The Real Costs of Deferred Maintenance
When it comes to ownership of real property, and even personal property, budgets and finances always overshadow all that we do. I have never had a project with an unlimited budget and never expect to have one. After spending most of my career seeing things from an Architect’s point of view, my last almost seven years has been spent seeing those same issues from an owner’s perspective. When you have to oversee well over 143 million square feet, even tens of millions of dollars (which sounds like a lot of money) really are insignificant with respect to the needs and demands. Decisions have to be made with the limited funds available on how to distribute those funds most effectively. How do you get the greatest return for funds expended?
In that environment, the real question is how do you maximize the value of those limited funds? To arrive at that conclusion, many factors must be weighed. This article will attempt to bring forward some of those complex inter-related factors and inspect those issues in an attempt to develop a methodology that may allow for decision-makers to create tools to utilize in more effective prioritization of capital asset maintenance expenses. These are actually expenses, but if exploited in a strategic manner they actually become more like an investment, with a return on investment (ROI), and other benefits.
Foundation – TNSTAFL
In one of my first classes in Economics 101 my instructor started class off by writing on the board TNSTAFL. He asked us if anyone knew what these letters stood for. After no one getting it correct, he then said, “There’s No Such Thing As a Free Lunch.” He asked how many believed that statement was true. Many said that it was incorrect, as there is such a thing as a free lunch. If someone else pays for it, then it is a free lunch was the reason presented. Many in class agreed with that statement. Our instructor continued on to disagree with us, saying that there is a cost even if you do not pay for the lunch; it is your time that is the cost extracted. You chose to spend time at that lunch that someone else was paying for, so the lunch still had a cost of your time. The following discussion became quite enlightening. Talk of a pure economic view of costs, that sure was, and it certainly was correct, just not a thought process most of us had prior to that discussion.
This concept had a huge impact the rest of the semester, especially when we discussed opportunity costs. That discussion laid a foundation for my studies in economics that made me realize there is a cost to everything; the question always is, am I willing to pay that cost for the benefit received? When we start to look at real and personal property from an owner’s perspective this becomes a paramount concept. It does not matter if you are making these decisions as an individual or as part of a group. Nothing changes; the foundation is the same for these decisions.
Once a decision is made to acquire real or personal property, responsibility is an unavoidable by-product of that acquisition. For instance, when you buy a car, your responsibility of buying fuel is implied. If you do not purchase that fuel, the car does not continue to move. Outside forces may require additional responsibilities. As in the previous car example, the State may require you to carry and maintain insurance on that car in order to drive the car. This is also implied, as it is expected that you will comply with the laws of the State in order to drive that car.
Changing oil also becomes part of those responsibilities. If you do not change the oil, you will shorten the life of that car. Not to date myself, but those who are aged a little might remember the Fram Oil Filter commercial, “You can pay me now, or you can pay me later.” The principle still exists and is still the same. When I was much younger, I had someone I know lease a car for five years. As the fifth year approached, his car broke, down and I took him to the mechanic after having the car towed there. The mechanic asked when was the last time he changed the oil, and he said never. Back then there was none of the synthetic oils on the market, so an oil change was about $20 every three months. The cost to change the oil in his car for those five years totaled about $400, while the new engine cost him about $5,000 to install. That is a substantial increase in costs for deferred (or no) maintenance.
A savvy owner of real or personal property will be able to recognize this and find a way to balance the increased pressure to reduce budgets while at the same time balance the life extension of capital assets. This article will attempt to give guidance on how to balance many of these interdependent factors, and maximize the life of intensely invested capital assets.
Differed Maintenance Ramifications
Let us begin this discussion with defining what exactly is deferred maintenance. The greatest mistake made when people or groups utilize this idea of deferred maintenance is the complete misapplication of this principle. In an attempt to avoid propagating this misapplication, we must first grasp some basic concepts of exactly what deferred maintenance really is. Going back to what was previously stated, there is a cost associated to everything, deferred maintenance is no exception. In order to find out what the real cost of deferred maintenance is, we must first begin by establishing what the cost of maintenance looks like. I will use numbers to illustrate this principle, but these numbers are not to be construed as being relational to anything in particular.
For any capital investment, let us say that the annual cost to maintain that investment in good operating condition is $1,000 a year. This number should actually increase as the capital asset ages, but we will not use that factor in this example as that will complicate the illustration beyond comprehension of many readers. So, the current year revenues are down, there is not $1,000 to expend on this required maintenance for this capital asset; a decision is required on what to do with the short fall in the budget. Many options are available, each with their own costs associated with each specific decision, making each a unique solution to the situation for the budget short fall.
The most common solution today is to just ignore it, do not pay the $1,000 and deal with it later when revenues are better. That is absolutely the wrong approach. I do not usually use words of such an unlimited value when talking about solutions, but this is one of the very few times such a powerful word is applicable in the realm of solutions, which will be demonstrated as we continue this discussion. Each and every decision-making person or group involved with these types of decisions are fiduciaries in one form or another. This means that they are obligated to make the best use of the funds available. So, we are going to proceed under that particular parameter for the rest of this discussion; all decision-makers are fiduciaries. This ideology should imply that the most sustainable position is the goal for any capital asset management decision.
