Lease, Buy, or Service Contract for an Eight-Year Cleaning Operation
An Air Force logistics center must choose among three options for an eight-year specialized parts-cleaning operation. Option A is to buy and install equipment for $1.8 million, with annual O&M of $240,000, a $300,000 overhaul in year 4, and a $150,000 salvage value at the end of year 8. Option B is a service contract starting at $520,000 in year 1 and escalating 3% annually, with no upfront cost. Option C is an eight-year lease at $410,000 per year with the lessor responsible for overhaul and salvage; the equipment’s useful life is 10 years. The center uses a 3.5% real discount rate. The program office’s estimate for Option A omits the overhaul and salvage and uses a 2.8% escalation rate for O&M. The center has $1.2 million in current-year procurement funds and can phase the equipment purchase over two years. The service contract and lease fit within the O&M budget. The comptroller must compare the options on a life-cycle, present-value basis and address budget scoring and color-of-money constraints.
1. Identify the cost-estimating errors in the program office’s Option A estimate and explain how each affects the comparison.
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The estimate omits the $300,000 overhaul in year 4, which understates Option A’s life-cycle cost. It also omits the $150,000 salvage value, which overstates the net cost of ownership. Using 2.8% escalation for O&M is not necessarily wrong if it reflects a specific price index, but the comptroller must confirm that the escalation rate is consistent with the 3.5% real discount rate; mixing real and nominal figures distorts present value. A complete estimate should include installation, training, initial spares, disposal, and any facility modifications, not just the purchase price and routine O&M. For the service contract, the estimate must include the 3% escalation and any transition or termination costs. For the lease, it must include the full stream of lease payments and clarify who bears residual-value and overhaul risk. The comparison should be on a fully burdened, present-value basis with consistent timing and escalation assumptions.
2. Calculate and compare the present value of costs for the three options. Show your assumptions and identify which option is least costly.
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Use end-of-year cash flows and a 3.5% real discount rate. The eight-year annuity factor is 6.8739; the year-4 discount factor is 1/1.035^4 = 0.8714; the year-8 discount factor is 1/1.035^8 = 0.7594. Option A: purchase $1,800,000 + PV O&M $240,000 × 6.8739 = $1,649,746 + PV overhaul $300,000 × 0.8714 = $261,433 − PV salvage $150,000 × 0.7594 = $113,912. Total ≈ $3,597,267. Option B: $520,000 growing 3% for eight years discounted at 3.5%; PV = $520,000 × [1 − (1.03/1.035)^8]/(0.035 − 0.03) ≈ $520,000 × 7.5976 ≈ $3,950,752. Option C: $410,000 × 6.8739 ≈ $2,818,315. On a pure present-value cost basis, the lease is least costly, then the purchase, then the service contract. However, the lease result is not decision-ready until budget scoring is resolved.
3. How should the comptroller handle budget scoring, affordability, and color of money for the preferred option?
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The comptroller must determine whether the eight-year lease is an operating lease or a capital lease. The lease term is 80% of the equipment’s 10-year useful life, and the present value of lease payments exceeds 90% of fair value, so it likely meets capital-lease criteria. If it is a capital lease, it should be scored as an asset acquisition, not as an annual O&M expense; procurement funds may be required and the apparent O&M affordability advantage disappears. The center cannot use O&M to evade the procurement threshold or the need for full funding. The $1.2 million current-year procurement balance can cover a phased purchase only if the out-year funds are programmed and available. The service contract is an O&M obligation and is budgetarily feasible, but it has the highest present-value cost. The comptroller should present the lease as a capital-lease scenario, confirm the scoring determination with the budget office, and compare the options on both economic cost and budgetary scoring before recommending an award.