Renewal Annuities

The average annual annuity of a forward cash flow program (renewal program) is that sum of money that needs to be put aside every year to ensure that (over the annuity period) the amount of money needed will be derived. It can include an allowance for return or interest.

When using a properly constructed renewal annuity as the depreciation item in our operating statements, there is a need to properly account for the yearly variations (surpluses or deficits) that will occur between the annuity figure and the actual cash flow required for the current renewal program.

In the case of young assets, the fully funded annuity will result in significant surpluses being generated.

In the case of older assets, the short-term cash flow may significantly exceed the long-term renewal annuity and additional borrowing may be required to fully fund the works programs.

One method to account for these funds would be to adopt the following policy.

A holding account would be set up for the total demand in funds required by individual service programs.

This holding account would include the funds for the optimized renewal of existing assets as well as an average annuity of the program required to meet the expectations for new assets through expanded responsibilities or increased customer expectations.

The funds in these holding accounts would be protected from misuse for either the renewal program or the creation of new assets or asset services.

Once the future programs are accurately established for all asset groups, the council should then consider the various demands for funds and the available sources including those programs that are currently running at a surplus.

Where necessary, loan accounts could be set up to take those surpluses from the holding account in one service program and enable a loan to be given to another program that may be in a deficit situation.

In this way individual programs will be protected and in each annual report asset values will need to include the amounts loaned to other service programs.

Where accurate renewal programs are available, e.g. Total Asset Management Plans (TAMP's), the term of the loan can be set to ensure that it is paid back when that service program requires all its funds for the deficit period in its cash flow.

For programs that require cash flow in excess of the funds generated by these average annual annuities, then borrowing may be required and should be allowed for in the appropriate financial programs.

The key factors in the level or size of the annuities relate to:

• The overall condition of assets (and the subsequent renewal program required) and
• The period over which the annuity is taken.

These funds could be used between different service programs, or between different categories of assets in the one service program. This approach could be used to tie funds between the various organization units.

Example 1

In the large regional authority sector it may take the form of loans between the water and the sewerage programs.

Example 2

In the municipal arena this technique could be used to balance the cash flow in the complex number of activities undertaken by council by loans among the various service programs e.g. roads, drains, water, sewerage, buildings, parks and gardens, recreation, plant and equipment etc.

Example 3

The same techniques are equally applicable to private enterprise where appropriate transfers could be made between major divisions such as for BHP between minerals, oil and their steel programs, all within the individual programs. e.g. between Iron Ore, Raw Steel Production, Blast Furnaces etc. and the Steel Rolling Mills.

An argument can be made against this proposal. By using the asset group or service that is in surplus to support those groups in deficit, we are removing one of the key success factors found in successful cost reduction asset management programs. It is those organizations that are facing liquidation or bankruptcy in which the greatest gains (improvements) are being made in asset management. These organizations have been forced to concentrate on those activities that drastically reduce the cost of service using appropriate deferral and other cost reduction techniques.

Without this "high cost" driver, we may not see the greatest micro economic reforms and innovation necessary to reduce the cost of service. Many of the results and experience gained in this critical environment are likely to benefit the industry or the organization as a whole.

The greatest challenge for today's managers, stakeholders and regulators is to provide the same catalyst for change in "profitable organizations" or in organizations that are clearly viable.

This must be done by sound (advanced) asset management irrespective of the organization’s viability.

Where possible, we should price our services at values or incomes acceptable to customers and make the best profit possible. This profit should then be used to fund other programs or the provision of new services.