Chapter 6 Servicizing and Leasing – Sustainable Operations and Closed Loop Supply Chains, Second Edition

CHAPTER 6

Servicizing and Leasing

6.1 Introduction: Servicizing vs. Leasing

In the previous chapter, we discussed the difference between biological and technical nutrients. The Cradle-to-Cradle® design protocol indicates that biological nutrients (biodegradable items) can be safely returned to the earth and composted, whereas technical nutrients (such as steel, aluminum, plastic) should be upcycled—designed to be recycled in a way that the material does not lose any of its technical properties, and can be used to produce the same product (or better) again. Thus, products are designed such that technical nutrients can be reused for (theoretically) an infinite number of times. McDonough and Braungart indicate one way for this scenario to be practically feasible: firms should have control of the product after the end of their use by consumers—that is, firms should sell the service the product provides, not the ownership of the product. In their words1:

In order for such a scenario to be practical, however, we have to introduce a concept that goes hand in hand with the notion of a technical nutrient: the concept of a product of service. Instead of assuming that all products are to be bought, owned, and disposed of by “consumers,” products containing valuable technical nutrients—cars, televisions, carpeting, computers, and refrigerators, for example—would be reconceived as services people want to enjoy. In this scenario, customers (a more apt term for users of these products) would effectively purchase the service of such a product for a defined user period—say, 10,000 hours of television viewing, rather than the television itself.

Thus, McDonough and Braungart posit that servicizing is inherently green—as long as the product is designed in such a way that technical and biological nutrients can be easily separated, and there are no “monstrous hybrids.”

There are many different business models for manufacturing firms that sell a service instead of selling a product, but we can consider two types here, leasing and servicizing, which are fundamentally different, especially in the way that the customer is charged for the service. A leasing agreement is like a rental, where the firm rents the product to the customer for a relatively long period of time, such as years, and the customer pays a fixed fee per period, typically monthly, independent of the usage. The product stays with the customer, and is returned at the end of the lease. Some examples of leasing are presented later. In contrast, in a servicizing model, the customer pays the firm only for the exact amount of the product used. For example, Xerox offers a service where the customer pays only for the number of pages printed. Similarly, many cloud computing and storage services are charged by usage. Finally, car sharing services such as ZipCar are ubiquitous in larger cities, as well as bike sharing services.

6.2 Are Servicizing and Leasing Always Green?

First, consider servicizing. The following arguments support the environmental superiority of servicizing over the usual model of selling products2:

1. Since customers are charged by the amount they use the product, they may be incentivized to use less, which reduces energy consumption during the use stage of the life cycle.

2. Under some servicizing models, the firm does not provide each customer with a dedicated product; customers draw from a pool of products. Such pooling means that the customers’ needs are met with fewer units, which means there is lower production, hence reducing environmental impact during the production stage of the life cycle. For example, not all ZipCar users need to own a car, which reduces the amount of cars produced by the manufacturers.

3. The manufacturer may be incentivized to design and manufacture products with higher efficiency, as it lowers its operating costs. Again, this lowers the environmental impact during the use stage of the life cycle.

There are arguments, however, that also suggest that servicizing may not be greener3:

1. Because the manufacturer charges customers by usage, it may reach customers who would not otherwise be able to afford (and use) the product, thus increasing total usage, and hence a higher total environmental impact during the use stage of the life cycle.

2. Although pooling may decrease the production volume, it also allows the manufacturer to charge a lower price, and hence increase adoption and use, thus increasing the total environmental impact during the use stage of the life cycle.

3. A more efficient product reduces the firm’s operating costs, and hence allows it to charge a lower price, increasing adoption and usage. This increases the total environmental impact during the use stage of the life cycle.

Now, consider leasing. The main argument for leasing as a green business model is that it promotes reuse: end-of-lease equipment is still functional, and can be reused as-is (as is the case with cars, for example), or can be refurbished for a new life. Xerox is an example of a firm that designs products for multiple generations. Products have a modular design, and “sturdy” frames that can be reused with little rework, after the end of the leasing period with customers. Thus, a Xerox copier returned from the customer after leasing expiration can be easily upgraded (through the modular design, which allows easy replacement of obsolete modules with new ones) to a newer product generation, after the remanufacturing process.

