AMORTIZATION OF PRODUCTION EQUIPMENT, IMPACT IN PART COST
Each company has their own period of time and way to recover the investment they do in production assets, i.e. production equipment. But one thing is for sure, the companies we all know are not Non-Profit Organizations and they invest in order to make money. Which is just fine, we wouldn’t be here talking today otherwise.
The common practice, in order to be competitive in part prices, is to extend the period of amortization as the investment goes up. For example, a CNC Lathe worth $200k could be amortized in 5 years, an aluminum high-pressure injection molding machine worth $800k will probably be amortized in 7 years; large forging or stamping presses worth millions of dollars will probably be amortized in 10 or more years.
But let’s see how this investment affects piece price. First of all, the complete investment should not be considered for the piece price cost, because there will be a remnant of money for which the equipment could, in the majority of cases, be sold after this period. This is called the “residual” value. So, we have to amortize the investment minus the residual value.
Now comes the question of, “what’s my new machine going to be producing during the amortization period?”. Two possible answers: 1: anything that the equipment can do, or 2: only this part for which I bought it. Both answers are fine and acceptable, but we MUST KNOW it. Option 1 is called “shared equipment”, whereas option 2 is called “dedicated equipment”.
A SHARED equipment is typically a flexible piece of equipment that, with minimum change over, could do any product that fits the machine characteristics, or that it costs so much and have such short cycle times, that even with long change-over times, you can’t allow to dedicate it to any product (you will not be competitive at all!). Examples of typically shared equipment: Mono-spindle CNC lathes, Machining centers, Forging presses, Stamping presses, Aluminum High Pressure Die Cast machines, heat treatment furnaces, etc., etc.
A DEDICATED equipment is, on the other hand, either build to print customized for a particular part, or the part produced takes most of the available yearly capacity with a complex or long change-over time. Typical dedicated machines could be: special assembly machines, custom-made 100% gauging equipment, Multi-spindle lathes, special end-of-line testing equipment, etc., etc.
In both cases, the company buying the equipment will most probably need to ask to a bank for the money (or even if they have their own funds), they will want to pay it back with interests. Let’s see how to calculate the cost/pc based on equipment amortization.
For SHARED equipment, during the amortization years, we need to pay back an amount per year that includes interest. There are nice formulas in Excel that helps you calculate this, like a mortgage on a house. This amount per year is then divided by the number of working hours during a year, and there you have it: cost/hr. Then we apply the typical formula of cost/pc = (cost/hr) / (pcs/hr), and you have your amortization cost per piece.
Let’s make up an example: A turned part in a CNC lathe worth 300k USD (let’s assume 7 years amortization), cycle time 60 sec/pc, uptime 85%. What’s the amortization cost per piece?
Interest rate: 4% annually
Residual value: 15% (45000 USD)
Working: 3 shifts, 8 hr/shift, 235 days/yr
Amortization per year => PMT(4%,7,-300,000,45,000) = 44,285.45 USD/yr
Amortization per hour = 44,285.45/(235x8x3) = 7.85 USD/hr
Pieces/hr = (3600 sec/hr x 0.85) / (60 sec/pc) = 51 pcs/hr
Amortization cost per piece = (7.85 USD/pc) / (51 pcs/hr) = 0.154 USD/pc
If we made the same calculation for 4 year amortization, cost/pc = 0.25 USD/pc
What if we added $50,000 to the initial cost?
Interest rate: 4% annually
Residual value: 15% (52500 USD)
Working: 3 shifts, 8 hr/shift, 235 days/yr
Amortization per year => PMT(4%,7,-350,00-52,500) = 51,666.36 USD/yr
Amortization per hour = 51,666.36/(235x8x3) = 9.16 USD/hr
Pieces/hr = (3600 sec/hr x 0.85) / (60 sec/pc) = 51 pcs/hr
Amortization cost per piece = (9.16USD/pc) / (51 pcs/hr) = 0.179 USD/pc
In this case, using our assumptions, $50,000USD changed the Should Cost by ~ $0.026.
So, depending on the material cost and any other operations that might be needed in the part, this is not going to be the main cost driver of the part. But still, it could represent an important percentage that should be known.
Now, for DEDICATED equipment, this changes. Now we need to look at the NUMBER OF PARTS planned to be produced during the amortization period, and divide the investment plus interest by the number of parts in that period: (Investment – residual value) / (number of parts to be produced) = amortization cost per piece.
Sounds quite easy, doesn’t it? Well, the debate starts when the amortization period is over. Should we completely eliminate the amortization cost from the piece price? Not really, at least not all of it.
After the amortization period, the equipment is normally quite used and worn and SHOULD go though a thorough refurbishment. This cost is quite less than the cost of a new machine, typically between 10 and 25% of the cost of a new machine. Therefore, the amortization cost should be reduced 75-90%. But in addition, even a refurbished piece of equipment is not the same as a new machine, we should expect a lower efficiency (more non-scheduled stops), and even a higher scrap level (more vibrations, more consumables, …). So yes, there should be a significant reduction of the amortization cost per piece, but not all of it. This is a nice discussion to have with companies to understand what’s their “renewal” plan for their equipment and how this will impact the amortization costs.
Above is valid for shared and for dedicated equipment. For this later case, the number of parts produced should be achieved, and for this reason companies should write a clause in their contract about the number of parts planned for amortization, and this amortization cost per piece should not be reduced until this number is achieved.
Some people would also argue whether this dedicated equipment belongs to the customer after the amortization has been paid off in the parts produced. This is a subject for debate as there might be arguments for both options. As long as it is understood, discussed and agreed between the supplier and the buyer, chose whatever option satisfies both sides.
There is a third way for some companies to calculate their amortization cost per piece for DEDICATED equipment, this is, target profit for investment. This is, they plan to make a direct profit for their investment. For example, let’s assume 1M USD investment for a particular project (for this example, let’s assume the interest is included here), and the company targets 10% profit for this, in a project life of 5 years. This means that they need to charge 1M / 5 yrs = 200k USD per year + 10% profit = 220k USD/yr in amortization cost per piece. Divide this 220k USD by the number parts produced in 1 year and you have the amortization cost/pc. Bear in mind that this amortization already has the profit included, so this amortization cost has to be removed from the rest of manufacturing costs (electricity, consumables, floor space,…) at the time of calculating the part profit, so it’s not accounted for twice.
Being transparent in our costs helps us all.
Hope you enjoyed the topic. Take care!
Leo Hernandez
Co-Founder
Society of Cost Engineers