Leasing information technology assets is relatively common in the corporate world. With the transition to a distributed computing environment, the lease versus buy decision has become more complex. No longer should IT managers rely solely on the results of the typical lease/buy financial analysis in determining whether to pursue leasing.
There are many other factors – some quantifiable, some not – you should consider when you are deciding whether to lease or buy. This article takes a look at several of these factors, as well as the quantitative analysis, and addresses a methodology for analysing the factors when determining whether leasing or buying is more appropriate for your organization.
The decision factors are grouped into Financial, which are purely quantitative in nature, and Strategic/Environmental, which are qualitative in nature and, in some cases, soft dollar costs.
Lease vs. buy analysis.
Here’s where you’ll conduct the purely quantitative, cash-flow-based analysis. Please note that it should be performed by a knowledgeable party. The analysis compares the costs of leasing vs. the costs of buying for the specific equipment. The key variables of the lease/buy analysis are: the equipment cost; length of useful life (or lease term); assumed residual value at the end of the useful life/lease term; depreciation; and the corporation’s income tax rates.
The IT lease/buy model should also incorporate the supplemental costs associated with leasing or buying. These can include: taxes (use/sales, property); closing/documentation fees; installation costs; removal/return/recertification costs; shipping costs; maintenance costs; insurance costs; and security deposits. In some instances, these costs will be the same for both the lease case and the buy case and can therefore be ignored in the lease/buy analysis. However, you can’t automatically assume they will be the same under both cases – this needs to be verified and the lease/buy model tweaked as appropriate.
You may also want to run some what-if scenarios in the lease/buy analysis to examine the dollar impact of early termination and/or renewals ( see Item 6 below). Termination/renewal info should be available in your Master Leases with your lessors.
1. Corporate treasury strategic direction.
The company’s corporate treasury strategic direction is usually a key driver in the organization’s desire to lease (or not). Leasing can be an effective way for a company to reduce its on-book debt. This can be a powerful motivator because it can impact the company’s credit rating and other important corporate financial objectives. There are some stringent criteria that must be present in any lease in order to qualify as an operating lease (also called off-book or tax leases), where the payments for the equipment are expensed.
2. Business/IT requirement for rapid technology turnover and leading-edge technology.
If your company needs cutting-edge technology, which drives a rapid technology refresh scenario, leasing may be more advantageous. In order for leasing to be cost effective, however, the refresh needs to be accurately forecast and carefully disciplined in its execution. On the other hand, if your organization is slower to adopt new technology, purchasing may be more favourable.
3. Business/IT requirement for flexibility in use/modification of the equipment.
Leases can be very restrictive in how equipment is used, upgraded, changed, moved, and so on. They can also require the lessee to restore the equipment to its original state prior to return – potentially a costly and time-consuming effort. Some of these matters can be mitigated to a certain degree in lease negotiations, but if you’re the lessee, you should be on the lookout for these “gotchas.”
If the equipment under consideration will be moved or modified during its use, purchasing will, in general, be more favourable because, of course, when you own the equipment, you can do exactly as you desire without risk of penalty. Alternately, if the equipment is less mobile and/or more static (unlikely to be modified), this will facilitate leasing and make it a more viable option.
4. Environment: homogeneity of the technology.
If you’re looking at leasing equipment that’s fairly standardized in nature, leasing may be the favourable choice. However, as soon as more models and configurations, not to mention other types of equipment, are added to the mix, things get very complex and difficult to manage very soon. Leasing a high volume of anything is complicated. When each item is different, if not unique, the complexity grows. Then, if there are staged or multiple roll-outs (with different lease termination dates), there is yet more complexity. All other things being equal, a heterogeneous mix of equipment favours purchasing.
5. Environment: centralized or decentralized user base.
Here’s where you address the culture and environment of your organization and which type is more conducive to leasing from the management/administrative perspectives. It’s related to Item 4 but extends further to the general management and culture of your organization. A centralized, top-down-managed organization is much more conducive to leasing. If the organization is decentralized and autonomous in its culture and management, it can be very difficult to track the assets and administer the leases effectively. In that case, purchasing is more advantageous.
6. Flexibility in the length of actual useful life of the equipment (vs. the lease term).
While leases can be advantageous for rapid or planned technology turnover, the equipment must be relinquished at exactly the end of the lease for the economics to stay in the lessee’s favour. If, for example, you lease PCs for two years, and their actual useful life is 18 months, you can return them early, but you’ll most likely be subject to a termination fee. Conversely, if the PCs’ actual useful life turns out to be greater than two years, you can renew the leases, but again, your economies go south because in essence you’re overpaying for the value of the equipment. Lessors make most of their money on renewals and terminations, and they are betting when they cut you a lease that the useful life will not equal the lease term.
Purchasing is typically more favourable for this factor (that is, the uncertainty of the useful life). If the actual useful life of the purchased equipment turns out to be very short, you still have to acquire replacement equipment, but you won’t be penalized by a termination fee. If the useful life is long, you win, because you own the equipment and can use it as long as you want.