Realistically speaking, however, few products are designed in a way that makes it feasible (technically and/or economically) to completely upcycle the materials for reuse in the manufacturing of equivalent new products. Thus, there exist some arguments indicating that leasing might not be greener than selling under some scenarios. These are shown in Table 6.1.

The first point in Table 6.1 is particularly important, because in practice, few firms design products in a way that makes recovery after lease economically and environmentally attractive. Firms vary significantly in their level of recovery activities, as well as the design of their products. Some examples are shown in Figure 6.1, and discussed below.

Table 6.1 Reasons why leasing might not be greener than selling

Reason

Explanation

Premature disposal of the product by manufacturer

Remanufacturing end-of-lease products is an alternative to recycling for materials reuse. Some leasing firms may opt for prematurely ending a product life cycle (i.e., prematurely disposing the end-of-lease product, which could have another life after remanufacturing) for fear that the remanufactured product cannibalizes sales of corresponding new products. The midlife disposal of the product may result in more products being produced, and more being disposed overall than under a selling situation, which may make leasing environmentally worse.4

Consumers value resale value of a product if there is an active secondary market

When customers buy a durable product (such as a car), they take into account its resale value, if there is a secondary market for the product. Thus, customers are willing to pay a higher price for a product that is more durable (which has a higher resale value). This may provide an incentive for manufacturers to design more durable products, with a higher resale value if they sell the product (as opposed to designing a less durable product when they lease it).5

Leasing may create a lack of ownership among users

When customers buy durable products for which there is a secondary market, they invest in care and maintenance of the products, because that yields higher resale values. With leasing, the opposite may occur—the lack of ownership has the inverse effect.

Operating leases restricted to a length of 75 percent of the product’s useful life

In operating leases (where the lessor retains ownership of the product; see next section), the length of the lease is restricted to a maximum of 75 percent of the product’s useful life. Thus, under operating leases, the lessor (“landlord”) may dispose of a product with more than 25 percent of its useful life remaining (if it is not economically feasible to recycle it or remanufacture it), implying a higher rate of production and disposal overall. This point is related to the “premature disposal of the product by the manufacturer” above.

Figure 6.1 Firms vary in their level of recovery activities.

Dell, the computer manufacturer, derives a small percentage of its revenue from leasing, and it does not engage significantly in remanufacturing of its end-of-lease units. Technological obsolescence presents a challenge in remanufacturing older equipment, and current processes for e-waste recycling make it difficult to upcycle materials (particularly not only plastics, but also some metals).

Interface is a carpet manufacturer, specialized in a modular carpet design, where the carpet is manufactured and installed in tiles. Thus, the customer has the ability to “mix and match” different designs, and also has the ability to selectively replace carpet tiles that are worn out (as opposed to the entire carpet, as in the traditional broadloom carpet). Interface also had a limited carpet leasing program, but where financing was done primarily through a third party. The leasing program at Interface was limited not so much due to a deliberate strategic choice by Interface, but due to most customers’ reluctance in leasing carpet, where the leasing payments become an operational expense (as opposed to a one-time capital expenditure), and the carpet was reclaimed at the end of the leasing period (when the carpet still has more than 25 percent of its useful life remaining), which may inconvenience customers. Interface has developed, however, a breakthrough process for recycling carpet—the process, named ReEntry, allows for a clean mechanical separation between the backing (typically made of vinyl or polypropylene) and facing (made of Nylon 6 or Nylon 6,6), allowing both materials to be upcycled and used in the production of new carpet,6 forming a true closed-loop system.

