If you can imagine for a moment that a leased car is a block of ice that begins to melt as soon as it is driven out of a showroom, you are well on your way to understanding the modern concept of automobile leasing.

"The essential fact to keep in mind is that the leasing customer doesn't pay for the ice. He pays for the melting process," says Chuck Parker, president of Rollins Auto Leasing Corp., New Castle, Delaware, "and in the leasing business we call that melting process depreciation."

Although the concept of leasing cars has grown to be­come a viable - often preferable - alternative to purchasing business fleets, an astonishing number of business fleet administrators fail to recognize how depreciation, interest on borrowed money, and administrative costs combine to produce the "rates" they collect from the procession of leasing salesmen who march into their offices.

Without a proper understanding of how leasing compa­nies arrive at their quoted costs, the leasing customer is at an admitted disadvantage when he attempts to decide which leasing contract, if any, is appropriate for his company.

"What happens then," says Parker, "is that the informa­tion the fleet manager needs to make an intelligent choice seems clouded and unspecific. General management priori­ties tend to get misplaced. Without long-term financial analysis, the short term objectives crowd the decision mak­ing process (for example: 'What's the lowest rate you can quote me?') and they tend to provide the only support and justification for selecting a lessor and a leasing plan."

Unfortunately, to take the potential leasing customer be­hind the doors of the typical leasing company, it is necessary to begin by stating one of the few simple, well known facts of auto leasing.

Essentially, there are only two leasing concepts available to automotive fleet management:

Common Designation        Concept        Cost Structure

Closed-End                        Net Rental    Fixed

Open-End                          Finance         Variable

In a finance (open-end) lease, the customer takes all the risk that his blocks of ice will not melt faster than the leasing company predicts.

Technically, the customer agrees to make a certain num­ber of payments of a certain amount while he uses the cars. At the end of the lease period, the leasing company dispos­es of the used vehicles for a certain price (usually at whole­sale).

When the total of the customer's payments plus the price secured for the used cars equals the cost of the cars when new, plus the cost of the money borrowed to finance the cars, plus the lessor's administrative costs, everyone is happy. This doesn't happen very often because predicting the gains and losses of the used car market is about as easy as playing the stock market without blue chips.

If the net price secured in the sale of the used cars is more than costs outlined above, the lessee receives a credit amounting to the difference or an adjustment of the depre­ciation portion of the monthly rental. This results in a cre­dit of an amount is excess of the remaining unamortized value (commonly called the depreciated book value).

Contrary to popular belief, the lessee never "makes money" on a resale return. Essentially, he is credited for an overpayment.

On the other hand, he can "lose" money. If the net re­sale return is lower than the vehicle lease reserve, the lessee incurs an additional liability. That is to say, if his block of ice melts faster than the leasing company expected, or if there happens to be a glut of that particular ice block on the market, the lessee has to come up with more money than he expected to pay.

In the alternative leasing plan, the lessor guarantees the rate at which the block of ice melts. In a net lease the lessee agrees to make a fixed number of payments of a fixed amount. At the end of the lease period there is no reconcil­iation of the residual book value against the net resale return. In industry vernacular the lessee "walks away." Profit and loss is the lessor's risk.

A properly structured finance lease includes the same elements of depreciation, interest and administrative costs as the net lease. Therefore, it should cost the same. In point of fact, it usually does cost the same.

Pressure to quote a competitive rate often causes a lease salesman to write a contract that develops an underaccrual of depreciation reserves, making the finance lease appear less costly - that is, until a final accounting is made at the time of the vehicle resale.

Both types of leasing have many cost assignment and service variations which may include maintenance, tires, or insurance, licenses and taxes on a fixed or variable cost basis.

The attractiveness of a lease with some form of mainte­nance management is that the lessor can usually obtain fleet discounts and provide economies and control accordingly, again, either on a fixed cost or cost plus fixed fee arrange­ment.

Let's go over the three basic cost elements in an automo­tive lease in greater detail.

Depreciation - Under a finance lease the amount in­cluded in the monthly rate is determined as a monthly per­centage of the capitalized cost, usually 2-percent per month or more.

The capitalized cost is the lessor's cost including the deal­er's handling and mark-up. Sometimes it includes a lessee fee or mark-up.

When utilizing a net lease, the amount of monthly depre­ciation included in the rate is based on the lessor's estimate of the vehicle value of salvage at the end of the lease period, or his estimated depreciation amortized over the lease term.

Let's assume that the capitalization cost of a vehicle is $4,850 (includes $50 to $125 for the dealer's profit and handling).

Let's assume further that the lease is for 24 months.

The lessee and lessor mutually or unilaterally estimate that the used car market at the end of the lease period will return about 46-percent of the original capitalized cost for a certain car, considering the vehicle usage, mileage, type and location.

