Assets to Include

Don’t let perfection be the enemy of good enough. The thought of detailed asset replacement planning given an asset register of hundreds of thousands of accumulated fixed assets over decades can give pause to the even the most noble intent.

A pragmatic approach to asset lifecycle management will begin with setting a threshold value for assets to be individually considered. This threshold value will vary by organization and level of materiality and can range from $10,000 to $1m, or even more. Setting the level too low may generate excessive noise and distract from a clear focus on the critical components. Setting the level too high, may underestimate the heft of the iceberg beneath the surface. A practical recommendation is to start with a higher value to establish the process, and progressively lower the value, if required, as the process matures.

Below this threshold value, assets can be grouped and valuated according to their accounting treatment. The forecast depreciation charge for future periods will provide a reasonable projection of required capital expenditure to sustain current operations.

Above the threshold value, existing assets should be individually identified. This analysis is usually based on the organization’s fixed asset register. The relevant value is not the historical cost or net book value, but the projected future replacement cost. An asset purchased 10 years ago is likely to inherit a significantly higher cost of replacement in present value.

Replacement Cost

A simple extraction of an asset listing, based on acquisition cost inflated by age, and exceeding the pre-determined threshold value, is a good place to start.

But technological advances will seldom mean that a simple like-for-like replacement is desirable, or even available.

The practical responsibility for surveying an organization’s asset base and identifying likely replacement costs ultimately relies on the managers of individual areas.

At a site level, managers will be keenly aware of the dependence on critical infrastructure. They will likely be incurring significant on-going maintenance costs to ensure its reliability. They will also have a much better idea of likely replacement cost. Your asset replacement plan should capture and use this local knowledge over simple historical cost projections.

Accounting Fixed Assets vs Serviceable Equipment

Indeed, the valuation and identification of assets can be a key difference between the perspectives of financial fixed asset accountants and plant maintenance engineers.

Fixed Asset accountants are required to classify, valuate, and report the cost and depreciation of assets in accordance with accounting principles. For most organizations, this is the lower of historical cost or net realization value. The most important data for asset accountants is the asset depreciation classification, acquisition cost, and responsible cost center.

Plant engineers, by contrast, think more about physical equipment, its functional location, and the required maintenance effort to sustain ongoing reliability. Maintenance planners will provide spare parts for critical equipment and conduct regular condition assessments. Based on the current performance characteristics and maintenance costs of existing plant and equipment, and potential replacement alternatives, engineers are continuously making repair, renewal or replacement decisions. Maintenance-relevant data includes technical details, inter-dependency relationships, and maintenance history. The key financial concerns of the plant maintenance team are moderating the total long-term cost of ownership of capital equipment.

In large Enterprise Resource Planning (ERP) systems like SAP, these different perspectives are so acute that the same physical asset is represented by two different ID’s, the fixed asset number and the equipment number (where applicable). These are internally linked, but each department can focus on the details and transactions related to them.

Asset Useful Life and Obsolescence

Both accountants and engineers refer to the useful life of assets. However, they mean different things.

From an accounting perspective, the focus is on the period of depreciation for tax and accounting purposes. The accounting and tax useful lives and depreciation methods are often different, and countries may use their tax systems to incentivize or defer capital expenditure for economic purposes. Accounting useful lives are often standardized and generalized across broad categories of assets with little adjustment for specific installation and usage patterns.

From an engineering perspective, it is the practical useful life that is more relevant.

Functional obsolescence occurs when an asset is no longer fit-for-purpose. It may still work, but it is no longer utilized due to a change in the operating environment. A kid’s bicycle may be a good example: once the family grows up, perfectly good bikes are functionally obsolete. The asset may still have a resale value, but from an engineering point of view it is practically useless.

Physical end-of-life is when the equipment no longer functions at all. The old bike that’s now rusted through and has buckled wheels. Assets at the end of their physical useful life can typically only be scrapped and will have a negative value due to required disposal costs.

Technological obsolescence occurs when technological advances make the asset redundant. Like CD players. They’d probably still work, but hardly anyone listens to CDs anymore.

Economic obsolescence occurs when it is no longer viable to keep the asset running. Like your old car. It gets you from A to B, and you can still buy petrol, but spare parts are increasingly expensive and too often required!