The next point that must be acknowledged is the fact that at anytime in the future (immediate or distant) the lowest cost available for any capital improvement / building renewal is the present time. At any point in the future, even in as little as weeks, costs will potentially be increased, and the farther in the future, the more the cost increases will become. This increase will be caused by a myriad of potential reasons, costs of raw materials, inflation, supply and demand, shortages, etc. So, any deferred maintenance impacts must be expressed in the terms of these increases. These projected costs are always just that, projected, so they will vary. The hope is that the variance will only be small. If they vary more than that; then the projection was off for some reason that must be identified to help future projections to be more accurate.
Due to this relationship, the increased costs of the future expenditures can be offset by the actual setting aside of some funds from today in an account for when the deferred work will be completed. This trust / escrow account should be used to help offset the increased costs from the additional deferred maintenance costs, otherwise the total impact of those additional costs will have to be absorbed in the future thereby creating added pressure on those future revenues. The trick to this method is that the projection must be very accurate, or the planned expenditures may skyrocket unexpectedly. Then there is a hybrid system which is a cross between both of these approaches, which sets aside more than nothing, but less than the full cost of the maintenance being deferred. If the full cost of the maintenance is set aside, then the question is why defer the maintenance? So that is why it would normally be something less than the full cost of the maintenance.
Realizing What Deferred Maintenance Really Costs
So, for ease of illustrations, let us go back to that $1,000 cost that needs to be deferred. If the decision was to defer the maintenance for one year, then the increased costs, at the very least, would be inflationary. If that inflationary cost was just two-percent, then the increase to that $1,000 would be $20. If raw material costs went up say one-percent that same year, then there will be an additional cost of $10 that will have to be included into the deferred maintenance costs, for a total of $30, bringing the cost for the deferred maintenance to $1,030. Now this does not sound like much, but what would this be if the initial costs for this maintenance were 10,000 times this or 100,000 times or more? You can sure see how these number grow really quickly.
Now, let us say that the decision-makers set aside the projected increase alone, say the $30. Now in next year’s budget cycle all that would be needed to perform the required maintenance would be the original $1,000 cost. That would have a net zero impact on next year’s budget pressure as the original $1,000 is still the only required obligation to meet the need, but would require that $30 be held in some sort of escrow or trust account from this year’s budget. However, if that set aside in this year’s budget were say $515, the cost for the maintenance in next year’s budget would only be $515, reducing the pressure on next year’s budget. Now this would have a very positive impact on both years’ budgets, saving cost in each budget cycle and still performing the required deferred maintenance. Now even though the costs went up, there was less of an impact on each year’s budget. This increased cost has much less of an impact in each year. Again, imagine if these magnitudes were increased 10,000 or 100,000 times. This is planning ahead, or as it was said in my MBA program, strategic thinking. This really is very simple stuff.
Now let us look at the deferred maintenance being five years from now. The inflation would be compounded, so the same two-percent per year inflation raises the inflationary costs to around $104. If raw material costs increase at the same one-percent compounded per year as previously discussed the material costs increase to about $51, making the entire cost of the deferred maintenance $1,155. Again, you can imagine the impact of these costs if they were magnified 10,000 or 100,000 times. Do not forget that these calculations do not anticipate cost increases as a result of supply and demand, such as shortages, or increased cost due to the nature aging of the system(s), which will continue to grow those deferred maintenance costs.
What must always be remembered is that there is an associated cost whenever one gambles on deferred maintenance. No one can really see into the future, so predicting future market conditions and costs always carries the risk of an incorrect projection. Making these projections is as much an art form as it is a science, and inaccuracies can add up to very large numbers extremely quick.
Now this is not the only school of thought regarding deferred maintenance. Another approach I have come across has been even more intriguing, and with the limited data I have in our Agency, find the concept to at least be in the ballpark. That concept has been referred to as the “Inverse-Square Rule for Deferred Maintenance” developed by David Geaslin, of the Geaslin Group. When I was first introduced to this concept, I will be honest my thought was “hell no”, there is no way this can even be close to the ballpark. The numbers grew way too quick to be accurate. Now I will admit, as one that is in facility upkeep, I really liked the fact these numbers grew quick as that would help me build a solid case for our building renewal needs, but as an analyst I could not place data out there for general consumption that could not be supported or could be substantially challenged. Even my Agency’s Deputy Director of Finance held these same sentiments and concerns. Then I took a few projects that our Agency had recently completed to “reverse engineer” the costs to test if this was even close, and to my astonishment it basically proved out. Now I will be the first to admit that it is not a mathematical equivalency, because it did not come out exactly with the cost, but the closeness was beyond surprising. It was almost startling at its shadowing. So, I would submit this concept not as a mathematical axiom, or law, but more of a general concept or principle.
