January 2008, Fleet Financials - Feature
How to Determine the Correct Depreciation Reserve
By Staff
Using the Components
Understanding a TRAC lease’s various components and how they interact, we can now begin to analyze how they can be used to develop a depreciation reserve rate that best meets a fleet’s unique needs.
Before this analysis can be done, however, the fleet manager must access historical data, to see how actual resale performance is impacted by the replacement policy and what the experience has been in TRAC adjustments. Some assumptions help develop the model:
- Fleet of 500 vehicles.
- Replacement cycle of 36 months/70,000 miles, whichever occurs first.
- Fleet is national in scope; different territories experience different usage (mileage, etc.).
- Amortization rate (rate of reserve) is 50 months. (2-percent per month) for the entire fleet.
- Over the prior three years, the fleet has been entirely replaced.
It is not possible for any fleet to replace vehicles in exact accordance with its policy; some vehicles are replaced sooner, some later. This is primarily due to seasonal issues, driver turnover, and inventory requirements. In this test case, about 167 vehicles are replaced each year.
The first step in the analysis is to break the company territories down into groups that reflect differing usage, mileage driven, topography, etc.
- Urban.
- Suburban.
- Rural.
- Extreme (mountainous terrain, desert, off-road).
The lowest mileage accumulation would be in the urban and, to a lesser extent, suburban territories, and the highest mileage in the rural areas. Extreme usage will have both; however, this usage places extreme demands on the vehicles.
The next step is to review the historical data on vehicles sold with an eye on that period in the replacement cycle when the sales took place and to which territory group the vehicle can be assigned. The TRAC payment for these sales generally shows whether the reserve rate properly reflects the usage:
- Category 1. 250 vehicles sold (in the prior three-year period) between 24 and 27 months and between 68,000 and 72,000 miles. Average TRAC adjustment is +$425.
- Category 2. 200 vehicles sold between 18 and 24 months with 68,000-72,000 miles. Average TRAC adjustment is for these is -$2,200.
- Category 3. 50 vehicles sold at 36 months or more with greater than 80,000 miles. The average TRAC adjustment is +$1,400.
At first glance, it seems that overall the 50-month reserve rate is working fairly well for those vehicles replaced at or near the policy. However, the earlier they are replaced (accumulating mileage more quickly), the reserve rate accuracy begins to deteriorate; the market value declines at a faster rate than a 50-month reserve can reflect. Finally, those 50 vehicles kept beyond the policy, without exceeding the replacement mileage by a great deal, saw that reserve rate significantly faster than the market rate.
What does this exercise show? First, for at least half the fleet, the reserve rate fairly reflects the market. For vehicles sold in two years or thereabouts with close to the targeted mileage, a reserve rate of 50 months does a solid job reflecting how these vehicles depreciate.
For category two, which shows vehicles that accumulate mileage more quickly, however, this doesn’t appear the case. How so? The TRAC adjustment using 50 months as a reserve rate is substantially greater (a payment of $2,200 to the lessor versus a credit of $425 to the lessee, a difference of $2,625), which reflects the fact that a newer, higher-mileage vehicle declines in value at a rate faster than 50 months. Finally, the 50 vehicles in category three, which build mileage at a rate slower than the previous two (perhaps urban territories) reflect the greater value of slightly older vehicles with lower mileage.
Based upon this data, the fleet manager can reasonably assume that, although there is a small TRAC adjustment, it is not substantial enough to use a different reserve rate. Further research would reveal which territory category these vehicles inhabit, interesting data to the extent that if one category dominates, reserve can be established by category, rather than on a case-by-case basis.
It is also likely that those vehicles that fall into the third TRAC category (longer-term, lower-mileage) might well fall into the urban territory designation, where mileage is accumulated more slowly.