So, when it comes to long-term asset replacement planning, which is the correct useful life to apply? Clearly, accounting and tax useful lives are irrelevant to practical capital sustenance planning. The relevant useful life is determined by the shortest functional, physical, technological or economic lifespan. This is determined by the operating environment and requires experienced assessment. Practical asset useful lives need to be regularly reassessed as they are significantly impacted by usage or consumption.

Consumption Metrics

When assessing the practical useful life of your installed assets and equipment, it is useful to identify the most relevant consumption metric.

Some assets practically depreciate simply over time. Buildings, for example, age whether they are inhabited or not. Naturally, regular maintenance like painting and repair will extend a building’s useful life, but the number of inhabitants won’t make a significant difference.

Other assets are directly impacted by usage. For a vehicle, this may be by distance travelled. For an aircraft, operating hours. For manufacturing equipment, the number of widgets produced. For a furnace, the number of heats.

Based on your organization’s experience, the useful life of key assets can be extrapolated by recording and tracking this consumption. If a delivery truck in your business is generally good for 200,000km, and tends to operate at 50,000km a year, the expected useful life on acquisition should be estimated at 4 years. If after two years, a particular vehicle has only averaged 40,000km per year, the useful life may well be extended to 5 years.

The key point is that the useful life of an asset is not standardized or static. It will depend on the specific operating environment and consumption, and your asset replacement planning should make the collection of consumption metrics as efficient as possible to ensure that realistic replacement schedules are defined.

Maintenance and Operating Cost

In addition to physical depreciation through consumption, economic usefulness is directly impacted by ongoing maintenance and operating costs.

An asset is acquired based on cost assumptions – where actual experience varies significantly, the asset economic useful life will be directly impacted.

Operating costs may vary significantly over time. Energy costs often have a material impact on economic viability. Whilst operating a gas furnace in a certain country may have made sense on acquisition, changes in gas supply and prices because of external factors may quickly render that asset economically obsolete.

Similarly, maintenance costs may diverge from expectations due to limited availability of spare parts or skilled technicians.

Predicting on-going economic viability of assets requires effective comparison of planned and actual maintenance and operating costs. When these running costs diverge materially from planning assumptions, the economic useful lives should be re-appraised and adjusted, as necessary.

Repair, Renew, or Replace Assets

As an asset approaches the end of its useful life, the decision as whether to repair, renew or replace the asset.

Some assets can be almost indefinitely repaired, one spare part at a time. This may not, however, be an operationally or economically optimal strategy. Typically, replacement parts become scarcer and more expensive, as anyone maintaining an old car would be aware.

Refurbishment is a more efficient bulk-repair approach. Rather than risk equipment breakdown and the higher cost of ad-hoc repair, equipment can be periodically proactively renovated and renewed. Refurbishment and renewal differ from repair in that major refurbishments are typically funded from the CapEx budget, whereas repair costs are expensed in the period incurred.

Complete asset replacement involves the disposal of the current asset and the installation of a new asset. This has both cost and performance implications. Replacement may be more expensive but provides greater utility. Or replacement may be economically justified but incur operating risk if new innovative technologies are deployed.

To help make optimal asset replacement decisions, you need an effective project scoring and ranking method maximize asset replacement value by evaluating all investment options.

Project Scoring and Evaluation

The demand for asset refurbishment and replacement funding invariably exceeds the available funding and technical resource capacity available. Effectively ranking and prioritizing initiatives is thus essential to ensure that time and money are allocated where is matters most.

Sustenance, Growth and Savings

The first step is to identify the primary investment reason behind every proposed asset replacement initiative. Is the goal simply sustenance of the current operating infrastructure, or is the real objective to expand capacity or achieve savings based on adoption of new technology?

Identifying the investment driver will impact the scoring model applied. Sustenance initiatives will be evaluated primarily on risk assessments. Growth and savings initiatives will need a financial analysis to be performed to effectively evaluate the project benefits.

Like-for-Like or Better

When identifying a required asset replacement, there are nearly always options to consider. Like-for-like replacement is often only a theoretical option. Given the rapid pace of technological change, most asset classes have experienced significant changes over the last few years.

