Outright purchase or contract hire? The choice facing fleet operators

16.03.2020

You need to replace a vehicle and you have some cash available or access to a bank credit line.
You’ve always purchased vehicles in the past, but is buying the best option?

Buying a vehicle gives the owner complete control over its use, but that also means responsibility for any depreciation, servicing and repair costs.

Buying a vehicle gives the owner complete control over its use, but that also means responsibility for any depreciation, servicing and repair costs. Contract hire passes full responsibility for the management of vehicles to a leasing company – removing considerable uncertainty in running costs and the headache of fleet management, but at the expense of overall control.

There are also secondary issues to consider within a purchase versus contract hire decision. In particular, costs associated with using a bank credit line or cash held within a business. Some of these costs can be described as ‘hidden’.

The most obvious cost involved in purchasing any asset is depreciation and a calculation should be made as to how the vehicle’s cost will be written off over the period of intended use. This will be a factor in comparing the real costs of purchase to contract hire.

A second issue is whether any available cash is best used to invest in new vehicles. The Office For National Statistics calculates that the return on capital generated by UK businesses has averaged about 12.5% over the past three years. Given that the transport and logistics industry spans the entire UK economy, it is not unreasonable to assume that players in this market would generate a similar average return. The key point here is that cash invested by a business to fund operational expenses will generate income equating to its return on capital. It is therefore this figure, when calculated, that represents the opportunity cost of using cash to purchase vehicles rather than investing in the general running or expansion of the business.

To give an indication as to how the opportunity cost can be calculated, let’s assume a vehicle costing £50,000 can be hired for £50,000, over 4 years, with 16 quarterly rentals of £3,125 (for the purpose of this exercise all other costs associated with running the vehicle have been excluded). On the face of it the two costs are identical but outright purchase involves paying £50,000 immediately, whilst the hire option spreads payment over four years. Let’s also assume the vehicle operator is able to generate a 12.5% return on any cash held in the business, and calculate the income that might be generated by hiring the vehicle and retaining cash:

The chart above shows the benefit in financial terms of retaining cash in a business for as long as possible; this example suggests an overall return of £11,719 if payment was spread over four years. In other words there is an opportunity cost of nearly £12,000 which should be added to the cost of the vehicle if outright purchase was the chosen option.

For many operators considering the purchase of a vehicle, cash might not be readily available, in which case the acquisition could be funded through a bank loan or hire purchase agreement. There are some additional considerations when using a bank loan.

The obvious cost associated with a bank loan is the interest rate. In the current environment, interest is likely to be relatively low, but any fleet operator needs to be aware that if interest rates rise in the future, so might the cost of their bank loan.

A second factor might be the need to keep credit lines open. Over recent years, banks have tended to apply more caution to lending and business owners need to be aware that, once agreed, credit lines might not be readily extended. Thought needs to be given about whether drawing off an agreed credit line to fund the purchase of vehicles might restrict funding for future alternative purposes such as business expansion.

So whether using cash from the business or a bank loan, a choice to either buy a vehicle or take out a contract hire agreement must be made. Buying gives all the benefits associated with ownership but also means that depreciation, servicing and repair costs. Contract hire spreads the payments over time and removes any headache associated with the running and disposal of the vehicle.

Finally, consideration should also be given as to whether buying vehicles is the most effective way to use cash held by a business, or funds available through a bank credit line.

Andy Milsom, Head of Partner Training & Development at BNP Paribas Leasing Solutions

Andy is an experienced sales and finance professional with over 25 years’ experience in sales aid leasing. Andy is widely recognised as an expert in business finance and has in recent years focused his attention on developing partner sales teams develop an understanding of how businesses secure project financing. His training programme – Finance Unlocked – is a highly rated customisable course and is offered at no cost to partners.

If you’re interested in helping your sales team overcome finance-related hurdles during the selling cycle, please get in touch with Andy on 07966 114 243 or email here.

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