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

              Year1234510
              Value$333,000333,000333,000333,000333,000333,000
              Minus Maintenance costs$60,00050,00040,00025,00040,00040,000
              Net cash flow$273,000283,000293,000308,000293,000293,000
              Project net present value @10% DCF = $1,784,000
              However, considering the improvements suggested results in the following:


              Improved design resulting in reduced costs and improved output

              Year1234510
              Value$333,000333,000333,000333,000333,000333,000
              Minus Maintenance costs$25,00025,00025,00025,00025,00025,000
              Plus Increased output$50,00050,00050,00050,00050,00050,000
              Net cash flow$358,000358,000358,000358,000358,000358,000
              Net present value @10% DCF = $2,199,000 (+23%)




              Top Plant
              The Top Plant program honors outstanding manufacturing facilities in North America.
              Product of the Year
              The Product of the Year program recognizes products newly released in the manufacturing industries.
              System Integrator of the Year
              Each year, a panel of Control Engineering and Plant Engineering editors and industry expert judges select the System Integrator of the Year Award winners in three categories.
              June 2018
              2018 Lubrication Guide, Motor and maintenance management, Control system migration
              May 2018
              Electrical standards, robots and Lean manufacturing, and how an aluminum packaging plant is helping community growth.
              April 2018
              2017 Product of the Year winners, retrofitting a press, IMTS and Hannover Messe preview, natural refrigerants, testing steam traps
              June 2018
              Machine learning, produced water benefits, programming cavity pumps
              April 2018
              ROVs, rigs, and the real time; wellsite valve manifolds; AI on a chip; analytics use for pipelines
              February 2018
              Focus on power systems, process safety, electrical and power systems, edge computing in the oil & gas industry
              Spring 2018
              Burners for heat-treating furnaces, CHP, dryers, gas humidification, and more
              April 2018
              Implementing a DCS, stepper motors, intelligent motion control, remote monitoring of irrigation systems
              February 2018
              Setting internal automation standards

              Annual Salary Survey

              After two years of economic concerns, manufacturing leaders once again have homed in on the single biggest issue facing their operations:

              It's the workers—or more specifically, the lack of workers.

              The 2017 Plant Engineering Salary Survey looks at not just what plant managers make, but what they think. As they look across their plants today, plant managers say they don’t have the operational depth to take on the new technologies and new challenges of global manufacturing.

              Read more: 2017 Salary Survey

              The Maintenance and Reliability Coach's blog
              Maintenance and reliability tips and best practices from the maintenance and reliability coaches at Allied Reliability Group.
              One Voice for Manufacturing
              The One Voice for Manufacturing blog reports on federal public policy issues impacting the manufacturing sector. One Voice is a joint effort by the National Tooling and Machining...
              The Maintenance and Reliability Professionals Blog
              The Society for Maintenance and Reliability Professionals an organization devoted...
              Machine Safety
              Join this ongoing discussion of machine guarding topics, including solutions assessments, regulatory compliance, gap analysis...
              Research Analyst Blog
              IMS Research, recently acquired by IHS Inc., is a leading independent supplier of market research and consultancy to the global electronics industry.
              Marshall on Maintenance
              Maintenance is not optional in manufacturing. It’s a profit center, driving productivity and uptime while reducing overall repair costs.
              Lachance on CMMS
              The Lachance on CMMS blog is about current maintenance topics. Blogger Paul Lachance is president and chief technology officer for Smartware Group.
              Electrical Safety Update
              This digital report explains how plant engineers need to take greater care when it comes to electrical safety incidents on the plant floor.
              Maintenance & Safety
              The maintenance journey has been a long, slow trek for most manufacturers and has gone from preventive maintenance to predictive maintenance.
              IIoT: Machines, Equipment, & Asset Management
              Articles in this digital report highlight technologies that enable Industrial Internet of Things, IIoT-related products and strategies.
              Randy Steele
              Maintenance Manager; California Oils Corp.
              Matthew J. Woo, PE, RCDD, LEED AP BD+C
              Associate, Electrical Engineering; Wood Harbinger
              Randy Oliver
              Control Systems Engineer; Robert Bosch Corp.
              Data Centers: Impacts of Climate and Cooling Technology
              This course focuses on climate analysis, appropriateness of cooling system selection, and combining cooling systems.
              Safety First: Arc Flash 101
              This course will help identify and reveal electrical hazards and identify the solutions to implementing and maintaining a safe work environment.
              Critical Power: Hospital Electrical Systems
              This course explains how maintaining power and communication systems through emergency power-generation systems is critical.
              Author Information
              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