SOCIETY OF

MINING ENGINEERS
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EQUIPMENT POLICY: THE EFFECT OF INFLATION
ON ECONOMIC LIFE AND PROFITS
James Douglas
Associate Professor of Civil Engineering
Stanford University
Stanford, California
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EQUIPMENT POLICY: THE EFFECT OF INFLATION
ON ECONOMIC LIFE AND PROFITS
by James Douglas
l
For the past several years, inflation has placed increasing pressure on our
economic system. The total effect of inflation is complex when combined with
other factors .,hich affect the economics of equipment. A mathematical model is
described herein hich can be programmed on a computer to determine the effect
of inflation on economic life and profits after taxes. The computer output
results in graphic plots hich clearly sho the relation of various percentages
of inflation to life and profits.
Inflation has become a common topic of conversation in the recent past.
Hhat is it and ho can it be measured? Hbat effect does increased inflation have
on equipment policy?
Research now in progress at the Construction Institute at Stanford University
is beginning to unravel some of the mystery of inflation. As a start, let us
answer the first question by defining the word inflation. The dictionary says
that inflation is "an increase in the volume of money and credit relative to
available goods resulting in a substantial and continuing rise in the general
price leve 1. (12 I t appears, in fact, that we are in an inflationary spiral whi ch
is (la continuous rise in prices that is sustained by the tendency of wage
increases and cost increases to act on each other.,,3
Inflation behaves just like compound interest. It takes more dollars of
future years to buy an equal amount of a given commodity, be it a material or a
service. Let us assume an annual inflation rate of 5 p e r c e n t ~ Assume that
1Associate Professor of Civil Engineering, Stanford University,
Stanford, California.
2Webster's Seventh New Collegiate Dictionary, Springfield, Mass., G. and C.
Merriam Co., 1969.
3
Ibid

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today one can but a widget for a dollar. One year from now, it will cost
(1 + i) x $1 , and two years from now it will cost (1 + i)2 x $1. If we make
out a table for the future cost of the widget, it will look like this:
Present value
Cost of of dollar to
Year widget buy widgets
0 $1.0000 $1. 0000
1. 0500 0.9524
2 1. 1025 0.9070
3 1. 1576 0.8638
4 1. 2155 0.8227
5 1. 2763 0.7835
TABLE 1. Present Value of Inflated Dollars
The present value of the "recounted" dollar to buy widgets is equal to
$1/(1 + i)n where is the annual rate of inflation and n is the number of
years hence. This is identical to discounting dollars to obtain the present
value from compound interest formulas. A glance at the interest tables in Grant
and Ireson's text on engineering economy4 will confirm that these are also
discounts at 5 percent compound interest. Honey has a time value related to the
rate of inflation as well as the interest rate and the two are additive.
But, how does one measure the rate of inflation? There are many ways to do
this, for each commodity has its own rate. The Consumer's Price Index (CPI) is
the most common measure and is generally used in the union agreements on w a g ~ s to
determine the so-called "cost of livingtf increases. It is also used by the
Federal Government to determine the value of the dollar related to some base
year. The present base year for the CPI is 1967 (+100). In July 1971 the CPI
\,'as 121.5, which is to say that was 21.5 percent higher than in 1967.
The Consumer's Price Index measures the monthly changes in the prices of
hundreds of goods and services purchased by consumers in 56 cities across the
4
Grant, E. L. and Ireson, W. G., Principles of Engineering Economy, Fifth
Edition, Ronald Press, New York, 1970.
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3
country. The package is made up on spending the following proportions of income:
Housing
Food
Health and recreation
Transportation
Clothing
Mis ce llaneous
33.0%
22.5%
19.5%
14.0%
10.0%
~
100.0%
Other price indexes measure other mixes of labor and materials. Some of the
more commonly known of these are the Wholesale Price Index, the Engineering New-
Record Cost Indexes (Building and Construction), and the Highway Bid Price Index.
None of these, including the CPI, is an exact measure of the rate if inflation
for equipment ownership and operating costs. What really is needed is an
Equipment Index which has a proper mix of costs so that the equipment owner can
evaluate the changes taking place.
The various rates of inflation as measured by these indexes mentioned above
are as follows:
ENR
6
FHlVA
6
Cons t.