This concept is very basic. If you take the cost of the initial maintenance to be done, and allow that required maintenance to progress to the next level of failure before acting, you find that the costs to make that repair, at the increased failure level, will cost real close to the square of the initial cost of the unmet maintenance. For example, a leak in the roof has a cost of $500 to repair, and it is determined that the repair will delayed because there is no room in this year’s budget. Next year, since it has not been a reported problem, it delayed another year, and so on. Finally buckets have to be placed under the leaks during rain storms. The insulation now has to be replaced, the roofing warranty is voided because the leaks were not repaired or reported. Now some of the roof deck may need replacement, some of the ceiling has to be replaced, water has gotten into light fixtures that need to be replaced, maybe walls have been damaged and require the gypsum board to be replaced and re-painted, maybe some of the flooring has to be removed and replaced, organic material may be forming (mold); you can see how the secondary damage from the lack of initial action has now grown to huge proportions. Now the entire repair will cost $10,000. Do not forget to add in the cost to relocate the users of that space while repairs are being made. How much more does the total costs grow? It starts to look really big, really fast.
Now, I want to go back even before the $500 repair was determined. This type of repair is almost never found until a report has been made and a maintenance work order has been issued, which means that some occupant has made a report of a visible problem. By then that is even too late; secondary damage is already occurring. If the roof PM was being done at least twice a year as it should, that issue most likely would have been discovered long before water leaks made their way into the occupied space. Even if you payed a person $25 per hour to walk that roof twice a year, and it took say an hour to inspect that roof, which it should not even take that long for an experienced roof inspector, you may have found that potential leak when it would have cost almost nothing to repair. By the way, what is $25 squared? The answer $625, not that far off of the $500 repair is it? Maybe there is a foundation to this inverse square rule? You be the judge.
Building Renewal – the Best Hedge Against Replacement Costs
As we continue this discussion, I want to remind everyone of the oil change example discussed earlier. When decision-makers fail to keep capital assets in good condition, they will wear out prematurely which will impact future budgets adversely, and knowing Murphey’s Law it will never be at a good time. When investing in a capital investment, such as a building, millions of dollars are placed at potential risk. If the building wears out prematurely, then resources were squandered away; conversely when they extend beyond their life expectancy, equity is built. That should be a very simple equation.
This extension of life to a capital asset is achieved through two distinctive processes, building renewal and preventive maintenance. Both of these are essentially the same, the replacement of systems designed to wear out as a means of adding life to the capital assets. Most all systems are designed to basically wear out at some point; whether we are talking about the brakes, belts, spark plugs, etc. in a car; or the roofing, HVAC, fire alarm system, etc. in a building they all have life cycles. The main goal is to extend the life of the building. The primary difference between preventative maintenance (PM) and building renewal is the cycle in which these systems have. The general approach by the academic / study literature that I have been exposed to is that if the replacement cycle is less than a year it is PM, longer than a year it is building renewal. Other than the cycles PM and building renewal are substantially the same. When maintenance, under either PM or building renewal, is performed, life is added, or extended, to the capital asset. This now raises the next question, what is an appropriate amount of resources to allocate for this PM / building renewal?
To begin, this quantity is always expressed in terms of the cost of new construction. This is also sometimes referred to as replacement costs. The reason for this PM / building renewal costs being expressed in terms of new construction costs is that the ultimate cost of system renewal is found at the end of the life cycle when the system has to be completely replaced. In this case that ultimate replacement is the replacement of the entire building system as the ultimate end of life cost. That is why this is expressed in the terms of new construction costs. This cost is expressed as one – two percent of new construction costs per year, based on the academic / study literature I have read.
So, to carry that concept forward, if the replacement cost of a specific building type and occupancy is $225 per square foot, the amount spent on that building for PM / building renewal should be between $2.25 – $4.50 per square foot per year. If the building was 100,000 square feet, that would extend to somewhere between $225,000 – $450,000 per year for that building. You can see how this adds up very quickly. However, this maintenance could add years to the life of the building. If you add to the life of the building, equity is created. This is where the expenses of maintenance can start to act more like investments.
Now if the square footage portfolio is millions of square feet, you can see how fast the cost for PM / building renewal can increase, thus possibly creating a need for an effective deferred maintenance program.
The single largest investment we make as individuals and organizations is in our capital assets. Providing those assets with the longest life expectancy is paramount to a sustainable survival pattern to any individual or organization. When we turn expenses into investments we build equity, thereby bringing added value as owners. That is the primary (and only) responsibility of a fiduciary. Deferred maintenance, like all things budget driven, has to happen from time to time when revenues are not what was expected, but if it is applied appropriately it will not cost the individual or organization huge amounts of resources prematurely or in future budget cycles.
Even in our “throw-away” society, most buildings should have a life of no less than 50 years, but if we reassign (not increase, necessarily) our initial construction costs, we can extend that life to 70 years. When we use PM and building renewal appropriately, we may be able to extend that building life even longer. Once the building survives beyond its initial life expectancy, it now creates equity that can be used to rebuild once the building’s life is surpassed. That is where maintenance insight really gives a return on investment, but that is the long term waiting game, and not what every decision-maker possesses.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2017 Dan Demland