Some of the benefits of newer assets relate to feature, form, and function. They may look better, do things better, and do different things. Other benefits of new assets may be non-functional: they may be safer, or better for the environment.

It is important when defining a scoring model to evaluate the relative benefits of asset replacement options that financial, operational and non-functional factors are considered.

Effectively identifying and evaluating asset replacement options is essential to an optimal asset replacement plan and project portfolio optimization.

Two levels of project evaluation are required: the best option for an asset replacement needs to be identified, and then that option needs to be compared to other asset replacement initiatives and ranked accordingly.

Urgency is the Risk of Failure

The primary driver of asset replacement initiatives is the risk of operational failure because of asset obsolescence.

This risk is normally classified with reference to a standardized risk matrix that assesses likelihood of imminent failure and potential consequences.

An effective scoring approach is to consider this risk of failure as the primary driver of urgency. Naturally, given a candidate list of asset replacement initiatives, the most urgent should be prioritized.

Risk Reduction is not your only Benefit

The primary objective of asset sustenance initiatives is to reduce operating risk. The degree of risk reduction helps to identify the most beneficial option.

However, risk reduction is a rough guide only. Risk assessments are inherently subjective, and relying too much on these judgements can be unreliable and lead to inconsistencies. Or two options may offer similar levels of risk reduction but vary in other significant ways.

Cost is an important quantitative measure. Given two similar options to replace an asset, the cheaper option is normally preferred.

In addition to risk mitigation and cost differentials, various asset replacement options will provide additional qualitative benefits. You should identify the important characteristics of your assets by asset class (e.g., furnaces, forklifts) and evaluate the qualitative benefits of each option accordingly. These utility benefits may include throughput, quality, and usability, for example.

A full analysis of the relative benefits of asset replacement alternatives should consider risk reduction, cost, and utility value.

Implementation Risk will Impact your Options

Some asset replacement options will be riskier than others. Typically, like-for-like replacements are the least risky option.

Other replacement options will invariably introduce functional performance and change management risks that will need to be assessed.

Even like-for-like replacements are not risk-free. All asset replacement initiatives involve the procurement of goods and services and the application of internal effort. Supplier, commercial, project inter-dependency, and scheduling risks are inherent in all project delivery and your option prioritization should formally assess these risks to identify any key differences.

Strategic Alignment is Imperative

As capital asset replacement projects consume significant capital and human resources, and involve substantial risk, it is paramount that they are aligned to strategy.

If the organization is pursuing a growth strategy, replacement projects that also expand capacity will be more strategically aligned than like-for-like replacements.

Many organizations have made environmental commitments and have set themselves emissions abatement goals. A key mechanism to achieve these goals is through electrification. Consequently, asset replacement initiatives that involve electrification of current industrial processes will be more strategically aligned than others that don’t.

Similarly, organizations may have set social and community engagement goals. Vendor selection will be affected by these policies and may play a crucial role in selection of asset replacements alternatives.

Strategy should cascade down throughout the organization. Every area should have clear strategic priorities and initiatives should be aligned and prioritized accordingly.

Time, Capital and Resource Constraints

The ranking of asset replacement initiatives is based on a balanced assessment of urgency, benefit, implementation risk and strategic alignment. The actual portfolio selection for each year must then be determined within schedule, capital and human resource constraints.

Bucket vs Zero-Based Budgeting

Most organizations combine bottom-up and top-down CapEx planning.

Each area determines required asset replacement sustenance initiatives and combines these with discretionary growth and saving initiatives to produce a CapEx wish-list.

The CapEx controller will work with finance to determine an overall CapEx funding capacity which is distributed down through the organization by business unit and region to individual areas.

Area managers must then prioritize their project selection accordingly. Project scoring and ranking provides an objective basis for this selection, but this must still be validated and refined through judgement and experience.

TotEx is more Important than CapEx or OpEx

A key challenge for many organizations is managing the accounting split between Capital Expenditure (CapEx) and Operational Expenditure (OpEx). Repair costs are OpEx, and bottom-line financial results are impacted immediately. Replacement expenditure is CapEx, and the financial impact is reflected as a depreciation charge over future period.