6
CPI
s
WPI
s
Bldg. Const. Hwy. Bids Wages
Last year 4.7% 3.5% 14.5% 13 .3% 12.3% 14.0'/0
Last 4 years 5.0"10 3.4% 7.2% 8.7% 7.0% 8.4%
Las t 10 years 3.1% 1.9% 4.4% 5.7% 4.6% 6.0%
TABLE 2. Various Rates of Inflation
lVhile one might argue about the relevance of the indexes shown in the table
above to equipment costs, it is abundantly clear that inflation is occurring at a
present rate of 5 percent to 15 percent. It also appears to be increasing since
SEconomic Indicators, Congressional Joint Economic Committee and Council of
Economic Advisers, lVashington, D. C. :U.S. Govt. Print Off, August 1971.
6Engineering News-Record, New York:McGraw-Hill Publishing Co., June 17,
1971.
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4
the rate for the past year is much higher than the average for the past four
years. Both are considerably higher than the average for the past ten years. The
average annual increase in the Consumers' Price Index from 1913 to 1967 was only
2.25 percent. Truly an inflationary spiral has set in!
A small amount of inflation is characteristic of a healthy American
economy. An inspection of source data
7
reveals that a carpenter's hourly wage in
1861 was $0.069. In 1961 his basic wage was $4.30 per hour. Over the intervening
century, his wage increased an average of 4.25 percent annually! It would appear
that some inflation has been good for us and the nation has responded with an
increase in productivity to offset the higher rate of wage increases over prices.
This has not been true over the recent past and we have ample cause to worry.
The awesome problem that confronts us is how to account for these changes in our
equipment policy.
Research has demonstrated that this problem can be alleviated by using a
computer to solve a complex mathematical model to determine the economics of
equipment ownership.
Over the past several years, a complex model of this sort has been developed
and studied at Stanford University at the Construction Institute. The technique
of building this model is described in Technical Report No. 22.
8
The model is
very simple conceptually. It may be described best as a discounted cash flow
model. Revenues and costs are expressed as exponential functions. The latter
are subtracted from the former and discounted back to the present time to yield
the present worth of profits after taxes. The model becomes more complex as the
finer points of equipment economics are examined until we end up with a group of
equations that only a computer can facilitate.
7Historical Statistics of the United States, Colonial Times to 1957, U.S.
Department of Commerce, Washington, D. C.:U.S. Govt. Print Off., 1960.
8Douglas, James.
Equipment. Technical
May 1963.
Obsolescence as a Factor in the Depreciation of Construction
Report No. 22. Construction Institute, Stanford University,
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5
A mathematical model is simply an equation or group of equations portraying
a system. In the development of this model, a group of equations is written to
simulate the costs of owning, maintaining and operating construction equipment.
By manipulating the variables in these equations, the decision maker is able to
confirm quantitatively the decisions he must make which involve the economics
of his equipment. For the purposes of this discussion, the economic life of a
machine is defined as that life which maximizes the return to the owner during
the lifetime of the enterprise.
The development of all this economic theory related to equipment has been
in process for more than forty years. New concepts have been added from time to
time so that we now have a rather sophisticated body of mathematical theory
to support what intuition has been telling us all along. Needless to say, in
making decisions about equipment policy, modern economic environment dictates a
consideration of at least the following basic concepts.
(a) time value of money
(b) technological advances in equipment (obsolescence)
(c) effect of taxes (depreciation techniques, etc.)
(d) influence of inflation
(e) increased cost of borrowing money
(f) continuing replacements in the future
(g) increased cost of future machines
These basic concepts have been covered in other technical reports published
by the Construction Institute at Stanford.
9
The interested reader is referred
to them for a more detailed explanation of the short description which follows.
Exponential curves are used to represent the revenue and cost functions.
These are in the form of
-=
y = e Figure 1 shows a family of this type of
curve. If one needs to represent an increasing cost rather than a decreasing
one, the function y = R(l - e-
ax
) may be used as illustrated in Figure 2. A
more complete discussion of the utilization of these curves and their application
9See also Technical Reports 22, 61, 69, and 85.
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6
to actual cost functions will be found in Technical Report No. 61.
10
These
exponential functions are used not only because they are so flexible, but
they can be combined readily with the continuous discount factor
ll
to simplify
the mathematics.
In this model, costs and revenues are considered for all machines, both
present and future. These may be classified as follows:
(a) revenues from the services of the machines
(b) maintenance and operating costs including annual fixed costs,
penalties and overhead
(c) capital costs, including interest on investment and depreciation
charges
(d) discrete costs such as engine, track and final drive overhauls
(e) income and corporation taxes, considering depreciation method,
recapture of income on sale and investment credit.
