A method for determining capital investment strategies - average age of plant ratio

Healthcare Financial Management, June, 1990 by Raymond A. Snead, Jr.

Each year, healthcare chief financial officers (CFOs) must decide how much capital investment to recommend to their boards of directors. Capital management activities fall under the scope of managing a hospital's assets and liabilities at the policy level. A basis for escalating consideration of capital budgets to the policy level exists in HFMA'S Financial Analysis Service (FAS-Plus) average age of plant ratio.

The ratio measures the average age of a hospital's plant and equipment by dividing the balance of accumulated depreciation by annual depreciation expense. The concept refers to the weighted average age of plant and equipment, taking into account assets ranging in financial life expectancy from less than three years to more than 30 years.

LIFE EXPECTANCY. Financial life expectancy generally is defined by the American Hospital Association's asset life schedule. Along with a financial life, capital equipment has a physical life (based on the equipment's ability to function over a period of time) and a technological life (based on the equipment's usefulness until it is superseded by more modern technology).

A new facility with new equipment typically has a weighted average financial life expectancy of approximately 18 years, assuming that depreciation is broken into components. Similarly, a facility's annual capital expenditure budget will have a weighted financial life expectancy based on the mix of equipment and facilities. Under the following example, the average life expectancy of an upcoming capital equipment budget is estimated at 10 years. This assumes a larger investment in equipment than in bricks and mortar. The actual weighted average age of a proposed capital expenditure budget can be calculated by multiplying the depreciable life of each asset by its acquisition cost, summing the results, and dividing the sum by the total proposed investment. Personal computer-based electronic spread sheets are useful in making this calculation. INVESTMENT STRATEGY. Determining how much a hospital should invest requires creating an overall capital investment strategy. The practical application of a capital investment strategy begins with a hospital's strategic plan, which discusses major corporate initiatives over a three-year to five-year period. A strategic plan should be followed by a facility master plan covering the same time frame.

A hospital's master plan should outline implementation of the strategic plan by determining the best course of action for facility improvement. Because of resource limitations, the facility master plan must be tempered by an appropriate level of investment.

Another practical consideration is the conflict between the facility master plan and a hospital's ongoing capital equipment budget. The capital investment strategy should address an organization's intent to maintain its facilities in a modern state of repair. This can be objectively measured by comparing a hospital's average age of plant ratio with the industry ratio. Exhibit 1 shows an average age of plant ratio for a typical hospital. Improving a poor average age of plant ratio can take several years, and resource limitations may force a hospital to improve its average age of plant by 1/4 to 1/2 a year annually over a period of several years (for example, reducing equipment age from 8 years to 7.75 years). Many hospitals use half-year increments to record depreciation for assets placed in service during the current period. The following year, depreciation expense on those assets would increase because assets placed in service during the previous year would incur a full year of depreciation.

Even so, depreciation expense will be lost as older assets are retired. In this analysis, the new depreciation expense created by taking a full year of depreciation next year on the current year's purchases will be offset by depreciation expense lost through retired equipment.

Doing this leaves the coming year's projected depreciation expense unchanged before adding depreciable assets in the next 12 months. Accepting this assumption simplifies calculations presented here and should be acceptable in most situations in which the analysis is applied at the policy level. Facilities with automated fixed asset systems can model future depreciation expense to consider these effects. INVESTMENT GOAL. In this case, the hospital should be concerned with bringing the average age of plant up to the industry standard. To determine the amount of investment needed for this goal, the numbers are placed in an equation designed to produce the required investment. Average age of plant will be determined for the coming year by:

  (NY)
          AD   LY   (.5x (--))
                         (AL)
      AP=______________________
                     (NY)
             LY (.5x (--))
                     (AL)

Where: AP = Average age of plant next year - Current actual of 8.05 years - Target = 7.30 years; AD = Accumulated depreciation at the end of last year = $2,372,500; LY = Last year's depreciation expense = $294,700; NY = Next year's capital investment - Unknown; AL = Average financial life of the capital expenditure budget