This distinction is important to management, especially where incentive bonuses are based on financial outcomes. It is also relevant to the calculation of the present value of the tax shield on the expenditure. When expenditure is classed as CapEx, the tax savings are deferred, and the NPV of those deductions is worth less than when the expenditure is OpEx, and the tax benefit is available immediately.

This distinction is often reinforced by the financial systems in use. OpEx planning and variance reporting is normally well supported within the accounting system. CapEx is frequently reliant on external systems or spreadsheets for administration.

Economically, it is the Total Expenditure (TotEx) that counts. The system for developing the asset replacement plan and for supporting repair or replacement decision should focus on prioritizing the projects that will matter most, and allocating expenditure most effectively, irrespective of the accounting classification.

Rent, Lease or Buy

Due to cashflow constraints, alternative financing arrangements should be considered. As opposed to outright purchase, equipment can be leased. These leases can be operating leases (rentals) or financial leases. Financial leases transfer most of the rights and obligations of ownership to the lessee, and such leased assets should be treated as organizational assets for all practical purposes.

The cashflow implications of this funding approach should be consistently reflected in the analysis of the capital projects portfolio. The economic evaluation of leases should be standardized to support effective lease vs buy decisions.

Net Present Value of Future Expenditure

Due to the long-term nature of major asset development, the timing of future cashflows is important to a fair evaluation of project costs.

Initial project expenditure may occur over multiple years, and the effective present value cost of each option should be calculated by discounting these cashflows on a consistent basis.

Some options may cost more but be completed sooner. That means related benefits will also start sooner. To properly assess the relative capital efficiency of alternative projects or implementation alternatives, it is necessary to discount both the costs and future benefits to determine the Net Present Value (NPV) of the proposed investment.

Resourcing

In addition to capital efficiency, an important constraint to determining a viable asset replacement plan is the availability and capacity of key resources.

The work breakdown structure (WBS) and key activities required to deliver each project should be defined. The dependency on technical and business resources for successful project delivery of these activities should be identified.

The total capital project portfolio can then be analyzed to determine the demand for key resources. If necessary, some projects can be deferred, and others brought forward, to ensure that these key people have sufficient capacity to deliver the project portfolio successfully.

Scheduling

The timing of projects can impose a further constraint to portfolio selection.

Some projects will be dependent on others, and these inter-dependency relationships are important to factor-in.

Some projects can only be executed within defined time-of-year windows. For example, retailers will typically not schedule capital projects during their busy seasons.

Many capital asset replacement projects are executed during a scheduled operational shut-down or turn-around window. These projects require careful planning to ensure that all required activities can be accommodated. Often projects will need to be deferred if they cannot be successfully executed in this window.

A key consideration in re-scheduling projects is to determine the ramp-up period. Where long lead-time purchases are required, or multiple resources are required to be mobilized, these ramp-up times will be longer. It is important to identify these ramp-up schedules when rescheduling projects to accommodate capital, resource or timing constraints.

Collaboration and Approval

Preparing an optimized asset replacement plan and budget requires effective collaboration and approval by key stakeholders and technical specialists.

Various perspectives are required including the technical operation, maintenance, procurement, asset accounting, tax and financial reporting implications of asset replacement projects.

A single source of truth for the capital plan will enable secure and efficient access for all participants. Integrated workflow capabilities will keep all participants informed and engaged at the right time in the right sequence to make timely and confident approval decisions.

How to Optimize your Asset Replacement Plan and Capital Budget

An optimized Long-Term Asset Replacement Plan and Capital Budget are essential to align operational activities with strategic priorities.

Invariably there is insufficient time, money or resources to address all asset replacement demand and invest effectively for future growth.

Your sustenance options are to repair or rejuvenate obsolete assets. The primary drivers of this critical decision are risk, return and strategic alignment. Standardize your project scoring and ranking methodology to incorporate these dimensions to ensure you’re prioritizing the initiatives that matter most.

Integrated asset replacement planning and capital budgeting solutions will ensure that your capex budget is optimized accordingly. Stratex Online is the leading solution to comprehensively support capital asset replacement planning and capital budgeting with effective investment proposal scoring, financial analysis calculations, seamless workflow and detailed monitoring and analytic capabilities.