Figure 3 shows a typical cost curve for the present machine and an infinite
series of replacement. In this figure, the present machine is held two years
until disposal, and future machines are replaced thereafter at three-year intervals.
Costs decline from machine to machine because of technological improvements but
increase in each machine as it ages. N is the number of years the present
machine will be held until it is replaced and machines will be replaced thereafter
in L years.
lODouglas, James. Construction Equipment Policy: The Economic Life of
Equipment. Technical Report No. 61. Construction Institute, Stanford University,
Stanford, California, July 1966.
lIThe continuous discount factor is an exponential function in the form
of e-
it
.
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No inflation factor is present in the cost curve shown in Figure 3
since future costs are estimated in present dollars. The only time 'it is
necessary to include an inflation factor is in combining dollars of different
years. This will occur in the following situations:
(a) repayment of borrowed capital, including interest on the loan
(b) depreciation computations
(c) gain on sale
In their final form for inclusion in the computer algorithm, the equations
look formidable. For example, the equation for the present worth of the gai.n
on sale for all future machines, G
2
' looks like this:
There are presently some 36 equations and 72 associated variables which can be
included in this program to derive the desired output. Fortunately the computer
has rescued the dedicated analyst from a lifetime of drudgery.
The computer will output a graphic plot of the present worth of profits-
after-tax versus age at replacement which will give the owner a complete picture
of the profits resulting from his policy on economic life. Figure I, shows a
typical plot with the economic life and profit life of the machine marked on
the curve. This solution is much more revealing than the usual d i s ~ r e e t solution
to this same problem. The owner is able to see the consequences of inappropriate
policy in terms of reduced profits. Since the model is designed for a series
of replacements to an infinite hori.zon, annual profIt may be easily derived by
mUltiplying the present worth by the interest rate.
In setting up the model to check the sensitivity of profits and economic
life to changes in the rate of inflation, cost data from the transit mixer study
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8
described in Technical Report No. 61
12
were used. Figure 5 is a simplified plot
to show the changes in economic life and profits as the inflation rate varies
from 0% to 20% in 5% increments. In this plot, double declining balance
depreciation is used with a useful service life of five years. No investment
credit is used and periodic overhauls are suspended. 75% of the funds required
to finance the equipment are borrowed at 8% simple interest for a term of three
years. This results in smooth curves which clearly show what happens with
increased inflation. Printout verifies the data on the graphic plot as follows:
Inflation Economic P.W. of Profits
Rate Life (Years) After Taxes ($)
o % 6.1 24456
5 % 6.3 22973
10 % 6.5 21732
15 % 6.6 20681
20 % 6.8 19784
Table 3. Life and Profits, Inflation 0 % to 20 %.
Figure 6 is a simplified plot based on the data above but showing what
happens with runaway inflation up to 80 percent. In this case, profits are
depressed even more and economic life is lengthened further. The printout for
these data show:
Inflation Economic P.W. of Profits
Rate Life (Years) After Taxes ($)
0 % 6.1 24456
20 % 6.8 19784
40 % 7.2 17200
60 % 7.4 15558
80 % 7.6 14410
Table 4. Life and Profits, Inflation 0 % to 80 %.
l2Douglas, J ~ e s . Construction Equipment Policy: The Economic Life
of Equipment.
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It is more likely that we shall see inflation rates up to the 20% in Table
rather than the 80% in Table 4. With a rate of 20%, economic life is increased
12% and profits are 19% less than with 0% inflation. And, although we have
not had an inflation rate of even 20%, there are Latin American countries
which have had rates up to 80%. In this case economic life is 25% longer and
profits are down 41%.
These results are true only if policy on economic life is changed as tbe
inflation rate increases. If an ol",er had a policy of replacement at a life
of five years, and did not change as inflation increased to 80%, profits would
be as follows:
Life Inflation P.W. of Profits
(Years) Rate After Taxes ($)
5.0 0 %
23779
5.0 5 % 22032
5.0 10 % 20520
5.0 15 % 19203
5.0 20 % 18050
5.0 40 % 14608
5.0 60 % 12347
5.0 80 % 10746
Table 5. Profits with Five Year Life, Inflation 0 % to 80 %.