7. Residual value (to the lessee) of the equipment at lease-end.
If you’ve received lease rates, you already know what the residual value of the equipment is to the lessor. The $64,000 question (literally) is what the value of this equipment will be to you, the lessee, at the end of the lease term. “Value” can be what you think you can sell the equipment for (it will be at wholesale), or it can be the value to you as trickle-down technology within the organization, or it can even be the goodwill of donating equipment to charitable or educational organizations. This important decision factor must be carefully examined from the business perspective as well as the technology perspective. For example, certain equipment cascades easily, and other types do not.
If the residual value that the lessor assigns is greater than the value to you, leasing is favoured. Alternatively, if the lessor assigns a lower residual value than yours, purchasing is favoured.
In the world of leasing, this area can be the tail that wags the dog. Many, if not most, users severely underestimate the administrative complexity of leasing, and often it isn’t until months or even a year or more into a lease that the reality hits. At this point, if the user has not put a process into place, there is very likely to be an administrative mess piling up. While it is possible to effectively administer leases, it requires the right processes, a few tools, and much management discipline. And additional staff almost always is required.
The major administrative components of leasing include:
Complexity of leasing. With a lease, the user organization is paying an invoice (or frequently, many invoices) monthly, or occasionally on a quarterly basis. All of the accounts payable activities are invoked for everyone: receipt, verification, posting, cheque-cutting, etc. Leasing is also subject to legal filings with banks, the lessor, etc. Initiating new leases involves lots of time-critical paperwork among the manufacturer, lessee, lessor, and sometimes additional parties such as value-added resellers. It’s easy to see how leasing high volumes of equipment (in the case of leasing any distributed equipment) can quickly increase the administrative burden.
Nature of the third-party leasing market. Exacerbating the actual administrative burden is the nature of the third-party leasing market itself. Lessors frequently sell off the underlying paper, resulting in the lessee having to deal with yet another new party and/or groups of investors in the relationship. In addition, the market has also gone through many mergers and acquisitions, and numerous lessors have gone bankrupt. While both these circumstances result in additional administration, lessor bankruptcy can be particularly disruptive and risky because the bankruptcy court can find, for example, that the original deal was “uneconomic,” potentially resulting in legal costs for the lessee in order to defend the deal.
Purchasing is more advantageous (that is, less burdensome) than leasing from the standpoint of the above-mentioned paper-pushing requirements.
Requirement for asset-management discipline. Because the lessee doesn’t own the leased asset, its fiduciary responsibility for that equipment is even higher than that for owned assets. Penalties for lost equipment can be high. Also, many lessors require the return of the exact piece of equipment (by serial number) – another dangerous “gotcha,” especially in the distributed computing world. Also, related to the invoicing matter, the lessee may have to prove, for example, that it has returned equipment. Many lessors’ administrative back-offices, records and systems are not as efficient and accurate as the lessee might expect, and over-billings and continued billings after equipment is returned occur all too frequently, along with many other costly errors. The lessee must take an active role in managing the assets – in association with the lessor billings – to ensure it is getting the full value of its leases and is not overpaying or continuing to pay month after month for non-existent, returned or lost equipment. While managing owned assets is very important, careful asset management is critical and much more strenuous for leased assets; again, purchasing is more advantageous (i.e. less burdensome) than leasing for this decision factor.
Disposal concerns. In terms of asset disposal that are of minimal or no value to the lessee, leasing has an advantage from a pure convenience standpoint because the lessor is responsible for disposing of the equipment. Therefore leasing is more favourable for this factor.
EVALUATING THE DECISION FACTORS
The decision to lease is a very complex one. If you’re going to incorporate the non-quantifiable factors as well as the quantifiable ones, it may be useful to use a decision model to help organize the evaluation.
There are many models and matrices to perform such an evaluation – the tool is not as important as the information analysed and the care and thoroughness used in the evaluation.
The first step is to establish your decision criteria. We have outlined numerous decision factors. Are these appropriate for your organization? Are there others? In order to determine the relative importance of one criterion over another, develop weights for each factor.
The remainder of the exercise is then to examine and evaluate each criterion within the context of your organization, culture, management/technology direction and administrative strengths. This is not an easy task and should be performed periodically to ensure that your direction continues to be the best one for your company. Having a starting point, however, in terms of identified criteria and a sound analysis tool, can go a long way towards putting some structure into the complex and important lease versus buy decision.
Remember, the leasing decision goes beyond the lease/buy financial model. Don’t overlook the qualitative strategic and environmental factors when making this critical choice. A fully developed analysis that takes these matters into account will help drive a better decision for your company.
Marlene Bauer is a senior consultant with high-tech procurement consultants International Computer Negotiations, Inc. (ICN), Winter Park, Florida. ICN’s web site is at: http://www.dobetterdeals.com