The calculation then would be:

$4,850 x 46% = $2,231 (est. net resale)

$4,850 - $2,231 = $2,619 (actual depreciation expected)

$2,619 ÷ 24 (months) = $109.1 3 (monthly depreciation charge)

$109.13 ÷ $4,850 = 2.25% rate of depreciation

Interest - the interest cost is usually calculated at the lessor capitalized cost and is based on simple interest and an average outstanding balance for the projected usage period or amortization schedule.

An average amount is fixed in the rate each month (usually adjusted on each anniversary date) and a "balloon" balance or unamortized lease amount at the end of the lea term is established.

For the purposes of this analysis, let's assume that the average interest retirement rate is the same as the depreciation rate and that the lessor's effective borrowing interest rate is 7.5-percent.

The interest then would be $22.13 per month even though most finance leases include a larger amount for in­terest the first year and lower amount in the second. In the end, it always averages out as illustrated.

Lessor administrative cost - The general and administra­tive cost allocation included in the typical lease rate is often hard to find because most lessors "bury" the figures under a heading such as finance and administration, management fee, or in the capitalized cost (mark-up). When all things are considered and analyzed, the lessor's costs and returns are always in the neighborhood of $1 5 to $20 per month.

Some rate structures, particularly under a finance lease, will appear to be less. Nevertheless, when the lessor's actual buying economies, manufacturer's allowance and guaranteed resale programs, plus undocumented resale expenses are fac­tored in (as only the lessor himself can do) the lessor's re­turn is often twice that reflected in the lessee's rate structure.

The services performed by the lessor with the lease have a direct effect on the factor as do his service philosophies and capabilities. (The advantages go to the larger lessor here.)

The size or planning potential of the lessee's fleet may also cause the lessee to adjust the general and administrative expense as a kind of volume discount.

For the sake of simplicity, let's assume that the actual size of this item is $17.50 per car, per month.

Executed properly, then, a comparison of the net and finance lease for a specific $4,850 automobile looks like this:

 

Depreciation (2.25%)*   $109.13    $109.13
Interest (average)  22.13 22.13
Lessor Administrative Cost 17.50     17.50
TOTAL $148.76   $148.7

             

*Based on the net resale return after all resale expenses, including transportation, clean-up, resale fees, repairs and so-called reconditioning.

Wait a minute here. Are the costs always the same under the two leasing concepts?

Not really. In the final analysis, it's all in the melting block theory. Was the estimate of the vehicle salvage at the beginning of the lease an accurate one? That's the question.

It all depends on the used car market at the time of re­sale, particularly where the vehicles are sold, to whom, by whom and for whose account. The vehicle condition, type, equipment, mileage, location, even the color and the num­ber of doors can affect the final net return value.

Let's make some further assumptions and see the effect on the last step of completing the lease - "The sale of the used vehicle" and the final accounting of the net return af­ter the expenses of the resale process are recorded.

The used car sold for a net price of $2,095 (after resale expenses) so the accounting of the transaction under either leasing concept would be:

 

  Residual Value (Book Value)  U/C (Net Return) Difference    Additional Dep.Charge
FINANCE $2,231 $2,095 ($316) $136
NET $2,231 $2,095  ($316) -0-

                                                                                                                                                                                                                                                                                                                                                                             

On the favorable side, another example of the disposal of the used vehicle results in a net resale amount in excess of book value and a "gain on sale" is recognized.

 

 

  Residual Value U/C Sale (Net Return) Difference Lessee Depr. Credit  
FINANCE $2,231 $2,315 $84    ($84)  
NET $2,231 $2,315 $84 -0-  

                                                                                 

In reviewing these examples, it is evident that in automo­tive leasing, depreciation is the most important factor in developing a rental rate. That is why competent leasing companies go through an extensive analysis and projection process to insure that the new vehicle being purchased for the lessee will be the most desirable and resalable used car at the end of the lease term.

Even with years of experience, with a wealth of know­ledge, and with all the pertinent data at hand, the lessor is still just guessing. The future is subject to changes in con­sumer personal preference, conditions of the economy, energy costs. Ultimately, these will affect the price of the used car at the end of the lease term.

However, the element of risk can be minimized if the lessee or the lessor will thoroughly analyze the real usage and needs of each fleet driver and mutually establish a rate structure that represents a "balance" for both parties. Les­see-clients who are concerned only with "rate" cause lessors to reduce the monthly depreciation reserve (which is really legerdemain because this is the lessee's own money he's juggling).

This preoccupation with the rate by the lessee is damag­ing to the business relationship and to the service capability of the leasing company. Lowering the rate means lowering something. The depreciation reserve and the lessor adminis­trative fee are the only places to cut, and with these go a reduction of the lessor service and lessor involvement in the lessee's fleet management problems.

There is no "magic" in automotive fleet economies. Cap­ital expended for good service, with the selection of the right leasing concept, from a capable fleet management company, at an equitable cost, can bring your company" high return on its people transportation investment.

Can there be any other acceptable way to lease either a car or a block of ice?

Originally posted on Automotive Fleet

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