Pitney Bowes (PB) is an OEM that manufactures mailing equipment used in businesses, for large-scale mailing (such as those used in a marketing campaign). PB offers leasing for most (80–90 percent) of its production of new equipment, with a typical leasing period of four years. At the end of a lease, PB’s customers may upgrade to newer equipment if available. Used equipment is returned to PB, which may be remanufactured and re-sold or re-leased as a cheaper alternative to new products. We also discuss PB in Chapter 7.

Xerox designs products with the intent of reusing it through multiple life cycles, through a modular design and “sturdy” designs, as discussed before.

Of course, there are other aspects of leasing (other than environmental) that may make it attractive to businesses, and we discuss some of the more conventional arguments for leasing (as opposed to selling) in the next section. The World Leasing Handbook estimated that leasing worldwide accounted for more than $1 trillion in 2015 (up from $650 million in 2010); North America makes up 41 percent of the leasing volume worldwide, with Europe, and Asia accounting for 32 percent, 22 percent of the world volume, respectively.

6.3 Types of Lease: Operating and Capital Lease

From an accounting perspective, there are two basic types of leases:

Operating lease. The lessor (“landlord”) enjoys the rewards and bears the risk of asset ownership. Payments are fixed, and as a result the lessor bears the risks (or rewards) associated with interest rates. The lessor is also responsible for recovering the value at the end of the lease, and there is thus technological risk. Operating leases are treated as “operating expenses,” and as a result they are not treated as an asset in the lessee’s balance sheet, which improves the lessee’s Return on Assets (ROA).

Capital lease. Here, the lessee enjoys the rewards and bears the risk of asset ownership. Thus, a capital lease is the simultaneous acquisition of a long-term asset, and a long-term liability corresponding to the lease payments.

The Financial Accounting Standards Board (FASB) has specific requirements for leases to be treated as capital or operational, and they are listed in Table 6.2. If the lease meets none of the four conditions listed in Table 6.2, then the lease should be treated as an operating lease. The distinction between operating and capital leases is important, because of financial accounting and reporting implications, as we discuss next.

In general, in addition to the (potential) environmental benefits, the economic arguments for firms to start offering a leasing model include:

Potential tax savings to both lessor and lessee. Operating lease payments are considered as operating expenses to the lessor, and fully taxable revenues to the lessee. Because ownership is retained by the lessor in operating leases, the lessor writes of depreciation. Thus, if the lessor is in a higher tax bracket than the lessee, both benefit, as the lessor enjoys a higher depreciation write-off than the lessee would if it had ownership of the product (i.e., if the product was sold as opposed to leased). In addition, financial accounting reporting is simplified for the lessee in operating leases, as there is no need to include leased equipment depreciation in its financial reporting.

Table 6.2 A Lease meeting any (or more) of these four conditions implies a capital lease

Nr

Condition (Meeting any one or more of these conditions implies a capital lease)

1

Asset ownership is transferred to the lessee at the end of the lease term

2

Transfer of ownership is likely due to a “bargain purchase” clause at the end of the lease (i.e., less than fair market value)

3

The lease extends for at least 75 percent of the asset’s life

4

The present value of the minimum contractual lease payments equals or exceeds 90 percent of the fair market value of the product at the time lessee signs the contract

Leases enable lessees to spread out payments. It becomes easier for lessees to make large capital investments, and that may increase demand for the lessor’s products.

Additional revenue opportunities for lessor. Leasing contracts frequently provide the lessor with the ability to add other services, such as maintenance, increasing revenues.

Leasing provides a stable source of revenue for lessor. Because leasing is a long-term agreement, as opposed to a one-time transaction, it is more resilient to economic downturns.

Leasing allows for closer customer relationships. Closer relationships with customers have the potential to increase follow-on business opportunities and contracts for the lessor.

Leasing allows for greater control of product resale. As discussed above, the lessor retains ownership and control of the product at the time the lease expires, which provides the lessor with more control of the secondary market. For example, the lessor may decide to remanufacture end-of-lease products, which gives the lessor greater control over the quality of the remanufacturing process. This results in greater and more consistent quality of the lessor’s remanufactured products, which helps to protect its brand. In contrast, when the customer buys the product, he/she has control of the product’s resale; as a result, the product may end up in the hands of low quality third-party remanufacturers, which may be damaging to the OEM’s brand.