In the above example, where the age at replacement was held at five years,
profits are down 24% at 20% inflation and 55% at 80% inflation. This clearly
shows the necessity of flexible replacement policy in a dynamic situation such
as rapidly increasing inflation.
Figure 7 shows a set of curVeS for inflation rates from 0% to 20% but
including variable depreciation, investment credit and overhauls at 2.5 year
intervals. Again, 75% of the cost of a new machine is financed @ 8% simple
interest on a three year term. In this plot, note the following points:
Time
(Years)
(a) 2.3
(b) 2.5
5.0
7.5
(e) 3.0
Cd) 4.0
6.0
8.0
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10
Item
Switch from straight line to 150% declining
balance depreciation
Periodic overhaul expenses
Switch from 150% declining balance to double
declining balance depreciation
Investment credit
Table 6 shows the economic life and profits related to various inflation
rates from 0% to 20% taking into account the factors mentioned.
Inflation Economic P.W. of Profits
Rate Life (Years) After Taxes ($ )
0 % 5.0 22823
5 % 5.0 21076
10 % 5.0 19563
15 % 5.0 18246
20 % 5.0 17093
Table 6. Life and Profits, Inflation 0% to 20%.
In this case, economic life is dominated by the second major overhaul
at the end of five years. Profits dropped 25% as inflation increased from 0%
to 20%.
From these examples, it can be seen that the influence of inflation is
rather complex because of the interactions of the numerous factors affecting
the economics of equipment. This problem can best be solved by use of a computer
at a reasonable cost. Using the IBM 360/67 computer and Calcomp Plotter at
Stanford University, the cost is $600 an hour. A typical computer run to output
a graphic plot with 5 curves took 6.24 seconds to execute. The total execution
time was 0.94 minutes and the cost about $10.
It is anticipated that this system can be used in the mining industry
with more facility than in construction work. The large amounts of overburden
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11
and ore moved in mining provide much more stability than road or dam construction
operations. Starting with good, reliable cost data, it would be fairly easy
to come up with predictions of economic life and profits of mining equipment.
And this could be done with much more confidence than we have in dealing with
construction jobs which are inherently unstable.
In conclusion, it can be said that this computerized model has demonstrated
several things about inflation:
(a) its effect is complex and cannot be handled by less than a computer
(b) generally, increase in inflation will increase the economic life
of a machine
(c) profits will always decrease with an increase in inflation
(d) use of acclerated depreciation is even more important for higher
profits than when there is no inflation
What the effects of new federal regulations will be on life and profits cannot
be known until they are published and clarified. Such things as higher invest-
ment credit and shorter depreciation write-offs will surely call for policy
changes. Whatever the new regulations bring forth, you can be assured that
they can be analyzed quickly by the computer as an aid in making the necessary
management decisions.
y
y
)'
O.S
-ax
"
12
a = 0.0
0.1
0.2
0.3
.4
O.OL-______ ~ r _ - - - - - - ~ - - - - - - - - ~ - - - - - - - - ~ - - -
x
Figure 1. Family of exponential curves, y
y
R(l - e -ax)
2.0
x
Figure 2. Family of exponential curves, Y
-ax
e
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13
1st 2nd 3rd
4th
Repl. Repl. Repl. Repl. Repl.
I
Infinity
10
I
8
0
0
...,
r
'" u
'" 0
U
rl 5
OJ
"
"
"
"'"
N L L L
10
15
Time (years)
Figure 3. Typical cost curve
Economic
Life
o
Profit Life
5
10
Age at Replacement (years)
Figure 4. Typical graphic plot of profit vs. life
25
20
15
8
0
10
0
.-<
<.f>-
C-
Ol
5
'-'
'M
4-<
0
...
0
p.,
-5
25
20
15
10
a
5
0
0
.-<
<.f>-
e
0
m
.u
....
4-l
0
-5
...
p.,
o
0
14
Age at Replacement (Years)
Figure 5, Simplified Plot, Inflation Rate: 0% to 20%
2
8
Age at Replacement (Years)
Figure 6. Simplified Plot, Inflation Rate: 0% to 80%
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10
25
20
0
0
0
15
H
</}-
C-
oo
10
'-'
'M
4-<
0
"
5
""
0
-5
0
Figure 7
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15
Age at Replacement (Years)
Plot with variable depreciation, overhauls @ 2.5 years,
and investment credit. Inflation rate: 0% to 20%