2.4. Components Summary

Now, let us move on to the next important component of the ownership cost and that is your cost of investment. So, investment cost represents the annual cost of capital invested in the machine. It is similar to the cost of acquiring ownership of the machine.

Investment costs refer to the annual expenses associated with the capital invested in equipment or machinery. This is essentially the cost incurred for obtaining a machine, which can be either through borrowed funds (like loans) or direct purchase using company assets. The idea is to account for the capital that could have otherwise been invested elsewhere.

Imagine you plan to buy a car using a bank loan. The interest on that loan is an investment cost you have to pay annually. Alternatively, if you buy the car outright with your savings instead, the interest you could have earned by investing that money instead is another form of investment cost.

So, in both cases, whether you are going for borrowed funds or your purchase from your own companies, you have to take the cost of investment. The investment cost is nothing but the interest rate multiplied by the value of your equipment.

To determine the investment cost, you multiply the interest rate (which can represent either the cost of the loan or the expected return on your capital) by the value of the equipment. This gives you an annualized figure for your investment in the machine.

If you bought a machine worth $100,000 and the interest rate on a loan for that amount is 5$5,000. This is akin to a car loan: if the car costs $30,000 and your interest rate is 4$1,200 annually just for financing the purchase.

The cost of investment can be calculated by 2 different methods: time value method and average annual investment method.

There are two primary methods to calculate investment costs. The time value method is more precise, taking into account the timing of cash flows over different time periods, which provides a more accurate analysis by considering the time value of money. The average annual investment method, on the other hand, approximates costs over the machine's useful life, using the average value of the investment.

Think of the time value method as tracking your savings in a high-interest account over several years versus the average annual investment method as simply estimating how much you save per year. Using the precise interest accumulation from every deposit gives you a clearer picture than estimating based on average deposits.

The time value method is going to be very accurate. It requires converting all cash flows occurring at different times into an equivalent value at a specific time period.

In the time value method, cash flows that happen at different intervals need to be converted to a single point in time for accurate comparison. This is done by using compound interest factors that account for how money grows over time through interest. Thus, it considers both inflows and outflows of cash at their appropriate time frames.

Imagine you receive $100 today and$100 in a year. If you invest the first $100 at an interest rate of 5$100 after one year. If you wanted to understand the total cash flow today, you’d need to calculate how much that future $100 is worth today — this is the time value of money in action.

The average annual investment method provides an approximate value based on the average value of the machine over its lifespan.

This method simplifies calculations by taking the average of the machine's value across its useful life. It assumes depreciation occurs gradually, and it expresses ownership costs as a percentage of this average value. This makes it easier to estimate ownership costs without delving deeply into the complexities of time value.

Consider a car that loses value over time. If you bought it for $20,000 and expect it'll be worth$10,000 in five years, one way to consider its value is to average the initial and final values: ($20,000 +$10,000) / 2 = $15,000. This average can help you better estimate costs like insurance and maintenance.

The next important components of the ownership cost are the insurance costs, taxes, and storage costs, which are expressed as a percentage of the average annual investment or the average value of the machine.

Ownership cost isn't just composed of the investment cost; it also includes costs like insurance, taxes, and storage. Each of these is typically calculated as a percentage of the average annual investment, reflecting the total carrying costs associated with owning the equipment. For example, if insurance costs 2% of the machine's average value, this will add significantly to overall expenses over time.

When you own a home, you not only pay the mortgage (similar to investment costs) but also insurance for protection, property taxes, and maintenance (akin to insurance, taxes, and storage). Understanding all these costs helps you budget effectively.

Total Ownership cost = Depreciation + investment cost + Insurance cost + Tax & storage.

To summarize ownership costs, one must account for several components including depreciation (the loss of value of the asset), the cost of investment (the cost of financing or opportunity cost), and other periodic costs like insurance and taxes. This total provides a clearer picture of the expenses associated with owning a piece of equipment.

Think of this as budgeting for a monthly household expense. Each month, you pay rent (depreciation), utilities (investment costs), insurance on your belongings (insurance), and property taxes — all these together sum up to your total living costs.

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