In the next section, we provide an example of a simple financial analysis to illustrate the benefits and pitfalls of a leasing model (as opposed to a selling model) to both lessors and lessees.

6.4 A Spreadsheet Analysis of Leasing versus Buying Decision

In this section, we provide a simple example that illustrates some of the accounting issues highlighted in the previous section, particularly how operating leases are included in the lessor’s balance sheet (but not in the lessee, being then treated as an operating expense). The example is hypothetical but representative of a scenario where Indiana University (IU) considers the acquisition of a large-scale mailing machine from PB, which will be used by the University for its mailing campaigns (e.g., promotions, fund raising, mailing admissions materials or letters, etc.). The useful life of the machine is eight years, but IU would move to a newer technology after five years. IU is considering whether to buy or to lease the machine:

Buy: IU can simply buy the machine from PB for $52,000. IU needs to spend $600 per year in labor for regular maintenance, and $2,000 in replacement parts starting in the third year after acquisition of the machine (these parts will be acquired from PB). At the end of five years, IU can sell the used machine to a broker for $5,000.

Lease: IU can lease the machine from PB for a period of five years. This is an operating lease. Monthly leasing payments are $1,000. In addition, IU must buy a maintenance program offered by PB for $2,200 per year, which covers both labor and parts. At the end of the leasing period, the machine is then sent back to PB, which can remanufacture it; the used machine has a salvage value to PB of $7,000.

Assume that PB’s cost of goods sold (COGS) is 55 percent, and that its corporate income tax is 35 percent (IU, being a non-profit organization, has a 0 percent corporate tax rate). The data are summarized in Table 6.3.

The depreciation schedule used is the Modified Accelerated Cost Recovery System (MACRS) with a 2.0 declining balance method, which is generally used for income tax reporting purposes, and thus appropriate for estimating tax savings from depreciation. The MACRS depreciation schedule is 20 percent, 32 percent, 19.2 percent, 11.5 percent, 11.5 percent, and 5.8 percent for years 1, 2, 3, 4, 5, and 6, respectively (the MACRS system assumes firms acquire depreciable assets at the midpoint of the first year, regardless of the acquisition date; there is thus depreciation carrying to half of year 6).

Table 6.3 Data for leasing versus selling analysis for PB/IU example

Parameter description

Value

Lease term

5 years

Monthly lease payment

$1,000

Yearly discount rate

10%

Income tax rate (PB)

35%

Annual maintenance cost (PB: contractual offer)

$2,200.00

Annual maintenance cost (IU: labor only)

  $600.00

Annual maintenance cost (IU: replacement parts purchased from PB; after year 2)

$2,000.00

Equipment price

$52,000.00

Salvage value after 5 years: IU

  $5,000.00

Salvage value after 5 years: PB

$7,000.00

PB cost of goods sold (COGS)

55%

We select our time unit to be years. To keep it simple, we use a yearly discount rate of 10 percent for the purposes of computing net present value (NPV). The results are shown in Table 6.4 for IU, and in Table 6.6 for PB. We use the standard Excel convention that cash flows are presented at the end of the period, for simplicity, and traditional accounting convention that negative cash flows (i.e., expenses) are shown in parenthesis.

Indiana University Analysis

The formulas in Table 6.4 are straightforward, but we point out a few things. IU buys the machine at the beginning of year 1, or, alternatively, at the end of year 0. The NPV formula in cell B28 is given by =NPV(0.10,C27:G27)+B27, where 0.10 is the discount rate (10 percent) for NPV calculations in this example. Annual lease expense is $12,000, as the monthly lease payments are $1,000. The formula in cell B36 is simply the NPV of the lease-only payments (i.e., not including maintenance), that is =NPV(0.10,C32:G32). The formula in cell B37 represents the ratio between the NPV of the lease payments, and the cost of the machine (buy) at year 0, that is, 45,489/52,000, which yields 0.87; this ratio is below 90 percent, which is necessary for an operational lease. We see that the NPV of the buying option is ($55,280), whereas the NPV of the leasing option is $53,829, which implies that the leasing option is cheaper by $1,451 over the five-year planning horizon. Notice that there are no depreciation calculations for IU under the buying option, as the firm pays zero corporate income tax.

