When it comes to making a decision on a capital expenditure, it's never simply a roll of the dice. Don't make these decisions based on hunches, but instead, rely upon factual assertions back up by real numbers. Use a systematic approach to buying that much needed piece of equipment. Companies often think there is some huge difficulty in figuring out whether to move forward on a capital expenditure. The fact is, the approach itself is very straightforward. The difficult part is to make sure the data you plug into the equation makes sense. It’s all about having the right information and making your analysis work. Here's a simple four step process you can perform when making a decision on a capital expenditure.
We’ll approach this from the mindset of a company that wants to increase their manufacturing capacity with a new piece of machinery. You have a cost for the purchase and a potential value that will be derived from the purchase. The question therefore becomes; "what is the benefit of the purchase and how will it help this business increase its productivity rates ?"
Company "X"
The sales for this company's flagship product line are skyrocketing, but the company wants to increase their manufacturing productivity rates by purchasing an additional piece of equipment. They have the demand for their product, but are encountering overtime and are losing out on gross profit. In order to maintain their profit levels, they want to purchase a new CNC (Computer Numerical Control) machine and see it as a way to help increase their production throughput.
Here are the conditions for Company "X"
- Current production is 200 units a day.
- Equipment will increase production throughput by 15% daily = 230 units total a day
- The additional volume per week is 150 units, 600 per month and approx 7200 units per year.
- The net profit for each additional unit produced is $2.00/each.
- Machine costs $30,000.00.
- Interest rate on machine per year is 6%.
- Number of work days per year: 264
- Lost days last year because of machine down time: 10
In reading the above, perhaps the only thing you are comfortable knowing is that the machine costs $30,000.00. There is nothing at all wrong with this. Most people see that as a guaranteed value – it’s a known cost. If you purchase the machine outright with cash, then this $30,000.00 is your total spend. However, if you decide to lease it or use credit, then you are looking at maybe 6% interest rate on the purchase. This means the machine will cost you approximately $1800.00 extra per year in interest charges. Of course this amount will decrease with each subsequent payment.
1. Calculate Your Potential Return on the Capital Expenditure
What’s the Net Profit on the additional volume with the new equipment?
Making a decision on a capital expenditure means to dollarize the benefit of the purchase. Knowing that your company will produce approximately 30 units extra per day with this machine, and that each additional unit will bring in a net profit to your company of $2.00/unit, you should have an additional net profit of $60.00 per day (30 units x $2.00/unit).
- Additional net profit per day: $60.00
How many lost days of production does your company have yearly?
In reviewing your production logs, you know that the number of lost production days in a year typically runs about 10 days. However, with this new piece of equipment, you expect those lost production days to be cut in half, if not all the way down to 0.
- Lost production expected this year with new equipment: 5
- Benefit to company: 1150 additional units! (5 x 230/day)
Let's assume your employees work approx 22 days per month, or 264 days per year. Making this a straightforward example, your additional net profit taking the 264 days, minus the expected 5 days of lost production, equals 259 days x 30 units = 7770 units x $2.00 net profit per unit = $15,540 additional net profit per year.
- $15,540.00 additional net profit
2. Calculate the Cost of the Capital Expenditure
You now need to know what the length of time it will take to pay it off.
The machine costs $30,000.00 with 6% yearly interest. The faster you pay off the machine, the less expensive it becomes. Every year it takes to pay it off, costs you 6% on the remaining amount. So, if you wanted to, you could take your $15,540 net profit and apply it immediately to pay off the machine. Doing this would allow you to pay off the machine in approximately 2 years. Without going into too much detail, the interest cost for the first year is $1800.00 (6% * 30,000) and $900.00 (6% * 15,000) for the second year. In total, your company will be paying $2700.00 on interest payments for the machine. Therefore, the total cost of the machine is $32,700.00 – IF you pay it off in 2 years.
- Total Cost of the investment is $32,700.00
3. Determine How Long Machinery will be Used
Perhaps the single most important part of making a decision on a capital expenditure is to know how long your company will use the machine. For simplicity, let’s assume that your company anticipates using this machine for 5 to 10 years as you know your product’s life in the market will only be extended. If you use the machine for 5 years x $15,540.00/year then your total benefit is $77,705.00.
4. Rely Upon Market-Based Information
None of these steps mentioned above work if the company doesn’t have a clear idea of its product’s life in their market. The first question most often asked is “will we continue to use this machine?” – the only way to properly answer this question is to have a solid understanding of your company’s product in the market. This comes from either having contractual agreements on supply from multiple customers, or from understanding your product’s life cycle. Make it a point to understand your industry and market.I’ve taken a step by step process to determining the cost benefits analysis on a capital expenditure. It is a straightforward example. It all amounts to answering the following questions:
- Should I buy this equipment?
- What is the benefit of buying the equipment?
- How long will it take to pay off the equipment?
- How long will I use it for?
- Will I make enough to pay for it, and still have something extra?
When it comes to making a decision on a capital expenditure, it really amounts to putting in the right values and understanding the company’s future demand for its product. Afterwards, it's simply taking the information from the market and assessing the viability of the purchase.
The above video is about setting up the lean work cell. You can read more by going to: Simplifying Lean Manufacturing: Work Cell Output, Cycle Time Variances & Production Volumes
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