual estimated benefit that will result from improved production operations will be $333,000. Under this scenario, the payback period is 3 yr, which is considered the company maximum.

However, among other policies related to capital projects, the company recently implemented a project review process for all projects over $100,000, which requires a fairly thorough review of the job by the project engineer and appropriate senior level shop floor personnel (mechanics, electricians, operators, etc.).

These groups analyzed the job and made several recommendations:

  • Some material should be stainless steel for much longer life

  • Additional instrumentation is needed to better control the process

  • Spares are inadequate

  • Access and lay down space are inadequate as shown

  • The best (most reliable and easiest to maintain) pumps are something different than specified.

    • Unfortunately, taking their advice increases the cost of the project to $1,200,000, without any obvious increase in benefit above the $333,000 already anticipated. If their advice is followed, the project no longer meets the company's payback requirement. Consequently, the suggestions, and their added cost, are initially declined.

      However, the company also reviewed historic costs for maintenance as a percent of plant replacement value (PRV). The data revealed that the first year maintenance costs were 6% of PRV, second year were 5%, third year 4%, fourth year 2[en]3%, and 4% thereafter.

      Further research revealed:

      • Maintenance costs at the best comparable plants are sustained at near 2.5% of PRV

      • Unplanned equipment downtime is running 5% or more vs a best in class of 1%

      • Production losses are running 5%, largely due to instrumentation, vs a best in class of 1%.

        • If the production rate losses could be reduced and maintenance costs minimized by taking the advice of the people who are in a reasonable position to know what the problems are, then future costs could be reduced or future benefit increased.

          Reviewing the potential impact of the suggestions shows that it's reasonable to expect two facts.

          1. Maintenance cost for the new equipment will be 2.5% of replacement value, from the beginning.

          2. Production losses will actually be further reduced and have a positive effect as a result of this "improved" capital project. This positive effect is valued at a minimum of $50,000/yr.

            1. Rather than a payback "analysis," perform a life cycle analysis, assuming a 10-yr life, and using the discounted cash flow (DCF) technique. In the base case, the "payback" becomes:

              Taking the advice of the shop floor personnel minimizes future losses and costs while yielding a 23% greater ROI on the project. It also returns an additional $415,000 — more than double the $200,000 incremental initial investment.

              Put a different way, by taking into account the opportunity cost of the base case, the initial capital investment is really $1,000,000 plus the opportunity cost of $415,000, or $1,415,000 when compared to the better scenario. This approach reduces maintenance costs and increases reliable production capacity.

              A number of assumptions are made to this example, but none of these are as simplified as the so-called payback analysis. Further, data used for maintenance cost as a percent of plant replacement value are very common, production losses due to unreliable equipment are likewise very common, and the benefit to be achieved is common.

              Much of this loss and cost can be effectively eliminated in the design stage, if we look more fully at equipment histories and losses from ideal production, and why they are occurring. It is critical to think more in terms of life cycle costs, and take more seriously the advice of those who are closest to the problems in our plants — shop floor personnel.

              Discounted cash flow/life cycle analysis—base case

              <table ID = 'id2736557-60-table' CELLSPACING = '1' CELLPADDING = '3' BORDER = '0'><tbody ID = 'id2736565-60-tbody'><tr ID = 'id2736567-60-tr' STYLE = 'background-color: #CCCCCC'><td ID = 'id2736572-60-td' CLASS = 'copy'>Year</td><td ID = 'id2736577-61-td' CLASS = 'copy'>1</td><td ID = 'id2737009-62-td' CLASS = 'copy'>2</td><td ID = 'id2737015-63-td' CLASS = 'copy'>3</td><td ID = 'id2737020-64-td' CLASS = 'copy'>4</td><td ID = 'id2737026-65-td' CLASS = 'copy'>5</td><td ID = 'id2737032-66-td' CLASS = 'copy'>10</td></tr></tbody><tbody ID = 'id2737039-69-tbody'><tr ID = 'id2737041-69-tr' VALIGN = 'middle' STYLE = 'background-color: #EEEEEE'><td ID = 'id2737048-69-td' CLASS = 'table'>Value</td><td ID = 'id2737054-70-td' CLASS = 'table'>$333,000</td><td ID = 'id2737059-71-td' CLASS = 'table'>333,000</td><td ID = 'id2737065-72-td' CLASS = 'table'>333,000</td><td ID = 'id2737071-73-td' CLASS = 'table'>333,000</td><td ID = 'id2737076-74-td' CLASS = 'table'>333,000</td><td ID = 'id2737082-75-td' CLASS = 'table'>333,000</td></tr><tr ID = 'id2737089-77-tr' VALIGN = 'middle' STYLE = 'background-color: #EEEEEE'><td ID = 'id2737095-77-td' CLASS = 'table'>Minus Maintenance costs</td><td ID = 'id2737101-78-td' CLASS = 'table'>$60,000</td><td ID = 'id2737107-79-td' CLASS = 'table'>50,000</td><td ID = 'id2737113-80-td' CLASS = 'table'>40,000</td><td ID = 'id2737118-81-td' CLASS = 'table'>25,000</td><td ID = 'id2737124-82-td' CLASS = 'table'>40,000</td><td ID = 'id2737130-83-td' CLASS = 'table'>40,000</td></tr><tr ID = 'id2737137-85-tr' VALIGN = 'middle' STYLE = 'background-color: #EEEEEE'><td ID = 'id2737143-85-td' CLASS = 'table'>Net cash flow</td><td ID = 'id2737149-86-td' CLASS = 'table'>$273,000</td><td ID = 'id2737154-87-td' CLASS = 'table'>283,000</td><td ID = 'id2737160-88-td' CLASS = 'table'>293,000</td><td ID = 'id2737166-89-td' CLASS = 'table'>308,000</td><td ID = 'id2737172-90-td' CLASS = 'table'>293,000</td><td ID = 'id2737177-91-td' CLASS = 'table'>293,000</td></tr></tbody><tr ID = 'id2737185-94-tr'><td ID = 'id2737187-94-td' CLASS = 'tfoot' COLSPAN = '7'>Project net present value @10% DCF = $1,784,000
              However, considering the improvements suggested results in the following:
              </td></tr></table>