Table 6.4 Indiana university lease versus buy analysis

Pitney Bowes (PB) Analysis

The first step here is to calculate the tax savings from depreciation. Because this is an operating lease, the machine “stays” in PB’s balance sheet as a depreciable asset. This is shown in Table 6.5.

The capital value (base) for depreciation is the cost of goods sold at PB, which is equal to 52,000 × 0.55, or $28,600 (cell B73). The depreciation schedule in cells C74:H74 is given, as indicated above. Thus, for example, for year 1, the depreciation is $5,720 (=C74 × $B$73), and the depreciation tax savings for year 1 (cell C76) are $2,002 (= 5,720 × 0.35). This means PB saves $2,002 in taxes in year 1 by depreciating the equipment—depreciation is not an actual cash flow, but it impacts PB’s cash flows by reducing its corporate income tax burden.

Table 6.5 Depreciation calculations for PB

The complete analysis for PB is given in Table 6.6. If PB sells the machine, then it receives the revenue of $52,000 at the beginning of year 1 (alternatively, end of year 0). Revenues afterward consist of only selling the replacement parts to IU, which amounts to $2,000 per year in years 3–5. Total revenue is given in row 48. We then subtract the cost of goods sold (which is 55 percent of revenues, so for example, cell B49 is set to “=–0.55×B46”), yielding Earnings Before Tax (EBT), in row 50. Tax (row 51) is 35 percent of row 50, and that yields Net Income, in row 52. The NPV of the selling option (cell B53) is $16,412, given in Excel by the formula “=B52 + NPV(0.10, C52:G52).” Notice that in the selling option, the machine belongs to IU, and it is not in PB’s balance sheet, so there is no depreciation expense for it.

The leasing option presents PB with revenues from leasing and maintenance payments from IU (rows 56 and 57, respectively). In addition, row 58 corresponds to the residual value of the machine to PB, which is $7,000 at the end of year 5. The sum of rows 56, 57, and 58 is given in row 59, total revenues. We then subtract the costs: COGS (again, at 55 percent of revenues) for the machine itself, and the maintenance cost, given in rows 60 and 61, respectively. Earnings Before Interest, Depreciation, and Tax (EBIDT) is then given in row 63, as the sum of rows 59, 60, and 61. Because corporate income tax is calculated based on Earnings after incorporation of depreciation as an expense, but depreciation is not an actual cash flow, one can equivalently (from a purely cash flow perspective) calculate corporate tax (row 64) based on EBIDT (i.e., 35 percent of EBIDT), and then add back the tax savings from depreciation, from Table 6.5. Thus, row 65 (net revenues) is given by row 63 plus row 64. Note that there is no tax at year 0, as the product is depreciated (tax impact occurs in years 1–6). Row 66, tax savings from depreciation, is equal to row 76 from Table 6.5. Adding rows 65 and 66, we find the net income from the leasing option, which is row 67. The NPV of the leasing option (cell B68) is given by the formula “=B67 + NPV(0.10,C67:H67),” yielding $13,973. Comparing with cell B53, that provides a preference for lease for PB of ($2,440).

Table 6.6 PB lease versus buy analysis

This analysis illustrates the fact that the lessor (PB) is in a higher corporate income tax bracket than the lessee (IU); this translates into tax savings of depreciation, which allows PB to pass these tax savings to IU in the form of low lease and maintenance payments. In addition, the salvage value of the used equipment to PB is higher than for IU, because PB can salvage parts and/or remanufacture the old equipment, whereas IU can only sell it in the secondary market to a broker.