One question I get asked a lot is how to justify buying new equipment?
It has nothing to do with buy vs. lease, or new vs. used, it’s just about how one justifies a significant capital investment.
On a theoretical and general level, the answer is easy. If you are significantly better off with the investment than without, then it is justifiable. However, if you need an answer, you can do something with, you need to dig deeper and do some work.
There are a number of elements you need data for:
Total investment: how much do you need to spend?
Alternative: What is the alternative? Is there a ‘do nothing’ alternative?
Benefit: What is the benefit of the investment?Cost of the investment
Most of the time the cost of a capital investment is more than just the purchase price. In addition to the purchase price of the equipment you might have initial tooling cost, exchange rate cost, freight, and insurance cost. Today, most machines are purchased with many of these costs already included. You still need to understand if items such as offloading, additional container costs and rigging are included. As it is good practice to do a test run at the equipment factory before the equipment is shipped, it means that travel cost and test material costs need to be included as well.
Installation cost is not just the factory technicians and their travel expenses; it is also costs such as changes to buildings (walls or pits), connecting to the infrastructure (electrical connection, dust collector, compressed air, etc.) and if required, the disposal cost of old equipment. You can also add the hiring and training cost to the total investment cost.Alternative
What other options do you have? What happens if you do not make this investment? This would be the base line you compare too. So, not investing could mean fewer sales, or in the case of a replacement investment, increased operation cost and repair cost. You can out-source at a higher cost. Picking the most conservative alternative is typically the best reference point.
Some investments have a real alternative. You need a dust collector, compressor and safety hazards must be dealt with. You can use this calculation to decide between different options. Benefit
Being better off means there is a quantifiable benefit for the company. Most of the time, we are looking for financial benefits. There are also important other benefits, which are difficult to quantify in financial terms. For example, investments to reduce risks or strategic investments are very difficult to quantify properly.
Most investments, however, allow you to quantify benefits and here are the typical ones:
Capacity increase/ removal of bottleneck (if it will not increase sales, it will be of no benefit)
Reduced direct or indirect labour cost (increased output, re-deployment, or head-count reduction)
Increased quality (reduced re-work, re-make, higher price)
Increased flexibility/reduced set-up (increased output, higher productivity)
New processes (new product sales, less processing time)
Increased yield/reduced material cost
Increased reliability (less waiting time, smaller buffers (WIP)
If you want to do the financial justification of an investment by the book, you need to build two financial models. You build the projected profit and loss statement and balance sheet, once without the investment and again with the investment. The difference shows the benefit and how financially better off you are.
Such a calculation is complex, and quite frankly, I have seen these types of calculations with large investments and larger corporations only.
In my opinion each significant investment decision should go through the same thought process. You need to go through the exercise (at least in your mind) and see what actually will change in the P & L Statement and/or balance sheet if you make the investment.
There are three main categories of benefits: Sales increase
If the investment will lead clearly to a volume and sales increase than the benefit is the gross margin of the incremental volume increase.
This is the most potent benefit. Cost reduction
The cost reduction can be in any category of costs. Direct or indirect labour, material, consumables, overhead individually or in combination can change due to the investment.
Cost reduction is the most common benefit used for financial justification.Working capital reduction
If a new investment allows the operation to operate with less inventory, then basically the expected working capital reduction can be deducted from the investment amount. For example, if the investment allows you to change from batch manufacturing with a high level of work-in-progress and finished good inventory to a short manufacturing lead-time, just-in-time (make-to-order) facility, then you can deduct the value of the permanent reduction from the investment cost. Theoretically if the inventory reduction equals the investment cost, then the equipment is paid off as soon as the inventory reduction has been realized. Practically, the equipment does not cost anything. I do not see this investment justification used often.Be aware of false savings
You need to compare your investment option against the do-nothing-option, or against the lowest cost alternative. For example, if you walk instead of taking a taxi, it saves you $25, but if taking the bus is also an option, you should only use the $3 for the bus ticket as the potential cost saving.
Another example is if the investment allows you to free up floor space of a leased building. You cannot use the freed floor space at the lease per sq. ft. cost as benefit unless you stop paying for it or use it successfully for a different purpose. Picking the
There are a number of return-of-investment calculation models available. Accrual accounting rate-of-return method (ROI), internal-rate-of-return, and net-present-value are some of them and all have their use. Practically, I do not see them used in our industry in small and medium size companies. What I do see, if companies calculate a financial justification at all, is the payback period. Taking the total investment and dividing it by the average annual benefit, you get the number of years it takes to recover the investment.Be conscious of accuracy
The accuracy of any investment calculation is based on the accuracy of the input numbers. If any number in the calculation is based on assumptions the result will only be as accurate as the assumption. Putting inaccurate numbers into a fancy calculation formula just gives you the illusion of accuracy. To calculate the payback period to the second decimal doesn’t make sense when the input data are just assumptions.Trust your gut feeling
In an environment where we want to calculate and justify every one of our decisions, we need to learn to also listen to our intuition. Intuition however must not replace rational thinking and the calculation. We still need to go through the analysis and through the justification process.
But with all the calculations done and redone, if your intuition strongly tells you differently, listen to your gut feeling.
To borrow something from Albert Einstein: The rational mind needs to be the servant to the intuitive mind, not the other way around.