              Improved design resulting in reduced costs and improved output

              <table ID = 'id2737207-102-table' CELLSPACING = '1' CELLPADDING = '3' BORDER = '0'><tbody ID = 'id2737215-102-tbody'><tr ID = 'id2737217-102-tr' STYLE = 'background-color: #CCCCCC'><td ID = 'id2737222-102-td' CLASS = 'copy'>Year</td><td ID = 'id2737227-103-td' CLASS = 'copy'>1</td><td ID = 'id2737233-104-td' CLASS = 'copy'>2</td><td ID = 'id2737238-105-td' CLASS = 'copy'>3</td><td ID = 'id2737244-106-td' CLASS = 'copy'>4</td><td ID = 'id2737249-107-td' CLASS = 'copy'>5</td><td ID = 'id2737255-108-td' CLASS = 'copy'>10</td></tr></tbody><tbody ID = 'id2737262-111-tbody'><tr ID = 'id2737264-111-tr' VALIGN = 'middle' STYLE = 'background-color: #EEEEEE'><td ID = 'id2737271-111-td' CLASS = 'table'>Value</td><td ID = 'id2737276-112-td' CLASS = 'table'>$333,000</td><td ID = 'id2737282-113-td' CLASS = 'table'>333,000</td><td ID = 'id2737288-114-td' CLASS = 'table'>333,000</td><td ID = 'id2737294-115-td' CLASS = 'table'>333,000</td><td ID = 'id2737299-116-td' CLASS = 'table'>333,000</td><td ID = 'id2737305-117-td' CLASS = 'table'>333,000</td></tr><tr ID = 'id2737312-119-tr' VALIGN = 'middle' STYLE = 'background-color: #EEEEEE'><td ID = 'id2737318-119-td' CLASS = 'table'>Minus Maintenance costs</td><td ID = 'id2737324-120-td' CLASS = 'table'>$25,000</td><td ID = 'id2737330-121-td' CLASS = 'table'>25,000</td><td ID = 'id2737336-122-td' CLASS = 'table'>25,000</td><td ID = 'id2737341-123-td' CLASS = 'table'>25,000</td><td ID = 'id2737347-124-td' CLASS = 'table'>25,000</td><td ID = 'id2737353-125-td' CLASS = 'table'>25,000</td></tr><tr ID = 'id2737360-127-tr' VALIGN = 'middle' STYLE = 'background-color: #EEEEEE'><td ID = 'id2737366-127-td' CLASS = 'table'>Plus Increased output</td><td ID = 'id2737372-128-td' CLASS = 'table'>$50,000</td><td ID = 'id2737377-129-td' CLASS = 'table'>50,000</td><td ID = 'id2737383-130-td' CLASS = 'table'>50,000</td><td ID = 'id2737389-131-td' CLASS = 'table'>50,000</td><td ID = 'id2737395-132-td' CLASS = 'table'>50,000</td><td ID = 'id2737400-133-td' CLASS = 'table'>50,000</td></tr><tr ID = 'id2737407-135-tr' VALIGN = 'middle' STYLE = 'background-color: #EEEEEE'><td ID = 'id2737414-135-td' CLASS = 'table'>Net cash flow</td><td ID = 'id2737419-136-td' CLASS = 'table'>$358,000</td><td ID = 'id2737425-137-td' CLASS = 'table'>358,000</td><td ID = 'id2737431-138-td' CLASS = 'table'>358,000</td><td ID = 'id2737436-139-td' CLASS = 'table'>358,000</td><td ID = 'id2737442-140-td' CLASS = 'table'>358,000</td><td ID = 'id2737448-141-td' CLASS = 'table'>358,000</td></tr></tbody><tr ID = 'id2737456-144-tr'><td ID = 'id2737458-144-td' CLASS = 'tfoot' COLSPAN = '7'>Net present value @10% DCF = $2,199,000 (+23%)
              </td></tr></table>
              <table ID = 'id3002734-0-table' CELLSPACING = '0' CELLPADDING = '2' WIDTH = '100%' BORDER = '0'><tbody ID = 'id3008406-0-tbody'><tr ID = 'id3003010-0-tr'><td ID = 'id3003012-0-td' CLASS = 'table' STYLE = 'background-color: #EEEEEE'>Author Information</td></tr><tr ID = 'id3003021-2-tr'><td ID = 'id3001860-2-td' CLASS = 'table'>To do otherwise could lead to a situation where payback analysis, though simple, is actually quite expensive.Ron Moore is managing partner for The RM Group, Inc., Knoxville, TN, and author of Making Common Sense Common Practice: Models for Manufacturing Excellence. He can be reached at RonsRMGP@aol.com or by telephone at 865-675-7647.</td></tr></tbody></table>


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